Is optimism the same as realism?

Wolfgang Munchau, columnist for the Financial Times, wrote in a recent article that one should wake against some complacency that the financial and economic crisis will give way to a speedy recovery process, which financial markets may have started to discount in recent months.

Last week, the green shoots shrivelled. In South Korea, China and Germany, exports were declining once again. In the US, the Federal Reserve’s Beige Book said “economic conditions remained weak or deteriorated further during the period from mid-April through May”.

The March signs of revival turned out to be little more than a technical inventory correction, with no change in the underlying trend. The world economy is still contracting, though perhaps not quite as fast as at the start of the year.

Global industrial output is still on the same trajectory as it was during 1930. The only question is whether we can avoid 1931 and 1932. The answer is yes, but on conditions that seem increasingly implausible if we extrapolate current policies. We can avoid calamity if monetary and fiscal policies remain supportive throughout the duration of this crisis, if we fix the banking system and if we impose regulations to constrain a resurgent financial sector. We also have to be lucky to avoid another round of market turbulence in the near future.

In other words ... the answer may well be no. Central banks and governments therefore risk moving too swiftly out of a recession-mode strategy. When the president of the Bundesbank, Axel Weber, publicly talks at this time about how to communicate a rise in interest rates, it tells me that the danger of a premature exit, at least in Europe, is clear and present.

Nobody is solving the toxic asset and recapitalisation problems of the banks. Financial regulation does not seem to be extending much beyond populist pseudo-measures on tax havens. Plus there is still financial meltdown potential in the system. Latvia, for example, is a ticking time bomb.

So at this point, I see the chances as roughly even between a global slump and a return to quasi-stagnation. What is so galling about this scenario is that it is avoidable. The central banks took the right decisions. But the political reaction has been near-catastrophic almost everywhere.

Instead of solving the problems to generate a recovery, the political strategies have consisted of waiting for a recovery to solve the problem. The Europeans are relying on the Americans to generate growth. The Americans are relying on the Chinese, who in turn are waiting for the rest of the world.

Even if the US were to generate some growth, as is likely after this summer, it would not benefit global exporters; China may be one of the fastest growing economies in the world, but it is only about half as large as the eurozone in dollar terms. While Chinese investments are up by more than 30 per cent from last year alone, imports are down 25 per cent. All this hype about decoupling and China pulling the world out of recession is baloney. The data tell us that China’s exports and imports are both falling, and that imports are falling faster.

As everybody expects the others to move first, nobody ends up moving. In the meantime, the problems grow worse. US house prices, which are down by a little over 30 per cent from their peak, still have some way to fall. Until the US housing market hits rock bottom, perhaps sometime in 2010, there is no chance of a recovery in the securitisation market, without which there may not be sufficient credit growth.

As the recession continues, the number of personal and corporate insolvencies will rise, which in turn will aggravate the problems of the banking sector. I am not surprised that the Bundesbank’s Mr Weber resists the publication of stress tests for the banking system. It would show that the German banking system was insolvent – and that bad and potentially bad assets were equivalent to about one-third of gross domestic product.

This is why last week’s news about the withering green shoots is so important. It tells us that the non-strategy of waiting until things get better is not working. The March signs of life reinforced complacency. Optimism will get us out of this crisis only if it is founded in reality.

Getting rid of TARP...

Financial Times reported today that the US Treasury has announced that it would allow 10 banks to repay government aid because they raised sufficient capital.

The Treasury will recoup $68bn, much more than it had originally expected, if the banks choose to return the full amounts that they received. The swift return of the funds is a sign that some stability has returned to a sector that was stricken last year and could restore confidence in US banks.

“These repayments are an encouraging sign of financial repair, but we still have work to do,” said Tim Geithner, US Treasury secretary, said in a statement.

