New QE? Bernanke Said That the Fed Could Further Expand It's Balance Sheet

The "REPO" or "repurchase agreement" market is where primary dealers finance their inventory of US Treasuries, where companies find short term financing and where money market funds invest much of their capital.

A company requiring short term financing pledges their US Treasuries as collateral with another party who lends them cash. Because of the little to no risk involved money markets invest heavily in the repo market. Below are a few oversimplified examples of how the market works.

Company A, a primary US Treasury dealer has $100 billion in US treasuries. They pledge those treasuries as collateral in the repo market and receive $98 billion cash in exchange. They take that $98 billion and buy more US Treasuries and so on. In a repo even though Company A pledged those treasuries they still in fact own them and receive the interest payment.

Company B has $100 million in surplus cash each night and wants to invest that money to earn interest versus leaving it at the bank interest free. They agree to lend that money to Company A overnight with Company A's US Treasuries as collateral.

The key to this whole market is having collateral. For example in the mortgage market there are millions of homeowners who want to refinance to stay in their homes. There is also plenty of money available to lend. What there is not enough of is equity in homes to be used as collateral. The result, new loans are not created and the market is collapsing.

With QE1 and then QE2 the Fed "printed money" to purchase Mortgage Backed Securities (MBS) and US Treasuries. The result they removed the very collateral from the market needed to make it function causing two serious problems.

Repo Rates have declined not because of lack of demand for credit. The demand is still there but lack of collateral - US Treasuries.

With the decline in rates money market funds are at risk of permanently leaving in search of higher yielding investments.

Imagine if money market funds opt to invest in other products in hopes of finding higher yield for their investors. Company A in the example above needs to be able to access the repo market to finance their inventory of treasuries but with hundreds of companies in a similar position and with the available capital decreasing, someone will be shut out of the market and unable to meet their financing needs. Overnight another Lehman style collapse could happen.

This then begs the question was Bernanke bluffing when he said recently the Fed could further expand its balance sheet or was ready to act if the economy weakened? I have no doubt when pressed the Fed will in fact act but I do doubt the size of their next action under current market conditions.

If the Fed were to do another QE1 or QE2 they would remove more collateral from the repo market in the form of MBS and Treasuries. They cannot add any more stress to this market. They run the very risk of chasing away money market funds to other higher yielding investments. This cannot happen. The economy will crash overnight.

If the Fed were to adjust the duration of their balance sheet (meaning the average maturity of their holdings) they will hurt the banking sector. For example if they sold their two year treasuries and used those funds to purchase ten year treasuries they would flatten the yield curve (two year yields would rise and ten year would fall). This would hurt the banks and discourage lending. They could go the other direction and use the proceeds from the sale of ten year treasuries to purchase the two year which would steepen the yield curve but would cause mortgage rates to rise which would further weaken the housing market and their holdings of MBS from QE1.

If the Fed were to adjust the duration of their balance sheet which is the most likely next step it would not necessarily mean the printing of money but rather a simple change to the makeup of the holdings. Unlike QE1 and QE2 no additional capital would come to the system.

In reality the Fed did a real world test of printing trillions of dollars to see how it would impact economic growth. It failed and they are aware of that. Beyond a theoretical model perhaps they had to do this real world test. They are seeing the results.

They tried to grow the economy at the risk of the repo market but may have pushed too far. They will likely try to find that middle ground but to think Bernanke is ready to launch QE3 in traditional form is a dangerous bet. To think that "operation twist" will have a similar affect on equities as prior asset purchases is another dangerous bet.

Continued: Dividend Discount Model (DDM) - Part Due

Zero-Growth Rate DDM

Since the zero-growth model assumes that the dividend always stays the same, the stock price would be equal to the annual dividends divided by the required rate of return.

Stock’s Intrinsic Value = Annual Dividends / Required Rate of Return

This is basically the same formula used to calculate the value of a perpetuity, which is a bond that never matures, and can be used to price preferred stock, which pays a dividend that is a specified percentage of its par value. A stock based on the zero-growth model can still change in price if the capitalization rate changes, as it will if perceived risk changes, for instance.

Example—Intrinsic Value of Preferred Stock

 

If a preferred share of stock pays dividends of $1.80 per year, and the required rate of return for the stock is 8%, then what is its intrinsic value?

Intrinsic Value of Preferred Stock = $1.80/0.08 = $22.50.

Constant-Growth Rate DDM (Gordon Growth Model)

The constant-growth DDM (aka Gordon Growth model, because it was popularized by Myron J. Gordon) assumes that dividends grow by a specific percentage each year, and is usually denoted as g, and the capitalization rate is denoted by k.

Constant-Growth Rate DDM Formula

Intrinsic Value =	D1 ────── k - g	D1 = Next Year's Dividend k = Capitalization Rate g = Dividend Growth Rate

The constant-growth model is often used to value stocks of mature companies that have increased the dividend steadily over the years. Although the annual increase is not always the same, the constant-growth model can be used to approximate an intrinsic value of the stock using the average of the dividend growth and projecting that average to future dividend increases. 

Note that if both the capitalization rate and dividend growth rate remains the same every year, then the denominator doesn't change, so the stock’s intrinsic value will increase annually by the percentage of the dividend increase. In other words, both the stock price and the dividend amount will increase by the constant-growth factor, g.

