“Do we need to fire Pimco?”

Thousands of institutional investors, financial advisors and wealth managers are faced with one of the most uncomfortable questions imaginable:

Do we need to fire Pimco? 

Pimco’s flagship fund, Total Return, can be found in allocations everywhere. From pensions to endowments, from 401(k) sponsors to retirement plans, in the accounts of private investors and insurance companies, wirehouse FAs, bank branch brokers, RIAs – Total Return is ubiquitous. It’s got one of the only mutual fund ticker symbols that brokers call out as though it were a stock, as in “Why don’t you just buy the guy some P-Tax”, a shorthand for PTTAX, the call letters of the fund’s A class shares. As the second largest bond fund on earth and largest active one, it’s also extraordinarily widely held, and this is why the news of Bill Gross leaving the firm (or being pushed out) is such a huge story for the industry.

How did Pimco Total Return get so entrenched in the first place?

Our story begins, as it often will, with an amazing track record of outperformance. Put simply, whatever Pimco was doing, for a long time, was working. A potent mixture of market-beating returns, marketing savvy, intellectual leadership for the industry and outsized personality fostered a devotion to the firm and its best-known product. The cult of personality surrounding Bill Gross is unlike anything we’ve seen in this industry since the heydays of Peter Lynch and Bill Miller. The bond fund and its manager have been sold to clients with impunity for two decades. Pimco Total Return has become the IBM of mutual funds, in that “No one ever gets fired” for recommending it.

This reliance on Pimco on the part of asset allocators worked very well for years, and, as a result, it became a standard inclusion into portfolios around the world. The regular investor letters and commentaries from Mr. Gross kept professionals up to date with their designated manager’s ongoing take on the markets and the economy. The ubiquity of Mr. Gross in the media was reassuring for the retail investor and more casual shareholders who were invested through a retirement account somewhere. And once the Harvard endowment’s Mohamed El-Erian re-joined in 2007 to become the second face of the firm, it was almost a fait accompli that Pimco would become gigantic.

The system worked perfectly – Gross would make wagers on the bond markets and interest rate curves while always having something clever or insightful to say about it publicly. And so long as he was delivering an annual return near or slightly above the benchmark Aggregate Bond Index, the money kept rolling in. Gross delivered a 13% total return in 2000, a year during which the Boomers experienced the first real stock market losses of their adult lives. During the next five years, he delivered above-index returns and cemented the franchise’s industry dominance. Pimco’s orders had grown so large that the Wall Street desks who executed them began to refer to the firm as The Beach, as in, “The Beach wants another $16 million in 5-year swaps at one-spot-nine-three.”

So what happened?

In hindsight, of course, the first crack in the Pimco story becomes a glaring one when we look back at it.

In February of 2011, Gross loudly proclaimed his newest big bet to anyone who would listen: Pimco Total Return had taken its allocation to US Treasury bonds down to zero. As recently as the previous December, Pimco Total Return had been carrying as much as 22 percent of its AUM in Treasurys, so this was a radical shift for such a large fund. Gross compounded the move by being extremely vocal about his rationale – he went so far as to call Treasury bonds a “robbery” of investors given their ultra-low interest rates and the potential for inflation. He talked about the need for investors to “exorcise” US bonds from their portfolios, as though the asset class itself was demonic. He called investors in Treasury bonds “frogs being cooked alive in a pot.” The rhetoric was every bit as bold as the fund’s positioning.

It’s really hard to pound the table like this and then be flexible in the aftermath when evidence to contrary begins to surface. Once the market starts to go against a famous manager, and he’s become associated with the wrong trade so publicly, there’s a obvious temptation to dig in deeper or to hunker down. To throw people out of one’s office when they voice dissension. To view the movement of the market as an affront to one’s intelligence or as a debate adversary that must be talked out of its obvious wrongness. For a private investor, this mindset can be dangerous, but for a highly-visible professional investor becomes utterly debilitating. And in 2011, no one was more visible on the rate question than Bill Gross.

Or more wrong.

