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Archive for October 2013

Archive for October, 2013

Patrick Cox: This Biotechnology Platform Could Save Millions of Lives

 

TICKERS: INO

Source: George S. Mack of The Life Sciences Report  (10/24/13)

Patrick Cox, editor of the brand-new publication Transformational Technology Alert, is acutely aware of how transformational technology platforms can enable efficiencies and improve scale a la Moore’s Law. A sweeping new synthetic vaccine platform that poses infinite possibilities for researchers and could produce novel preventive and therapeutic drugs is a quintessential example. In this interview with The Life Sciences Report, Cox delivers a single name that holds the potential to save lives on a mass scale, cheaply and efficiently, in both the developed and developing world—and deliver health and wealth to investors’ portfolios as well. 

COMPANIES MENTIONED: INOVIO PHARMACEUTICALS INC.

The Life Sciences Report: Congratulations on your new publication, Transformational Technology Alert (TTA). I’ve read the first issue, and I think your readers will find a lot of value there. Why did you start TTA?

PC: The driving force behind this new effort came from readers of former publications who are much better at trading than I am. I was encountering people who read the articles, understood the basic science, understood the markets that the breakthroughs would address and then combined that knowledge with techniques like channel trading.

TLSR: Tell me what you mean by channel trading.

PC: There is a lot of volatility in startup biotechs. That fluctuation is a favorite domain of shorters. I became really impressed that people were able to buy on dips and then sell part of their holdings when the price went up. They were making enormous amounts of money, frankly.

TLSR: These traders seem to know where the resistance and support levels are, is that right?

“I became really impressed that people were able to buy on dips and then sell part of their holdings when the price went up. They were making enormous amounts of money, frankly.”

PC: That’s my impression—in fact, that’s sort of the point behind this new publication. The publisher, Mauldin Economics, has given me a team of excellent analysts who study resistance and are looking very closely at the past behavior of companies to help people predict what the channel or range of prices between support and resistance is going to be, and how to play that channel. I like the idea of holding fewer stocks but having more confidence in them. Not that there’s anything wrong with holding more.

TLSR: It’s hard to find a brand new idea that encompasses a massive market, isn’t it?

PC: Just when I think that there’s no possible way we can find anything else as important or as big as what we’ve already found, something new and exciting comes along. But that’s the nature of these times. We are in a period of accelerating science. I’m constantly surprised and amazed at the new discoveries being made and applied in the field of medicine.

TLSR: Tell me how Gordon Moore’s Law applies to biotechnology. This was a theme in your webinar entitled Science Saves the Future, which you and your colleagues at Mauldin Economics hosted on Oct. 15.

PC: Informational technology (IT) people are inventing and creating new computer systems from scratch, and as these systems become more powerful we see researchers applying those tools to biological systems that are very sophisticated—actually far more sophisticated than the IT systems. If you compare DNA to microcircuits—well, there just is no comparison. The systems of our biology, of our DNA, are vastly more sophisticated and interesting than anything IT experts have made.

“Information technology is giving biotechnologists the ability to analyze systems like they have never done before.”

However, IT is giving biotechnologists the ability to analyze these systems like they have never done before. Moore’s Law states that the density of data on a circuit will double every 18 months or so for the next 20 years. In the last 10 years, research, which is often computer-intensive, has become so much easier. I am told on a regular basis that we are seeing the rate of discovery increase by several orders of magnitude per decade. Data is processed a thousand times faster, in fact, than it was just 10–15 years ago. We are witness to new fixes for old problems, and we are going to see even more new fixes in the coming years.

TLSR: Can you summarize the Moore’s Law component in this process for me?

PC: We’re talking about improvements in everything from target discovery to in silico synthesis of compounds to reducing times of clinical trials to increasing efficiency associated with drug discovery and development. Moore’s Law is about collapsing timeframes in all areas of technology and development.

TLSR: What about your webinar topic, Science Saves the Future? Tell me the thinking here.

PC: These advances in IT and biotechnology are important because of our economic problems. Right now 36% of the U.S. budget consists of transfer payments (Medicare, Medicaid and Social Security) to older individuals. That’s three times what those payments were when they started, and they have doubled since 1970. This is mostly because we have seen a demographic transition, with people living much longer. Life spans have almost doubled in the last century or so, and birth rates have fallen to half of what they were since 1970, causing the demographic pyramid to flip. The ability of younger people to support older people, who are living longer, is gone.

“Just when I think that there’s no possible way we can find anything else as important or as big as what we’ve already found, something new and exciting comes along.”

Instead of resisting that trend, we need to embrace it. We have the ability now to work much longer, and we will do that. This is not a question of policy. This is just practical. Retirees are working past the age of entitlement eligibility already, and most say they expected that to happen.

Biotech breakthroughs are going to extend life spans further, and they are also extending health spans—that portion of a person’s life that is vigorous, robust and strong. That means enhanced productivity, so savings and investment will increase. This trend is going to solve problems like the debt and entitlement crises that the entire Western world is facing right now.

TLSR: Can we talk about investment? You currently have an exciting theme revolving around DNA immunization. Would you briefly give some background?

PC: Inovio Pharmaceuticals Inc. (INO:NYSE.MKT) came out of the work of David Weiner, who is the father of DNA vaccines. He is the chairman of Inovio’s scientific advisory board, and also a professor at the University of Pennsylvania, where he is chairman of the gene therapy and vaccine program at the medical school.

