Flutter on mispriced US equities could prove a winner

There are three things one needs to know in order to excel in gambling:

1. Knowing the 60-40 end of a proposition
   
2. Money management
   
3. Knowing yourself
   

To understand whether the odds of the financial markets are mispriced at any point in time, one needs to use consensus forecasts for a company's key value drivers. With these expectations, one would be able to assess the probability of the company meeting those expectations by looking at the fundamentals.

The author has noted three observations that show that the US equities are mispriced:

1. Ratio of cash flows to net income is at very healthy levels. This creates strong balance sheets for companies.
   
2. The equity risk premium, as a multiple of risk-free rate, is pretty low compared to historical data.
   
3. Expectations for future value creation are near an all-time low, in spite of the fact that returns on invested capital, a prime measure of value creation, are at an all-time high.

Revamping of the Fed’s Flawed Mandate

Ben Bernanke's purpose for QE2 is to create easier financial conditions in the form of resurgence in stock and bond markets. This would lead to improved confidence and an impetus to aggregate demand inspired by asset-based wealth effects. This has also been the policy pursued by the previous Fed chairman, Alan Greenspan, as well. Looking at what happened in the past, such policies only helps to create asset bubbles.

Currently, the Fed's policy goals include full employment and price stability. A third leg to the stool should be added – a financial stability mandate. With this additional mandate, it would be hard for the Fed chairman to ignore asset and credit bubbles.

QE2 presents a few risks to the economies in the US and the world. Below are three key risks:

• If there is an asset-market-led rebound of US consumer demand, America will run lower income-based savings rates, America's current account deficit will widen again. This would exacerbate global imbalances.
  
• Suppose Ben is wrong and the liquidity injection fails to make US consumers spend. This new found liquidity would leak offshore and create asset bubbles in other economies around the world.
  
• QE2 is dollar negative. This policy only helps to build trade tension around the world. This would push world economies down the slope of competitive devaluation, trade frictions and protectionism.
  

Opinion: Although the author makes a good case for including financial stability in the Fed's mandate, the author has missed out a key point. How does one pinpoint an asset bubble? There are no hard and fast rules on identifying bubbles. No one, least of the government authorities, have the ability to pinpoint bubbles. Thus, it would be difficult to implement such a mandate.

Fundamental Index Investing

Regular passive index investing is a strategy that "buys high and sells low". Surprised? Think about it. A regular index is created by weighting the stocks according to their market values. This method of weighting passively creates an index that rebalances towards stocks that have recently increased their market value. Thus, the strategy is highly inappropriate.

Currently, there have been developments for indexes that are weighted according to the underlying stocks' fundamentals (Rafi Index). The basic idea behind these fundamental indices is that companies should be invested according to their real world size, not their market value. Real world size can be measured by earnings, dividends, revenues or even employee numbers. These indices have been back-tested to provide superior returns to regular indices. This methodology is able to do so as it is tilted towards value stocks and gives the holder a disciplined tilt towards contra trading against the market sentiments.

The German Consumer

Germany's economy has recovered more strongly than the rest of the European Nations as the government's stimulus measures were equivalent to a larger share of GDP in most other European Union countries helped restore growth. In particular, government subsidies allowed companies to hoard labor rather than fire workers as in the US. These measures contributed to the sustained fall in official unemployment.

Due to these stimulus measures, there are signs that the economy is rebalancing and that German consumers are starting to spend. This is evident in the rebalancing in the German economy. In the past, German consumers were difficult to handle. Retail sales have neither soared nor nosedived on the swings in German macroeconomics but have been stable. The German model is working unlike in the US and UK where there was too much expansion of the non-traded sectors – too many people in construction, real estate and finance. There was no need to make any changes to the German economic model.