Gross’s directional bet on bond yields going higher and bond prices going lower was a disaster. In fact, the exact opposite of what he had called for is what ended up happening. Treasury bond yields plummeted from that February 2011 flag-planting moment. Yields on the 10-year Treasury bond had dropped from an earlier year high of 3.75 percent to as low as 2 percent in the summer. By August, Bill Gross was forced to defend himself in public. He admitted to the Wall Street Journal that he had been “losing sleep” over the bet. He called it a “mistake” in the Financial Times a few days later. By that point in the year, Pimco Total Return had underperformed 84 percent of its peers. For the first time in a long time, the Bond King of Newport Beach had begun to look extremely fallible.

This moment is captured in the chart I made below:

pttrx

As you can see, Total Return has pretty much never recovered from this bet, with the brief exception of a fleeting moment in the fourth quarter of 2012. In 2013, Total Return had its worst year ever, a negative 2 percent return, which trailed the performance of nearly three quarters of its peers.

Since the Taper Tantrum last spring, things have gotten tougher for the bond management business in general, but the bleeding of this fund has been especially pronounced: Some $70 billion in net outflows have left Pimco Total Return since its peak AUM of $293 billion in April of 2013. As performance suffered and rate fears began to take hold, the outflows at Pimco Total Return began last spring – and they never stopped.

See the below chart from the LA Times:

pimco total

Finger-pointing is the constant companion of outflows in this industry. Lower AUM means smaller bonuses which mean stressful conversations at home and belt-tightening at work. Everyone at an investment organization is miserable when this cycle begins, everybody feels it. That’s when the in-fighting begins and stress fractures within a culture start to show.

Rumors of tensions within the firm began to make their way into the press and it became harder to sort out which were true and which were exaggerations. In February of 2014, things came to a head when the Wall Street Journal’s Gregory Zuckerman and Kirsten Grind ripped the facade away and put out an extensively-sourced piece about the personality clashes within the firm. These arguments over strategy and communication had chased out El-Erian and turned Bill Gross into a sort of King Lear figure within the company. For the first time ever, we were hearing specific snippets of dialog from within the firm and it wasn’t pretty:

“I have a 41-year track record of investing excellence,” Mr. Gross told Mr. El-Erian, according to the two witnesses. “What do you have?”

“I’m tired of cleaning up your s—,” Mr. El-Erian responded, referring to conduct by Mr. Gross that he felt was hurting Pimco, these two people recall.

For investors who had assumed Pimco’s stewardship was rock-solid and its process was unimpeachable, this was a wake-up call. All of a sudden, the $1.9 trillion asset manager looked vulnerable and human. The psychological impact this revelation had on the investing public cannot be overemphasized. Faith in a manager, once shaken, becomes as fragile as any belief system in the presence of too much scrutiny.

Bill Gross’s appearances began to take on an almost performance-art caliber of surrealism. By this time things had come to a head internally in the wake of El-Erian’s departure. The bleeding from Pimco continued. BusinessWeek’s cartoonish Bill Gross cover this April, along with the bizarre keynote speech he did while wearing sunglasses at June’s Morningstar conference were the final straws (see below):

bw cover

BusinessWeek, April 2014

gross sunglasses

Bill Gross deliver his keynote speech at this summer’s Morningstar Conference in Chicago

Advisors who had been (reluctantly) recommending the fund company to their clients and telling people to “stay the course” finally had the excuse to hit the sell button. Firing a manager is extremely difficult for financial intermediaries to justify, the longer that manager has been a part of the recommended strategy the harder it is to do an about-face. But turmoil at the top or a change in PM almost always gives advisors the cover they need to make a change while maintaining the guise of discipline. “Mr. Jones, as you know, we are long-term oriented, patient investors most of the time. However…”

It’s been estimated by Morningstar and others that the events of this past week will lead to Pimco outflows on the order of 15 to 30 percent of the firm’s total assets. Some of the money is expected to follow Bill Gross to his new unconstrained bond fund at Janus. Jeffrey Gundlach’s Total Return product at DoubleLine should also get a big bump, as advisors trade one cult for another and assure their people that Jeff is the real Bond King, the one who got the post-crash period right and with a smaller, more agile fund to boot.

But I think a lot of this fleeing cash will find its way to Vanguard (home of the world’s largest bond fund) or to the iShares / State Street cohort of fixed income index funds. Increasingly, investors will reach the conclusion that whatever alpha a manager may generate, it’s not worth the potential drama.