Example—Calculating Next Year’s Stock Price Using the Constant-Growth DDM

 

If a stock pays a $4 dividend this year, and the dividend has been growing 6% annually, then what will be the price of the stock next year, assuming a required rate of return of 12%?

Next Year’s Stock Price = $4 x 1.06 / (12% - 6%) = 4.24 / 0.06 = $70.67

This Year’s Stock Price = $4 / 0.06 = 66.67

Growth Rate of Stock Price = $70.67 / $66.67 = 1.06 = Dividend Growth Rate

Note that both the zero-growth rate and the constant-growth rate dividend discount models both value stocks in terms of the dividends they pay and not on any capital gains in the stock price; the holding period for the stock is irrelevant; therefore the holding period return is equal either to the dividend rate of the zero-growth model or the constant-growth rate.

In Bernanke We Trust? Ben Bernanke to give high profile speech in Jackson Hole

The head of the US central bank, Ben Bernanke, is preparing to give a key speech that will be closely watched by markets for any hint of new stimulus.  

He will speak at a meeting of central bankers in Jackson Hole, Wyoming. Last year, his speech paved the way for $600bn (£368bn) of quantitative easing - injecting cash into the financial system to try to boost the economy.

This year, with the US again slowing sharply, markets are speculating that further QE may be round the corner.

Market anticipation

 

Shares have rallied all week in anticipation that the Federal Reserve will act to reinvigorate the US recovery. Earlier this month, stock markets plummeted as economic data pointed to sluggish or virtually non-existent growth in the US and Europe.

"Recent events have made it blatantly clear that the economy is in a funk," says Paul Dales, senior US economist at Capital Economics.

"The housing market remains at rock bottom and even the manufacturing sector, which had been the shining light of this recovery, has come off the boil."

Gold also hit a new record high on Tuesday, before falling back as stocks rallied.

Investors see gold as a haven in times of economic uncertainty, and QE is expected to depress the value of the dollar versus gold, which also makes the precious metal more attractive.

Limited options

Mr Bernanke is not expected to make any major announcements in his speech.

But last year, unable to cut short-term interest rates any further, Mr Bernanke used his speech to lay out the Fed's alternative policy options.

Markets - correctly - took this as a signal that a second round of QE was imminent.

This year, Mr Bernanke's policy options to try to try to boost growth are seen as more limited.

Most, including QE, work primarily by lowering longer-term cost of borrowing. But government borrowing costs are already at post-World War II lows, leaving little room to fall further. Earlier this month, the Fed tried another ploy - announcing that it expected to hold short-term rates at zero until 2013. 

But it had little effect, as two-year interest rates were already close to zero.

KEEPING OPTIONS OPEN

Wyoming may conjure up images of the American Wild West, but markets aren't expecting Bernanke to ride into the mountain resort with guns blazing -- at least not yet.

While the economy has taken a turn for the worse -- growth ground to a halt in the second quarter and nearly flat-lined in the first -- there's a sense that the Fed will want to wait a bit longer to assess the impact of its past stimulus.

Other Fed policymakers have sought to downplay expectations of an imminent QE3 announcement. St. Louis Fed President James Bullard was quoted in Japan's Nikkei newspaper saying that while the Fed could buy more bonds if the economy weakened, the time was not right for such a move.

"Going into Bernanke's speech at Jackson Hole, people are positioned for a significant shift in policy. (But) we think financial market conditions have to deteriorate even further for more QE3," said Simon Derrick, head of currency research at Bank of New York Mellon.

Nonetheless, traders are still expecting Bernanke to signal in some shape or form that he hasn't run out of bullets and could start shooting again if need be.

"Based on our conversations with clients, we believe investors would be very surprised if the speech did not include a discussion of asset purchases," strategists at Goldman Sachs wrote in a note to clients.

They said this could involve the Fed reinvesting proceeds from maturing assets into 10- and 30-year Treasuries to hold long-term interest rates low.

"I think we'll see (QE3) because America needs growth, but I don't think we'll necessarily get it on Friday," said Neil Dwane, chief investment officer for Europe at RCM.

Current market moves reflect this. While still down about 15 percent from late July, the S&P 500 rallied smartly Tuesday and the dollar has struggled against major currencies.

More stock market gains could be in store if Bernanke gives a strong hint of future action. After Bernanke's speech last August, the S&P 500 began a rally that took it up nearly 25 percent by May 2011.


LAUNCHING QE3 NOW

Pulling the trigger now would have the element of surprise going for it and might spark the most aggressive market moves.

There's been some talk in bond market circles that the 10-year yield's dip below 2 percent reflected a pricing in of QE3, though those moves probably had more to do with recent dismal jobs, manufacturing and growth data.

Still, there are impediments to launching QE3. For one thing, Bernanke already caught investors off guard earlier this month and slowed a market rout when the Fed pledged to keep interest rates near zero until at least 2013.

Steven Bell, director of GLC Ltd, a global macro hedge fund in London with $1 billion in assets, also noted that higher inflation may make the Fed cautious. "We have core inflation going up," he said. "It may be low but it's still going up."

Political opposition is also on the rise. Texas Governor Rick Perry, a candidate for president, even said he would consider it "treasonous" if Bernanke "prints more money between now and the election" in 2012.

That populist anger stems partly from the fact that Fed policies have done little to increase hiring or spark a housing market recovery.