The Treasury did not reveal the names of the banks that are now eligible to begin the first wave of repayment. But people familiar with the matter said that the nine banks, all of which passed last month’s government stress tests, included JPMorgan, American Express andGoldman Sachs, plus Morgan Stanley, which had a capital shortfall. Northern Trust, BB&T, State Street, US Bancorp and Capital One Financial will also make repayments, according to people familiar with the matter. Morgan Stanley said it would be repaying its $10bn with “an attractive return for taxpayers.”

U.S. job losses continue, but at a slower rate

Unemployment figures are the key how deep the current global recession will be. Even if there are early signs of economic recovery, continued job losses will change the sentiment and confidence to dark pessimism.

Financial Times reported on the latest U.S. unemployment data as follows:

The US economy shed 345,000 jobs in May, bringing the unemployment rate to a 26-year high of 9.4 per cent, but offering a clear sign that the pace of job cuts is slowing.

The latest non-farm payrolls data were much better than the drop of 525,000 that economists were expecting and was nearly half of the average monthly decline during the last six months. Although the number remains painfully high, it is a sharp improvement from April’s revised 504,000 and offers hope that the economy’s free-fall could be ending.

Much of the May improvement was driven by a rise in education and health service jobs. The manufacturing sector continued to be hit hardest, shedding 156,000 workers, while construction lost 59,000 jobs - nearly half of what was lost in April - and professional and business services lost 51,000.

Since the recession began in December 2007, 7m jobs have been lost and the unemployment rate has climbed by 4.5 percentage points, leaving 14.5m Americans without jobs. Companies have been forced to slash their payrolls to cut costs in the face of falling demand for their goods and services.

Friday’s figures still provide a reminder that the stricken labour force will likely have a longer road to recovery than other parts of the economy. Movements in the labour market tend to trail the rest of the economy by several quarters, and economists predict more job losses and rising unemployment to come.

Last month the Congressional Budget Office said that while the US economy is likely to start growing again in the second half of this year, unemployment is expected to keep rising through 2010 to peak at more than 10 per cent. Barack Obama, US president, has argued that the $787bn stimulus bill will save or create 3.5m jobs by the end of next year.

A batch of recent indicators and a healthier stock market have fostered a new sense of optimism that the US economy is beginning to emerge from the deepest downturn since the Great Depression.

A more efficient market index?

Fundamental indexation has hit the investment community a year or two ago with real excitement and huge expectations. But thus far the performances of funds based on this methodology (securities are weighted according to their fundamental (economical) attributes instead of their market cap) have been mixed relative to the conventional indexation strategy.

John Spence of MarketWatch wrote the following story:

With a track record spanning about three years and including a brutal bear market, a new breed of index-based funds is showing mixed results, and the debate about them continues.

The backers of this new style of investing -- often called fundamental indexing -- contend that mutual funds and exchange-traded funds based on the Standard & Poor's 500-stock index , at the core of millions of small investors' portfolios, are flawed. The problem, they say, is that the S&P 500 can become top-heavy with pricey shares by using companies' market value as a way to weight stocks.

Their innovation: funds based on indexes that weight stocks by factors such as high dividend yields and low share-price-to-earnings ratios. They say these funds are less risky and offer a better chance for long-term outperformance.

So how have the ETFs that follow this approach fared?

PowerShares FTSE RAFI US 1000 Portfolio ETF averaged a negative return of 6.7% a year since its December 2005 launch through May 28, versus a negative 7.1%-a-year return for SPDR S&P 500 ETF for the period, according to Morningstar Inc.

For the past 12 months, it returned a negative 30.4%, versus a negative 32.8% for its S&P 500 rival.

WisdomTree LargeCap Dividend Fund has had a tougher time. From its June 2006 launch through May 28, it averaged a negative 9.9%-a-year return; the S&P 500 ETF lost 8.4% a year.

Rob Arnott, founder of Research Affiliates LLC, which created the index used by the PowerShares fund, says the market often values stocks incorrectly, so the goal "is to break the link between a stock's price and its weight." He favors weighting stocks by things like book value, cash flow, sales and dividends.