Founder of BlackRock, Larry Fink

Larry Fink (LF) believes that the euro will slide to $1.20 against the dollar. This is because there is a fundamental problem to the euro currency. That is that most European sovereign credit is owned by the banking system. At one point in time, the credit ratings of Ireland's debt and Germany's debt was the same, which is clearly inappropriate. The only reason why the euro has not slid to the level forecasted by Larry is the QE policy employed by the Federal Reserve in the US.

Larry believes that the best asset strategy for the current economic circumstances is to buy a portfolio of dividend stocks for the long-term. This is ironic as Larry is one of America's most widely respected debt investors.

Creative Accounting, Fraud and International Accounting Scandals

The four broad accounting strategies for creative accounting are as follows:

• Increase income
  
• Decrease expenses
  
• Increase assets
  
• Decrease liabilities
  

The author of the bank has done a study and found that the two most popular ways of boosting income were to exploit transactions with related parties and to recognize sales prematurely.

The following are the techniques used by the companies involved in accounting scandals:

• WorldCom – capitalization of expenses (manipulation of accounting provisions for estimated costs was the second most popular approach for expense reduction)
  
• Bre-X Minerals – asset inflation through the puffin up the value of inventory through the claim of having found a massive Indonesia gold deposit
  
• Enron – off-balance sheet financing
  

Besides looking out for the above accounting manipulations, investors also need to consider corporate governance norms, remuneration policies and the general regulatory context to make a decision on whether there is any creative accounting being used in the companies' books.

The Eurozone cannot live with a strong single currency

The managing director of foreign exchange strategy at UBS is of the opinion that the European Union will not be able to achieve prosperity in the region as growth rates are different for all European countries.

For countries to be able to keep the level of their debts stable to the size of their economies, nominal income growth in the Eurozone must match the yields paid on peripheral government bonds. This is highly unlikely as the Euro has been overvalued in recent years and with that the growth within the peripheral economies are hindered by the strong currency.

Growth rates are expected to remain low for these economies following deep recessions ever since the collapse of Lehmann Brothers in September 2008. This caused sharp rise in fiscal deficits and government debts to stave off depression and the very sluggish recoveries thereafter forced bond investors to wake up to the risks that these countries might not be able to sustain their heavy debt burdens indefinitely.

Ken Fisher: Gridlocked governments are good news for equities

Significant legislation is pure redistribution of money, property rights, and/or regulation. Ken has used the research available and concluded that landmark legislations are passed at times when the presidents have stronger control over Senate and Congress. When the political system is gridlocked, no landmark legislation will be passed. This will cause stock markets to rise as political risk aversion declines.

As at 18 Nov 2010, the author has noted that America, Germany, Australia, Italy, Belgium and Netherlands have their political systems gridlocked. This situation is great for the stock market. And since US and non-US stocks are positively correlated and America makes up a large share of the world. The same pattern appears in global stocks.

Interview with John Greenwood (HK’s Fixed Rate Regime)

The fixed rate regime in Hong Kong is here to stay. As the benefits are that in such a regime, the economy – wages, prices and the structure of the economy – ultimately adjusts to the exchange rate. Also, pegging the HKD to the USD enables US capital market conditions to be transmitted directly to Asia and enables Hong Kong to do far more in the way of IPOs and loan syndications that it would otherwise be able to do.

The cause of the lack of spending, which leads to high unemployment and low levels of capacity utilization, is the overstretched balance sheets of households and the financial sector in America. There are a few ways to repair the balance sheets. Firstly, you could raise capital if you are a bank or company. Secondly, you could sell away your assets. However, as asset prices have burst, prices are down and households cannot sell or do not have much to sell. Finally, cutting consumption, increasing savings and paying down debts slowly is what is happening now. This makes the growth anemic.

QE will not solve America's financial woes as the main thrust of QE is to counteract bank lending and keep money growth at a slow, albeit positive level. However, the people are already overleveraged and need to pay down their debts. QE will most likely lead to the proliferation of the carry trade.