"The history is $600 billion (in bond purchases) hasn't really made any difference to the U.S. economy," Dwane said. "It's still where it was when he was talking about it last August: nearly in recession."

If QE3 fails to boost growth or stokes inflation, markets may wish the Fed had done nothing.

"Investors are becoming more cynical," said Jack Ablin, chief investment officer at Harris Private Bank in Chicago. "Central bankers and governments seem to playing the role of the Dutch boy trying to plug holes in the dike."


MUM'S THE WORD

A humdrum speech that neither announces plans for QE3 or even hints at the Fed's willingness to act is probably the most unlikely scenario, as far as markets are concerned.

If Bernanke did go that way, it could signal that the hawks were gaining the upper hand. Three Fed policymakers voted against extending the zero interest rate pledge to 2013 and have argued that the Fed cannot do much more to boost growth.

Steve Jobs Retirement — Should You Sell Apple Stock?

If you didn't know, Steve Jobs announced his retirement on Wednesday, as his declining health has made it impossible for him to continue as Apple CEO. Here is the hole article:

Apple stock is taking a hit in pre-market trading, indicating traders are wondering the same thing.

Apple is s a company worth owning. It has been in the cutting edge of consumer electronics since the rollout of the iPod and has continued that dominance with the successful launch of the iPhone. It created a new market where none previously existed for tablet computers with the iPad.

The company is wildly profitable — it has profit margins of 24%, and its return on equity is an eye-popping 42%. It’s earnings are growing at over 100% per year. And shockingly, the company is cheap. It trades at a forward P/E ratio of less than 12, has no debt, and 8% of the stock price is cold, hard cash.

Yet despite all this, I couldn’t get comfortable with the company because of the unquantifiable risk that something might happen to Steve Jobs. How would Apple perform without Jobs at the helm? Frankly, I don’t have an answer for that question. And I couldn’t put money at risk with that kind of elephant in the room left unexplained.

History is full of stories of successful companies that have prospered after the departure of an iconic founder. Wal-Mart (NYSE:WMT), for example, has done just fine since the passing of Sam Walton. Going further back in time, John D. Rockefeller’s oil companies survived his death and thrived to the point of trust-busting, living on today as ExxonMobil (NYSE:XOM), Chevron (NYSE:CVX) and ConocoPhillips (NYSE:COP).

The difference, of course, is that innovation is far more important in a modern technology company than in a discount retailer or oil company. Jobs’ successors will no doubt do a fine job of selling iPods, iPhone and iPads. The question is “what next?” Without Jobs to think of the next great idea, is the rest of the Apple management team up to the task? Again, I don’t have a satisfactory answer to this question.

This is not the first time investors have pondered the “Jobs question.” In January, the iconic CEO took a leave of absence from Apple. Shares dropped 8% in late January to $325 as a result. Now the stock is up 15% from that low to about $375.

Will the shares shrug off this news again? Maybe. In the meantime, Apple investors are now left to ponder the following scenarios.

1. Given the stock’s cheap valuation, investors already long ago factored the possibility of Jobs’ retirement into prices. Thus, Apple is fairly priced.
2. Jobs’ recent contributions have been overstated because of his cult of personality in the industry, and his lieutenants will get along just fine without him. In this case, Apple is a screaming buy at these prices.
3. The intangible benefits of Jobs’ leadership — i.e. his vision and creativity — is even more valuable than investors currently appreciate. If this is the case, Apple faces a very uncertain future.

In my personal oppinion, market will shortly react to the resignation with a falling share price, so it is a good buying opportunity.

Head of S&P to Resign

I don't know if you hear it or not, but President of Standard & Poors resigned from his position. Here is part of the article:

"Standard & Poor's President Deven Sharma is leaving the credit-rating firm at the end of the year, the company said Monday night. 

Mr. Sharma will step down as president on Sept. 12 and be succeeded by Douglas Peterson, chief operating officer of Citigroup Inc.'s Citibank unit. Mr. Sharma will remain at S&P through the end of the year in an advisory capacity, working with McGraw-Hill Cos. Chairman, President and Chief Executive Harold "Terry" McGraw III as the company explores a separation of its education business.  


The moves come as S&P faces questions about its controversial downgrade earlier this month of long-term U.S. debt and as the Securities and Exchange Commission and U. S. Justice Department look closely at the conduct of S&P, as well as other major credit rating firms, for their roles in developing mortgage-bond deals that helped to trigger the financial crisis, according to people familiar with the matter.

Mr. Sharma's departure has been underway since the beginning of the year and is unrelated to the firm's controversial downgrade earlier this month of long-term U.S. debt, the firm said."

The way I see it it's only a political reason. I mean, they didn't downgrade AIG company which by CDS gave its AAA raiting to other companies, but you decided to be first to downgrade US? Yes, there were possibility for US to default, but everyone knows that they had budget celling which couse problems, not that they didn't have the money to pay their obligations (like Grecce). And if a firm like Enron was capable to arrange that some analyst that didn't rate them as "Buy", get sacked, what do you think No. 1 economy in the world is capable to do?

Gold Thoughts

Near the end of any investment cycle a transfer of ownership normally occurs, from investors to speculators. The asset moves from strong hands to weak hands, from real ownership to fictional ownership in the market for contracts for future delivery. That usually set up conditions for the penalty phase, as those still bleeding from the Silver bear market fully understand.

