The parting of the Mediterranean Sea: more freedom south, less freedom north.

One year ago, Tunisians kicked out Zine El Abidine Ben Ali, freeing themselves of a dictator in power since 1987. That set off the Arab Spring which changed the political landscape in North Africa and the Middle-East. Many people living on the southern and eastern shores of the Mediterranean took to the streets in protests against dictatorships, monarchy, corruption and poor economic conditions, seeking to free themselves from years of political, economic and social oppression.

Within less than 14 months, major or reasonably major positive outcomes have been observed in 15 Arab countries with protests ongoing in 9 of these countries.


During the next several months, countries on the northern side of the Mediterranean will be asked to ratify a treaty which will severely limit the sovereignty of democratic governments and radically change the lives of the people in most of the 17 countries forming the Eurozone.

Countries adopting the treaty will be living with a teutonic fiscal straightjacket which, combined with the 1999 loss of their national currency and monetary policy, will essentially result in the subordination of a large part of each nation’s economic and fiscal policies to the diktat of mostly non-elected eurocrats impacting the lives of extremely diverse people. The single option: get out and swim on your own!

How will that go? Not smoothly, that’s for sure.

It really all began with Angela Merkel, seemingly seizing the opportunity, declaring on November 14, 2011:

It is time for a breakthrough to a new Europe. The task of our generation is to complete economic and monetary union, and build political union in Europe, step by step. (…) That does not mean less Europe, it means more Europe.

For most European countries and most Europeans, it sure means a lot more Europe, or, to be more accurate, a lot less Greece, a lot less Italy, a lot less Spain, France, Ireland, etc. In effect, a lot less economic freedom for most everybody in Europe as politicians have agreed to cede much of their economic sovereignty to an unelected foreign body, the European Commission, with permissible budget deficits effectively set by the Germans and empowered by the European court.

Can politicians deliver a quick and smooth ratification? Can politicians convince their constituents that they must surrender a lot more powers than in the failed Constitutional Treaty of 2004? And, importantly, can national parliaments ratify without polling their people? And if there is polling, will it go through?

The political reality of Europe is that such a far reaching treaty will likely have to be ratified by a referendum in several countries. In 2004, referendums were required in 7 of the 25 EU states (Denmark, France, Ireland, the Netherlands, Luxembourg, Portugal and Spain). Spain and Luxembourg endorsed the treaty but its rejection by French and Dutch voters brought the ratification process to an end.

In the current saga, a vote against the agreement would also be a vote to leave the Eurozone.

Whatever the outcome, the reality is that the next several months will be dominated by Euro-politics and, given the current trends in European economies and the political situation in many countries, the ratification process will be anything but smooth.

Some (German) officials have suggested that the recent agreement be presented as an amendment to the existing treaty, thus eliminating the need for national parliament approval and possible referendums. But it is highly unlikely that the most significant constitutional change in Europe since WWII can be rammed through without proper and legitimate popular approval.

As an appetizer, here are the approval rates of political leaders in Europe:


Job approval of heads of state/government in EU

Unsurprisingly, governments in countries currently facing harsh economic conditions enjoy pretty low approval ratios, severely limiting their ability, and willingness, to fight against popular polling for such important changes.

There will be 5 crucial elections in Europe in 2012: Finland looks like a slam dunk, but France, Greece, Slovakia and Slovenia seem highly problematic. If anything, the French elections, to be held April 22 and May 6, will be carefully watched by investors.

So it has fallen to the Socialists – less compromised lately – to start the rebellion. “We cannot let the Germans alone appoint themselves experts and judges,” said party leader François Hollande. He called for “substantial modifications” to the fiscal compact if elected president in May, as he may well be since he is running six points ahead in the polls.

Pierre Moscovici, his campaign manager (and former Europe minister), has since upped the ante by threatening a referendum – mischievously noting the French voted ‘Non’ last time they had a chance in 2005.

“I am convinced that we will find allies for a renegotiation aimed at a policy change to pull out of its austerity spiral and recession. We don’t like the idea of a popular vote because we are pro-Europeans and we don’t want a “No”, but nor can we allow tensions to spill over.(UK Telegraph)

Furthermore, we can assume that pressures for referendums will be strong in Austria, Ireland, Luxembourg, the Netherlands, Spain and Portugal. Importantly, Italian elections are due only in 2013 but Mario Monti being unelected and pushing through major austerity measures, it seems plausible to expect a lot of heated discussions on the matter, to say the least.

There is no surprise in the fact that politicians approval ratings are closely synced with economic conditions. The current reality is that the cloud pictured below will most likely shift lower-left in coming months.

approval vs. economic conditions



  • No political smooth sailing ahead! No way to assess the final binary outcome.
  • High volatility to continue in fixed income and equity markets.
  • The euro will remain under pressure.
  • Gold should keep shining.
  • U.S. equities should keep outperforming in a rough global sea.
  • Euro banks remain unattractive: politicians will continue to hit on banks and bankers, any which way they can, as it will help smooth out greater fiscal austerity among citizens.
  • A not insignificant risk is egocentric action by “national” euro banks which, under political pressure, would use ECB funding to buy their own country’s debt while dumping “foreign” assets (i.e their European neighbor’s debt).
  • The ECB is unlikely to be “too” accommodative, keeping pressure on sinners to help ratification.


