Via Nic Colas of ConvergEx Group

There's been a lot of hand-wringing about busted Initial Public Offerings of late, but the process itself is hardly rocket science.  Like Tolstoy's comment about families, every "Happy" IPO is essentially the same, while every miserable one is different in its own way.  There are rules to the successful IPO, and today we offer up Nic Colas' manual, a step-by-step checklist for investors to assess if an offering is on track.  From maintaining the illusion of scarcity to managing company and investor expectations, the road from salesforce "teach-in" to final pricing is narrow but well-marked.

I spent the better part of a decade as a senior U.S. equity research analyst at Credit Suisse in the 1990s, covering the auto and auto parts sector.  This was in many ways the heyday of the equity research function at large investment banks, largely because analysts were so deeply involved in capital markets transactions as well as mergers and acquisitions.  In my nine year run I did a variety of lead and co-managed Initial Public Offerings as well as secondary equity issuances for the likes of Chrysler, General Motors, Budget and Dollar Thrifty Rent-a-Car, Goodyear Tire, Ducati, as well as a variety of lesser-known auto aftermarket parts companies and foreign automakers and suppliers.

The process of raising capital in U.S. equity markets has changed very little in the last decade – far less than other parts of the market such as electronic trading.  Companies still choose bankers based on formalized pitch meetings with positioning and valuation discussions.  Analysts do play a smaller role at the front end of the process, but their buy-in is every bit as critical during the marketing of the deal.  And equity salesforces still have an important position in the workflow, pitching the investment merits of the company at hand to first get a meeting and then an order from a long-only or hedge fund client.  Issuing stock is still a basically a specialized house-to-house search for appropriate owners, setting market expectations for near term performance, and getting the equity story out in a consistent and accurate manner.

At the same time, mistakes still happen in even the most well established business processes, as we have seen over the past week.  No need to “Name names” here, because it is not the point of this note to rewarm the leftovers of an already well-publicized failure.  Rather, as I watched the drama unfold in all its can’t-look-away-from-the-car-accident glory, it occurred to me that the wounds of the past week were somewhat self-inflicted.  There are rules to doing an Initial Public Offering.  By and large, investment banks follow these “Commandments” to the letter.  But when they don’t, well, that’s when someone loses an eye.

As I reminisced about the various transactions I witnessed during the 1990s, I started to jot down what I realized are the unwritten, but critical, rules to a successful public offering.  They apply reasonably well to both IPOs and secondaries.  And – conveniently – there are ten of them.

Our “Ten IPO Commandments” are as follows:

1)      Create The Illusion of Scarcity.  The biggest challenge to a successful stock offering is to convince the base of buyers that there is much more demand than supply.  Raising the price range of an offering a good sign.  Increasing the number of shares is much more problematic and requires a “Measure twice, cut once” approach.  It is, after all, a signal that the sellers – who are almost always better informed than buyers – think the price of the offering is compellingly attractive versus their knowledge of the company and its prospects.
2)      Maintain a Consistent and Improving Narrative about the Business.  For an IPO, there is a fairly long window between when you FedEx the initial documents to the Securities and Exchange Commission and the pricing of the deal.  Months, in fact.  Investors’ initial contact with the company comes when they read that initial filing.  From that point on, they want to see and hear an improving story about the business and its prospects.  If that means keeping expectations and commentary about the business modest at first, so be it.  Trajectory is everything.
3)      Make Management Available To Investors.  Chairmen/women and Chief Executive Officers rarely achieve those positions without a healthy dose of self-esteem.  And they often bridle at being quizzed about their company by investors who know much less about the business than they do.  Fair enough, but it is part of the process and investment bankers need to deliver that message and get the most senior people to travel on the roadshow.  My most memorable experience with rocks-star management was Lee Iacocca, the former Chairman of Chrysler, and a bigger-than-life personality.  The key to making sure he was happy on the roadshow was to simply book the biggest hotel meeting space in all the major cities on the agenda.  We called him “Sinatra” and he enjoyed the nickname.  And he was happy to go anywhere and meet anyone after selling out the big rooms.  Investors appreciated that, and I believe they cut the company a lot more slack over time because they had seen Sinatra up close and personal.
4)      Talk to your fellow underwriters.  The best capital markets officers I worked with always maintained an open dialog with their fellow lead and co-manager counterparts.  More information about how the market hears a story is always helpful.  And yet certain investment banks have a reputation for keeping things very close to vest.  Caveat emptor there.
5)      Know Who is Buying.  “Building a book” is the tough part of any stock offering. How much is “Real” – legitimate orders from institutions who want to own the stock – and how much are “Flippers?” Sadly for many capital markets desks, buy-and-hold institutions now trade far less than faster-moving hedge funds.  As deals heat up, customers will try to leverage their importance to the day-to-day trading operation of the underwriters in return for better a allocation.
6)      The IPO is Just the “First Date.”  Many companies think of the IPO as the end of a long journey, which may have started in a dorm room or a garage and ended by ringing a buzzer or a bell.  But for investors, that sound is the beginning of their involvement with the company.  No matter how great the business model or convincing the management team might be, the goal posts have shifted.  Bottom line – as a company, want your IPO to work on day one, week one, and month one.  It will pay dividends when you come back to the capital markets.  And, trust me, you’ll be back.
7)      Know Who is Selling.  No matter how carefully constructed the deal book might be, some significant portion of the accounts will be sellers.  The underwriter needs to have a home for those shares (see Commandment #5).
8)      Retail Is Different.  Most equity offerings allocate 20–30% of the deal to what investment banks call “Retail.” This term connotes individual investors, but can also mean smaller institutions.  If the business is consumer-focused, it will be at the higher end of the range, since these buyers are thought to be customers as well.  And retail is considered “Sticky” money, less likely to sell into any initial stock price pop.  The relationship, however, cuts both ways. A poorly executed IPO stands the chance to alienate customers and damage the company’s brand.  All of which means retail-heavy stock offerings need to be especially well run.
9)      Bankers – Manage Your Client.  The best bankers I have worked with over my career had one thing in common: they established themselves as a financial expert with their clients and never let go of that position.  This is not an easy thing to do, but the reason bankers add value to the process of raising capital is not their ability to socialize or play golf or feign enthusiasm for a company in a pitch.  Their value is that they know more about the intersection of business analysis and capital markets than the clients they serve.  If the client comes to feel that they know more about the process than their bankers, and is allowed to act on that impulse, you can turn out the lights and head home.  The deal isn’t going to work.
10)   Don’t be Afraid to Walk Away.  This applies to both buyers and bankers alike.  The stock market in the U.S. is open from 9:30am to 4:00pm every day.  If you are unsure about the deal, you can still buy it the next day, or the next week, or the next month.  The illusion of scarcity is just that.

And for my hustling banker friends, a story to close out this note…

The most stressful 24 hours of my professional career occurred when I found out a company I was working to take public had inadvertently hired a senior person with falsified credentials.  I took the information to the head of equities, a tough as nails West Point grad.  He immediately called the head of the firm and said the deal was off unless the individual with the fake resume was removed from the transaction.  This was a courageous move, for the deal was extremely high profile and we were the lead manager.  No one argued.  I never saw the fellow again.  I think he is a potato farmer somewhere.

Here are this week's reading diversions for your personal enlightenment. Have an awesome weekend!

Poultry — 13 Best Foods for Crohn’s Disease — Health.com

Here are 13 foods that should be easy on your digestion. However, the right Crohn's diet is highly individual—so use trial and error to see what works for you.

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Reasons Why Your Eye Keeps Twitching

Eye twitching is a common condition and is more of an annoyance than anything else. Rest assured, the majority of instances of eyelid spasms are indicative of minor health problems that can easily be remedied:

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Really? Never Brush Your Teeth Immediately After a Meal — NYTimes.com

Acid attacks the teeth, eroding enamel and the layer below it, called dentin. Brushing can accelerate this process, said Dr. Howard R. Gamble, president of the Academy of General Dentistry. “With brushing, you could actually push the acid deeper into the enamel and the dentin,” he said.

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Children and travel: How to travel with kids without going crazy — Canadian Living

Until you're a parent, you cannot possibly appreciate how much is involved in getting every member of the family ready to get out the door each morning, let alone for a family vacation. Family vacations take a lot of planning and preparation. I know this from experience. I also know that it's worth it, because family vacations can provide some of the best memories of your life. Following are tips and advice to help you make your next family vacation memorable, more stress free, and above all, fun.

Involve the kids

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Cheeseburger blues: could high-fat foods be making us depressed?