As we learn from Japan, owners of physical Gold in all forms are aggressively liquidating. From "Tokyo struggles to keep pace with gold rush" by L. Whipp from Financial Times, 20 August,

"Japanese families are rushing to sell gold jewelry, sake cups and even teeth to cash in on surging gold prices. The stampede to sell gold is so intense that shops buying the precious metal are struggling to cope and are even having to turn some disappointed customers away."
"In the past week, Goldplaza, which buys and melts down gold for resale, has been handling about Y100m($1.32m) of gold every day - about 15 times its daily average in July. The craze began in earnest on August 11 . . ." [Emphasis added.]

At same time, speculators are building massive positions. CME has been reporting record open interest for options on Gold futures. At one point last week those speculative trading positions represented ~126 million ounces, or ~3,900 tonnes. That is indeed speculation of size, and that activity has been the driving force for creating a speculative bubble in $Gold, and the parabolic curve shown in the chart below. Left axis is dollars while the right axis is percentage of 1999 low, the beginning of this market move.

A parabolic curve is a formation that is extremely dangerous as it is inherently unstable. As price rises, the slope of the price line becomes steeper in defiance of financial gravity. Imagine throwing a ball into the air and it rises faster the further it rises. This curve suggests that as price rises demand is rising, a wholly unnatural state of events.

We know two things about parabolic formations:

1. One, they always end in pain.
2. We never know when they will end, due to the unnatural conditions for demand.

All this might not be so worrisome if $Gold were not so over valued relative to financial assets, as shown in the graph below.

Old Article Worth Reading: Gold Versus The Dollar (Part Two)

US Money Supply Versus The Gold Price

 

Throughout the 1970s and early 1980s, American investors were gripped by a fear that their national currency would continue to lose purchasing power . There was a complete lack of confidence in the government's ability to restrict the expansion of the money supply, culminating in panic buying of precious metals in 1979/1980 as investors desperately sought to protect themselves from the effects of inflation.

The response of the US Federal Reserve at the time was to put the brakes on money supply growth through the instigation of extremely high interest rates. This policy achieved its purpose and by 1982 the rate of increase in the money supply was trending downwards, interest rates had fallen from their peaks, and the fear of inflation had abated. Investment capital had responded to the changed situation by moving from commodities into financial assets, and the great equities bull market had begun.

Below is a chart showing the relationship between the total US money supply (M3), M3 growth rates (shown as annualised monthly figures), and the gold price, from 1972 to present time. It can be seen from this chart that the gold price tracked the increase in money supply from 1972 until 1982, apart from the 1979/1980 spike. Between 1982 and the early 1990s the M3 growth rate trended downwards to a low point of zero in 1992. During this period money flowed into financial assets as confidence was restored in the ability of the Fed to control inflation, whilst the gold price remained relatively stable (apart from the 1985 to 1987 period when the G5 tried to "fix" the US trade deficit by engineering a 40% depreciation in the US dollar, which in turn led to a rising gold price and culminated in the 1987 share market crash as foreign capital panicked out of US assets) . 

Since 1993, the M3 growth rate has been trending upwards and is currently around 9%. Studies have shown that increasing money supply growth rates lead the commodities markets by 1.5 to 3 years. This means that we should have seen a rising gold price in US dollars by 1995/1996. What we have actually witnessed, however, is a declining gold price. In fact, with money supply now increasing at rates not seen since the early 1980s and the gold price falling almost continuously since February 1996, the chart shows a distinct divergence between the two . This has contributed to the currently popular belief that increasing the quantity of money no longer results in rising prices.

As mentioned at the beginning of this article, gold has performed quite well during recent years when measured in terms of almost any currency with the exception of the US dollar. In other words, gold has performed its historical function as a store of value for anyone living outside the US. However, since 1995, the time at which we would have expected to see the increasing supply of US dollars begin to have an impact on the gold price, a massive shift of investment into the US dollar has occurred. The excess dollars which have been created due to expanding US debt levels and trade deficits have been absorbed by foreign investors looking for stability. The seemingly insatiable demand of foreign capital for US dollars has been stimulated even further by the Asian financial crisis. The US is now seen as the only safe place in the world for investment.

The demand of foreign capital for US dollars and US debt has allowed US interest rates to remain at relatively low levels, given the money supply growth rate and the strength of the economy, and has supported a speculative boom in the US stock market since 1995. The US stock market is itself supported by debt, and that debt is in turn supported by the value of the stock market. A significant downturn in the stock market would most likely lead to widespread defaults on loans, a financial collapse and a severe recession. 

This situation will be avoided at all costs by the US political and monetary authorities using the power of the US Federal Reserve to "discount loans and other assets of banks or other private depository institutions, thereby converting potentially illiquid private assets into riskless claims on the government in the form of deposits at the central bank." If the Fed must purchase every non-performing loan in the US in order to avoid a serious recession, it will be done. A boom feeds on itself and is always propelled by liquidity. Once a speculative boom has occurred, liquidity must be maintained in order to avoid a bust. Look for continued high levels of US money supply growth.

Conclusion

 

The entire US financial system is based on confidence - the confidence of foreign investors who continue to pour money into US dollar assets, and the confidence of local investors who are betting their life savings on a continued stock market boom.