Dr. Weiner discovered how to genetically engineer plasmids, which are circular strings of DNA, to produce any protein that is normally produced by our DNA. We can create artificial DNA with these plasmids to make things like the antigens, which alert the immune system to the presence of disease when it’s normally hidden, and then cause the immune system to ramp up production of specific kinds of T cells that will allow the effective countering of viral diseases or cancers. This is really an astonishing technology, and that’s only the tip of the iceberg.

Inovio is the amalgamation of four or five different companies that started going after DNA vaccines. Over time, after the initial enthusiasm of big pharma waned, these companies ended up coming together as a single company.

TLSR: Briefly, please, how does this work? What is the theory?

PC: Interestingly, because these plasmids are large molecules, they are not readily absorbed into the cell. That would be a problem, except that Inovio owns the key intellectual property around electroporation. This proprietary technology gives Inovio the ability to deliver plasmids across cell membranes. The process uses controlled, millisecond-long, electrical pulsations, after the vaccine injection, to produce momentary pores that open up and allow the cell to absorb the synthetic vaccine material. The vaccine then enters the cytoplasm and eventually moves into the nucleus, where the plasmids begin to express whatever protein the researchers want them to express. The cellular mechanism uses the DNA code that was engineered into the plasmid to synthesize the proteins related to the disease being targeted. These protein antigens trick the immune system into producing a response that will protect against a disease associated with that antigen, or eradicate infected cells or cancer cells.

TLSR: Inovio stock has moved upward dramatically in the last six months. It is getting a lot of respect these days, isn’t it?

PC: When I first started writing about Inovio, it was so new that people were skeptical and were complaining that the company wasn’t making regular gains. In early September the company signed an agreement with Roche Holding AG (RHHBY:OTCQX) for two programs, both of which are preclinical and both of which are therapeutic vaccines, INO-5150 for prostate cancer and INO-1800 for hepatitis B virus. Its stock price is doing significantly better. Moreover, it now has the resources to pursue other applications of DNA vaccines.

TLSR: What about this impressive move upward? Is it hard to sell this as an investment idea with the stock up 260% since May?

PC: I’m not at all bothered about the fact that price has gone up. Inovio still has extraordinary potential, and I’ll tell you why. Here’s one example: Monoclonal antibodies are expensive therapies, and they are difficult to handle, but this technology can actually produce monoclonal antibodies in these little inoculation sites. It puts this code in your body, and you make the antibodies yourself.

“The ability of younger people to support older people, who are living longer, is gone. Instead of resisting that trend, we need to embrace it.”

The company has a majority-owned subsidiary, VGX Animal Health, that is using Inovio’s technology on animals in Australia. The vaccine technology is causing animals to express growth hormone-releasing hormone (GHRH), which makes them larger and more fertile. Think about that. The baby boom is aging. We see athletes taking growth hormones, but because it’s exogenous, coming from outside the body, it causes all kinds of problems. We know that it’s possible to get effective rejuvenation of many human systems—better skin, better muscle tone, that sort of thing—with GHRH. I think that down the road, after Inovio’s cancer and virus vaccines have begun to pay off and when the company is able to go where it wants to go, we’re going to be looking at monoclonal antibodies, then life-extension technologies, and then other exciting applications.

TLSR: Today Inovio has a market cap of $413 million, still small enough to be an easy acquisition. Do you anticipate this company is going to be acquired before it has a chance to grow into a fully integrated biopharma?

PC: It’s a possibility, but I don’t think Inovio is going to give up all of its technology to a single company. I don’t think it’s necessary. The company has many partnerships. For instance, it has made extraordinary progress on malaria, and the Bill & Melinda Gates Foundation, through its PATH Malaria Vaccine Initiative (MVI), is funding preclinical development of Inovio’s SynCon synthetic malaria vaccine.

I’m hoping that the company is not acquired. I suppose shortsighted investors would be happy about it, but I really want to see Inovio CEO Joseph Kim and Dave Weiner continue to push this technology into the future.

TLSR: Is there any other company you wanted to mention?

PC: One of the people who participated in the Science Saves the Future webinar is Cameron Durrant, who is a remarkable guy. He was a top executive at Johnson & Johnson (JNJ:NYSE), GlaxoSmithKline (GSK:NYSE), Merck & Co. Inc. (MRK:NYSE), and Pharmacia Corp. (acquired by Pfizer Inc. [PFE:NYSE]). He may be best known as the prophet who warned big pharma not to pursue beta amyloid as the cause of Alzheimer’s disease. He was proven correct. He’s just a brilliant scientist. He is also a founding board member of a private company, Bexion Pharmaceuticals, which has a remarkable cancer technology. He talked a little bit about that in the seminar. Retail investors can’t yet own any part of this company. Would you like to hear about the technology?

TLSR: Since it’s not public yet, give me just a brief description. Why is Bexion so interesting?

PC: It has taken two naturally occurring biologics and joined them to create a nanovesicle, which homes in on phosphotidylserines, which are the self-destruct mechanisms built into all of our cells. Our cells ordinarily follow a cycle of replication and apoptosis (natural cell death) to clear out aged cells for new cells. Cancer cells are, in a sense, the zombie cells. They’ve forgotten how to die because apoptotic functions are shut off. Bexion has demonstrated that its BXQ-350 induces apoptosis in certain glioma cell lines.

TLSR: So nice speaking with you today, Patrick. Thank you.

PC: Thank you. I enjoyed it.