From New$-To-Use large and busy marketing department: Winking smile 

NEW$-TO-U(SE) was launched on January 2, 2009. In addition to providing readers with investment-pertinent facts, trend analysis and other expert views and opinions, NTU makes regular assessments of U.S. equity markets, offering detailed and unbiased valuation analysis and clear investment stances taking into account both risk and reward potential. Here’s the record:


And the details:

Pointing up   On March 3, 2009, when the S&P 500 Index was below 700,  NTU explained and documented why U.S. equities were extremely cheap and offered a very attractive risk/reward ratio. NTU also introduced The Rule of 20 method of valuing equity markets. NTU’s detailed and rigorous analysis concluded that equity markets were clearly undervalued with very little downside risk. (S&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years)

Pointing up   On December 8, 2009, NTU explained and documented that, at 1100, caution was now warranted given that

“This is the first time since March 2009 that the Rule of 20 gives such downside against so little upside”. (…) “Given the fragility of the economy, of the banking system (housing and CRE remain dangerous), of the US dollar and the US budget deficit, equity markets that are merely fairly valued are not particularly attractive.

In conclusion, US equities are fairly valued using annualized Q3-2009 eps and 2% inflation. They could rise another 8% to 1200 (S&P; 500) if Q4-2009 reach the expected $67 level but the risk/reward ratio has become unfavorable for the first time since March. (US EQUITIES VALUATION ANALYSIS: DUCK, YOU (HAPPY) SUCKERS!)

Pointing up   On June 2, 2010, NTU posted that U.S. equities had become undervalued again at 1090 and that, barring deflation, they could rise to between 1240 and 1320:

Equities are thus currently 9-16% undervalued depending on whether one uses current trailing EPS or “normalized trailing EPS” using Q2 2010 estimates. Using 1.0% inflation, fair value would rise another 5% but such a low inflation rate may be too low for comfort unless monthly core inflation strengthens. (US Stocks Are Cheap But Beware of Deflation).

Pointing up   On November 7, 2010, still positive at 1225:

(…) On that basis, the S&P 500 Index at 1225 sells at 15.5 times, right on the historical median, pleasing both bears and bulls. However, the more appropriate Rule of 20 says fair value is at 19x EPS (20 minus inflation of 1%), or 1500 on the Index, a big 18% undervaluation. (…) investors might have the best of all world: a very cheap equity market, rising earnings, no double dip, very low interest rates for as far as the eye can see, reduced probabilities of deflation and, just in case, the Fed unlimited QE puts in the back pocket. (SO! WASSUP? Cheap Markets)

Pointing up   On January 28, 2011, even though valuation remained reasonable, the risk/reward ratio turned less attractive at 1285. Economic trends were suggesting  muddling-through at best, right when economists were becoming more positive.  “Even notable bears have mellowed their stance” and risks of negative surprises were now pretty high.

From a valuation standpoint, the Rule of 20 continues to point to 1500 on current trailing earnings of $79-80, for a 15-20% upside potential to fair value. This remains a good target for this year. However, the risk of a technical correction towards the 200 day m.a. (1170, -10%) is not insignificant, skewing the risk/reward ratio and raising a yellow flag for the shorter term. (YELLOW FLAGS ON EQUITIES)

Pointing up   On March 29, 2011, NTU published US EQUITIES: APRIL PEAK?, realistically warning that apparent undervaluation was being threatened by rising inflation and dangerous groundhogs:

While the Rule of 20 provides a rigorous mathematical and time-tested approach to PE multiples on US equities, it does not account for external risks. While many external factors are at play at any given time, it is fair to say that the current environment has more than its fair share of known unknowns (see KNOWN AND UNKNOWN UNKNOWNS (GROUNDHOGS)), many of which are potential game changers (list followed).

Liquidity is currently flowing liberally in the US economy and into its stock market. Yet, many of the above noted groundhogs could quickly change the outlook significantly. In addition, the era of excess liquidity could well end abruptly on June 30th or, more likely, fade away gradually during the summer months.

It is therefore likely that high uncertainty will keep PE ratios below what they would otherwise be in a more “normal” environment.

This is why caution is warranted here. It will be psychologically very difficult for investors to bid stocks up when PEs are no longer terribly attractive and given the number and dangerousness of the groundhogs out there.

Pointing up   On August 15, 2011 as politicians on both sides of the pond were playing Russian roulette with already sick economies, NTU pondered whether it was time tp take advantage of the significant undervaluation in U.S. equities at 1180:

Although rare and appealing from a value stand point, the current 21% undervaluation is not a guarantee of positive returns. In the last 90 years, similar undervaluation levels have not been followed by positive returns in the following circumstances:

  • Major war.
  • Deflation.
  • Rapidly rising inflation.

US inflation has been rising at a fast clip in 2011, from 0.8% in January to 3.6% in June (July CPI to be released Aug. 18). This very rapid rise in the deflating component of the Rule of 20 has been a major factor in my downgrading of equities during the early part of 2011. In effect, the S&P 500 Index went from a 21% undervaluation in November 2010 (1185) to a much less appealing 7% undervaluation last June (1320). The rise in the inflation rate cut the Rule of 20 fair PE by 2.8 points, offsetting the 14% jump in trailing earnings during the period.

(…) the way the economy is going, a total surprise to the Fed and to the economist community in general, who also used “transitory” to qualify the spring’s soft economic data. Fortunately, my readers have been repeatedly warned that the world was actually not transiting to anything pleasant (THE ECONOMIC AFTERLIFE (June 6), EQUITIES: TIME TO GO FISHING but NOT BOTTOM FISHING! (June 13), THE US ECONOMY NEEDS ANOTHER “MIRACLE” (June 17), EQUITIES: CAREFUL OUT THERE! (July 7).

I then offered 3 scenarios and took side this way:

For my part, given that we are only in mid-August (see SEASONALITY OF EQUITY MARKETS) with so little visibility and such high volatility, I remain on the sidelines for a while longer even though my fishing season is over (sigh).

Pointing up   On November 8, 2011, right in the middle of the Eurozone crisis I began my post (TIME TO INCREASE EQUITY EXPOSURE) with:

I have been very cautious on US equities since April 2011, warning that good apparent valuation would be overwhelmed by the significant macro risks. Recently, the US economy has distanced itself from recessionary risks, at least for the shorter term, and US inflation has started to recede, providing relief to consumers and a more solid background for valuation.