Old Article Worth Reading: Gold Versus The Dollar (Part One)

This article is from 1997 and is still worth reading today, as it will help you understand the realtionship between gold, US dollar and inflation. 

Introduction

 

Gold has been a poor investment for many years. This is a statement which is almost universally accepted in today's world, but one which is only partially true. The truth is that gold has been a very poor investment when measured in US dollars, but has generally proven to be a sound investment when measured in terms of almost any other national currency. The Indians and the Chinese, the world's largest buyers of gold, have seen the value of their gold investments increase by approximately 200% over the last decade. Due to a collapse in their national currencies, South East Asians and Koreans have also seen the value of owning gold . 

The US dollar reached a cyclical low in April 1995, from which it has risen over 50% against the Yen and 30% against the Deutsche Mark . This means that German and Japanese investors who exchanged their national currency for gold in April 95 would now be showing a profit on their investment, despite a 21% decrease in the US dollar gold price over the same period.

What we have witnessed over the past 2.5 years is a massive shift of investment capital into the US dollar from all other currencies, including gold. Investors around the world have placed enormous faith in the US dollar and, therefore, in the US economic, financial and political system which supports the dollar. Gold has been a victim of this flight to the US dollar, although it has fared better than many of the government controlled forms of money.

With the US dollar continuing to strengthen as capital flees from EMU-generated uncertainty in Europe and debt-based currency crises throughout Asia, why should anyone invest in gold ? Why not just invest in US dollars and US dollar denominated assets ? In my opinion, there are only two reasons to invest in gold.

Reason # 1 To Own Gold

 

Many supporters of gold continue to put forward the argument that Central Banks are controlling the gold price. The reason for the popularity of this argument appears to be the misconception that the demand for gold exceeds the supply of gold. After all, if the demand for something does exceed its supply by a substantial amount and for a long time, and the price goes down, then it is logical to assume that there must be dark forces at work to manufacture this unreal situation. The problem is, whenever you start from an incorrect premise and then develop your arguments based on flawless logic, you must necessarily arrive at the wrong conclusion.

Perhaps it is hard for goldbugs to accept that gold is a genuinely unpopular investment at the moment when compared to the all-conquering US dollar. However, the fact is that net CB sales of gold over the past few years have been small. Gold loans by CBs have probably had some effect, but the over-riding factor is that private investment demand for gold has reached its lowest point since 1971. Until there is an increase in this demand then the above-ground stock of monetary gold, more than 60% of which is held in private hands, will be an available source of supply.

Just as it is wrong to think that the supposed annual deficit in gold supply (the difference between newly mined supply and commercial demand) will lead to a higher gold price, it is equally wrong to think that the above-ground stock held by the CBs is necessarily sufficient to meet demand for many years to come. Trillions of dollars of investment capital is moving around the world each day searching out stability or protection or investment returns. If confidence in financial assets and government controlled currencies was to significantly reduce, then the total gold reserves of all CBs (worth 320 billion dollars at current gold prices) could be absorbed in an instant by private investors.

Government controlled currencies are liabilities of the monetary agents and are backed by debt. Their value is hence based on the level of confidence in the financial and political systems and their rates of exchange tend to oscillate daily based on changes in this confidence level. For example, if doubt arises regarding the quality of the debt which provides the asset backing for a currency, then capital will shift from that currency into an alternative investment. Gold, a tangible asset which has been valued as a store of wealth for thousands of years, provides an ideal alternative.

Those who are advocating the CB conspiracy theories are failing to appreciate a very important point : The primary reason to own gold as an investment is because it is not controlled by central banks and governments.

Reason # 2 To Own Gold

 

The second reason to own gold is a corollary of the first. The debt which forms the asset backing of a national currency can be split into two groups - private debt and government debt. The quality of private debt will reduce if the cashflow of the borrowers is insufficient to meet the repayments and /or the value of the underlying security for the loan (real estate, shares, etc) becomes less than the amount of the loan. This is the situation which Japan has faced since 1990 (lending based on collateral rather than cashflow followed by a substantial reduction in asset values has resulted in huge, non-performing private debts). Large scale defaults on private debts will force asset sales, pushing down asset values even further, and stop new investment . Liquidity will thus be removed from the system and interest rates will fall to a point where investment once again becomes feasible. The process is self correcting unless, of course, the government tries to help.

A different set of rules, however, apply to government debt . These rules can begin to be understood by first reading the following explanation of central bank powers taken from a speech given by Alan Greenspan in January of this year :

"Central banks can issue currency, a non-interest-bearing claim on the government, effectively without limit. They can discount loans and other assets of banks or other private depository institutions, thereby converting potentially illiquid private assets into riskless claims on the government in the form of deposits at the central bank. That all of these claims on government are readily accepted reflects the fact that a government cannot become insolvent with respect to obligations in its own currency."

As Greenspan points out, a government can never run out of its own currency. Therefore, the cashflow of a government will never be insufficient to service its internal debt. It can simply create as much money as it needs through the issue of new debt. It should also be noted that governments never have to concern themselves with the value of the assets used as security against their loans, because there are none. The asset which backs all government debt is the full faith and credit of the government. 

A problem for a country occurs when new money is created at a consistently greater rate than the increase in the supply of tangible assets, resulting in rising prices, reduced demand for financial assets, and increasing interest rates. This situation arises as greater and greater levels of debt are needed to sustain a stock market or real estate bubble, or to pay for government/business expansion, or simply to service the repayments on existing debt (both private and government).