Patrick Cox has lived deep inside the world of technology breakthroughs for the past 30 years. He has written more than 200 editorials for USA Today and has appeared in The Wall Street Journal and on CNN’s Crossfire television program. In the late 1980s, he edited and published one of the first industry-insider software magazines, writing about topics like open-source and user-supported software long before those ideas were widely understood. Later, he wrote presentations and speeches for the CEO of Netscape. His consulting work has taken him to Fortune 500 boardrooms and inside the war rooms of national political candidates. His independent research is based solely on his investigations in transformational wealth-building companies and is generated in close consultation with important economists and scientists. Patrick has just released a report on three companies he thinks have the most near-term potential in the transformational technologies space. Full details on these cutting-edge investment opportunities poised to build wealth, eradicate disease, and extend lives are available nowWant to read more Life Sciences Report interviews like this? Sign up for our free e-newsletter, and you’ll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Streetwise Interviews page.

DISCLOSURE:
1) George S. Mack conducted this interview for The Life Sciences Report and provides services to The Life Sciences Report as an independent contractor. He or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Life Sciences Report: Inovio Pharmaceuticals Inc. Streetwise Reports does not accept stock in exchange for its services.
3) Patrick Cox: I or my family own shares of the following companies mentioned in this interview: None. I personally am or my family is paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
4) Interviews are edited for clarity. Streetwise Reports does not make editorial comments or change experts’ statements without their consent.
5) The interview does not constitute investment advice. Each reader is encouraged to consult with his or her individual financial professional and any action a reader takes as a result of information presented here is his or her own responsibility. By opening this page, each reader accepts and agrees to Streetwise Reports’ terms of use and full legal disclaimer.
6) From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles and interviews on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise.

Patrick Cox: This Biotechnology Platform Could Save Millions of Lives

 

TICKERS: INO

Source: George S. Mack of The Life Sciences Report  (10/24/13)

Patrick Cox, editor of the brand-new publication Transformational Technology Alert, is acutely aware of how transformational technology platforms can enable efficiencies and improve scale a la Moore’s Law. A sweeping new synthetic vaccine platform that poses infinite possibilities for researchers and could produce novel preventive and therapeutic drugs is a quintessential example. In this interview with The Life Sciences Report, Cox delivers a single name that holds the potential to save lives on a mass scale, cheaply and efficiently, in both the developed and developing world—and deliver health and wealth to investors’ portfolios as well. 

COMPANIES MENTIONED: INOVIO PHARMACEUTICALS INC.

The Life Sciences Report: Congratulations on your new publication, Transformational Technology Alert (TTA). I’ve read the first issue, and I think your readers will find a lot of value there. Why did you start TTA?

PC: The driving force behind this new effort came from readers of former publications who are much better at trading than I am. I was encountering people who read the articles, understood the basic science, understood the markets that the breakthroughs would address and then combined that knowledge with techniques like channel trading.

TLSR: Tell me what you mean by channel trading.

PC: There is a lot of volatility in startup biotechs. That fluctuation is a favorite domain of shorters. I became really impressed that people were able to buy on dips and then sell part of their holdings when the price went up. They were making enormous amounts of money, frankly.

TLSR: These traders seem to know where the resistance and support levels are, is that right?

“I became really impressed that people were able to buy on dips and then sell part of their holdings when the price went up. They were making enormous amounts of money, frankly.”

PC: That’s my impression—in fact, that’s sort of the point behind this new publication. The publisher, Mauldin Economics, has given me a team of excellent analysts who study resistance and are looking very closely at the past behavior of companies to help people predict what the channel or range of prices between support and resistance is going to be, and how to play that channel. I like the idea of holding fewer stocks but having more confidence in them. Not that there’s anything wrong with holding more.

TLSR: It’s hard to find a brand new idea that encompasses a massive market, isn’t it?

PC: Just when I think that there’s no possible way we can find anything else as important or as big as what we’ve already found, something new and exciting comes along. But that’s the nature of these times. We are in a period of accelerating science. I’m constantly surprised and amazed at the new discoveries being made and applied in the field of medicine.

TLSR: Tell me how Gordon Moore’s Law applies to biotechnology. This was a theme in your webinar entitled Science Saves the Future, which you and your colleagues at Mauldin Economics hosted on Oct. 15.

PC: Informational technology (IT) people are inventing and creating new computer systems from scratch, and as these systems become more powerful we see researchers applying those tools to biological systems that are very sophisticated—actually far more sophisticated than the IT systems. If you compare DNA to microcircuits—well, there just is no comparison. The systems of our biology, of our DNA, are vastly more sophisticated and interesting than anything IT experts have made.

“Information technology is giving biotechnologists the ability to analyze systems like they have never done before.”

However, IT is giving biotechnologists the ability to analyze these systems like they have never done before. Moore’s Law states that the density of data on a circuit will double every 18 months or so for the next 20 years. In the last 10 years, research, which is often computer-intensive, has become so much easier. I am told on a regular basis that we are seeing the rate of discovery increase by several orders of magnitude per decade. Data is processed a thousand times faster, in fact, than it was just 10–15 years ago. We are witness to new fixes for old problems, and we are going to see even more new fixes in the coming years.

TLSR: Can you summarize the Moore’s Law component in this process for me?

PC: We’re talking about improvements in everything from target discovery to in silico synthesis of compounds to reducing times of clinical trials to increasing efficiency associated with drug discovery and development. Moore’s Law is about collapsing timeframes in all areas of technology and development.

TLSR: What about your webinar topic, Science Saves the Future? Tell me the thinking here.

PC: These advances in IT and biotechnology are important because of our economic problems. Right now 36% of the U.S. budget consists of transfer payments (Medicare, Medicaid and Social Security) to older individuals. That’s three times what those payments were when they started, and they have doubled since 1970. This is mostly because we have seen a demographic transition, with people living much longer. Life spans have almost doubled in the last century or so, and birth rates have fallen to half of what they were since 1970, causing the demographic pyramid to flip. The ability of younger people to support older people, who are living longer, is gone.