By recommending a bond manager, even a bond king, asset allocators are inherently putting their stamp of approval on that manager, come what may. And while firing a manager is not the end of the world, there is a limit to how many times you can actually do it. How many times can you call a client and repudiate your own fund picks before the client begins to second guess your expertise? Believe it or not, billions of dollars are currently allocated to bad funds or products because of the very “agency problem” I’ve laid out here. With a bond index fund, this issue goes away immediately.

Many investors will opt to do nothing of course. They’ll point to the new CIO and manager of Total Return, Daniel Ivascyn, and the depth of Pimco’s bench as reasons to stay. “The worst is over and finally the firm can focus on performance again with Gross out of the picture.” They may end up being rewarded for this loyalty in terms of future performance, even if they have to go to great lengths to justify sticking around in the near-term. They may be pilloried for neglectfulness and fired by their clients should the fund continue to falter. Anything can happen.

And so the question of “Do we have to fire Pimco?” will be the predominant topic at financial firms across the country and around the world. Virtually no large pool of assets in this industry is completely Pimco-free, whether we’re talking about Total Return or any of their other funds and SMAs. The issue cannot be ignored because the end-customers of these investors will have read plenty on the topic this weekend and will have questions and concerns of their own. No amount of reassurance from Pimco can change this fact right now.

This is the item that will lead off almost every investment committee meeting on earth tomorrow.

The Dollar’s impact on the S&P 500
Here’s a really key insight from my friend Ari Wald, technical analyst at Oppenheimer Asset Management.
You’re hearing a lot about divergences right now because the internals on the S&P 500, here near all-time highs again, are blatantly bad. The same is going on market-wide. Only 65 percent of the S&P 1500’s stocks are above their 200-day moving averages (or, in strong uptrends) vs the 80 percent reading we saw during the July high.
Two caveats:
1. We’ve seen this divergence before this year, it’s resolved itself to the upside each time as the “market of stocks” eventually caught up with the stock market in the end. Guys fading the market’s price this year because of its internal signals have been repeatedly burned. In some cases, a plunge in stocks above their 200-day moving averages has even been a buy signal, rather than a sign of imminent breakdown!
2. Upon closer inspection, it’s really two sectors driving the weakness – as Ari reveals, oil stocks and commodity names are the reason why there are significantly less stocks currently in an uptrend. He looks at the S&P 1500 above to capture the mid/small markets as well here, but the same applies for the big caps.
Here’s an excerpt from Ari’s research:

We use the % of stocks above their 200-day m.a. as a proxy for the % of stocks in an uptrend, and unconfirmed readings are a concern. For instance, the S&P 500 is out to a new all-time high, but the % of stocks in an uptrend (S&P 1500) has dropped to 65% vs. 80% in July. On closer inspection, Energy (32% fewer stocks in an uptrend since July) and Materials (22% fewer stocks) have been chief sources for this decline in participation as a strong US dollar hasweighed on these commodity-related sectors.

Josh here – as you can see, the 15 percent drop-off in uptrending stocks is being skewed much higher by a handful of sectors. These sectors are being largely impacted by the strong dollar trend. I’d throw in the industrials into this as well – they have to sell their products / services overseas and a stronger dollar makes them slightly less competitive.
The big story of the late summer, early fall so far is the rally in the buck. This just gives you one more reason to follow it.
Source:
Technical Analysis: Inflection PointsOppenheimer Asset Management – September 22nd 2014
Follow Ari Wald on Twitter! Zoom Permalink

The Dollar’s impact on the S&P 500

Here’s a really key insight from my friend Ari Wald, technical analyst at Oppenheimer Asset Management.

You’re hearing a lot about divergences right now because the internals on the S&P 500, here near all-time highs again, are blatantly bad. The same is going on market-wide. Only 65 percent of the S&P 1500’s stocks are above their 200-day moving averages (or, in strong uptrends) vs the 80 percent reading we saw during the July high.

Two caveats:

1. We’ve seen this divergence before this year, it’s resolved itself to the upside each time as the “market of stocks” eventually caught up with the stock market in the end. Guys fading the market’s price this year because of its internal signals have been repeatedly burned. In some cases, a plunge in stocks above their 200-day moving averages has even been a buy signal, rather than a sign of imminent breakdown!