Universite de Montreal researchers are reporting that high-fat diets increase anxiety and depressive-like behaviours in mice — a finding that a leading Canadian obesity expert said runs counter to almost everything we have been told about fat-dense foods.

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Why cupcakes are the new cocaine

Along with prescription drugs, internet porn, computer games and dozens of other consumer items, we are forming an intimate relationship with sugary snacks that supplements and complements the “traditional” addictions to alcohol, gambling and illegal drugs.

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Deskercise! 33 Ways to Exercise at Work | Greatist.com

Remember the days when “work” meant manual labor with a side of blood, sweat, and tears? Neither do we. These days, it seems we’re more likely to log hour after idle hour with our bums glued to our seats. And while you may be an Excel champ by day and gym rat by night, recent research suggests that the recommended 30 minutes of cardio five times per week may not undo the health risks of a sedentary lifestyle[

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Why We Love Salt (And How to Break the Sodium Addiction) | Greatist.com

Many foods have more salt than we may realize. (We’re lookin at you, Cheerios.) And since salt helps preserve food — not to mention making what’s on the dinner plate taste even better — it can be hard to cut back. In certain cases, salt may even be addictive[6]. (And we thought sugar was the only culprit[7]!) So here are some tips to keep that salt intake under control and help stop cravings for good:

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Are Your Allergy Medications Making You Fat? | Women's Health Magazine

Allergy season is upon us, and the record pollen levels we're experiencing this year may have you heading to the allergy relief aisle at your local drugstore. But what you take to alleviate your symptoms could have unpleasant side effects on your waistline. Researchers have suggested that allergies and weight gain go hand in hand, and that could have to do with the drugs you take or more subtle underlying problems.

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Easy Allergy Tips: Your Body On Allergies | Women's Health Magazine

It all begins with a mating game. Male pollen grains drift off in search of female plant parts to fertilize. Cute, except that the powdery stuff is so pervasive that you'll undoubtedly breathe it in or rub it into your eyes. If you're allergic, your body makes antibodies called IgE. Pollen launches them into action.

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Coffee linked to lower risk of death — latimes.com

Researchers have some reassuring news for the legions of coffee drinkers who can't get through the day without a latte, cappuccino, iced mocha, double-shot of espresso or a plain old cuppa joe: That coffee habit may help you live longer.

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by Showbhik Kalra, PIMCO

• Asian sovereign and corporate credit offer more attractive yields than a number of other global fixed income sectors as investors take on additional risk.
• Given Asian markets’ diversity and the global macroeconomic environment, investors may wish to consider investment managers with a strong global macro process coupled with strong relationships with local stakeholders and experience in local portfolio management and markets.
• PIMCO believes in the resilience of emerging Asian countries and that leads us to be open to adding exposure in sovereign credit and high quality corporate credits as attractive opportunities arise. ​

​ In the current environment, growth in Asia is one of the most talked about macroeconomic trends. After all, the region is expected to contribute around half of global GDP growth and makes up a significant and growing share of global GDP output. Asian central banks collectively hold around half of the world’s foreign exchange reserves and a number of these countries hold a record amount of reserves. In contrast to the developed economies, which have increasing government debt-to-GDP ratios, strong initial conditions and a rapid return to strong growth have facilitated stability in debt levels (with much lower absolute levels) across the major Asian economies. Over the last few years these fundamental improvements have been well recognized and sovereign ratings upgrades have outpaced downgrades consistently since 1999.

How do we take advantage of the growth in Asia?

Unfortunately, investment managers cannot invest directly in a country’s GDP growth or its expected level of foreign exchange reserves. Instead, one can invest in sovereign debt and corporate credit in Asia as a way to take advantage of the region’s growth. Corporate issuers in the emerging Asia markets are either serving the increasingly affluent and growing local consumer base or exporting goods overseas and, as a result, becoming regional and in some cases global powerhouses. Asian currencies are also attractive as many are undervalued by numerous purchasing power metrics. Authorities are also more open to letting their currencies appreciate as a way to deal with inflation and to rebalance their economies to be more consumption driven, rather than investment driven as in the past few years.

The first pan-Asia credit benchmark was created following the Asian financial crisis in the late ‘90s, marking the first step toward establishing Asian credit as an asset class. The Asian U.S. dollar denominated bond market today, as measured by the market capitalization of the JP Morgan Asia Credit Index (JACI), has grown from $50 billion dollars around a decade ago to over $300 billion dollars in June 2011. This index includes sovereign, quasi-sovereign (entities majority-owned by the state) and corporate credit (see Figure 1 for recent issuance). In recent years, the asset class has expanded progressively to cover 14 fast growing countries in Asia with sovereign ratings from S&P ranging from AAA to B-, as countries and corporates across the region looked to broaden their sources of financing. The typical size of investment grade issuances has increased over time, to average deal sizes of $1 billion currently. These larger issues contribute to the overall asset class as they tend to help boost secondary market liquidity.

Investing in growth

A notable development in the Asian credit space is the advent of high yield corporate issuers. The high yield corporate sector is dominated by China and Indonesia, but also includes issuers in Korea, the Philippines and Singapore. The high yield portion of the index has also grown substantially over the years from 30% of the index at the end of 2006 to 40% at the end of 2011. However, following recent upgrades to Indonesia, the high yield portion of the index has moved back down to 30% of the index.

For example, take a deeper look at Indonesia. Robust commodity demand from China and India has been a boon for the resource-rich country, particularly its coal producers. Sustaining industrial production in Indonesia also requires significant capacity expansion in basic infrastructure. Because Indonesia is the world’s fourth most populous country but still has a low penetration rate for wireless connection, cell phone demand will likely remain robust in the medium term. Indonesia’s rate of electrification is about 65% which means around 90 million people still do not have access to electricity. Not surprisingly, commodity, utility and telecommunication companies have dominated Indonesia’s high yield corporate issuance. Compared to the developed world, companies in these sectors across the region are still experiencing strong growth (Figures 2 and 3 illustrate growing demand for the telecommunications and utilities sectors). Note that particularly across emerging Asia there is a trend towards using multi-SIM cellular phones and mobile cellular subscriptions understate the true growth potential.

Attractive yields and greater stability

Asian sovereign and corporate credit is also attractive from a yield perspective. They offer significantly more attractive yields than a number of other global fixed income sectors (Figure 4) as investors take on additional emerging market sovereign and credit risk. What about the relative value comparison between Asian corporate bonds and developed country corporate bonds? A look at the historical credit spreads (over comparable maturity U.S. swaps) of Asian corporate credit compared to those of BBB rated U.S. corporates provides a strong argument. Figure 5 shows that spreads on Asian corporate bonds have consistently been higher than comparably rated U.S. corporate bonds during the past five years. The gap widened to as much as 134 basis points during the post-Lehman Brothers crisis, and recently was 87 basis points as at the end of March 2012 (the gap was close to zero prior to the Lehman crisis). A big reason for this gap is likely higher sovereign spreads embedded in Asian corporate bond spreads. We expect this gap to narrow as markets continue to revalue Asian sovereign risk to reflect stronger balance sheets and economic growth prospects.

In addition to indicating financial health, debt ratios can help uncover value in corporate bonds. One way involves looking at the ratio between debt and one-year earnings before interest, taxes, depreciation and amortization (EBITDA). A one-to-one ratio between debt and EBITDA can be thought of as a single “turn of leverage”. Figure 6 shows corporate bonds from Asia tend to have higher spreads (over comparable maturity U.S. swaps) per turn of net leverage on compared to corporate bonds from the U.S. By this metric, the yield from Asian corporates is potentially more attractive.

Despite a challenging year for risk assets in 2011, including the downgrade of the U.S. and trouble brewing in the eurozone, the JACI index stayed in positive territory and returned 4.12%. The investment grade rated portion (61% of the index) returned 4.92% and the sub-investment grade rated portion (39% of the index) returned 2.85%. The index has returned 7% on an annualized based in the five years from 2007 to 2011. Figure 7 shows how some different liquid Asian assets performed over the last five years and in 2011.

We must be mindful that Asia is not a homogeneous region and countries across Asia cannot be painted with the same brushstroke. India has fiscal challenges to deal with, China is going through a political transition and Vietnam is struggling to sustain growth while containing high inflation. Countries must make further progress on improving the quality of institutional frameworks, regulatory bodies and bankruptcy regimes. Given this backdrop and the global macroeconomic environment, investors may wish to consider investment managers that have a solid global macro investment process, strong relationships with local stakeholders and experience in local markets. PIMCO believes in the resilience of emerging Asian countries and that leads us to be open to adding exposure in sovereign credit and high quality corporate credits across portfolios as attractive opportunities arise.