“Just when I think that there’s no possible way we can find anything else as important or as big as what we’ve already found, something new and exciting comes along.”

Instead of resisting that trend, we need to embrace it. We have the ability now to work much longer, and we will do that. This is not a question of policy. This is just practical. Retirees are working past the age of entitlement eligibility already, and most say they expected that to happen.

Biotech breakthroughs are going to extend life spans further, and they are also extending health spans—that portion of a person’s life that is vigorous, robust and strong. That means enhanced productivity, so savings and investment will increase. This trend is going to solve problems like the debt and entitlement crises that the entire Western world is facing right now.

TLSR: Can we talk about investment? You currently have an exciting theme revolving around DNA immunization. Would you briefly give some background?

PC: Inovio Pharmaceuticals Inc. (INO:NYSE.MKT) came out of the work of David Weiner, who is the father of DNA vaccines. He is the chairman of Inovio’s scientific advisory board, and also a professor at the University of Pennsylvania, where he is chairman of the gene therapy and vaccine program at the medical school.

Dr. Weiner discovered how to genetically engineer plasmids, which are circular strings of DNA, to produce any protein that is normally produced by our DNA. We can create artificial DNA with these plasmids to make things like the antigens, which alert the immune system to the presence of disease when it’s normally hidden, and then cause the immune system to ramp up production of specific kinds of T cells that will allow the effective countering of viral diseases or cancers. This is really an astonishing technology, and that’s only the tip of the iceberg.

Inovio is the amalgamation of four or five different companies that started going after DNA vaccines. Over time, after the initial enthusiasm of big pharma waned, these companies ended up coming together as a single company.

TLSR: Briefly, please, how does this work? What is the theory?

PC: Interestingly, because these plasmids are large molecules, they are not readily absorbed into the cell. That would be a problem, except that Inovio owns the key intellectual property around electroporation. This proprietary technology gives Inovio the ability to deliver plasmids across cell membranes. The process uses controlled, millisecond-long, electrical pulsations, after the vaccine injection, to produce momentary pores that open up and allow the cell to absorb the synthetic vaccine material. The vaccine then enters the cytoplasm and eventually moves into the nucleus, where the plasmids begin to express whatever protein the researchers want them to express. The cellular mechanism uses the DNA code that was engineered into the plasmid to synthesize the proteins related to the disease being targeted. These protein antigens trick the immune system into producing a response that will protect against a disease associated with that antigen, or eradicate infected cells or cancer cells.

TLSR: Inovio stock has moved upward dramatically in the last six months. It is getting a lot of respect these days, isn’t it?

PC: When I first started writing about Inovio, it was so new that people were skeptical and were complaining that the company wasn’t making regular gains. In early September the company signed an agreement with Roche Holding AG (RHHBY:OTCQX) for two programs, both of which are preclinical and both of which are therapeutic vaccines, INO-5150 for prostate cancer and INO-1800 for hepatitis B virus. Its stock price is doing significantly better. Moreover, it now has the resources to pursue other applications of DNA vaccines.

TLSR: What about this impressive move upward? Is it hard to sell this as an investment idea with the stock up 260% since May?

PC: I’m not at all bothered about the fact that price has gone up. Inovio still has extraordinary potential, and I’ll tell you why. Here’s one example: Monoclonal antibodies are expensive therapies, and they are difficult to handle, but this technology can actually produce monoclonal antibodies in these little inoculation sites. It puts this code in your body, and you make the antibodies yourself.

“The ability of younger people to support older people, who are living longer, is gone. Instead of resisting that trend, we need to embrace it.”

The company has a majority-owned subsidiary, VGX Animal Health, that is using Inovio’s technology on animals in Australia. The vaccine technology is causing animals to express growth hormone-releasing hormone (GHRH), which makes them larger and more fertile. Think about that. The baby boom is aging. We see athletes taking growth hormones, but because it’s exogenous, coming from outside the body, it causes all kinds of problems. We know that it’s possible to get effective rejuvenation of many human systems—better skin, better muscle tone, that sort of thing—with GHRH. I think that down the road, after Inovio’s cancer and virus vaccines have begun to pay off and when the company is able to go where it wants to go, we’re going to be looking at monoclonal antibodies, then life-extension technologies, and then other exciting applications.

TLSR: Today Inovio has a market cap of $413 million, still small enough to be an easy acquisition. Do you anticipate this company is going to be acquired before it has a chance to grow into a fully integrated biopharma?

PC: It’s a possibility, but I don’t think Inovio is going to give up all of its technology to a single company. I don’t think it’s necessary. The company has many partnerships. For instance, it has made extraordinary progress on malaria, and the Bill & Melinda Gates Foundation, through its PATH Malaria Vaccine Initiative (MVI), is funding preclinical development of Inovio’s SynCon synthetic malaria vaccine.

I’m hoping that the company is not acquired. I suppose shortsighted investors would be happy about it, but I really want to see Inovio CEO Joseph Kim and Dave Weiner continue to push this technology into the future.

TLSR: Is there any other company you wanted to mention?