2. Upon closer inspection, it’s really two sectors driving the weakness – as Ari reveals, oil stocks and commodity names are the reason why there are significantly less stocks currently in an uptrend. He looks at the S&P 1500 above to capture the mid/small markets as well here, but the same applies for the big caps.

Here’s an excerpt from Ari’s research:

We use the % of stocks above their 200-day m.a. as a proxy for the % of stocks in an uptrend, and unconfirmed readings are a concern. For instance, the S&P 500 is out to a new all-time high, but the % of stocks in an uptrend (S&P 1500) has dropped to 65% vs. 80% in July. On closer inspection, Energy (32% fewer stocks in an uptrend since July) and Materials (22% fewer stocks) have been chief sources for this decline in participation as a strong US dollar has
weighed on these commodity-related sectors.

Josh here – as you can see, the 15 percent drop-off in uptrending stocks is being skewed much higher by a handful of sectors. These sectors are being largely impacted by the strong dollar trend. I’d throw in the industrials into this as well – they have to sell their products / services overseas and a stronger dollar makes them slightly less competitive.

The big story of the late summer, early fall so far is the rally in the buck. This just gives you one more reason to follow it.

Source:

Technical Analysis: Inflection Points
Oppenheimer Asset Management – September 22nd 2014

Follow Ari Wald on Twitter!

Will Bitcoin Heat Up Again for the Holidays?

When you value a stock, you have many levers you can pull to come up with an answer for “fair value” – whether it’s price-to-book-value or a PE ratio or some sort of discounting of future cash flows. When you value a commodity, you have actual real-world supply-vs-demand dynamics on your side – Will we consume more or less natural gas this year? Are there enough acres of corn planted to meet expectations from food producers?

With something like gold and silver, it’s harder. Because outside of jewelry demand there isn’t much actual use for these metals (we don’t do gold teeth or use silver in photography anymore). These precious metals trade more on an emotional desire to own them given a sentiment consensus about the future among individuals and world governments. Lately, thanks to the ETF financialization of the PMs, there’s an investment component that wags this dog as well.

With Bitcoin, none of these things apply. There’s no need for them nor is there any established supply / demand pattern given the novelty and newness of the thing. As such, there are only technicals – the charted manifestation of who wants in and who wants out. I don’t have volume of transaction data to complement the below price study I’ve done, but it’s still interesting on its own.

The $400 level seems to have some relevance to the Bitcoin marketplace, probably beyond coincidence. I think because the $400 level is where the parabolic rise began around Thanksgiving last year. If you recall, this rise was driven by the huge surge in headlines about retailers accepting BTC for ecommerce transactions during the holiday season. As the holiday shopping season crested, BTC’s price blew up and then blew off. It’s sucked pretty much every month since – but now we’re headed back into that time of year again.

If I were inclined to trade stuff like this, I’d be a buyer here and I’d grow emboldened should it smack $400 again and bounce off as it seems to have done this week. I’d be looking to sell by December as the enthusiasm for BTC purchasing comes and goes. The question for longer-term Bitcoin bulls is whether or not Apple Pay makes it so easy to buy stuff electronically that the idea of mining / storing digital coins and breaking them up for transactions becomes totally ridiculous, other than for narco-traffickers or international arms dealers.

Too soon to have a strong opinion, but this looks like a good risk/reward set-up for the bold:

image

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Buybacks and tradebots

Is anyone trading? Not really. Except HFT players and corporate CFOs executing the buybacks that generate their compensation packages.

You got a 7%+ gain in the S&P this year on basically nothing and for no reason other than float-shrink initiatives that have zero to do with fundamentals. For every Disney, a company that is truly killing it right now, there are a dozen stagnant names masking slowing growth with a smaller overall pie to spread profits across.

If IBM and McDonalds were trading on the actual condition of their respective businesses, the Dow would be 500 to 1000 points lower.

But they’re not, and this is why short-term price predictions based on fundamental research are moronic, generally speaking. Because this is not at all unusual. Distortions based on non-fundamental factors are a permanent feature of both bull and bear markets. 1 +1 doesn’t equal 2 in the short run.

Back to Buybackpalooza…

Wall Street Journal (emphasis mine):

Corporations bought back $338.3 billion of stock in the first half of the year, the most for any six-month period since 2007, according to research firm Birinyi Associates. Through August, 740 firms have authorized repurchase programs, the most since 2008.