Past performance is not a guarantee or a reliable indicator of future results.

Investing in the bond market issubject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Sovereign securities are generally backed by the issuing government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The Barclays U.S. Treasury Index is a measure of the public obligations of the U.S. Treasury. The Barclays U.S. Fixed Rate Mortgage-Backed Securities Index is composed of all fixed-rate securitized mortgage pools by GNMA, FNMA, and the FHLMC, including GNMA Graduated Payment Mortgages. Barclays Global Aggregate (USD Hedged) Index provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian Government securities, and USD investment grade 144A securities The Barclays Global Aggregate Credit Index is the credit component of the Barclays Aggregate Index. The Barclays Aggregate Index is a subset of the Global Aggregate Index, and contains investment grade credit securities from the U.S. Aggregate, Pan-European Aggregate, Asian-Pacific Aggregate, Eurodollar, 144A and Euro-Yen indices. The HSBC Asian Local Bond Index (ALBI) tracks the total return of local currency denominated, high quality, and liquid bond in Asia ex-Japan. The index returns for each country-based sub-index are calculated in the respective local currencies and the return for the overall ALBI index is measured in US dollars. The J.P. Morgan Asia Credit Index (JACI) tracks total return performance of the Asia fixed-rate dollar bond market. JACI is a market cap-weighted index comprising sovereign, quasi-sovereign and corporate bonds and it is partitioned by country, sector and credit rating. It is not possible to invest directly in an unmanaged index.

This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC.

Copyright © 2012, PIMCO.

by Noel Archand, iShares

What if I told you that today’s US exchange traded product (ETP) landscape is dominated by large, diversified exchange traded funds that seek to track an index? That statement should sound obvious, but it doesn’t line up with the headlines that seem to dominate ETF coverage of late. But sometimes, it’s good to step back and look at the facts to keep things in perspective.

It is often the more complex ETPs — those funds that might be better suited for institutions or trading professionals than buy-and-hold investors — that grab the attention of the media. It is also true that in recent years, the ETF Industry has introduced more complex ETFs, such as leveraged and inverse funds, or products that are backed principally by derivatives rather than physical holdings. These niche products have caused the media to question the suitability of ETFs for long-term or individual investors as the Wall Street Journal did in its recent piece, “Is It Time to Limit Access to Leveraged Exchange Traded Investments?”

iShares has been vocal about advocating a classification system that clearly defines the differences between exchange traded products, an umbrella term that is currently used to categorize a group of funds which can vary greatly in their goals and structure.  We think a system (ideally through nomenclature but also through “speedbumps” at time of purchase like additional paperwork) that helps to ensure that investors clearly understand what it is that they are buying is critical for the ETF Industry.

But beyond the headlines and discussions over a classification system, the fact remains that the vast majority of ETPs being used by investors today are traditional, market capitalization weighted ETFs that are designed track an index, like the Russell 2000 Index.

Like mutual funds, the vast majority of ETFs are structured as 1940 Act investment companies. ETFs are securities subject to market risk (the risk that an investment will go up or down). They are collateralized by an underlying portfolio of securities. The 40 Act limits the use of derivatives and prohibits affiliated transactions (i.e. a bank cannot serve as both a sponsor and a swap counterparty).

What do I mean when I say “vast majority”? Let’s look at US data from iShares and Bloomberg as of the end of the first quarter:

• The US ETP industry had $1.2 trillion in assets under management.
• The 100 largest US ETPs accounted for 80% of those assets under management.
• Of the 100 largest ETPs, 90 were ETFs that are governed by the 40 Act — the same act that governs mutual funds.
• Of the largest 100 ETPs, only 1 is an inverse/leveraged fund.
• All but 6 of the 100 largest funds hold physical securities.
• Of the top 100 funds, the average number of holdings in each one is 450 names.

At the end of the day these numbers show that it’s the big broad diversified funds that attract the bulk of the assets. Niche ETPs are exactly that — niche funds that are designed for a smaller segment of the marketplace and that might fulfill a particular investment need. These funds are not for everyone; as with any investment vehicle, it makes sense to talk to your financial advisor or ETF provider before making any purchasing decision.

Noel Archard, CFA is the iShares Global Head of Product Development & Management and a regular contributor to the iShares Blog.  You can find more of his posts here.

Copyright © iShares

by Matt Tucker, iShares

The high yield bond market is back in the news again.  On the back of increased concerns over the events in Europe there’s been an increase in high yield market volatility over the past few weeks.  Investors have seen this in the price movements of HYG (the iShares iBoxx High Yield Bond ETF). Of particular focus has been a series of redemptions out of HYG and other high yield ETFs.  These trades have been at times misunderstood by market participants, so I’m going to try to provide some clarity.

First off, it’s important to remember that HYG, just like all other iShares ETFs, has a process by which shares can be created and redeemed in large quantities on a daily basis (see a great video explaining this concept here).   So if investors are leaving the high yield bond market and selling shares of HYG, this may result in shares of HYG being redeemed and the shares outstanding declining.  This is a classic example of the ETF creation/redemption process in play.

But what’s interesting about the recent activity is that in addition to investors exiting the high yield market, some of the redemption activity we have seen in high yield ETFs is from investors who actually want to own high yield bonds.  Confusing?  I’ll explain.

Let’s say that you are a large investor and you want to build a high yield bond portfolio.  You know that transaction costs in the high yield market can be very high and that, due to the nature of the over-the-counter bond market, it could take days or even weeks to build a diversified portfolio.  With the growth of high yield ETFs, you now have a faster, cheaper way of building a bond portfolio – by buying shares of the ETF on the exchange, and then redeeming those shares in exchange for bonds from the ETF.

This is what happened with some of the redemptions we recently saw in the market.  Large investors wanted to own a diversified portfolio of high yield bonds, so they bought up shares of a high yield ETF on the exchange, and then redeemed the shares of the ETF for the underlying bonds. This is exactly what HYG and our other high yield iShares ETFs are designed to do – provide a liquid alternative to the over-the-counter bond market.

The key to such a trade is that HYG and our other fixed income iShares ETFs primarily use an “in kind” creation and redemption process, which ensures that the costs of creating and redeeming shares are kept outside the fund.  The transaction costs for creations and redemptions are borne by the transacting investor, and don’t impact other shareholders.

Investors should note that not all fixed income ETFs use the same creation and redemption mechanism employed by HYG. I would recommend that investors do their due diligence on any ETF that they are looking to invest in to ensure they understand the details.

Matt Tucker, CFA is the iShares Head of Fixed Income Strategy and a regular contributor to the iShares Blog.  You can find more of his posts here.

Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.

Shares of the iShares Funds may be sold throughout the day on the exchange through any brokerage account. However, shares may only be redeemed directly from a Fund by Authorized Participants, in very large creation/redemption units. There can be no assuarance that an active trading market for shares of ETF will develop or be maintained.

Buying and selling shares of iShares Funds will result in brokerage commissions.

Bank Of Russia To Buy “Considerable Figure" Of Gold Tonnage In 2012

Gold’s London AM fix this morning was USD 1,560.50, EUR 1,240.66, and GBP 996.04 per ounce. Yesterday's AM fix this morning was USD 1,558.50, EUR 1,239.27, and GBP 993.62 per ounce.

Silver is trading at $28.30/oz, €22.60/oz and £18.13/oz. Platinum is trading at $1,430.00/oz, palladium at $588.70/oz and rhodium at $1,275/oz.

Gold was off $1.70 or 0.11% in New York yesterday and closed at $1,559.50/oz. Gold fell in Asia prior to gains late in the session and these gains continued in early European trading as lower prices are leading to some safe haven demand.

Gold USD Chart – (Bloomberg)

Gold looks set to see a fourth consecutive monthly loss which will be bearish technically. Gold will need to rally nearly $100/oz between now and end of trading of next Thursday May 31st to not incur a monthly loss of some 6% in May.

It will be the first time it has had four consecutive monthly losses since the four months to January 2000 – prior to the current secular bull market.

Gold’s monthly decline is primarily in dollar terms and therefore a dollar phenomenon as it coincides with a very poor month for the euro which currently is down nearly 5% versus the dollar.

Thus, gold is only down 1% against the euro while most European equity indices are down by 5% plus.