PC: One of the people who participated in the Science Saves the Future webinar is Cameron Durrant, who is a remarkable guy. He was a top executive at Johnson & Johnson (JNJ:NYSE), GlaxoSmithKline (GSK:NYSE), Merck & Co. Inc. (MRK:NYSE), and Pharmacia Corp. (acquired by Pfizer Inc. [PFE:NYSE]). He may be best known as the prophet who warned big pharma not to pursue beta amyloid as the cause of Alzheimer’s disease. He was proven correct. He’s just a brilliant scientist. He is also a founding board member of a private company, Bexion Pharmaceuticals, which has a remarkable cancer technology. He talked a little bit about that in the seminar. Retail investors can’t yet own any part of this company. Would you like to hear about the technology?

TLSR: Since it’s not public yet, give me just a brief description. Why is Bexion so interesting?

PC: It has taken two naturally occurring biologics and joined them to create a nanovesicle, which homes in on phosphotidylserines, which are the self-destruct mechanisms built into all of our cells. Our cells ordinarily follow a cycle of replication and apoptosis (natural cell death) to clear out aged cells for new cells. Cancer cells are, in a sense, the zombie cells. They’ve forgotten how to die because apoptotic functions are shut off. Bexion has demonstrated that its BXQ-350 induces apoptosis in certain glioma cell lines.

TLSR: So nice speaking with you today, Patrick. Thank you.

PC: Thank you. I enjoyed it.

Patrick Cox has lived deep inside the world of technology breakthroughs for the past 30 years. He has written more than 200 editorials for USA Today and has appeared in The Wall Street Journal and on CNN’s Crossfire television program. In the late 1980s, he edited and published one of the first industry-insider software magazines, writing about topics like open-source and user-supported software long before those ideas were widely understood. Later, he wrote presentations and speeches for the CEO of Netscape. His consulting work has taken him to Fortune 500 boardrooms and inside the war rooms of national political candidates. His independent research is based solely on his investigations in transformational wealth-building companies and is generated in close consultation with important economists and scientists. Patrick has just released a report on three companies he thinks have the most near-term potential in the transformational technologies space. Full details on these cutting-edge investment opportunities poised to build wealth, eradicate disease, and extend lives are available nowWant to read more Life Sciences Report interviews like this? Sign up for our free e-newsletter, and you’ll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Streetwise Interviews page.

DISCLOSURE:
1) George S. Mack conducted this interview for The Life Sciences Report and provides services to The Life Sciences Report as an independent contractor. He or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Life Sciences Report: Inovio Pharmaceuticals Inc. Streetwise Reports does not accept stock in exchange for its services.
3) Patrick Cox: I or my family own shares of the following companies mentioned in this interview: None. I personally am or my family is paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
4) Interviews are edited for clarity. Streetwise Reports does not make editorial comments or change experts’ statements without their consent.
5) The interview does not constitute investment advice. Each reader is encouraged to consult with his or her individual financial professional and any action a reader takes as a result of information presented here is his or her own responsibility. By opening this page, each reader accepts and agrees to Streetwise Reports’ terms of use and full legal disclaimer.
6) From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles and interviews on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise.

Thoughts from the Frontline: A Code Red World

 

I wasn’t the only person coming out with a book this week (much more on that at the end of the letter). Alan Greenspan hit the street with The Map and the Territory. Greenspan left Bernanke and Yellen a map, all right, but in many ways the Fed (along with central banks worldwide) proceeded to throw the map away and march off into totally unexplored territory. Under pressure since the Great Recession hit in 2007, they abandoned traditional monetary policy principles in favor of a new direction: print, buy, and hope that growth will follow. If aggressive asset purchases fail to promote growth, Chairman Bernanke and his disciples (soon to be Janet Yellen and the boys) respond by upping the pace. That was appropriate in 2008 and 2009 and maybe even in 2010, but not today.

Consider the Taylor Rule, for example – a key metric used to project the appropriate federal funds rate based on changes in growth, inflation, other economic activity, and expectations around those variables. At the worst point of the 2007-2009 financial crisis, with the target federal funds rate already set at the 0.00% – 0.25% range, the Taylor Rule suggested that the appropriate target rate was about -6%. To achieve a negative rate was the whole point of QE; and while a central bank cannot achieve a negative interest-rate target through traditional open-market operations, it can print and buy large amounts of assets on the open market – and the Fed proceeded to do so. By contrast, the Taylor Rule is now projecting an appropriate target interest rate around 2%, but the Fed is goes on pursuing a QE-adjusted rate of around -5%.

Also, growth in NYSE margin debt is showing the kind of rapid acceleration that often signals a drawdown in the S&P 500. Are we there yet? Maybe not, as the level of investor complacency is just so (insert your favorite expletive) high.

The potential for bubbles building atop the monetary largesse being poured into our collective glasses is growing. As an example, the “high-yield” bond market is now huge. A study by Russell, a consultancy, estimated its total size at $1.7 trillion. These are supposed to be bonds, the sort of thing that produces safe income for retirees, yet almost half of all the corporate bonds rated by Standard & Poor’s are once again classed as speculative, a polite term for junk.

Central Bankers Gone Wild

But there is a resounding call for even more rounds of monetary spirits coming from emerging-market central banks and from local participants, as well. And the new bartender promises to be even more liberal with her libations. This week my friend David Zervos sent out a love letter to Janet Yellen, professing an undying love for the prospect of a Yellen-led Fed and quoting a song from the “Rocky Horror Picture Show,” whose refrain was “Dammit, Janet, I love you.” In his unrequited passion I find an unsettling analysis, if he is even close to the mark. Let’s drop in on his enthusiastic note:

I am truly looking forward to 4 years of “salty” Janet Yellen at the helm of the Fed. And it’s not just the prolonged stream of Jello shots that’s on tap. The most exciting part about having Janet in the seat is her inherent mistrust of market prices and her belief in irrational behaviour processes. There is nothing more valuable to the investment community than a central banker who discounts the value of market expectations. In many ways the extra-dovish surprise in September was a prelude of so much more of what’s to come.