The growth in buybacks comes as overall stock-market volume has slumped, helping magnify the impact of repurchases. In mid-August, about 25% of nonelectronic trades executed at Goldman Sachs Group Inc., excluding the small, automated, rapid-fire trades that have come to dominate the market,involved companies buying back shares.

According to Barclays, companies in the second quarter spent 31% of their cash flow on buybacks, the most since 2008 and up from 14% at the end of 2009. At the end of the second quarter, nonfinancial companies in the S&P 500 index held $1.35 trillion of cash, down from a record of $1.41 trillion at the end of last year, according to FactSet.

LOL.

If no one’s involved with the market directly – apart from buybacks and tradebots – then theoretically whatever sell-off may come should do very little damage to the real economy.

Comforting, a little.

Source:

Companies’ Stock Buybacks Help Buoy the Market (WSJ)

Photo credit: andreavallejos

Making snap judgments about Apple product launches

Here’s the stock market’s reaction to Apple’s massive roll-out of all new products and platforms today (via MoneyBeat):

Shares surged as much as 4.8% to $103.08, pushed close to a fresh record high, and at one point, was on track for one of its best days of the year. The rally contrasted with Apple’s previous product announcements, when the stock usually fell after the unveiling of new offerings.

UPDATE: Shares reversed course and dropped late in the trading session, falling by more than 1%.

LOL @ “reversed course”. As if there’s a course to begin with. It’s monkeys rattling their cages, tormented by emotion, armed with half-truths and misinformation, wracked by the need to do something, anything, in the presence of a new burst of stimuli.

I used to be in that game – making stuff up in my own head to justify why this or that stock should go up or down in the next few minutes, trading headlines with instant reactions and so forth. The further I get away from it, the harder it is not to laugh at the ridiculousness of the whole thing.

As if the people reacting at either 2pm or 4pm or at any point between even have the faintest idea of the import (or lack thereof) of what’s just been announced.

I don’t know if these new phones, the watch or the payment system will be world-changing or just an incremental win or loss for Apple. What I know for a fact is that anyone wagering big in either direction this early has absolutely no idea either. But I’m sure they’ve assured themselves that they do.

The hysteria in both directions today reminded me of this now-classic Seeking Alpha post, published the day after Apple’s initial rollout of its first-gen iPad in early April 2010:

Amazing, especially that last “pretty sure” part. To be “pretty sure” of anything in the seconds and minutes after something like that comes out? Based on what? Nothing.

By the time that blogger’s post was published, Apple was tabulating sales figures. It turns out the first iPad had been completely sold out in its first day in the stores, not even counting all of the pre-orders that had flooded into Apple beginning in March of that year. iPad has gone on to sell over 200 million units cumulatively since then.

Sometimes you’re allowed to not have such a strong opinion. Sometimes you can stay quiet and just digest, see how things shake out. Listening to people carry on about how they’ll “never wear a smart watch” or how they “can’t imagine anyone paying $500 for a phone!” is embarrassing. Maybe they’ll be wrong, maybe they’ll be right, but definitely they don’t know. No one does.

Go read about Ford’s can’t-miss launch of the Edsel in the late 1950′s if you want to see just how persistently hard these kinds of things have been to call throughout history.

Snap judgments and table-pounding predictions about something totally new like iPad, ApplePay, the iWatch, the iMac, the iPod, the smartphone etc are utterly ridiculous. Make a few of these calls and then find out how little you know. I sure have.

And as to the ol’ “wisdom of crowds” nonsense…give me a break. How many more episodes like this do we need to see before we end this deification of markets business altogether?

The emperor has no clothes and the crowd has no clue.

Photo Credit: Kevin Krebs

2015 will be the year of the stockpicker

2015 will be The Year of the Stock Picker, the year that professional active management makes its long-awaited comeback.

I feel pretty confident in making this forecast. Mostly because if it doesn’t happen, I can just roll it over into 2016, with a whole new set of reasons.

In 2013, something like 98 cents of every dollar of inflows to US stock funds went to Vanguard or a passive index product. In December, we were told that with almost no one attempting to pick winning stocks anymore, this would bring about an excellent climate for active managers in 2014. Furthermore, the drop in correlations meant more dispersion of returns between stocks – another boon for the stock selecting managers, who would surely be able to identify and benefit from owning the best names.