Although gold is a safe haven, in recent days speculators and investors burnt by riskier assets like equities, oil and industrial metals have been forced to liquidate their gold paper positions to cover losses in other markets.

While speculative players in futures markets can exert considerable influence in the short term, as ever physical supply and demand will be the ultimate arbiter of price in the long term.

The debt crisis in Europe looks like it may spiral out of control and trigger a global economic slowdown and contagion which will again support gold in the long term.

Holdings in the SPDR Gold Trust, the biggest bullion-backed exchange-traded fund, rose for a second day to 1,270.30 metric tons yesterday. Demand in Asia outside of India was “good” yesterday and interest in Europe is “evident,” UBS said in a report this morning.

Premiums of gold bars in Tokyo rose to as much as $1.50 per ounce above London prices, the highest level since last March, as investors turned from sellers to buyers during this most recent price correction, dealers told Reuters.

The IMF central bank gold demand figures for April were very bullish and suggest that central bank demand in 2012 may be even higher than the 456.4 tons added last year – which was the most in almost five decades.

The World Gold Council estimates that central banks will buy as much as 400 tons this year.

The data yesterday suggests that demand may be even higher than these levels and there is also the near certainty that larger central banks, such as the People’s Bank of China, are quietly accumulating gold reserves and not reporting their purchases to the IMF — as was done previously.

XAU/EUR Currency Chart – (Bloomberg)

Today, the deputy chairman of Russia's central bank, Sergey Shvetsov, said that the Bank of Russia plans to keep buying gold on the domestic market in order to diversify their foreign exchange reserves.

"Last year we bought about 100 tonnes. This year it will be less but still a considerable figure," Shvetsov told Reuters on the sidelines of a financial conference in Milan.

Russia's gold and foreign exchange reserves fell to $514.3 billion in the week ending May 18, from $518.8 billion a week earlier. However, they have risen from the $498.6 billion seen at the end of 2011.

Yesterday, Shvetsov said that Greece has plans for a parallel currency and that it is a “necessity” for Greece to leave the euro.

US exchanges are closed on Monday for Memorial Day.

XAU/GBP Currency Chart – (Bloomberg)

OTHER NEWS
(Bloomberg) — CME Group Cuts Margins for Gold, Hog, Lumber Futures 
CME Group Inc. cut margins for gold on the Comex in New York.

The amount that speculators must keep on deposit for an initial account in gold futures was reduced to $9,113 from $10,125, CME Group said today in a statement on its website.

CME also lowered margins for hog and lumber contracts.

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Cross Currency Table – (Bloomberg)

NEWS
Gold weakens on euro, on track for 6 pct loss in May — Reuters

Italians recycle family gold – The Financial Times

Gold ends up but stronger dollar limits gains – Reuters

Greek Exit Could Trigger a Run on European Banks – Business Week

COMMENTARY
Gold is near a critical turning point – where will it go next? — MoneyWeek

James Rickards: Currency Wars – The Making Of The Next Global Crisis — GoldSeek

Police Urging Greeks To Stop Stuffing Mattresses – Zero Hedge

Bond exodus on a par with eurozone bank run — The Financial Times

From Mark Grant, author of Out of the Box

A Tale of Two Cities

 Euro bonds “didn’t find much support” at the EU conference.

–Jean-Claude Juncker

 “A majority of European Union leaders at a Brussels summit this week backed joint euro-area bonds.”

–Mario  Monti

Encapsulated in these two comments is the problem that Europe is now facing. Two views, two radically different positions and no agreement on a middle ground because there is not one. Of course the periphery countries, the weaker nations want Eurobonds because it would dramatically drop their cost of funding. Of course Germany and their stronger EU countries do not want it because it would dramatically raise their cost of funding. Nations, in the end, will act in their own self-interest, this has been proven more than enough times in history, which is why I stand by my conclusion that Eurobonds will not be forthcoming regardless of the polite rhetoric attached to them. Germany cannot and will not ever accept Eurobonds not only for this reason but because it would not only raise the cost of their borrowing dramatically and because it would lower their standard of living, over a period of time, to the median of all of the Euro-17 nations and that would not only be political suicide in Germany. I therefore state that regardless of any and all pandering in the Press that Eurobonds will not happen because it is a political non-starter in Germany, Austria, Finland et al. They are like the Titanic; dead in the water.

Beyond this single issue is also the widening rift between the European Socialists and the Conservatives. Without assuming any moral high ground; Europe is now split between one view of the world and a distinctly separate second viewpoint and this will make the governance of Europe not only difficult but very close to impossible. I fully expect any number of issues where you have a Socialist majority and an intransigent  German led Conservative minority where vetoes will be used, threats will be made and no compromise will be found. All of the pushing by the weaker nations will result in a backlash where the funding countries will not allow themselves to be impaired by the lifestyles of the poor and begging and the flare-ups could become quite intense. Nothing was achieved at the summit this week and nothing of substance will be achieved at the one in June and floundering on the beach may be the only actual result. The fish is out of the water; let the sputtering commence.

"Waste forces within him, and a desert all around, this man stood still on his way across a silent terrace, and saw for a moment, lying in the wilderness before him, a mirage of honorable ambition, self-denial, and perseverance. In the fair city of this vision, there were airy galleries from which the loves and graces looked upon him, gardens in which the fruits of life hung ripening, waters of Hope that sparkled in his sight. A moment, and it was gone. Climbing to a high chamber in a well of houses, he threw himself down in his clothes on a neglected bed, and its pillow was wet with wasted tears."

–Charles Dickens, A Tale of Two Cities

• The Strategic Death Wishes
• Eurobonds will be forthcoming shortly.
• The ECB will be doing another round of LTRO any day now.
• Greece will not exit from the Eurozone.
• Spain will not need to approach the EU for financial assistance.
• Germany and France will reach a compromise position.
• Portugal and Ireland will be just fine and not need any further funding.
• America has decoupled and will not be impaired by the recession in Europe.
• The Euro is stable and will not decline further.
• Treasuries cannot have lower yields from here.

Mark J. Grant, Managing Director of Corporate Syndicate and Structured Products for Southwest Securities, Inc

Copyright © Mark Grant

Key Points

• Sometimes understanding the past can help you with your forecasts.
• Pattern repetition can lead to potentially more reliable forecasting.
• Study and learn from history, but we recommend that you don't base your trading strategies entirely on history.

Does history really tell us anything about today's market? Trading has certainly changed from the day of brokers trading in the streets to today's high-frequency traders. Indeed, the trading environment of yesteryear is as foreign to modern-day markets as a horse and buggy are to a Formula 1 race car.

And yet it often seems that the more things change, the more they stay the same. We often find that we rely heavily on past performance (or more specifically, past data) to forecast the future, because history has shown that past patterns often re-emerge, and quite frankly, history is all we have.
Technical patterns
As both an active trader and a market analyst, I spend quite a bit of my time looking for market patterns. Then I watch to see if things play out the same way this time. The belief that patterns repeat themselves is essentially the foundation on which technical analysis is based.

While I'm not strictly a technical trader, I think it's unwise to ignore technical indicators. Because whether or not I believe technical analysis has merit, as long as market participants take action based on technical events, these events are worth watching.

Taking this into consideration, what makes a pattern noteworthy? The answer is repetition—or how many times it has occurred in the past with the same or a similar result.
Golden Cross and Death Cross
In the world of technical analysis, one of the most frequently discussed patterns is the Golden Cross—when a 50-day simple moving average (SMA) crosses up through a 200-day SMA. This is often seen by technical traders as a sign of a continuing bullish market.

The opposite of a Golden Cross is known as a Death Cross—when a 50-day SMA crosses down through a 200-day SMA. As you might imagine, this is most often seen by technical traders as a sign of a continuing bearish market.

But do they work? To find out, I looked at S&P 500® Index (SPX) data from 1950 to the most recent Golden Cross (January 31, 2012) to see what typically happens following these events.

Since 1950, there have been 31 Golden Crosses and 32 Death Crosses. The average return for a long position on the SPX going forward one year from each of these signals was 3.8% for the Death Cross and 10.2% for the Golden Cross. So interestingly, the Death Cross signal wasn't actually bearish, just less bullish for the one-year period following the events observed.

Looking at more recent history, the results are pretty similar. Since 2003, there have been five Golden Crosses and five Death Crosses. The average return for a long position on the SPX going forward one year from each of these signals was 8.5% for the Death Cross and 9.2% for the Golden Cross. So again, the Death Cross wasn't actually bearish, just slightly less bullish.