Asia's balance sheet is strong and they did not have a credit and housing bubble like the rest of the world. That is why they are able to recover quickly.

The Irish are showing grit but time is running out

Dublin has repeatedly unveiled commendably bold measures to fight the financial crisis. First, it offered to guarantee the banks. Then it replaced its top regulator and central bank governor and embarked on an unusually forceful effort to inject transparency into its troubled banks. Its painful austerity plan has been accepted by voters and social cohesion is still high. Yet, investors are still pricing in a high default risk in Irish bonds with yields above 8%.

However, the trading volume of Irish bonds is very thin. The yield jump could be followed by an equally sharp fall in the yields and Dublin has until next summer to refinance its bonds. This gives the Irish government plenty of time to bring yields down. There are some catalysts that would help bring the yields down: passing of the budget plan next month, an audit of the banks' books using an external company.

There are some risks to the Irish's plan of lowering their bond yields. One is the sheer size of the fiscal hole, which could worsen with the austerity plan. Another is the uncompromising German stance towards bail-outs and credit haircuts. The fact that Ireland revealing news on their banks' losses would sap confidence as well.

However, there are other options available for Ireland to lower its bond yields. Ireland's sovereign wealth fund could start purchasing its own bonds to lower yields.

The problem now is that the euro zone leaders are not displaying any cohesion or levelheadedness. This results in investors shorting Irish debt.

Internet father in growth warning

We are onto our last 4 billion addresses and estimates highlight that these will run out in spring 2011 with the continued usage of IPv4. Without any new addresses, we will not be able to add any new people and the problem of trying to sell a telephone without a telephone number will set in.

Although the technical foundations for IPv6, the internet protocol format which would allow for trillions of new unique IP addresses, have been ready for many years, only a small number of business websites, routing equipment and internet service providers use it. There is a lack of compatibility between IPv6 and IPv4. As such, there could be connection problems between mature markets and other new markets.

Bullion's sharp rise in price

There are quite a few arguments as to why gold is continuing its march up to higher levels.

• Hedge fund managers have bought gold as an explicit bet against central banks' willingness to preserve the value of paper money.
• It has become more practical for investors to hold gold because a historical problem - that the metal provides no income - barely matters any more because interest rates are so low that neither does cash.
• Gold is also acting as a proxy for the Chinese currency. This is because investors want to hold onto the renminbi, in hope that the currency will appreciate. However, the currency is not freely traded. Hence, investors piled in on gold.

The president of the World Bank has advocated the use of gold as an international reference point of market expectations about inflation, deflation and future currency values. However, some believe that gold is not suitable as the price fluctuates widely. Deflation of 75% in the last decade is also not a good characteristic of a suitable currency.

Fed's dollar strategy still in doubt

The recent currency's surge runs counter to conventional wisdom. Many would expect QE2 to debase the US currency with central banks around the world struggling to diversify to a basket of currencies. However, there are theories to support the currency's recent surge:

1. Market participants could be unwinding the carry trades - in which the purchase of riskier, higher yielding assets is funded by selling low-yielding currencies - and covering short positions.
2. Market participants could have be having the expectation that the economy is recovering with QE2 as the Fed has hoped.
3. With the health of the eurozone in doubt, investors have been selling the euro and pushing the yields on the debt of weaker European countries sharply higher this week, boosting the dollar.
4. Imposition of capital controls by the emerging economies could be another explanation.

US Foreclosure Crisis

Banks have been sloppy in their documentation of the mortgage loans. Fannie Mae and Freddie Mac allege that underwriting guidelines have been violated. As a result, investors and the government agencies are fighting to get banks to repurchase the faulty loans.

There have been many questionable aspects of the underwriting process for home loans. It was revealed that during the housing boom, many bank staff cut corners by rubber-stamping thousands of court documents without verifying the accuracy of the information contained, such as how much borrowers owed and how behind they were on payments. The resulting legal quagmire undermines the ability to evict delinquent homeowners and put those houses back on the market, an important step towards a housing recovery.