Throughout history people have accumulated precious metals to defend their wealth from destruction as every form of paper currency ever created has been devalued through inflation. This is the second reason to own gold :

Gold is the only form of money which has maintained its purchasing power over a long period of time

Continue reading: Gold Versus The Dollar (Part Two)

Dividend Discount Model (DDM) - Part One

A security with a greater risk must potentially pay a greater rate of return to induce investors to buy the security. The required rate of return (aka capitalization rate) is the rate of return required by investors to compensate them for the risk of owning the security.

This capitalization rate can be used to price a stock as the sum of its present values of its future cash flows in the same way that interest rates are used to price bonds in terms of its cash flows. The price of a bond is the sum of the present value of its future interest payments discounted by the market interest rate. Similarly, the dividend discount model (aka DDM, dividend valuation model, DVM) prices a stock by the sum of its future cash flows discounted by the required rate of return that an investor demands for the risk of owning the stock. Future cash flows include dividends and the sale price of the stock when it is sold. This DDM price is the intrinsic value of the stock. If the stock pays no dividend, then the expected future cash flow is the sale price of the stock.

Intrinsic Value = Sum of Present Value of Future Cash Flows

Intrinsic Value = Sum of Present Value of Dividends + Present Value of Stock Sale Price

Formula for Calculating a Stock's Intrinsic Value
Stock Intrinsic Value = D1 + D2 + ... + Dn + P (1+k)1 (1+k)2 (1+k)n (1+k)n	P = Selling Price of Stock D = Annual Dividend Payment k = Capitalization Rate n = Number of Years until Stock is Sold; Present Value of Stock Sale Proceeds

In the above equation, it is assumed that 1 dividend is paid at the end of each year and that the stock is sold at the end of the n^th year. This is done so that the capitalization rate (k) is an annual rate, since most rates of return are presented as annual rates, and simplifies the discussion. We are only interested in the equation's pedagogical value rather than specific results.

Note that if the stock is never sold, then it is essentially a perpetuity, and its price is equal to the sum of the present value of its dividends. Since the DDM considers the current sale price of the stock to be equal to its future cash flows, then it must also be true that the future sale price of the stock is equal to the sum of the cash flows subsequent to the sale discounted by the capitalization rate.

In an efficient market, the market price of a stock is considered to be equal to the intrinsic value of the stock, where the capitalization rate is equal to the market capitalization rate, the average capitalization rate of all market participants.

There are 3 models used in the dividend discount model:

1. zero-growth, which assumes that all dividends paid by a stock remain the same;
2. the constant-growth model, which assumes that dividends grow by a specific percent annually;
3. and the variable-growth model, which typically divides growth into 3 phases: a fast initial phase, then a slower transition phase that ultimately ends with a lower rate that is sustainable over a long period.

For Analysts Things Are Always Looking Good

For years, the rap on Wall Street securities analysts was that they were shills, reflexively producing upbeat research on companies they cover to help their employers win investment banking business. The dynamic was well understood: Let my bank take your company public, or advise it on this acquisition, and—wink, wink—I will recommend your stock through thick or thin. After the Internet bubble burst, that was supposed to change. In April 2003 the Securities & Exchange Commission reached a settlement with 10 Wall Street firms in which they agreed, among other things, to separate research from investment banking. 

Seven years on, Wall Street analysts remain a decidedly optimistic lot. Some economists look at the global economy and see troubles—the European debt crisis, persistently high unemployment worldwide, and housing woes in the U.S. Stock analysts as a group seem unfazed. Projected 2010 profit growth for companies in the Standard & Poor's 500-stock index has climbed seven percentage points this quarter, to 34 percent, data compiled by Bloomberg show. According to Sanford C. Bernstein (AB), that's the fastest pace since 1980, when the Dow Jones industrial average was quoted in the hundreds and Nancy Reagan was getting ready to order new window treatments for the Oval Office. 

Among the companies analysts expect to excel: Intel (INTL) is projected to post an increase in net income of 142 percent this year. Caterpillar, a multinational that gets much of its revenue abroad, is expected to boost its net income by 47 percent this year. Analysts have also hiked their S&P 500 profit estimate for 2011 to $95.53 a share, up from $92.45 at the beginning of January, according to Bloomberg data. That would be a record, surpassing the previous high reached in 2007. 

With such prospects, it's not surprising that more than half of S&P 500-listed stocks boast overall buy ratings. It is telling that the proportion has essentially held constant at both the market's October 2007 high and March 2009 low, bookends of a period that saw stocks fall by more than half. If the analysts are correct, the market would appear to be attractively priced right now. Using the $95.53 per share figure, the price-to-earnings ratio of the S&P 500 is a modest 11 as of June 9. If, however, analysts end up being too high by, say, 20 percent, the P/E would jump to almost 14. 

If history is any guide, chances are good that the analysts are wrong. According to a recent McKinsey report by Marc Goedhart, Rishi Raj, and Abhishek Saxena, "Analysts have been persistently over-optimistic for 25 years," a stretch that saw them peg earnings growth at 10 percent to 12 percent a year when the actual number was ultimately 6 percent. "On average," the researchers note, "analysts' forecasts have been almost 100 percent too high," even after regulations were enacted to weed out conflicts and improve the rigor of their calculations. As the chart below shows, in most years analysts have been forced to lower their estimates after it became apparent they had set them too high. 