I then explained and documented the reasons why the Euro-scare had reached its high, concluding:

This is a binary situation and Angela Merkel will not want to go down in history as the euro sinker. The writing is on the wall and that German wall will also fall.

Then, I proceeded to explain and document the fact that the U.S. economy was not double dipping and that, in fact, it was doing surprisingly better:

Economic forecasts are more upbeat while inflation is tapering off.

US employment is slowly recovering The U.S. labor market is edging forward, with fresh data suggesting October’s modest job gains are continuing into November.

The US LEI keeps rising, gaining 0.9% in October after 0.1%in September and 0.3% in August. The October advance reflected gains in many areas that have been lagging in the recovery so far.

With the economic background more positive, highly attractive equity valuation levels became irresistible:

At 1221, the S&P 500 Index is selling at 12.9x trailing EPS. The last time the trailing PE fell below 13 was in March 2009. Prior to that, one has to go back to 1989 to find PEs below 13, a period when US inflation was in the 6% range.

The Rule of 20takes inflation into account when assessing equity valuation. Under the Rule of 20, the appropriate PE should be 16.5 (20 – 3.5) which, using $94.75 trailing EPS gives a fair value of 1563 for the S&P 500 Index.

(…) Of course, risks remain, particularly from the political side. This is why valuation is so attractive. However, the Euro risk has entered its “terminal” phase and while US politicians continue to act … as mere politicians, the resiliency of the economy and the easing of inflation, coupled with extraordinarily low interest rates promised for “an extended period” and ample liquidity, provide a good background for US equities.

Pointing up   On March 19, 2012 (EQUITIES: IT’S SPRING AGAIN!)

The big difference with the current situation compared with last year’s is that the risk is currently centered on earnings while in both 2010 and 2011 rising inflation was the reason for valuations getting less attractive. Changes in inflation rates are more gradual than earnings movements which can, at times, be sudden and violent. Thus, risk is more significant at this point than last year, something which we must integrate into the risk/reward analysis.

The 18% upside to fair value remains superior to the downside but not much. A more balanced risk/reward equation would be reached near the 1450 level, only 3.3% above current the current level.

Many commentators are reminding investors of the fact that equities peaked in the spring of both 2010 and 2011. So the next 8 weeks will be challenging because everyone, all mindful of left tail risk and knowing everyone might want to “sell in May and go away”, might want to get ahead of the pack and sell in April.

In 8 weeks, Q1 earnings season will be almost over. Let’s see how it goes. Meanwhile, assess your equity exposure, manage your risk and watch the technicals.



Tracking all pertinent news and stats, NTU is often among the first to detect trend changes. A few examples:

  • On June 6, 2011, NTU posted THE ECONOMIC AFTERLIFE which argued that Bernanke and most economists’ reassuring comments that recent poor economic stats were merely a “soft patch” and “transitory” were only wishful thinking and that the transition would in fact be toward a tougher life. By mid-summer, most economists got worried of a double-dip.
  • NTU was among the first last fall to document that the double dip risk was declining as the U.S. economy was in fact reaccelerating.
  • NTU was among the first to warn of a significant slowdown in China.
  • NTU was among the first to warn that U.S. inflation was peaking last summer.
  • NTU was among the first to spot GREEN SHOOTS IN US HOUSING? in mid-October 2011.

This is what New$-to-U(se) is all about:

  • NTU publishes (and archives) all pertinenteconomic facts objectively and dispassionately.
  • NTU analyzes trends and confronts them with conventional economic wisdom and the flavor of the day in the media.
  • NTU carefully analyzes and monitors equity market valuations using all appropriate tools but placing significant weight to The Rule of 20 which values equities using actual trailing earnings andinflation rates.
  • NTU assesses equities based on their risk/reward ratio as upside potential needs to always be measured against the downside risk.
  • Contrary to most people who let their assessments of the economic and financial environments dominate and dictate their valuation work, NTU starts with valuation, then assesses if the economic and financial environments are favorable to a closing of the valuation gaps if any.
  • NTU also offers competing views and opinions from other analysts and commentators, to challenge and verify my own initial ideas.


NTU is a personal site used for my personal investments but open to everybody. If you ever invest on the basis of NTU’s analysis, do it at your own risk and peril since there is no guarantee whatsoever about anything, including my own sanity. Remember that past performance is no guarantee for the future, even though I work very hard at it since our lifestyle totally depends on it.



Josh Brown is a New York City-based investment advisor for high net worth individuals, charitable foundations, retirement plans and corporations. His blog is neatly called The Reformed Broker.

I’ve witnessed every single mistake an investor could make since I came into this game and I’ve made most of them myself.  The mistakes where it’s very obvious that the odds are against you before you even begin are called the Money-Losers.  

His 10 money losers with some of my comments. His complete post is here.

  1. Buying out-of-the-money naked options: premium spec.
  2. Confusing your politics with your investing: stay cool when playing with money.
  3. Playing the tertiary name: Industry # 3+ players are generally the losers.
  4. Hiring an options advisor: Churn to earn!
  5. Private Placements: Unless you really know them, tell them to keep it private!
  6. Currency trading: Unless your initials are JT and you fish salmon, stay away.
  7. Listening to gut traders: You’re a prime candidate for #4 and 5.
  8. Confusing your time frame with someone else’s
  9. Knee-jerk Contrarianism: Think again, do the basic work again, wait for a turn…
  10. Betting on Jockeys: A few needles in haystacks

Anyway, these are ten things I don’t do.  It’s not that they can’t work, it’s that they won’t over any appreciable amount of time.



Felix Salmon today posted on the huge divergence in yields between stocks and bonds, wondering just how historically unprecedented this divergence was.