Bob Doll told my writing partner Jeff Macke back in January that this was going to be it! After a five year stretch during which 77 percent of active managers trailed their benchmarks, 2014 would mark the turning point:

Doll says this is finally the year when active managers start making up for lost ground. In the attached clip, Doll makes his case that 51% of active managers beating the market in the 3rd quarter was the start of something big. His argument starts with the high correlation between stocks over the course of the rally of the last 5 years. More than 400 of the 500 members of the benchmark S&P rose last year.  Active management is based on the idea of discriminating between companies and industries. When everything moves in the same direction any fees and friction lead to underperformance.

Only it hasn’t worked out that way.

2014, when all is said and done, may in fact turn out to have been one of the worst years for active management of all time.

We’ve been talking about this abysmal showing all year here on The Refor`med Broker. In August we mentioned that only 25 percent of US stock fund managers were ahead of the respective benchmarks. But it’s somehow gotten even worse.

Here’s Goldman Sachs vis Steven Russolillo’s MoneyBeat column:

Only 23% of large-cap mutual fund managers have outperformed the S&P 500 this year, rivaling the worst performance in the past decade, according to David Kostin, chief U.S. equity strategist at Goldman. By comparison, about 37% of fund managers have outperformed the benchmark since 2003. Only performances in 2006, 2010 and 2011 have been as bad or worse than the current year’s pace.

goldman

Why is this happening?

The explainers are out in force. Here’s Suzanne McGee at the Fiscal Times with a fair description:

We’re caught in the kind of market that only the most agile of traders can love. It is one characterized by rapid shifts in direction, a lack of clear leadership, inconsistent economic data and general confusion about what’s going to happen next. In other words, it favors those who are willing and able to take short-term positions and switch them at a moment’s notice.

For obvious reasons, this is not what the majority of active managers are able (or willing) to do in the mutual fund complex. That kind of activity is better left for traders who want to chop their own money to pieces, not for pros who have a responsibility to others.

I have some trader friends who are doing really well this year in the stock picking arena – they’ve focused on areas like tech and biotech that have been chock full of winners. It can be done. Just not by the majority of people – even among the best and the brightest. While the majority of stock picking mutual fund managers struggle, their more highly compensated brethren in hedge fund land aren’t doing much better, with the average fund up just 2 percent year-to-date – but that’s just par for the course.

In the meantime, the S&P 500 is up close to 9 percent including dividends, US small caps are up just under 2 percent and the bond indices are all higher as well (especially the long-bond). Developed International stocks (Europe and Japan) are flat and Emerging Markets are crushing it, up mid-teens on the broad average and much more for some specific countries. With performance like this, for the basic and broad asset classes, it’s a total non-sequitur that anyone should feel as though they need (or are entitled to) more.

They’re not getting it, in most cases, in 2014.

Maybe 2015 will be the year it all turns around!

Photo Credit: MIchael Becker

Where are the wage gains?
Bank of America Merrill Lynch put out a tidbit on the “downward wage rigidity” suggesting that this cycle has been very abnormal in terms of wage gains. Historically, a drop in unemployment meant a quicker uptick in how much employers were willing to pay in raises to retain workers. My partner Barry went into detail on this topic for our monthly client letter yesterday. Suffice it to say, the labor market is doing just fine, but would “feel” considerably better if this last component of recovery – bigger paychecks – would finally materialize.Here’s Ethan Harris & Co of Merrill’s global economics team:More jobs, no pay increases: A recent paper from the San Francisco Fed argues that if wage growth is already low and there is a major recession, many companies will face a choice of either cutting workers or cutting wages. Those who choose to hold the line on wages, end up paying the workers more than they would like, resulting in “pent-up” wage deflation. Hence, when the recovery occurs, they will not raise wages initially, but will wait until higher wages are fully justified. The data suggest that downward wage rigidities are particularly severe in this cycle. The share of workers reporting no changes in nominal wages is currently 16%, up from 11% prior to the crisis. This is historically high and has remained notably elevated despite the drop in the unemployment rate.
Josh here – no wage gains, no inflation – at least from where I sit.Source:A boost from constructionBank of America Merrill Lynch – September 3rd 2014 Zoom Permalink

Where are the wage gains?