The chart below depicts all of the 50/200 SMA crossover points for the past four years.

• The yellow line is the 50-day SMA and the pink line is the 200-day SMA.
• Notice how the crossovers never signal the start of a bullish or bearish trend, but rather the continuation of a trend.

Crosses in Action

Source: StreetSmart Edge®.

Now, let's say that since 2003 you had gone long only on the Golden Cross and short only on the Death Cross. Here's what would have happened:

• For the five bullish signals since 2003, the average return on the SPX going forward from each Golden Cross until each Death Cross was 8.6% (so a long position would have gained 8.6%).
• For the five bearish signals since 2003, the average return on the SPX going forward from each Death Cross until each Golden Cross was 0.0% (so a short position would have essentially broken even).
• The most recent Death Cross was August 12, 2011 and while that is typically seen as a bearish signal, if you look at this period until the Golden Cross of January 31, 2012, the SPX actually gained 12.3%.
• Since the most recent Golden Cross (January 31, 2012), the SPX has gained about 5% (as of this writing), although it has only been a few months.

Cyclical patterns
Technical patterns aren't the only events that re-emerge in the markets. Cyclical patterns can also occasionally provide insight into what the future holds. While investors should never base trading decisions strictly on cyclical patterns, the statistics associated with them are often interesting to discuss. Here are a few that I've found to be particularly noteworthy:

• Thirteen of the last 17 year-end rallies continued into January. Most recently, for example, SPX gained about 0.9% in December 2011 and about 4.3% in January.
• The fourth year of a bull market (e.g., 2012) is typically much stronger than the third (e.g., 2011). According to data compiled by Standard and Poor's Equity Research, the average third-year bull-market return for the SPX is 3% vs. 13% for the fourth year. The SPX returned 0% in 2011 and was up about 10% this year as of this writing.
• Presidential election years have been positive 12 of the last 15 times. They have an average return of 6.6% (and that includes the 38% decline in 2008). If you exclude the 2008 election, the average return jumps to 9.8% and then election years would be positive 12 of the last 14 elections. The other two losing election years were 2000 (George W. Bush) and 1960 (John F. Kennedy).

The chart below shows the start (green vertical line) and finish (red vertical line) of each presidential election year since 1950.

• The three down years (1960, 2000 and 2008) are identified with a red box.

Stock Market Action in Presidential Election Years

Source: Schwab Center for Financial Research.
Seasonal patterns
Now, let's take a look at the (sometimes) annual pattern often referred to as, "Sell in May and go away." Like so many other patterns, this "rule" appears to have historical merit. It seems like the market often begins to wind down around Memorial Day and then does not pick back up until around Labor Day.

I looked at SPX performance from 1950 through 2011 for the 68 trading days preceding the Labor Day holiday (basically June, July, August and the first week of September). Here's what I found:

• The SPX had an annual gain in 45 of those 62 years.
• But the period from Memorial Day to Labor Day (about 68 trading days) was only positive in 41 of those 62 years.
• During this 62-year period, the SPX increased from 16.66 to 1257.60, which was an average annual return of 7.22%. Note: To find out the annualized return we use the formula below.
• However, the average return for each yearly period between Memorial Day and Labor Day (68 trading days) was only about 1.1%.

So while 68 trading days represents about 27% of the approximately 250 trading days each year, the period between Memorial Day and Labor Day accounted for only about 15% of the total average annual returns. In other words, this tends to be a historically underperforming period of time.

Sometimes statistics can imply patterns that aren't quite as repetitive as they appear, so below is a list of the 10 most bearish years for the Memorial Day to Labor Day period going back to 1950. While there is definitely a small bias toward negative action in more recent years, it is not as skewed as some might expect.

As shown in the chart below, sell in May and go away was a pretty good strategy for three of the last four years. But in 2009, the year the bear market ended and the SPX rose 23% overall, this strategy would have missed out on about an 8.5% gain during this period of time.

Summer Market Activity During the Last Four Years

Source: StreetSmart Edge®.
Volatility patterns
An area of the market that has garnered a lot of attention in the past few years is volatility. One of my favorite statistics in the area of volatility relates to the CBOE^® S&P 500 Volatility Index (VIX). According to my calculations, the VIX has closed above 40, exactly 167 times since it was created in 1993:

• 95% of the time, when the VIX closed above 40 on a given day, the market was higher exactly 12 months later. The average gain was more than 31%.
• Only 5% of the time, when the VIX closed above 40 on a given day, the market was lower exactly 12 months later. The average loss was less than 10%.

In 2011, the VIX closed above 40 on 11 days between August 8, 2011 and October 4, 2011. The average level of the SPX between August 8, 2011 and October 4, 2011 was about 1,170. So from a strictly historical perspective, there could be about a 95% likelihood that the SPX will be higher than Q3 2011 by Q3 2012, perhaps sharply higher.

Looking at this data a slightly different way, because historical spikes in the VIX were concentrated in just seven specific periods of time, it may make more sense to view the results if you simply went long the SPX¹ on the day of the very first spike above 40. If you did, the results would have been as follows:

1. From August 31, 1998, the 12-month return was 37%
2. From September 17, 2011, the 12-month return was –15%
3. From July 22, 2002, the 12-month return was 20%
4. From September 19, 2002, the 12-month return was 22%
5. From September 29, 2008, the 12-month return was –3%
6. From May 7, 2010, the 12-month return was 20%
7. From August 8, 2011 to the time of this writing, the return has been approximately 15

The chart below shows the seven periods above. The green lines represent gains over the next 12 months; the red lines represent losses. The pink line represents the inverse of the VIX and the black line shows the SPX. The red line at the bottom illustrates the equivalent level of 40 on the VIX. Since the VIX is mapped inversely, any time the VIX closed above 40, the pink line will be below the red horizontal line on this chart.
Seven VIX Spikes

Source: Schwab Center for Financial Research.
Bottom line
No strategy, statistic, research or historical pattern can consistently predict the future. But experienced traders study history anyway because they know that while, "History doesn't always repeat itself, it often rhymes."

For additional information or for assistance with other trading strategies, please contact a Schwab Trading Specialist at 800–435-9050.

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With U.S. home values off 35% from peak to tough, about 25% of those homeowners who have mortgages are now underwater — their mortgages are greater than the value of their homes.

Zillow’s interactive map revelas what percentage of homes in your county or ZIP code are in negative equity, based on Q1 2012 data.

The United States of Atlantis

click for full interactive map

Zillow

(h/t: Barry Ritholtz)