Indeed, from 1985 through about 2002, it was just as common for the S&P earnings yield to be lower than the Treasury yield as it was for the yields to be the other way around. The two tracked each other, and the spread between them almost never moved beyond 2 percentage points either way.


In 2002, everything changed. The spread between the two jumped up to a very high level and stayed there, all the way through the onset of the financial crisis. This was the Great Moderation.

And when the Great Moderation imploded, the spread only widened further. Today, it’s about 7 percentage points. At these levels, it’s almost impossible to see how stocks could possibly be a worse long-term investment than bonds. Yes, earnings can fall. But even if they fall in half, stocks will still yield double what bonds do.

What happened? Felix does not know:

I have to admit that I really don’t understand what’s going on in this chart at all. While any given spike can always be attributed to a fearful flight to quality, that doesn’t explain the decade-long trend.

Let’s try to explain because this is important.

First, my data from S&P and the Treasury differ somewhat from that used in Felix’ chart. The difference is in the magnitude of the earnings yield (thus the PE) and probably has to do with whether one uses “as reported” or “operating” earnings. Nonetheless, it does not change the trend that Felix is pointing out. Here is my chart of the earnings yield – Treasury spread:


Second, this rise in the spread is not unprecedented as this chart from 1927 shows:


In fact, Felix’ chart, beginning in 1985, misses the fact that it is the period between 1980 and 2000 that was exceptional. Markets are currently merely returning to normal, if 1927-1980 is normal.

Third, there has been a long 25-year decline in real Treasury yields, from an almost century-high 9.3% in June 1984 to -1.4% currently. As the chart below reveals, negative 10 year yields is not new and current negative real yields are not extraordinary compared with previous periods of negative real yields.


More specifically to Felix Salmon’s question, real yields broke below the 2% level in mid-2002:


This coincided with:

  • the trough in US equities after a 46% collapse over 2 years. Enough to spook many investors.
  • Inflation troughed at 1% in June 2002, down from 3.7% two years before. US inflation quickly bounced back to 3% in February-March 2003 but US Treasuries stayed flat, likely due to investors reaching for safer investments.
  • Real yields were allowed to rise above 2% between September 2006 and August 2007 as US equities kept rising, gaining 90% from their 2002 low. The brutal renewed collapse that ensued might prove to be a generational change of attitude toward equity investing.
  • The Rule of 20 PE ratio (fair PE = 20 minus inflation) also broke down in 2002 (click on chart to enlarge). Whereas it used to move at least partly into overvalued territory in most previous up-cycles, the Rule of 20 PE balked at 20 in December 2009 and at 18.8 in April 2011.


Felix tried his own intuitive explanation:

So with the explicit proviso that I’m not going to try to explain this graph, I’ll tentatively put forward one hypothesis: that the dot-com bust of 2000-2002 had a much bigger effect on stock-market psychology than we might have thought. It made stock investors realize how fragile stocks really are, and concentrate on the risk that they could fall substantially in price. If you think that stocks are going to fall, then it almost doesn’t matter what their earnings yield is — you feel as though you should sell them at any price.

But frankly I don’t really believe it. There’s something more profound going on here; I just can’t put my finger on what it is.

I think Felix is partly right: equity investors have been fried twice within 10 years. Those who also owned a house must be totally numb as we speak and likely would not touch a stock with a 15-foot pole.

However, equity markets have changed a lot in the last 20 years and individual investors, even the traditional pension or mutual funds investors, are now dwarfed by computer trading where algos include no emotional parameters. Hence, as the Rule of 20 chart above and the actual PE chart below show, equity valuation remained well above historical lows.


What Felix did not consider is that it is the fixed income market that has changed significantly as emotional investors seek calmer waters with herd-like instinct. The clear move in real yields below the 2% level and the acceptance of occasional negative real yields since 2002 is a reflection of the substantial increase in the preference for safety on the part of individual and many pension fund investors as a result of their terrible experiences with equity and housing investments since 2000.

Given the fast aging of the population, the huge loss in confidence towards politicians and the alarming rise in sovereign debt levels across the world, it seems safe to assume that this is the new paradigm for a pretty long period.



Guest post by I. Bernobul, Esq.

I suspected it all along: Harold Camping is not who he pretends to be. A simple preacher can forecast the end of the world any day of the week, he’s in the fear business. But raising $80 million promising the end of the world is the business of a stock broker. He’s in the hope business, and people tend to pay richly for hope, even (especially) if it never materializes.

Still, Mr. Camping is no stock broker. The revelation came, we should have guessed it, from Salt lake City’s Deseret News:

Camping had said that the Rapture would begin on May 21, and despite no physical indications that it did, he’s arguing he was right. It was just his understanding of what that would look like that was wrong, he said.

So, the case is closed: Camping is an economist, or an equity strategist, in fact, likely both, an economist-strategist, a potentially lethal combination for the uninitiated.

May 21st did not turn out exactly as Camping forewarned, I am happy to confirm. But don’t despair! The delay may have to do with QE2, nowadays responsible for most bad things and unrealized bearish forecasts of the past year, but Camping’s hell will happen. In fact, it is all happening while we speak. Don’t you, mere mortals, not see what Harold is seeing. The signs are all there, in Greek, in Spanish, in Portuguese. God, even in plain English, if you can fathom a bit of Irish accent.

The French people, for their part, are oblivious to all that, busy as they are to decipher DSK’s behavior and uncover the “machination” behind an affair which, for most of them, is not the end of the world. One of the stories, in French bien sûr, is that it will soon be revealed that the hotel maid had just got engaged and that DSK, convinced that he would be France’s next President, merely took upon himself to exercise his legitimate droit de cuissarde, just like French kings (and seemingly many Presidents) have done before in the normal course of their business.

If Harold Camping can get away with misreading the Bible and mixing May 21 with October 21 on such an important matter as the ending of the world, why can’t DSK get away with thinking that America’s Constitution is but an English replica of the French one. After all, Benjamin Franklin and Thomas Jefferson spent sufficient time in France to appreciate les coutumes de la noblesse?