Bank of America Merrill Lynch put out a tidbit on the “downward wage rigidity” suggesting that this cycle has been very abnormal in terms of wage gains. Historically, a drop in unemployment meant a quicker uptick in how much employers were willing to pay in raises to retain workers. My partner Barry went into detail on this topic for our monthly client letter yesterday. Suffice it to say, the labor market is doing just fine, but would “feel” considerably better if this last component of recovery – bigger paychecks – would finally materialize.

Here’s Ethan Harris & Co of Merrill’s global economics team:

More jobs, no pay increases: A recent paper from the San Francisco Fed argues that if wage growth is already low and there is a major recession, many companies will face a choice of either cutting workers or cutting wages. Those who choose to hold the line on wages, end up paying the workers more than they would like, resulting in “pent-up” wage deflation. Hence, when the recovery occurs, they will not raise wages initially, but will wait until higher wages are fully justified. The data suggest that downward wage rigidities are particularly severe in this cycle. The share of workers reporting no changes in nominal wages is currently 16%, up from 11% prior to the crisis. This is historically high and has remained notably elevated despite the drop in the unemployment rate.

Josh here – no wage gains, no inflation – at least from where I sit.

Source:

A boost from construction
Bank of America Merrill Lynch – September 3rd 2014

How corporate share buybacks are destroying America

Profits Without Prosperity, an incredible article at the Harvard Business Review, shows exactly how corporate share buybacks have gotten out of control in the last decade. It then goes on to point out the various ways in which buybacks-gone-wild are killing the capital formation process in America, holding back the investments needed to keep us competitive and decimating the middle class workforce that actually built this country.

The evidence is presented by William Lazonick, professor of economics at the University of Massachusetts Lowell, and one of the nation’s foremost experts on corporate buyback activity. Having studied the subject for some three decades, Lazonick concludes that an SEC rule rewrite in the early 1980′s meant to drive Value Creation has instead ushered in an era of Value Extraction – wherein an increasingly smaller group of corporate executives and hedge fund managers reap an increasingly larger share of the productivity benefits of the economy.

For example, buybacks and dividends – which serve to drive compensation higher, enriching shareholders while diverting resources away from investment and innovation – accounted for over 75 percent of net income for long-time S&P 500 member companies last year. Contrast that with the retain-and-reinvest model that the economy ran on from the end of World War II to the end of the 1970′s, in which corporations were much less preoccupied with “maximizing shareholder value” and padding CEO salaries.

The chart above illustrates this point starkly.

Lazonick writes:

Since the early 1980s, when restrictions on open-market buybacks were greatly eased, distributions to shareholders have absorbed a huge portion of net income, leaving much less for reinvestment in companies. (Note: Data are for the 251 companies that were in the S&P 500 Index in January 2013 and were publicly listed from 1981 through 2012. If the companies that went public after 1981, such as Microsoft, Cisco, Amgen, Oracle, and Dell, were included, repurchases as a percentage of net income would be even higher.)

Josh here – No one is denying that stock prices haven’t gone up as a result of this trend. The claim, however, is that much more value has been extracted as a result of this than has been created for the real economy and other stakeholders – like taxpayers, employees and society at large.

You may not agree with all of Lazonick’s points or his prescriptions for a better way forward, but I guarantee this piece will change the way you think about how markets are currently working and whom they’re actually working for.

Find the time to read it (free registration may be required, just do it):

Profits Without Prosperity (Harvard Business Review)

The financial advisor’s challenge

The hardest part about what we in the advice business do is managing investor expectations and behavior. The other stuff may be more interesting or get lots of attention – but it’s largely secondary. My friend James Osborne did an important post about asset allocation last summer that got me thinking more about this topic today.

Thanks to quantitative databases filled with market stats, software programs brimming with options and spectacular advances in asset management products, the portfolio allocation part is much easier than ever before. We can all create models or use the portfolios of outside managers and demonstrate their efficacy with a nearly unlimited array of backtesting and projection tools.

This is an age of miraculous efficiency, unprecedented innovation and incredibly democratized market knowledge.

But that’s the fun part. That’s not the challenge.

The real challenge is keeping our clients from acting on their worst instincts. It’s keeping the Recency Bias in check, the performance-chasing impulse restrained and the grass-is-greener wolf away from the door. Easy in theory, hard in the real world.