by Greg Feirman, Top Gun Financial

May 24, 2012

What a disappointment Friday’s Facebook IPO was. How anticlimactic after all the build up and hype. What a debacle for Morgan Stanley and Nasdaq in what should have been their moment of triumph. Where to begin in this comedy of errors? It starts with Morgan Stanley’s decision to increase the size and price of the offering. An IPO that was originally targeted at $10 billion ballooned to $16 billion. Gauging the seemingly limitless demand for shares, Morgan Stanley must have thought the market could bear the increased size. In retrospect, they dumped too many shares at too high a price into the market resulting in the IPO being dead on arrival. As if that wasn’t enough, Nasdaq’s computerized system botched the transaction process. The 30 minute delay in opening shares was the result of their trying to resolve a bug that prevented traders from modifying and cancelling orders. The mistake they made was opening the stock without fixing the bug which led to complete chaos. Traders who had placed orders but then modified or cancelled them did not receive confirmation. Therefore, many traders did not know if they owned shares or not or at what price for about three hours. This is the trading equivalent of playing football in the dark. My own experience appears to be typical. Shortly after Facebook started trading at about 8:30am PST, I put in a limit order for 250 shares. After a few minutes, I tried to cancel my order but received an error message. Again and again I tried to cancel my order, only to receive error messages. After about an hour, I gave up in frustration. It wasn’t until early Saturday morning when I checked my account that I saw 250 unwanted shares of FB. George Brady, a 66 year old from North Carolina, had the same experience when he tried to cancel his order for 1,000 FB shares (“Investors Pummel Facebook”, The Wall Street Journal, May 22, A1). I sold my shares first thing Monday morning at $34. However, that left me with a $1500 loss having bought shares at $40 ($6 * 250 = $1500). Immediately after selling, I called Scottrade to complain. My local branch office was overloaded by calls and I was redirected to a call center where the broker I spoke with was completely unhelpful. A few hours later I called back, spoke with a broker in the local office, and registered a complaint. I am happy to say that Scottrade called me a few hours ago to say that my trade had been scratched. If you experienced something similar, make sure to call your broker and tell them what happened. Don’t just assume you got screwed and have to eat the loss. The best account of what happened at the Nasdaq was by Thomas Joyce, CEO of Knight Capital, Monday morning on Squawk on the Street who called it “the worst IPO by an exchange ever”. Joyce explained the Nasdaq system failure to accommodate order modifications and cancellations which left traders, including his company, trading in the dark for almost three hours. He said that Bob Greitfeld, CEO of the Nasdaq, should not have opened trading before fixing this bug. The responsible thing to do would have been to delay the IPO to Monday instead of recklessly plowing ahead. He said the overall losses to the industry could approach $100 million. His interview was a tour de force and nobody has said it better. ***** But the fact that all of us are shocked and outraged that an $18 billion IPO — the 2nd largest in history — priced at 100 times earnings flopped is really more noteworthy than another instance of greed and incompetence on Wall Street. Facebook is the vanguard of a new generation of internet companies and its failure foreshadows theirs. The larger meaning of the Facebook Fiasco is the pricking of Tech Bubble 2.0. While most of the country is in a lackluster recovery, the Silicon Valley is booming. Stimulated by the incredible new wealth of Facebook’s founders and investors, hundreds of new social networking and internet startups have been launched and funded here in the last few years. Indeed, the activity and frenzy has reached a new pitch in correlation with Facebook’s path to IPO. The Wall Street Journal reported on Friday that there are now 20 privately held internet companies with a valuation of more than $1 billion — compared with 18 in 1999 and 2000 (“The $1 Billion Start-up Club List, Minus Facebook”, WSJ.com Digits Blog, May 18). The most recent new member of the club is Pinterest, an online scrapbooking site with little revenue and no profit, which raised $100 million at a $1.5 billion valuation last week. It was valued at only $200 million last October. While Pinterest has little revenue or even a business model, it had more than 20 million unique visitors last month (“Pinterest’s Rite Of Web Passage — Huge Traffic, No Revenue”, The Wall Street Journal, February 16). It wasn’t too long ago that it seemed reasonable to value companies on web traffic as a proxy for future revenues. In retrospect, we learned that those future revenues don’t always materialize. But memories are short in the Silicon Valley where all the men are strong, all the women are good looking and all the children are above average. Some of the other hot new +$1 billion internet start ups include DropBox, which allows you to share files between all your computers and smart phones, Evernote, maker of note taking apps, and Airbnb, which has created a market for the rental of rooms in private homes. Twitter and FourSquare — also on the list — are yesterday’s news. In addition to being worth more than $1 billion, another thing most of these companies have in common is unprofitability. Indeed, many of them scarcely have any revenues. They are valued by venture capitalists primarily on their future potential and they fund their operations through these investments. One result of these massive infusions of venture capital is a hiring boom for technology workers in the Silicon Valley who now make more than $100,000/year on average (“Average Silicon Valley Tech Salary Passes $100,000″, The Wall Street Journal, January 24). Most of these tech workers are young men who prefer to live in San Francisco. Flush with cash from their high paying jobs, they have bid up the apartment market in the city. The average apartment rental asking price in the city in the 1st quarter was $2,633 — up 16% from $2,299 a year ago (Average Rental Asking Price SF 1Q12 Chart Attached). Studio and one bedroom apartments are seeing the strongest demand with their asking rents up 19% and 17% from the year ago period (“Renters Scramble As Market Takes Off”, The Wall Street Journal, April 19, A9B). Rents and home prices are not the only beneficiaries of the boom. Money trickles through the entire service sector that serves these newly rich, high income, young tech entrepreneurs and employees. “I hate the word trickledown, but that’s how regional economies spread the growth”, says Steve Levy, director of the Center for Continuing Study of the California Economy based in Palo Alto. For example, the popular Rosewood Hotel at the intersection of Sand Hill Road and 280 in Menlo Park has grown from 250 employees when it opened three years ago to 420 today. Occupancy rates as well as food and beverage sales are up and as a result Michael Casey, Rosewood’s general manager, is hiring restaurant workers and housekeepers (“IPO Wealth Trickling Through The Region”, The Wall Street Journal, April 19, A9A). What does all this have to do with the Facebook IPO? Venture capitalists invest money in companies in order to sell them for more down the road. The two classic exits are acquisition by a large company and IPO. Wall Street is greedy, dumb and myopic but there are limits. It will buy hot, new, unproven internet companies at 100 times earnings or even without earnings as long as their stocks go up. But one thing Wall Street does not like is losing money. Once they stop going up, you will have a hard time selling them new issues. Investors have not completely forgotten 1999 and 2000. Nobody knows exactly when this moment occurs but we know that it invariably does. The Facebook Fiasco looks to me like the tipping point.

Copyright © Top Gun Financial

by Mike Boyle, Advisors Asset Management

From 4/2/12 through 5/18/12 the S&P 500 lost 8.73%. This marks the18th time since 3/9/09 (the beginning of the current bull market) that the S&P 500 has corrected by at least 3% and the eighth time that the S&P 500 has corrected by at least 7%. In addition, our research of the last 50 years shows 3% pullbacks occur on average four times a year. So, clearly pullbacks are commonplace during a normal bull market; however, every time they occur they still set investor emotions on edge and test their resolve. At times like this we like to try and decipher what drove the selloff and try to resolve if we think it is just a normal correction or the beginning of a longer trend down and possibly the start of a new bear market.

In late March, we highlighted that the equity markets appeared to be due for a correction and consolidation as the run from the 10/3/11 bottom seemed unsustainable and the equity markets appeared overbought. April then began with a mild selloff (-4.26%) but then it traded back towards its near-term high in late April and early May. However, as May progressed investor appetites soured and the equity markets turned south again driven by seasonality fears (Sell in May…), banking concerns (JP Morgan’s trading loss) and worries over the viability of the Eurozone due to the recent elections in France and Greece. On their own, any one of these factors was enough to push the market lower and together they drove a pretty strong selloff of 7.87% for the S&P 500 (5/1/12 – 5/18/12). Yet it wasn’t all bad news, but the good news on corporate earnings and U.S. economic strength was just that, good news, and the markets were in need of great news to help stem the short-term tide.

Some of this good news includes an earnings season that is, statistically, better than last quarter. In addition, EPS (Earnings Per Share) for the S&P 500 has risen over 10% year-over-year and is expected to grow about the same over the next year. On the value side the P/E (Price per Earnings) for the S&P 500 now sits at 13.29 well below its value of 15.32 from a year ago and its 60-year average of 16.4. Other good news includes reports of home inventories shrinking over 20% year-over-year, existing home sales rising and vehicle sales hitting levels last seen four years ago. This reinforces our thesis that the U.S. economy is continuing to mend (albeit slowly) and should continue to do so and should be helped along the way by the positive feedback cycles we are beginning to see from a number of industries including housing and autos.

Will there be more bumps in the road and more gut check moments? Absolutely! However, we still like the outlook for equities and are standing by our end-of-year target of 1430 for the S&P 500. We would continue to recommend investors take advantage of the dips as they come (disciplined dollar cost averaging if they can) and would favor our themes of investing in companies and strategies that offer quality dividends, quality balance sheets and quality (above trend) growth.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at ~/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com

Copyright © Advisors Asset Management

Some rise by sin and some by virtue fall.
– Shakespeare

I saw this quote recently while researching another topic. I found it to be appropriate to capture the challenge that professional money managers have in finding investments appropriate for the current domestic economic and geopolitical environment. The rules (that apply to what makes an investment good or bad) that have been established over the previous 40 years of investing are no longer relevant, and those investments that typically would struggle during a massive global recession have been successful in achieving a rising valuation. The Fed’s actions of late have certainly created buoyancy in a rather questionable market. But to what end? Are we slated now for yet another round of quantitative easing? QE3 to the rescue…

The Fed’s Answer to Recovery

Trying to find the right blend of investments during any normal market cycle can be trying. Throw into the equation the Fed’s involvement with quantitative easing, colloquially known as “QE,” and suddenly everything you may have thought you knew is no longer relevant. To add to the confusion, there are few historical references on which to base our future decisions – creating a recipe for complexity. The standard variables that an advisor may use to determine investment quality or the technical analysis that has worked over the previous decades may not apply in the same manner as before.

The term quantitative easing, as defined by Investopedia, describes a form of monetary policy used by central banks to increase the supply of money in an economy when the bank interest rate, discount rate, and/or interbank interest rate are either at, or close to, zero.