I can imagine a day in 2016 when the unemployment rate is still well above Janet’s NAIRU estimate and the headline inflation rate is above 4 percent. Of course the Fed “models” will still show a big output gap and lots of slack, so Janet will be talking down inflation risks. Markets will be getting nervous about Fed credibility, but her two-year-ahead projection of inflation will have a 2 handle, or who knows, maybe even a 1 handle. Hence, even with house prices up another 10 percent and spoos well above 2100, the “model” will call for continued accommodation!! Bond markets may crack, but Janet will stay the course. BEAUTIFUL!!

Janet will not be bogged down by pesky worries about bubbles or misplaced expectations about inflation. She has a job to do – FILL THE OUTPUT GAP! And if a few asset price jumps or some temporary increases in inflation expectations arise, so be it. For her, these are natural occurrences in “irrational” markets, and they are simply not relevant for “rational” monetary policy makers equipped with the latest saltwater optimal control models.

The antidote to such a boundless love of stimulus is of course Joan McCullough, with her own salty prose:

And the more I see of the destruction of our growth potential … the more convinced I am that it’s gonna’ backfire in spades. Do I still think that we remain good-to-go into year end? At the moment, sporadic envelope testing notwithstanding, the answer is yes. But I have to repeat myself: The data has stunk for a long time and continues to worsen. And the anecdotes confirming this are yours for the askin’. The only question remaining is for how long we can continue to bet the ranch on wildly incontinent monetary policy while deliberately opting to ignore the ongoing disintegration of our economic fabric?”

And thus we come to the heart of this week’s letter, which is the introduction of my just-released new book, Code Red. It is my own take (along with co-author Jonathan Tepper) on the problems that have grown out of an unrelenting assault on monetary norms by central banks around the world.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

© 2013 Mauldin Economics. All Rights Reserved.
Thoughts from the Frontline is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.

Please write to subscribers@mauldineconomics.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.MauldinEconomics.com.

To subscribe to John Mauldin’s e-letter, please click here: www.mauldineconomics.com/subscribe
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Thoughts From the Frontline and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President and registered representative of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.

131026-01

Thoughts from the Frontline: A Code Red World

 

I wasn’t the only person coming out with a book this week (much more on that at the end of the letter). Alan Greenspan hit the street with The Map and the Territory. Greenspan left Bernanke and Yellen a map, all right, but in many ways the Fed (along with central banks worldwide) proceeded to throw the map away and march off into totally unexplored territory. Under pressure since the Great Recession hit in 2007, they abandoned traditional monetary policy principles in favor of a new direction: print, buy, and hope that growth will follow. If aggressive asset purchases fail to promote growth, Chairman Bernanke and his disciples (soon to be Janet Yellen and the boys) respond by upping the pace. That was appropriate in 2008 and 2009 and maybe even in 2010, but not today.

Consider the Taylor Rule, for example – a key metric used to project the appropriate federal funds rate based on changes in growth, inflation, other economic activity, and expectations around those variables. At the worst point of the 2007-2009 financial crisis, with the target federal funds rate already set at the 0.00% – 0.25% range, the Taylor Rule suggested that the appropriate target rate was about -6%. To achieve a negative rate was the whole point of QE; and while a central bank cannot achieve a negative interest-rate target through traditional open-market operations, it can print and buy large amounts of assets on the open market – and the Fed proceeded to do so. By contrast, the Taylor Rule is now projecting an appropriate target interest rate around 2%, but the Fed is goes on pursuing a QE-adjusted rate of around -5%.

Also, growth in NYSE margin debt is showing the kind of rapid acceleration that often signals a drawdown in the S&P 500. Are we there yet? Maybe not, as the level of investor complacency is just so (insert your favorite expletive) high.

The potential for bubbles building atop the monetary largesse being poured into our collective glasses is growing. As an example, the “high-yield” bond market is now huge. A study by Russell, a consultancy, estimated its total size at $1.7 trillion. These are supposed to be bonds, the sort of thing that produces safe income for retirees, yet almost half of all the corporate bonds rated by Standard & Poor’s are once again classed as speculative, a polite term for junk.

Central Bankers Gone Wild

But there is a resounding call for even more rounds of monetary spirits coming from emerging-market central banks and from local participants, as well. And the new bartender promises to be even more liberal with her libations. This week my friend David Zervos sent out a love letter to Janet Yellen, professing an undying love for the prospect of a Yellen-led Fed and quoting a song from the “Rocky Horror Picture Show,” whose refrain was “Dammit, Janet, I love you.” In his unrequited passion I find an unsettling analysis, if he is even close to the mark. Let’s drop in on his enthusiastic note:

I am truly looking forward to 4 years of “salty” Janet Yellen at the helm of the Fed. And it’s not just the prolonged stream of Jello shots that’s on tap. The most exciting part about having Janet in the seat is her inherent mistrust of market prices and her belief in irrational behaviour processes. There is nothing more valuable to the investment community than a central banker who discounts the value of market expectations. In many ways the extra-dovish surprise in September was a prelude of so much more of what’s to come.

I can imagine a day in 2016 when the unemployment rate is still well above Janet’s NAIRU estimate and the headline inflation rate is above 4 percent. Of course the Fed “models” will still show a big output gap and lots of slack, so Janet will be talking down inflation risks. Markets will be getting nervous about Fed credibility, but her two-year-ahead projection of inflation will have a 2 handle, or who knows, maybe even a 1 handle. Hence, even with house prices up another 10 percent and spoos well above 2100, the “model” will call for continued accommodation!! Bond markets may crack, but Janet will stay the course. BEAUTIFUL!!