Despite acknowledging that he’s misunderstood the importance of each date before, Camping said he’s completely sure this time, without a doubt.

That, my friends, is a sure sign of a media-savvy economist-strategist! Without a doubt. Delicately, almost imperceptibly humble, yet clearly resolute. Openly confident, even assertive though not totally overbearing nor unbearably dogmatic. Finally, logical and pragmatic, obviously hedge fund ready:

He won’t be giving any of his own belongings away before Oct. 21, and he said he doesn’t see the sense in anybody else doing that. “Whoever I gave it to,” he said, “what would they do with it?”

Finally, our economist-strategist is a survivor. Next to politicians, economists-strategists are remarkable for their ability to keep going like nothing happened, whatever they said would or would not happen did or did not happen. In the worst of times, they have been misquoted or taken out of context. For them, nothing is the end of their world even though some of them became rich and famous predicting the end of your world.

Another sort of survivors are financial analysts. Wherever and whenever these happy campers pitch their tent, they seem to be in heaven, more precisely in Lake Wobegon, as Catalpa Capital Advisors reveals:

According to Wall Street analysts, 92.6% of the companies in the S&P 500 Index are above average. Compared to the children in radio’s famed fictional town of Lake Wobegon, all of whom are above average, the stocks in the index come up short. But just barely.


The overall rankings show little variation over time. Currently, the median rank for all of the stocks in the S&P 500 is 3.9. Since 2008, the median has ranged between 3.7 and 4.0. Even in the wake of the 2008 financial crisis, analysts ranked most stocks now in the index above average and gave just three stocks a rating below 2.

As predictors of future returns, the consensus ratings provide little guidance. For instance, the ratings from a year ago can be regressed against the subsequent returns for the stocks in the index. Doing that math gives an r-squared of 0.004. Statistically speaking, in other words, the consensus analyst ratings for the stocks in the S&P 500 have zero explanatory power.

During my investment management years, I used to tell visiting street analysts that I cared for their stories on companies but not much for their views on the stocks. I could make up my own mind as to the investment validity of companies given my own style and objectives. I did and still do my own, extensive, valuation work. Analysts’ reports are generally magnanimous on the stories, but pithily short on the admittedly more boring but ultimately more rewarding valuation analysis.

So it is with most (i.e. not all) economists-strategists: they are pretty good at enumerating all that goes well and, mainly, not so well in the world. The long side of their respective ledger generally and simplistically dictates their respective market views which are too often “summarized” in empty, unsubstantiated assertions and biased relationships, optimally ornate with the ultimate hedge formula “on the other hand…”.

Zero Hedge’s Tyler Durden wrote a post on the “(F)utility of trading the news”, quoting SocGen’s strategist Dylan Grice who, after a couple of months without reading the news, realized that

(…) surprisingly, I didn’t actually feel less informed; it made no difference to the performance of the pitifully small Grice retirement fund (…) ; it  made no difference to conversations I had with friends or family; to my overall sense of well being. I found that if anything was important it would find me. And reaction is easier than prediction.

But I also realised that I missed the news for its pure entertainment aspect. Finding out how sub-stories end after the fact without the suspense before was a bit like seeing only the football results on a Monday morning. I had as much information as anyone who watched the match, but I hadn’t taken part in the richness of the journey, and the safe thrill of not knowing how it would all end. Without the news, I was missing the joy of a good story.

Grice wanted to experiment on Nassim Taleb’s idea that

the news makes idiots of us because it gives us confidence, not insight.

There is much truth to that which economists-strategists and analysts profusely exploit, burying us in news and macro and micro stories, generally entertaining, but often pointless as to the ultimate objective: make better investments. Unsurprisingly, Grice confesses his news-junkyness:

So I’m back reading the news again. I know it won’t give me any particular competence at forecasting the big events, any more than watching the football will make me better at predicting the scores. I’m reading the news because I like to read the news (…).

We all do, we all like stories, however futile and useless, however unbelievable as some of the French stories can be. But beware! Entertaining stories can seriously affect your judgment and be dangerous to your financial health. Hence the need for disciplined, unemotional valuation work if, having been entertained, we also fancy a little financial return. Objective valuation based on facts, thereafter supported by stories, not the other way around. Grice agrees, offering this important piece of advice:

So treat the news for what it is. Read it, speculate about how stories will end, enjoy it. But be cautious about how much help it will be to you when investing. Writing about what things are worth might not make for as compelling reading, but I think it’s actually far more important.

So, let’s look at current equity valuation:


At 1335, the S&P 500 Index remains slightly (9%) undervalued using the dependable and objective Rule of 20 valuation method. Interesting but not quite the end of the world. This is when the stories intervene: currently, doom and gloom stories are arguably much more readily available, convincing and consequential than positive economic scenarios. The number of game changing groundhogs is such that 9% undervaluation does not strike me as appropriate compensation for the risks involved.

Add the unfavorable seasonality (SELL IN MAY…: 62% PROBABILITY) and the unattractive technical picture (U.S. Equities: Is The Correction Over?) and one would be totally justified to merely enjoy life for a while, read a few entertaining stories from non-financial scribes, go fishing and revisit the financial world after the Camping season scheduled to end October 21st. Sounds like heaven, doesn’t it?


Note: in the meantime, if you need your occasional financial fix, here are a few strategists who will truly entertain you while also attending to your investing needs: Don Coxe, long time friend, smart investor and exquisite writer, the versatile and thorough John Mauldin, the sage Jeremy Grantham,  and the witty James Montier, to name just a few. Don is a not an economist (historian), Mauldin seems to not want us to know he is, while Grantham and Montier, perhaps exceptions that prove the rule, have successfully overcome this handicap Winking smile.