While a few analysts, like Meredith Whitney, have made their names on bearish calls, most are chronically bullish. Part of the problem is that despite all the reforms they remain too aligned with the companies they cover. "Analysts still need to get the bulk of their information from companies, which have an incentive to be over-optimistic," says Stephen Bainbridge, a professor at UCLA Law School who specializes in the securities industry. "Meanwhile, analysts don't want to threaten that ongoing access by being too negative." Bainbridge says that with the era of the overpaid, superstar analyst long over, today's job description calls for resisting the urge to be an iconoclast. "It's a matter of herd behavior," he says. 

So what's a more plausible estimate of companies' earning power? Looking at factors including the strengthening dollar, which hurts exports, and higher corporate borrowing costs, David Rosenberg, chief economist at Toronto-based investment shop Gluskin Sheff + Associates, says "disappointment looms." Bernstein's Adam Parker says every 10 percent drop in the value of the euro knocks U.S. corporate earnings down by 2.5 percent to 3 percent. He sees the S&P 500 earning $86 a share next year. 

As realities hit home, "It's only natural that analysts will have to revise down their views," says Todd Salamone, senior vice-president at Schaeffer's Investment Research. The market may be making its own downward adjustment, as the S&P 500 has already fallen 14 percent from its high in April. If precedent holds, analysts are bound to curb their enthusiasm belatedly, telling us next year what we really needed to know this year.

The bottom line: Despite reforms intended to improve Wall Street research, stock analysts seem to be promoting an overly rosy view of profit prospects.

Continued: Security Analysts and Their Recommendations

In his December 2004 paper, Michael Cliff examines the period 1994-2003 to answer the following question: “Do Independent Analysts Provide Superior Stock Recommendations?” For his investigation, “independent” means not involved in an investment banking relationship between one year before and two years after a recommendation. He finds that:

• Independent analysts are less likely to issue Strong Buy and Buy recommendations and more likely to issue Sell recommendations than are conflicted analysts. (See the chart below.)
• The Strong Buy and Buy recommendations of conflicted analysts significantly underperform the overall market, with higher volatility. The Strong Buy and Buy recommendations of independent analysts perform about the same as the overall market. Conflicted analysts were especially slow to downgrade, with the bear market exacerbating their underperformance.
• The Hold recommendations of conflicted analysts dramatically underperformslightly outperform the overall market. the overall market, while the Hold recommendations of independent analysts
• The Sell recommendations of conflicted analysts underperform the overall market to a degree that suggests shorting (although shorting would have drawn margin calls during the first half of the period examined). The Sell recommendations of independent analysts significantly outperform the overall market, surprisingly doing better than any other category.
• The banking relationship conflict of interest is the most likely reason that conflicted analyst Strong Buy, Buy and Hold recommendations underperform independent analyst recommendations.
• Many terminations of coverage plausibly result from a desire by conflicted analysts to limit damage to banking relationships.
• It is a mystery why anyone pays attention to analyst recommendations, whether conflicted or independent. “The few glimpses of positive performance are probably largely offset by transactions costs.”

In summary, if you consider analyst recommendations when picking stocks, you really should check for investment banking conflicts. Better yet, just ignore the analysts.

Security Analysts and Their Recommendations

Stock prices, especially those with high price-earnings ratios, are usually based on future expectations, which often originate from the recommendations of security analysts. A security analyst (aka sell-side analyst) is a person who works for a brokerage, bank, or mutual fund, who studies specific companies, usually within a sector, publishes financial reports on those companies, and makes buy-sell-hold recommendations about the companies’ securities. The recommendations consist of 5 categories:

1. strong buy,
2. buy, outperform, overweight
3. hold, equal weight
4. sell, underperform, underweight
5. strong sell.

The designations overweight, equal weight, and underweight are used in regards to portfolio weightings. Hence, a stock with an overweight rating would be a recommendation to weigh the portfolio more heavily with the stock, since the analyst expects it to outperform the market; equal weight would indicate that the stock is expected to perform as well as the market, while an underweighted stock is forecasted to underperform the market.

Security analysts also forecast a target price, based on their expectations of future earnings and revenues.

However, numerous studies and scandals have shown that analysts’ recommendations are not reliable, and that there has often been a conflict of interest among analysts and the firms that they work for. Companies were often rated buys so that the investment banks could win their business. In the late 1990’s, at the height of the stock market bubble, less than 2% of the companies were designated with sell recommendations.

For instance, Jack Grubman, who worked for Saloman Smith Barney of Citigroup as a top telecommunications analyst, allegedly upgraded his rating of AT&T, so that Saloman would be selected in managing AT&T’s large stock sale. He also supported WorldCom, McLeodUSA, Global Crossing, and Rhythms Netconnections—companies that filed for bankruptcy after the tech bubble burst in 2000. In fact, according this New York Times article, Grubman kept his buy rating on WorldCom until a few days before WorldCom announced its accounting irregularities, forcing it to declare bankruptcy shortly thereafter.

In 2003, the SEC secured a settlement from 10 Wall Street firms—including Citigroup, Credit Suisse Group, and Goldman Sachs—of $1.4 billion for potentially misleading investors with their biased recommendations, and coerced the firms to provide independent stock research at a cost of $432.5 million for a 5-year period that ends in May, 2009. The settlement included a prohibition of investment banking members from reviewing or influencing research reports made by the banks’ analysts.