Research Affiliates readjusts its index annually, shifting the ETF more heavily into sectors where fundamentals are strong but stock prices have fallen. This has the practical effect of loading the index with "whatever stocks are most loathed" and lightening up on "whatever stocks are most beloved," so that investors can benefit "when market mood turns, as it always does," Arnott said.

The most recent rebalancing, in late March, boosted the PowerShares ETF's exposure to financial stocks to about 27% or so from 13% or so, said Jason Hsu, Research Affiliates' chief investment officer. The ETF benefited from the rally in financial stocks in April and May.

Because banks historically have been big dividend payers, the WisdomTree ETF's dividend-heavy focus exposed it to financial stocks during the worst of last year's financial crisis. Even so, the ETF bested the S&P 500 ETF for calendar year 2008, down 35% versus 36.7%.

"Investors need to keep their eye on long-term performance" of at least three years, said Luciano Siracusano, chief investment strategist at WisdomTree Investments Inc. .

In general, WisdomTree's earnings-focused ETFs have fared better than its dividend-weighted ones over the past two years, Siracusano said.

The firm's international dividend ETFs also have performed better, mainly because more international companies pay dividends, so there is a bigger subset from which to choose, he says. To accommodate investors in the U.S. who don't want to bet heavily on the financial sector, the firm recently restructured two of its 34 dividend ETFs to exclude financial shares, he said.

At Vanguard Group Inc., which decades ago pioneered indexed investing for the masses based on the S&P 500, Chief Investment Officer Gus Sauter remains a skeptic of the new methodology. He said it gives a tilt to "value" investing, the hunt for shares that are undervalued.

"My view is that fundamental indexing is a triumph of marketing," he said. "It's a midcap value fund dressed up as something different."

Fundamentals-based indexing beat the S&P 500 during the bear market of 1973 and 1974, and after the dot-com bust of 2000-02, Sauter noted, but not during the tech-stock rally of the late 1990s.

Hsu and WisdomTree President Bruce Lavine say fundamental-indexing strategies aren't designed to outperform in speculative markets. They perform well in other environments, however, especially after bubbles burst, Hsu added.

As measured by money under management, the revolutionaries trail. The PowerShares ETF had about $434 million recently, and the WisdomTree LargeCap Dividend had about $350 million -- compared with more than $60 billion in the S&P 500 ETF

The beginning of a new bull market? No, leading investors don't think so

Barclays Capital found in a recent survey among leading decision-makers and investors that most are sceptical that the current rally is sustainable.

Financial Times reported the following story:

The majority of the world’s leading investors do not believe the recent strong performance of stocks and other risky assets is sustainable. The FTSE All World equities index has surged more than 60 per cent since hitting a low for the year in March.

But Barclays Capital has revealed that just 17.5 per cent of the 605 investors interviewed for its quarterly FX investor sentiment survey – including central banks, asset managers, hedge funds and international corporate customers – think risky assets have further to rise.

This is one aspect of a generally gloomy outlook for the global economy, which undermines optimism that “green shoots” of recovery are starting to emerge.

Just 4.5 per cent of respondents believe the trajectory of the global economy over the next year will be “V-shaped” – indicating weakness followed by a sharp recovery.

The majority, 69 per cent, believe the path of the global economy will be either “U-shaped” or “W-shaped”, meaning that growth will remain weak for some time before a gradual recovery begins, or that a recovery will prove temporary and renewed weakness will set in.

Six out of every 10 respondents believed that the recent rise in equities is a “bear market rally”, indicating that global investors still have a large share of their funds parked on the sidelines in cash. The survey revealed that 91 per cent of investors were running positions that were “light” or “average” in terms of their risk limit or capacity. This leaves just 9 per cent whose positions are “large” or “at limit”.

Investors are most optimistic on Asia’s prospects, with 57.5 per cent believing emerging market currencies in the region will outperform those in Latin America and eastern Europe in the next three months.