Quantitative easing is a phrase that has been added to the vocabulary of nearly every human in the developed world. Over the last four years, actions by the national banks across the globe have taken steps to stave off massive economic downturns by finding ways to inject liquidity into their respective economies. Historically, where government spends– a bubble develops. Only to be further followed by the eventual collapse of the bubble and the wake that is created.

The now infamous quantitative easing is the Fed’s answer to providing a potential recovery to the markets and economy. In past years, the Fed’s “go to philosophy” was to simply cut or raise interest rates to either cool or ignite the economy. While arguments exist in support of this methodology the question might be: why not stick with what works? Well, to answer my own question– because it wasn’t working.

When the Fed lowered rates to near zero it became a game of “what next.” What fiscal silver bullet existed that the Fed could use to create an up swell in the overall sentiment of the American and global investor? While the idea of QE seemed a fresh perspective on our shores for solving the financial crisis one didn’t need to look back too far to find an eerily similar event.

Japan: A QE Case Study

Japan is the only economy in the modern age to have tried a nationwide stimulus of QE for a significant period. The Bank of Japan lowered its rate aggressively with no effect on the economy. Once at zero the Bank of Japan (BOJ) instituted the first set of QE and ran the process for the following five years. Some economists would say that it appeared that the BOJ continued to have a hand in the economy by injecting liquidity from time to time even up to the current day. Like a defunct junkie, the economy of Japan is attempting to wean itself from the BOJ and its liquidity injections. Is this what the future holds for not only the US, but all economies that have participated in the game of QE (read – Euro zone)?

With today’s active methodology of QE the RIA would have to ask what this means to the current day investor. If we have this one example of the impact of QE on Japan’s monetary policy as our historical reference, we would ask what the impacts of QE were and how do we use this knowledge to our advantage? Looking at Japan as our case study, we find that the period that the BOJ was active in its QE philosophy corresponded to the largest expansion of Japan post WWII. In my readings many economists would not credit the QE with this expansion. I believe we would be remiss to think one did not impact the other.

QE and the Investor

With that said– should an investor throw caution to the wind and build an all equity exposure portfolio and let it ride? Hold on before you push that trade button. There is always another side to the market. What happened in the past will certainly happen again. Let us not forget to refer to our history lessons. Japan experienced significant volatility within the bond markets during the advent of QE. A bond bubble was created that had a significant impact on the economy of Japan. So much – that it nearly thrust them into another bought of stagnation, and ultimately a depression. This bond correction forced more action from the BOJ. This proverbial teeter totter of activity by the Japanese Fed has still yet to fully play out.

The consideration in this history lesson is asking the question how should one (country) use the power of QE? While most agree that QE is an effective measure to help stabilize short term liquidity issues, QE will never serve to provide the replacement for the truly hard decisions that need to be made by government to create a healthy and productive capitalist system.

We know that QE works, at least for a short term fix. The question is how long is this fix going to be used? We also know that from a historical precedent there are pitfalls, specifically in the bond market.

With the recent commentary coming out of the Fed identifying several downside risks. Is it time to reevaluate your current position?

Or to quote Shakespeare once again:

A fool thinks himself to be wise, but a wise man knows himself to be a fool.

Being a firm believer in deferring to the experts, allow me to share a timely interview with Bill Gross of PIMCO.

First we'll go to the technicals.  Back in mid April I had opined a 'bear flag' formation was being created. [Apr 17, 2012: Potential Bear Flag Forming]  But the market being the difficult beast it is, head faked everyone and rather than a break down from said flag it first went UP and nearly touched yearly highs.  This caused everyone to think the bear flag had failed…. only to lead to a horrid May in the market.  Generally a bear flag will resolve relatively quickly but the longer that one lasted the more doubt it created and potentially transitioned into a market that was creating a new range before a new move up.  Hence, why it was so tricky.

I speak of this only because we potentially are forming a new bear flag.  After extreme oversold conditions the markets finally held a previous low Monday and rallied.  This had been expected for a few days but anyone trying to catch the knife last week had their fingers chopped off… repeatedly.   We had mentioned a potential bounce level to 1338 minimum [May 22, 2012: Market Bounce Arrives — How Durable?] but as of Tuesday mid day the rally only hit 1328 as it was rejected by the quickly falling 10 day moving average.  Then yesterday started horribly as news surfaced that discussions / preparations for a Greek exit from the EU are formally starting behind the scenes, and it really looked like the bears would take charge.  Instead it was a trap, as rumors out of Europe that (a) Merkel supports backstopping all EU bank deposits (b) Italy and France support Eurobonds [May 22, 2012: Are Eurobonds Coming?] and/or © pick your rumor, hit.

The larger picture is this environment is akin to summer 2010 and latter 2011 where headline rumors, European comments, intervention hopes dominate the landscape and the market is herked and jerked around while in a downward path.   The action is violent in sharp contrast to January and February of this year.   Stocks are moving en masse as correlations return, and individual stock picking is nearly useless again.  Meanwhile the safe havens – the U.S. dollar and Treasury bonds, surge.  Therefore, unless you know the rumor/intervention hope of the day ahead of time it's really not a place anyone with intermediate term views is going to risk a lot of capital.

Speaking of the bear flag, yesterday's sharp rally to take markets out of steep losses to very modest gains helps define a current potential bear flag range of about 50 points: S&P 1290 to 1340.  While we did not reach the 1338 in the S&P 500 I am still going to include that in the range as that is a multi month resistance/support level the market has been dealing with throughout the year.   So just as I said in mid April what happens WITHIN that range means nothing.  The market could be UP 25 S&P points or DOWN the same, but as long as it's within that range it is only a basing activity and nothing but "white noise".  And until further notice it is has the potential of a new bear flag forming.   Of course we sit almost smack dab in the middle of said range today.

If you turn this chart upside down you would call this very bullish…. we'd be saying after a large move up, the market is going sideways for a few days to digest the move.  Hence, it is only fair to lean bearish when we have the inverse situation.  The market can always differ and change things – technicals are only a roadmap and in a world of massive intervention they can quickly be obliterated as said roadmap.  So if we hear that to stop bank runs every single cent of bank deposit in the Eurozone will be backstopped by the ECB or "Germany" (with what money???) you will get a 'face ripper' type rally I am sure.  You can see that from yesterday where nothing but rumors got the Dow up 200 points from the low.  We repeat the same pattern year after year now, downfall, bad news, crisis, intervention, rally.  Rinse, wash, repeat.

As for economic news overnight – it continues bad.  China continues to weaken, but I think commodities have been telling us this for months.  Expect more easing in the future although they cut reserve requirements 50bps a week and a half ago.  And Europe data is also very weak, but this should come to no surprise to anyone.  I think some/much of this is 'priced in' the market but the mess that is the Eurozone remains the key issue.  Everyone awaits the authorities to swoop in and "fix it" (kick the can).  My thesis that QE3 is arriving has not changed since last fall, and is only being strengthened by the day.  In fact we might get coordinated global central bank action since the level of worries are global – we'll see in a few weeks.

• The euro zone composite PMI, a combination of the services and manufacturing sectors and seen as a guide to growth, fell to 45.9 this month from April's 46.7, its lowest reading since June 2009 and its ninth month below the 50-mark that divides growth from contraction.
• Markit, which complies the PMIs, or purchasing managers indexes, said the reading was consistent with gross domestic product, which stagnated in the first quarter, falling by at least 0.5 percent across the region in the current quarter.
• "The flash PMI figures for May look horrible and provide a clear warning that euro zone GDP will almost certainly show a contraction in Q2 after stagnating in Q1," said Martin van Vliet at ING.
• Across the channel, official data showed Britain's economy shrank more than first thought between January and March, after the deepest fall in construction output in three years, while government spending made the biggest contribution to growth.
• PMI data from Germany, Europe's largest economy, showed its manufacturing sector contracted at a far greater pace than was expected, and its service sector saw minimal growth. In neighboring France, both sectors contracted faster than predicted by most economists.
• German business sentiment also dropped for the first time in seven months in May, the Ifo think tank said, missing even the most conservative forecasts, in a sign that Europe's largest economy is vulnerable to euro zone turmoil despite holding up well until now.
• HSBC's Flash China PMI, the earliest indicator of China's industrial sector, retreated to 48.7 in May from a final reading of 49.3 in April. It marked the seventh straight month that the index has been below 50.  "The series of highly disappointing April activity data – exports, imports, industrial production and retail sales indicators all fell short of even the most pessimistic forecasts – the first gauge for economic activity in the current month is a further signal that internal and external headwinds are still biting into economic momentum," said Nikolaus Keis at UniCredit.

by Daniel Morillo, PH. D., Head of Investment Research, iShares

As minimum volatility investments gain popularity, clients are asking me if investments that track minimum volatility indexes can be used as a tool to “time” exposure to the equity market during risk-off periods.  While it’s an interesting question, I think it overlooks the real benefit of this kind of exposure in an investment portfolio.