Janet will not be bogged down by pesky worries about bubbles or misplaced expectations about inflation. She has a job to do – FILL THE OUTPUT GAP! And if a few asset price jumps or some temporary increases in inflation expectations arise, so be it. For her, these are natural occurrences in “irrational” markets, and they are simply not relevant for “rational” monetary policy makers equipped with the latest saltwater optimal control models.

The antidote to such a boundless love of stimulus is of course Joan McCullough, with her own salty prose:

And the more I see of the destruction of our growth potential … the more convinced I am that it’s gonna’ backfire in spades. Do I still think that we remain good-to-go into year end? At the moment, sporadic envelope testing notwithstanding, the answer is yes. But I have to repeat myself: The data has stunk for a long time and continues to worsen. And the anecdotes confirming this are yours for the askin’. The only question remaining is for how long we can continue to bet the ranch on wildly incontinent monetary policy while deliberately opting to ignore the ongoing disintegration of our economic fabric?”

And thus we come to the heart of this week’s letter, which is the introduction of my just-released new book, Code Red. It is my own take (along with co-author Jonathan Tepper) on the problems that have grown out of an unrelenting assault on monetary norms by central banks around the world.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

© 2013 Mauldin Economics. All Rights Reserved.
Thoughts from the Frontline is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.

Please write to subscribers@mauldineconomics.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.MauldinEconomics.com.

To subscribe to John Mauldin’s e-letter, please click here: www.mauldineconomics.com/subscribe
To change your email address, please click here: http://www.mauldineconomics.com/change-address

Thoughts From the Frontline and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President and registered representative of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.

Outside the Box: Earnings Growth to Ramp Up? Call Me a Skeptic

 

In today’s Outside the Box, Sheraz Mian, Director of Research for Zacks Investment Research, gives us an overview of corporate earnings trends for the past several quarters and consensus expectations going forward, and asks, “How realistic are these expectations?”

Not very, he says, and tells us why. This is the sort of thorough, no-nonsense analysis Zacks is famous for. Zacks Investment Research was founded in 1978 by Len Zacks, PhD. Many innovations have come from this firm over the years, including the creation of the Earningps Consensus that many investors use now to compare versus actual earnings reports. Most notably, Len discovered the predictive power of earnings estimate revisions. He harnessed these benefits into the proprietary Zacks Rank stock rating system that has allowed Zacks Rank to compile an outstanding track record.

I am in New York for the next few days doing a media “tour” for my new book, Code Red, which will be out next week. I saw the book for the first time last night and sat down to read it again, skipping here and there, somewhat like a curious father viewing his new offspring. Co-author Jonathan Tepper and I will be speaking and sitting for a video as well. Tom Keene was very complimentary about the book this morning. It will hopefully be in bookstores this weekend.

The headline on Bloomberg as I send this note is “Europe Breakup Forces Mount as Union Relevance Fades.” You can go to the bank that this will mean the ECB will soon be issuing yet another Code Red version of easy money to try and smooth over a crisis. It’s a familiar pattern. And one that in the end will not yield the results they desire.

I hope this book does as well as Endgame. Tomorrow night (Wednesday) is the book launch party at the Hyatt Union Square from 5:30-7. It will be fun to see old friends and celebrate book #6. Come on by if you like.

Your hoping for more kind reviews analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com


 

Earnings Growth to Ramp Up? Call Me a Skeptic

By Sheraz Mian

Stocks have performed impressively this year and have largely been able to hold on to the gains despite monetary and fiscal uncertainties and the less than inspiring economic and earnings pictures. In a price-earnings framework for the market, most of the gains this year have resulted from investors’ willingness to pay a higher multiple for pretty much the same, or even lower, earnings.

Reasonable people can disagree over the extent of the Fed’s role in the market’s upward push, but few would argue that the Bernanke Fed’s easy-money policy has been a key, if not the only, driver of this trend. If nothing else, the Fed policy of deliberately low interest rates pushed investors into riskier assets, including stocks.

But with the Fed getting ready to institute changes to its policy, investors will need to go back to fundamentals to keep pushing stocks higher.

We don’t know when the Fed will start ‘Tapering’ its bond purchases, but we do know that they want to get out of the QE business in the not-too-distant future. What this means for investors is that they will need to pay a lot more attention to corporate earnings fundamentals than has been the case thus far.

The overall level of corporate earnings remains quite high. In fact, aggregate earnings for the S&P 500 reached an all-time record in 2013 Q2 and are expected to be not far from that level in the ongoing Q3 earnings season as well. There hasn’t been much earnings growth lately, but investors are banking on material growth resumption from Q4 onwards. This hope is reflected in current consensus expectations for 2013 Q4 and full-year 2014. 

I remain skeptical of current consensus earnings expectations and would like to share the basis for my skepticism with you. The goal is to convince you that current earnings expectations remain vulnerable to significant downward revisions.

Negative estimate revisions haven’t mattered much over the last few quarters as the Fed’s generous liquidity supply helped lift all boats. But if the Fed is going to be less of a supporting actor going forward, then it’s reasonable to expect investors to start paying more attention to fundamentals. It is in this context that the coming period of negative revisions could potentially result in the market giving back some, if not all, of its recent gains.

This discussion is particularly timely as we are in the midst of the 2013 Q3 earnings season that will help shape consensus estimates for Q4 and beyond. In the following sections, I will give you an update on the Q3 earnings season and critically review consensus expectations for Q4 and beyond.