Banks, in their haste to securitising trusts for sale, they cut corners by assigning the loans in blank form and planned to fill in the paperwork later.

To cut costs, banks came up with a digital registry known as Mortgage Electronic Registration System, Mers. Supposedly, the system would give the banks the right to foreclose on any of those properties if borrowers stop paying. However, recent rulings has said that Mers is no more than a placeholder and cannot bring foreclosure actions on behalf of the bank. In fact, it is unclear whether the banks technically own the mortgages with the usage of Mers.

Worst case scenarios of the foreclosure crisis are not expected to put banks out of business, but they are expected to slow earnings.

Emerging markets to counter QE2

A string of governments in Asia and Latin America are expected to consider introducing capital controls to stem the side effects of inflows that will increase due to QE2. These emerging markets would be affected by so-called carry trade, in which money moves from low- to high-interest environments. Such inflows put upward pressure on exchange rates, making exports less competitive, and threaten the possibility of a balance-of-payments crisis if flows suddenly reverse. Inflows will also exacerbate inflation.

Capital controls include the introduction of taxes on capital inflows, such as imposing a withholding tax on capital gains and interest payments for government and state-owned company bonds. There are also measures imposed to encourage outflows like the removal of limits on overseas investment and eased restrictions on lending to foreign borrowers.

All these measures are no longer objected by the IMF. Policies that stem excessive capital flows are now considered prudent.

Bretton Woods II

Robert Zoellick, president of the World Bank Group, has called for an accord to be formed that would be Bretton Woods II to promote pro-growth reforms, open trade and exchange rate co-ordination. To do this, he has pointed a few pointers for the G-20.

1. The G20 countries need to agree on parallel agendas of structural reforms, not just to rebalance demand but to spur growth. China, for example, should transfer attention from export industries to new domestic businesses, and the service sector, provide more social services and shift financing from oligopolistic state-owned enterprises to ventures that will boost productivity and domestic demand.
2. G20 countries need to agree to forgo currency intervention.
3. Emerging economies would then be able to rely on flexible exchange rates and independent monetary policies. Capital controls can still be used to curb short-term hot money flows.
4. G20 also needs to help the private sector development in developing countries.
5. A co-operative monetary system needs to be built to reflect emerging economic conditions. This system should consider using gold as an international reference point of market expectations about inflation, deflation and future currency values.

Risk of Peripheral European Bonds Spiking to Unsustainable Levels

EU's announcement on 29 Oct 2010 was the pivotal moment when the bond spreads spiked upwards. The announcement was that they wanted investors to foot a greater share of the bill for future bail-outs, i.e. a haircut being one of the option. The PIGS came under pressure again as worries about them defaulting on their bonds surface again.

Many question the timing of the announcement, including ECB's president. However, everyone knew that Germany was always going to insist at some point that investors have to share some of the burden in the event of future sovereign defaults. European politicians have shaken the confidence in the peripheral economies again.

US can learn from Japan on policy for bad home loans

The author of the article believes that there are similarities within between the current situation in the US and the situation in Japan in the 1990s. Back then, Japanese financial institutions were plagued with bad loans, which the banks and politicians refused to acknowledge or deal with. At that time, many policymakers argued that this policy of forbearance was essential to preventing a damaging property price crash. Although this attitude did prevent a property price crash, in place of it was a climate of deeply ingrained cynicism and unease. Many people knew that Japanese banks were sitting on this set of problems and the mood of corrosive distrust and unease set in, which created a deflationary mindset.

Looking back on this, the author believes that banks need to be allowed to proceed on abusive foreclosure process, that has been forestalled recently due to the robo-signers issue, or proceed on universal modification of loans. Whatever that needs to be done needs to be done swiftly, or else the deflationary mindset will seep in. This mindset will not be able to be fixed by cheap money.