If we can do these things day-in and day-out, with the vast majority of our practice, we are going to be successful advisors whose clients are able to retire and fund their hopes and dreams.

If we cannot, then our clients will fail and, eventually, so will we.

It’s very simple.

I don’t care how “optimized” our models are or how much math we have behind them – if we can’t keep our clients in them, what’s the difference? A fantastic portfolio that our clients can’t stick to is worthless, we may as well be throwing darts at ETFs.

It won’t merely be the depth of the next sell-off, but the duration of it that will give us the most trouble. Investors will have the urge to sell or to trust the first charlatan they hear crowing in the media about how they called the top. They’ll be drawn to strategies and funds that happened to have done well in a short period of time because they will be convinced that they offer “the answer” – all of the upside, none of the downside. They will second-guess everything that once made sense to them once the old stress fractures of the market become visible again. They will forsake the data that tells them not to act rashly, opting instead for whatever seems to be the quickest fix – a move to cash, a move to gold, a Black Swan fund…anything!

They will, once again, ignore history and even common sense. They will forget all about the things that matter and the time frame that is relevant.

They will, in short, behave as investors always have since the beginning. And in some cases, it will cost them everything.

The automated (robo) advisors will run into this problem during the next downturn, as will I and virtually all of my industry peers. Our responses will be all over the map.

Some advisors will emerge from this period having done more for their clients than others. Some will fight the tide and work their asses off on education and communication to get their clients through. Others will fail. They will rely on email blasts or try to run out the clock or even worse – they’ll give in to the worst requests and demands of the clients they’ve sworn to protect. They’ll violate a sacred trust in the name of expediency, allowing investors to work against themselves out of a misplaced fear of “losing the relationship.”

It’s best to start thinking about this sort of thing now, in the salad days, and to be preparing ourselves for the inevitable. Even if it doesn’t begin this year or next. It’s coming. How we prepare our practices and our people in advance will be critical.

This is the challenge. This is how advisor fees are either earned or not.

Portfolios are now free – valueless. Advice, on the other hand, is invaluable – but only if it’s delivered with meaning and when it counts.

Photo credit: pikadilly

“Millennials don’t care about money”

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The New York Times is out with its latest catch-all piece on how strange and different the millennial mindset is from the rest of the nation.

I straddle the fence between Gen X and the millennials; born in ’77, I have way more in common with the millennials than with the “slackers” and Gen-X’ers who were born in the early 1960′s and think Caddyshack is the pinnacle of comedy.

From my vantage point, I can tell you that some of the insights shared in the piece are spot-on while others confuse a difference in ages for a difference in attitudes.

Take this howler, which you’ve probably seen repeated elsewhere in some version or another:

Consider the approach many take to the workplace. Thanks to the 2008 economic crash, millennials know how fleeting wealth can be. Their solution? For many, it is to acquire not more, but less.

“Almost two-thirds (64 percent) of millennials said they would rather make $40,000 a year at a job they love than $100,000 a year at a job they think is boring,” the Brookings Institution recently noted in a report by Morley Winograd and Michael Hais titled “How Millennials Could Upend Wall Street and Corporate America.”

This is clever but misleading. Those “almost two-thirds” of millennials also don’t have children of their own yet, nor do they have mortgages in most cases. In general, they are in their twenties and responsible to no one but themselves – for the moment. Call me when that changes and tell me if they’re any different from any other generation before them, in the aggregate.

They won’t be.

And once this generation hits its mid-30′s, we’ll finally see the all-important household formation process kick into high gear – perhaps the only thing that will truly rescue the economy, the one ingredient that’s been missing so far.

I think this will happen, despite all the zeitgeist articles about how millennials don’t care about money and just want to be able to pogo-stick their way to the open-plan, non-traditional office space so they can hack-a-thon all night on their wireless devices, fueled by energy drinks and dreams of a sequined hoodies. It’s largely nonsense.

Besides, this is a generation whose most notable cultural icon is the mega-billionaire uber-capitalist hustler Mark Zuckerberg, not Jack Kerouac or John Lennon or Kurt Cobain. Let’s stop pretending that people born between 1980 and 2000 have some kind of mythical, altruistic ethos that frees them from the shackles of need and want that the rest of us have been encumbered with since the dawn of time.

Give it a rest.

Photo credit: Moyan Brenn