Mohamed El-Erian: The Irresponsible Core

Mohamed El-Erian was recently inducted to the Fixed Income Hall of Fame. His remarks on the changing fixed income market are worth reading even though the important questions he raises will remain unanswered for a little while. (My emphasis).

(…) I will share with you some thoughts on something (…) that is going on in global fixed income—something that is as deep, more durable, and very consequential yet it is insufficiently discussed notwithstanding the potential impact on our industry and the role it performs in society.

Like other markets, the fixed income markets are navigating some major national and global re-alignments. Think of this in terms of the distinction that we were taught at school between variables and parameters.

Variables change often and, in most cases, tend to be mean reverting. Parameters are fundamentally different. They provide foundations that, fortunately, do not change that often. They are de facto anchors for much of the conventional wisdom that prevails in markets and institutions, and they underpin many of the analytical shortcuts that are used (including benchmarks).

So, if and when parameters change, we should all pay close attention. And, today, many parameters are on the move.

Let me give you some examples to provide you with a sense of this important issue, starting with Europe where we have witnessed dramatic changes in the characteristics of the government bond market in the Euro-zone.

What for most investors was for years a market dominated by just interest rate risk, has become a volatile combination of both interest and credit risk. Indeed, there is even uncertainty as to where the line between interest rate and credit risk should be drawn within this important region for global fixed income. The result is a government fixed income market that behaves very differently—in terms of risk and return—than just 18 months ago; and one that plays an evolving role in traditional asset allocation and portfolios.

The same can, and should be said of the US municipal bond market. Here we are also experiencing a major transformation in terms of interest rate and credit risk.

This is another change that has caught quite a few investors by surprise. Consistent with this, there has been a tremendous reduction in investor exposures, especially among the retail sector. Witness the 21 consecutive weeks of mutual fund outflows, amounting to a staggering total of some $45 billion since November.

We should also note development in the emerging market segment of global fixed income. This is about much more than just the maturation of an existing market segment in the context of the developmental breakout phase being experienced by several systemically-important emerging economies. It is also about the creation of new market segments and the completion of links among sectors that are reaching critical mass.

Finally, there is the most material aspect of all, what is happening at the very core of the global fixed income market. At this critical core, lies the US Treasury market: the grandparent of the very few “risk free” instruments in the world; the AAA of AAAs; and the provider of a range of global public goods.

A strong core is essential to the good functioning of a market system that inevitably has to deal with all sorts of unexpected exogenous shocks. Simply put, it helps hold the system together.

In the midst of the global financial crisis, policymakers took the right decision in using public balance sheets to offset the massive disorderly de-leveraging of private balance sheets—those of banks, companies and households. To use the phrase of my good friend, Paul McCulley, the responsible thing was to be irresponsible.

But it has been two and a half years since the collapse of Lehman, and the core of the global system is still acting irresponsible. America’s fiscal deficit is still at an alarming 10% of GDP. The debt stock has grown materially. We still do not have consensus on a medium term fiscal reform vision, let alone a detailed plan. And contingent liabilities are piling up.

The longer this situation prevails, the greater the risk of erosion at the core of global fixed income markets.

This is not historically unprecedented. Great Britain was forced out of the core by the tragic events of two world wars. But there was a good candidate for replacing Britain—the United States of America.

If—and, fortunately, it is still an if—the global standing of US Treasuries erodes significantly from here, there is no readily available candidate to step in. Since you cannot replace something with nothing, the global system would, in this scenario, have to function with a weak core.

This scenario raises the interesting questions of how would global fixed income markets operate in such a world. This is an extremely complex question. For example, it is not even clear whether the right analytical framework is an absolute or relative one. Would  everything simply re-align, or would the system recast in a fundamentally different manner?

Put all this together, and what you have is an interesting and uncertain evolution for the global fixed income markets over the next few years. With a number of parameters in motion, our collective responsibility is to be intellectual curious, open minded, operational agile, and culturally adaptable.

Inevitably, we will be forced over the next few months and years to question conventional wisdom, as well as long-standing analytical and operational short cuts—and we should be ready to do so. Benchmarks will need to evolve further, and investment guidelines will need to be updated.

We will all be challenged to be more global, and to find better way to compare and contrast a growing number of changing market segments.

It is critical that we all step up to this challenge. It is a key fiduciary responsibility that we owe to those who have entrusted us with their savings, pensions, investments and retirement funds. It’s a responsibility that must be met to the best of our ability.

It is also an important social responsibility. Remember, the global fixed income markets play a key role in mobilizing and allocating capital around the world. In the process, they impacts investment, consumption and employment. Most fundamentally, they impact the welfare and well beings of billion of people around the world. (…)



Exactly two years ago (see my record), I shed my bear fur amid almost unanimous gloom and doom. Now that the bull ranks are growing, it may be wise to have it handy. Fashion can be fickle …

After the most unpopular doubling in equity prices in history, bears are finally coming out of hibernation realizing that fashion, under the apparent influence of Ben Bernanke’s magical QE2 frock, has evolved from bear fur to bull skin. Whether this is real or artificial overcoat, or even smartly inflated rawhide, remains subject to much debate among the academic community, but it has again become socially acceptable, if not desirable, to have a positive views of equities.

Why have the bears been so wrong?

  • Profits have strongly recovered. The S&P 500 quarterly EPS went from $-0.09 in Q4 2008 to $21.94 in Q4 2010, a mere 9% below the all-time high ($24.06) reached in Q2 2007. US corporate productivity has once again prevailed over weak economic growth.
  • Inflation has declined from more than 5% in mid 2008 to 1.6% last January. Core CPI is below 1.0% compared with 2.5% in mid-2008.
  • US interest rates have declined from about 4.0% in mid-2008 to 3.5% on 10-yr Treasuries. T-Bill rates went from 2% to almost zero in the meantime.
  • The Fed and many other central banks flooded the economy with liquidity. This became especially obvious after Bernanke’s Jackson Hole speech in late August 2010 after double dip fears had pulled equities down 17%, jeopardizing Bernanke’s wealth effect strategy. Bond investors got the cue and money migrated into equities as it became obvious that the Fed was going all-out to boost the economy even at the risk of creating inflation down the road.