To me, the value of a relatively low-risk investment like a minimum volatility portfolio is not its low risk, but how its returns can compare with those of a capitalization-weighted equity portfolio, or a so-called market portfolio. I would argue that a minimum volatility portfolio of equities potentially offers a better way for long-term investors to invest in equities – even if they have no interest in the lower risk that these portfolios provide.

Yes, I know. To many readers, this might seem like a bold statement. After all, according to modern portfolio theory, the market portfolio (aka the cap-weighted equity portfolio) is generally considered to be theoretically “efficient” in that it should provide the best possible trade-off between risk and return.

Let’s look at the traditional “portfolio frontier” chart that can be found in almost every introductory finance textbook[1].

The chart shows that over the long run, equity markets are expected to reward riskier assets with higher returns. In this case, the market portfolio (the cap-weighted equity portfolio) is expected to provide the highest level of return for its level of risk, while the low risk minimum volatility portfolio should provide commensurately lower returns.

The problem with this picture is that a wide range of empirical studies have found that the market portfolio does not appear to deliver enough additional return to compensate an investor for the additional risk it takes compared with the minimum volatility portfolio[1].

Let’s look at this modified chart:

by Peter Tchir, TF Market Advisors

The market continues to trade with extreme volatility. Yesterday’s decline was deep and painful, only to be followed by an equally vicious rally on rumors of a rumor. This morning has already seen Europe rally, fade, then rally again. The overall theme remains the same, with concerns about Europe being counterbalanced by hopes of central bank action and government policy. Maybe as a bank bull down here, I am reading too much into it, but the whale trade fiasco seems to finally be getting put into perspective. That is good for JPM and the financials and the market.

The fear that the EU is preparing a plan for Greece to exit seemed like the worst excuse to sell off that the market has used. There is a real chance Greece will exit. Without significant concessions from the ECB and Troika, it will be there only option. I would much rather that Greece planned for it rather than just gave it a shot. Any hope of a Grexit not being incredibly disruptive to itself and to the rest of Europe will depend on planning. Real planning, not the typical EU style that assumes the market will do what it would like, but one that puts some stresses on the potential outcomes and works hard to deal with them. Given how much money the ECB and Troika are on the hook for, the concerns of deposit flight in other countries if redenomination risk rises, the EU will have to be very careful what it does. I think that as the EU actually works on some plans (shocking that it hasn’t yet) their concern for their own safety and their ability to really manage the worst case scenario will come into doubt, and they will make some concessions with Greece to give everyone time.

And timing is everything. Lots of people are asking what changed from Friday, or from yesterday afternoon. The answer is very little. But what actually has occurred from 2 weeks ago when the S&P was 1,357. The answer there is also very little. Fears of an imminent Grexit have been overblown. That has been our message. Neither side will have the guts (nor stupidity) to rush this decision. It will take time. Time is key because it does give hope that enough can be done that the exit doesn’t turn into a full blown crisis in Europe and that risk of currency flight in Spain and Italy can be contained. Timing is key, because without imminent catalysts, the oversold conditions and “carry” can come into play. RSI, as simple as it is, remains one of my favorite indicators. So much bearishness has been stuffed into the market, that the ability to rally on next to nothing remains high. We even ignored some okay housing data, which only 2 months ago everyone agreed was the key to a successful recovery.

Shorting credit is expensive. Everyone seems to forget about that. Seeing IG18 blow out from 93 to 123 reminds everyone how cool it is when credit blows out. HYG down from 91 to 87.5 is another great example of how quickly credit moves. Spanish CDS at 540 and still near the record highs posted last week is another example where it blew out from a low of 355 in March, to 555 last week. The problem here with being short is how expensive it is. HYG is paying 7% per annum and the price is rising. The cost to sit short is high, and if you take away the noise around Greece (overdone) and JPM (overdone) the arguments for it to be higher than this are all still in place. Even with Spain, you pay 100 bps running and have a pull to par effect, so you slowly bleed money being short. Add to that, the fear that one of these mash it all together and throw government money (that the government doesn’t have) solutions is enough to get the markets excited and you have the making of a short squeeze. The true “trading float” of Spanish bonds in particular is very small. Most bonds are held in buy and hold accounts at banks and insurance companies. Neither of these groups, overexposed as it is, are buying, but they aren’t selling either, so any improvement in the situation can result in a move disproportionate to the improvement. This is also true, to a lesser extent, in the Italian bond market.

I remain constructive here under the assumption that

• Central banks continue to be extremely dovish and may even take some actions
• Grexit, while likely isn’t imminent and the EU will start trying to sound less arrogant and belligerent towards Greece
• The sell-off in financials, part in Greece, but at least in part due to the whale trade, is over and is reversing as people are able to understand that even at JPM the CIO’s entire book is okay, and that this was not a systematic trade affecting all banks
• Data will continue to be mediocre, but with enough bright spots that the bulls can latch on to something and try and push high
• Sell in May and go away may be a good investment strategy, but selling ahead of a long weekend typically isn’t

Copyright © TF Market Advisors

By Tom Bradley

I find the kerfuffle about the Facebook initial public offering (IPO) interesting. I don’t know if anything nefarious went on behind the scenes, but it seems to me that what played out on this overhyped and highly priced IPO (the $38 issue price equates to over 20x revenue) fell within the range of possible outcomes.

Facebook is impossible to value at this point in its development. It’s already one of the most important web platforms (along with Google, Apple and Amazon) and it certainly has a shot at becoming a highly profitable company (as the others did), but it’s still a bit of a crap shoot. Ultimately the stock price will be determined by how well the company monetizes (makes profits from) its user base. In the meantime, because Facebook’s valuation is so far out of the normal range, the stock will ebb and flow with every new analyst report, privacy abuse and Zuckerberg sighting.

Clearly the company and large shareholders got greedy in pricing and sizing the issue. Employees and other early shareholders sold over $9 billion of stock to the public, while only $6.8 billion was put into the company’s coffers. But should the buyers of Facebook shares, on the IPO or in the market afterwards, be surprised that Wall Street is hyperventilating (it was before the issue, why not after) and media sentiment is swinging like a baby on a Jolly Jumper? Certainly the sophisticated institutional buyers shouldn’t be. They read every page of the prospectus and knew the risks. Individual investors bought through full service advisors, so presumably their Facebook shares were put in the ‘high growth / high risk’ bucket of their portfolios.

I’m not trying to make light of investors’ short-term paper losses, but the result here was well within the realm of possibility. New issues aren’t a one-way street. They don’t all go to massive premiums on the first day of trading. Indeed, the fact that some do, like LinkedIn and Groupon, just reinforces how imprecise the IPO process is.

While the sur-realities of just what Corzine and the rest of the MF Global 'traders' did has been extensively discussed here and elsewhere, PBS' Frontline provides the most succinct (and relatively in-depth) documentary on just what occurred from how the corrupt CEO lobbied regulators who had the power to stop his risky bets to the endgame realization of the missing customer money. A narrative, not just of "a bet that went bad", but "a Wall Street morality tale". Must watch!

The story of Jon Corzine, the former head of Goldman Sachs and political power broker, who took over MF Global in the spring of 2010 with oversize ambition and a passion for risk. But after a massive bet on European debt turned sour, the firm lay in ruins, with more than a billion dollars of customer funds missing.

Chapter 1: Six Million Dollar Bet — The Power of Jon Corzine

Watch Six Billion Dollar Bet on PBS. See more from FRONTLINE.

Chapter 2: Six Million Dollar Bet — The Final Days Of MF Global

Watch Six Billion Dollar Bet on PBS. See more from FRONTLINE.

Copyright © FOX Network

by Andrew Horowitz, The Disciplined Investor

It has been a wild ride over the past 52 weeks and some markets came out looking good, some not so good.

Clearly the U.S. has the best overall return in 2011 and that shows through on the peak to trough range – and still holding up well.

Europe (ex-Germany) has not had as good as a run. Even with the big uptick due to the LTRO, the markets have been punished.

Asia speaks for itself – Japan is still a mess though…

Copyright © The Disciplined Investor