William Baker, a marketing professor at San Diego State University, conducted a study of analysts’ recommendations for stocks in the Dow Jones Industrial Average (DJIA) and the technology sector of the S&P 500, and found that stocks with buy recommendations performed no better than stocks with hold or sell recommendations, and that technology stocks with hold or sell recommendations outperformed the S&P 500 Index by 8.3% compared to 4.4% for those with buy recommendations.

Another part of the study that examined more than 1,000 analysts’ recommendations—issued between January, 1998 and November, 2005—on stocks in the DJIA found that the recommendations were no more predictive of stock performance than could be attributed to chance.

Still another study has shown that analysts' recommendations are not very valuable themselves, but that upgrades and downgrades were more indicative of future stock prices.

A major recommendation to enhance the reliability of analysts’ ratings is to have their record of recommendations available to investors. The public availability of their previous recommendations would motivate analysts to improve their track record to improve their credibility. Some rules by the self-regulatory authorities do require the listing of an analyst’s recommendation for companies that they are currently covering, but companies no longer covered by the analysts can be excluded.

A major consideration to keep in mind when reviewing recommendations is that stock analysts are no more able to predict future market conditions than other market participants. Target prices are based on the assumption that the current market conditions will continue.

Secondary Securities Markets Continued: Third Market

Third Market—Trading Listed Securities in the OTC Market

The third market is the trading of exchange-listed securities in the over-the-counter market.

Up until 1972, the NYSE charged fixed commissions on all trades on its exchange. 

 

However, many traders felt that there should be lower commissions for larger trades. Consequently, traders with large blocks to trade started trading NYSE listed stocks in the OTC market for reduced commissions, using brokers who were not members of the NYSE. Eventually, in May, 1975—known as May Day—all commissions became negotiable. In that year, the lowest price for a seat on the NYSE was $55,000, whereas 10 years earlier, the lowest price was $190,000.

Fourth Market—Electronic Communication Networks (ECNs)

Electronic Communication Networks (ECNs) are electronic networks that can connect buyers directly with sellers for listed securities—no brokers or market makers are involved. Often called the fourth market or network, ECNs can eliminate the spread that dealers charge, if a crossing match can be found for the buy or sell orders that were entered. The ECN earns its money from fees for the transactions, rather than from commissions or a spread. Most ECNs are also connected to NASDAQ through the Intermarket Trading System. Participants, mostly institutional investors, post bids or offers on the ECN. The ECN will try to match the order with another participant on the ECN, or, if that fails, it will send the order to NASDAQ. Most large traders also like ECNs because of their anonymity—the rest of the market does not know who is buying or selling large blocks of securities.

ECNs must be registered by the SEC, and by the NASD if it wants to connect to the NASDAQ market. 

The National Market System (NMS)

Because stocks are listed on multiple exchanges and in the OTC markets for different prices, the SEC wanted to promote competition among the different trading centers by consolidating the quotes in 1 place—the National Market System, which was the result of Regulation NMS. The SEC has been trying to implement this strategy since 1975, but because of technical problems and industry opposition, it has taken some time, with the latest changes being implemented in 2007. The NMS would allow individual investors to see the same quotes as big institutional investors. 

Consolidated Tape—Network A and Network B

 

The National Market System began with the Securities Act Amendments of 1975 that gave the SEC authority to effect some institutional changes so that quotes from different markets could be consolidated. One result was the consolidated tape, which began operating in June, 1975, and is composed of Network A and B.

Network A lists the best prices for NYSE-listed stocks from the NYSE, local exchanges, and the OTC market. Network B lists the best prices for AMEX-listed stocks from AMEX, the local exchanges, and the OTC market, and also stocks that are only listed on local exchanges and the OTC market.

The Consolidated Quotation System (CQS) electronically disseminates these quotes across the networks.

Intermarket Trading System (ITS)

 

The Intermarket Trading System is a network that links the NYSE, the AMEX, NASDAQ, and the Boston, Chicago, National (formerly Cincinnati), Pacific and Philadelphia local exchanges, and the Chicago Board Options Exchange. This system, begun in 1978, allows market makers and brokers to transmit quotes to other exchanges for better prices for the approximately 4,500 stocks listed on multiple exchanges. Thus, if a customer for a broker who is a member of the Philadelphia Stock Exchange, sees a better price on the NYSE, the broker can route the customer’s order to the NYSE, then the trade is reported on the Consolidated Quotation System. 

One of the problems with the ITS is that the orders are not routed automatically to the best price, but must be sent there by a market participant. For instance, if an NYSE specialist receives an order for a stock, but sees a better price on the ITS system, then he must either send the order to that exchange, or match the price. The ITS system is also considered too slow for the NYSE.

However, a major drawback is that it does not include quotes from ECNs, which are transacting increasing numbers of shares because of their low cost.

The solution for the future is to have an electronic network that links all of the markets, aggregating all orders into 1 central limit order book, where the best inside prices can be quoted. This not only gives the best prices to the customers, but will also force the exchanges to become more efficient, since the lowest cost networks will generally have the best prices. Eventually, there will be no market makers or specialists—buyers will simply buy directly from sellers, electronically, for the lowest transaction cost possible.