Bears find it convenient to credit QEs for “artificially” boosting equities but they neglect the fact that, surprise, surprise!, profit growth has been the critical driver of the rally. Even since the August 25, 2010 Jackson Hole speech, after which the S&P 500 Index staged a spectacular 26% advance, trailing EPS have grown 16%.

Of particular interest is the amazing notion that US equity markets might now be “reasonably valued” at 15.6x trailing earnings after having been “overvalued” 12 and 24 months ago when prices were 50% lower! What Nouriel Roubini once called a “sucker rally” sure has changed viewpoints and attitudes, including his own.

In reality, equity investors have enjoyed significantly undervalued markets throughout the last 2 years. Moreover, the factors causing the undervaluation were pretty clear and reasonably safe. This is no longer the case. While equities remain undervalued, valuation risks are creeping up at a rapid pace.

Nouriel Roubini has recently justified his skin mutation on the fact that profits are very strong and that “some (economic) things are going well”.

He is quite right on profits although (1) he is, again, backward looking and (2) using trailing profits, as I generally do, makes this a moot point.

He is also quite right on improved economic “things”, although this is not necessarily bullish. In fact, a meaningfully better economy is one of the developing risks for equity valuation.

For 2 years, the main attraction of US equities, from a risk standpoint, was its low inflation-adjusted PE multiple. The time-tested Rule of 20 stipulates that fair PE is 20 minus inflation. As long as inflation stayed below 2.0% without deflating, fair PE on trailing earnings was 18-19; yet the actual PE remained substantially below fair PE all along, substantially eliminating valuation risk from the investment decision. Given the weak Western economies and the significant slack in resource utilization, inflation risk in the fair PE equation was insignificant.

This has changed.

I did a graphical analysis of inflationary risks in my Feb. 23rd post CORE INFLATION RISING AT THE CORE  which set the picture on core inflation pretty clearly: it is rising just about everywhere in the world. Even in Japan, the land of the rising sun and falling prices, core CPI has turned positive (6-month annualized rate) after 10 years of deflation. In the US, the Cleveland Fed’s work on inflation trends indicate that the underlying trend in core CPI has troughed at 0.6% in early 2010 and is now 1.8% and rising. Most PPI, ISM and other PMI data (manufacturing and non-manufacturing) point to rising core inflation around the globe. China, the source of global deflationary trends for the last decade, has exhausted its own cheap resources and is experiencing rising price pressures throughout its economy. US import prices ex-fuels have increased at nearly 8% annualized in the last 3 months and the weakening US dollar is compounding the problem.

Add the fact that non-core inflation (food and oil) is not only meaningfully curbing discretionary purchasing power around the world, it is also threatening to morph into core as the various supply/demand factors “temporarily” impacting food and energy prices could stick around for a while.

Most economists, including Fed officials, are brushing the risk aside arguing that the output gap and unemployment are too high at this time to worry about inflation. It may be early to worry about a serious inflation bout. However, the investment world is often moving on second derivatives (remember the green shoots).

  1. It is always calm before the storm and things often start slowly but can gather momentum. Look at the US economy: eUnemployment rateven Roubini now sees “things” going well there. Look at US employment: it is now showing much livelier signs. What is to say that the unemployment rate could not decline enough during 2011 to create some wage pressures in some critical areas (like is currently happening in technology). Many factors are in fact suggesting that the US full employment rate is no longer 5.0-5.5% but rather about 6.5-7.5%. The US unemployment rate has dropped from 9.8% in November 2010 to 8.9% last month, the largest decline in over 50 years in spite of still feeble employment creation.
  2. Core inflation does not need to get very high before it begins impacting equity valuation levels. Under the Rule of 20, each 1% change in the inflation number changes fair value by about 5%, not a big deal after a 100% jump in prices, but significant if what we can expect from here is closer to the historical 8-10% norm.
  3. The Rule of 20 has been constructed using total CPI. It does makes sense to use core CPI when total CPI is impacted by a reasonably clearly temporary phenomenon. But it is far from certain that recent jumps in world energy and food prices are only temporary flares. US Treasury yields may be pricing in some permanency in these recent price moves. January’s total CPI was 1.6% vs 1.0% for core but the last 3-month annualized rate was 3.6% vs 1.6% for core CPI. The risk to equity valuation is rising rapidly.




At 1325, the S&P 500 Index PE stands at 15.9x trailing earnings. Investors using the conventional 10-20x PE range have already crossed the 15x median PE slightly into overvaluation territory. These investors may be concerned about rising inflation, but they have no objective tool to adjust their assessment of “fair” PE. The Rule of 20 provides such a tool, enabling disciplined investors to adjust their portfolio as the risk/reward ratio changes.

As the chart below shows, the Rule of 20, using 2.0% inflation, says that equities are still in attractive valuation area, 12% below fair value at current trailing earnings levels.


But this is a static image while “things” are moving rapidly with many parts in simultaneous flux. The most immediate concern is inflation where the risk balance has suddenly shifted from the downside (deflation) to the upside. Inflation or inflation expectations moving from 2% to 3% in coming months would have two adverse impacts on equity markets:

  1. PE levels would decline at least 5%.
  2. The economic outlook would begin to incorporate monetary policy actions to fight the growing beast. Profit expectations would likely be discounted. Equity investors would be doubtful that faster profit growth could offset the PE discount.

Corporate profits have strongly benefitted from all the stimulus packages and monetary easing around the world since 2009. These have helped restore revenues while costs remained stable or even declined, resulting in a spectacular profit recovery. Trailing earnings, which had collapsed 57% in the 9 quarters between June 2007 and September 2009, took only 5 quarters to recover it all but 9%.

But this great ride is also over.

  • The huge productivity gains enjoyed so far are in line with historical recoveries but, as the WSJ’s Mark Whitehouse clearly demonstrates below, wage rates have not risen in a normal fashion, substantially fattening operating margins in 2009 and 2010:

From mid-2009 through the end of 2010, output per hour at U.S. nonfarm businesses rose 5.2% as companies found ways to squeeze more from their existing workers. But the lion’s share of that gain went to shareholders in the form of record profits, rather than to workers in the form of raises. Hourly wages, adjusted for inflation, rose only 0.3%, according to the Labor Department. In other words, companies shared only 6% of productivity gains with their workers. That compares to 58% since records began in 1947.


  • Briefly stated, the jobless recovery has also been the “marginfull” recovery. But as shown by the charts above, courtesy of Gluskin, Sheff, we have likely exhausted the productivity gains for this cycle. The February employment report confirmed that the private sector is resuming hiring which can only hurt productivity in the next little while. We can also expect wage rates to recover, further squeezing corporate profit margins.
  • I have examined how S&P 500 profits behaved following each of the recoveries in Mark Whitehouse’s above WSJ analysis. Profits continued to grow nicely in 5 of the 8 periods. However, following the 1982-83 recovery, the only other period when wage trends id not follow productivity gains, profits essentially stagnated until the end of 1986.
  • Profit expectations remain quite strong. Estimates are for 2011 profits to grow 15% to $96.19 with Q4 2011 EPS rising 18% YoY. The risk of negative surprises has clearly increased. Costs are rising fast and it is doubtful that revenue growth will accelerate enough to maintain operating margins at their current high level. As investors become increasingly nervous about fiscal and monetary policies in the face of rising inflation, negative earnings surprises would obviously hurt equities.
  • Quarterly EPS have already leveled off recently: quarter over quarter, 2010 profits rose 12.9% in Q1, 7.8% in Q2, 3.1% in Q3 and 1.8% in Q4.


US equities remain undervalued but the gap to fair value has narrowed to 12% (vs 41% in Feb. 2009 and 24% in August 2010) and there is now risk to the inflation assumption in the Rule of 20 equation, as well as potential negative earnings surprises. The “easy” ride is over!

  • Beware of the rising chorus in favor of equities.
  • Do not use estimates in valuing stocks. Rising costs and lower productivity are seldom factored in analyst estimates, especially at turning points.
  • Control your aggregate beta as volatility will increase.
  • Watch inflation trends ( has a nice INFLATION WATCH “spotlight” that provides continuous monitoring of inflation trends).
  • Watch the bond market for inflation expectations. Bond investors spend a lot more time scrutinizing inflation than equity investors do.
  • Do not believe people saying that equities are good in inflationary periods. Central banks will not allow inflation to settle in; the bond vigilantes will not allow central banks to “settle out”.


Risks, Hedges and Opportunities: Middle East and North Africa (MENA)

Managing an investment portfolio around geopolitical risks is difficult. Most of the time,  markets pay little attention to long term geopolitical risks until events of systemic
economic, political and financial significance erupt. The big reason is that disruptive events are only remote possibilities and not usual probabilities. They are, therefore, not predictable.

The second big reason is not that investors do not have historical models to understand geopolitical crisis. The problem is that history is too often segregated into narrow fields without a broad overall view necessary to connect all of the diverse strands.

The third big reason is that investors are, for the most part, only casually informed about applied politics, economics and international relations. Another big reason is that most investors are only good with simple extrapolations of past trends. They are terrible when it comes to abrupt events.

That is why it is not simple to make accurate predictions about disruptive future events.
Economists failed to predict credit crises, political scientists to foretell rebellions, the
government intelligence to avoid terrorist attacks and seismologists to forecast earthquakes. Philip Tetlock, a philosophy professor at Berkeley, wrote a widely acclaimed book named Expert Political Judgement in 2005 that made two very wise observations.

Firstly, those who make forecasts about events that can interrupt the orderly course are almost always wrong. It means that those who make them are not much better than making them by chance. Secondly, experts can  be separated into two groups, hedgehogs and foxes, an idea first suggested by Isaiah Berlin’s essay on Tolstoy in 1953.

Hedgehogs hold headstrong ideological opinions that infrequently change while foxes express nuanced opinions that change quickly with new evidence. Hedgehogs are more likely to predict big disruptive events like the current major uprisings in MENA. They forecast tenaciously that something big will happen for a very long time until it happens. Foxes make incremental and frequent forecasts in response to incoming data points.

Tetlock showed that neither the foxes nor the hedgehogs have the upper hand but, on balance, foxes seem to do better. I suspect that knowing one big thing is about the same as
knowing many little things or the other way around.

Given the current turmoil in the Middle East and North Africa, the foxes would argue that the situation is elevating the Iranian, energy, inflation, recessionary and political risks. The hedgehogs would quote the powerful political J-Curve phenomenon that stability dips as countries move from closed to open societies. In any case, I would not want to be caught with my pants down without any energy investments to protect my portfolio. It enhances the economics of North American oil and especially the Canadian Tar Sands. Imagine a rebellion in Saudi Arabia!

One should not separate the global oil complex from world politics for too much oil comes from unstable regions. The Islamic regions face competing ideologies, natural resource scarcities, historical grievances, intense subliminal frustrations, huge income inequalities and lack of economic dynamism. The situation looks calmer at the moment, but regime changes in MENA can only be a turbulent transition. It may take many more uprisings over many more years before any of these countries can turn into truly open and stable societies. Yet, the direction is good and welcome.

Hubert Marleau, Chief Investment Officer

Palos Management Inc.