The Q3 Scorecard

As of Monday, October 21st, we have Q3 results from 109 companies in the S&P 500 that combined account for 31.6% of the index’s total market capitalization. Total earnings for these 109 companies are up +7.5% year over and 63.3% of companies beat earnings expectations with a median surprise of +2.1%. Total revenues are up +2.1%, with 45.9% of the companies beating top-line expectations and median revenue surprising by +0.02%.

The table below presents the current scorecard for Q3

Note: One sector, Aerospace, has not reported any Q3 results yet. NRPT means ‘no reports’; NM means ‘not meaningful’.

With results from more than 30% of the S&P 500’s total market capitalization already out, we are seeing the Q3 earnings picture slowly emerge. This is particularly so for the Finance sector, where 51.8% of the sector’s total market cap has already reported. Other sectors with meaningful sample sizes include Transportation (47.3%), Consumer Staples (40.4%), Technology (36.9%) and Medical (25.2%).

Finance has been a steady growth driver for the last many quarters and is diligently playing that role this time around as well despite anemic loan demand, wind-down of the mortgage refi business and weak capital markets activities, particularly on the fixed income side. Outside of Finance, total earnings are up +4.4% for the companies that have reported already.

How do the 2013 Q3 results thus far compare with the last few quarters? 

The short answer is that they are no better than what we have seen from this same group of 109 companies in recent quarters. In fact, on a number of counts the results thus far do not compare favorably to either the preceding quarter (2013 Q2), or the 4-qurater average, or both.

Specifically, the earnings and revenue growth rates and revenue beat ratio are tracking lower, while the earnings beat ratio is about in-line

The charts below compare the beat ratios for these 109 companies with what these same companies reported in Q2 and the 4-quarter average (beat ratio is the % of total companies coming ahead of consensus expectations).

The trends we have seen thus far will shift to some extent as the rest of the reporting season unfolds, but not by much. A composite look at the Q3 earnings season, combining the actual results from the 109 companies with estimates for the 391, is for +2.1% earnings growth on +0.8% higher revenues, as the summary table below shows.

 

Earnings growth rate has averaged a little over +3% over the first two quarters of the year and will likely stay at or below that level in Q3 as well. With respect to beat ratios, roughly two-thirds of the companies come ahead of expectations in a typical quarter and the Q3 ratio will likely be in that same vicinity.

The ‘Expectations Management’ Game

In the run up to the start of the Q3 earnings season, consensus earnings estimates came down sharply. The primary reason for the estimate cuts – guidance from management teams. Companies guided lower for Q3 while reporting Q2 results, a trend that has remained in place for more than a year now.

The chart below does a good job of showing the evolving Q3 earnings expectations over the last few months.

The Q3 estimate cuts weren’t unusual or peculiar to the quarter, as we have been seeing this trend play out repeatedly for more than a year now. The chart below compares the trends in earnings estimate revisions in the run up to the Q3 and Q2 reporting seasons

These expectations mean that Q3 wouldn’t be materially different from what we have become accustomed to seeing quarter after quarter, with roughly two-thirds of the companies beating consensus earnings estimates. This game of under-promise and over-deliver by management teams has been around long enough that it has likely lost most of its value in investors’ eyes.

Beat ratios may not carry as much informational value this time around, but what will be particularly important is company guidance for Q4 and beyond. Guidance is always very important, but it has assumed added significance this time around given the elevated hopes that Q4 represents a material earnings growth ramp up after essentially flat growth over the last many quarters.

Evaluating Expectations for Q4 & Beyond

Let’s take a look at how consensus earnings expectations for 2013 Q3 compare to what companies earned in the last few quarters and what they are expected to earn in the coming quarters.

The chart below shows the expected Q3 total earnings growth rate for the S&P 500 contrasted with the preceding two and following two quarters. (Please note that the Q3 growth rate is for the composite estimate for the S&P 500, combining the 109 that have reported with the 391 still to come)

The Finance sector has been a big earnings growth driver for some time. Outside of the Finance sector, total earnings growth for the S&P 500 was in the negative in 2013 Q2 and is expected to be no better in Q3. But the high hopes from Q4 and beyond reflect a strong turnaround in growth outside of Finance.

The chart below shows the same data as the one above, but excludes the Finance sector.

What this means is that quarterly earnings growth was +3.4% in the first two quarters of the year, is expected to be 2.1% in Q3, but accelerate to a +9.4% pace in Q4. And not all of the expected Q4 growth is coming from the Finance sector, as the rest of the corporate world is expected to reverse trend and start contributing nicely from Q4 onwards.

The chart below shows the same data, but this time on a trailing 4-quarter basis. The way to read this chart of steadily rising expectations is that total earnings for the S&P 500 are on track to be up +3.8% year over year in the four quarters through Q3, but accelerate to +4.5% in Q4 and +5.6% in 2014 Q1. Consensus expectations are for total earnings growth of +11.8% in calendar year 2014.

The two charts below show earnings for the S&P 500; not EPS, but total earnings. The first chart shows quarterly totals, while the second one presents the same data on a trailing 4-quarter basis. As you can see, the ‘level’ of total earnings is very high. In fact, quarterly earnings have never been this high – the 2013 Q2 total of $260.3 billion was an all-time quarterly record.

The data in this chart reflects current consensus estimates. This shows that consensus is looking for new all-time record quarterly totals in the coming two quarters. The high expected growth rates in Q4 and beyond are more than just easy comparisons, they represent material gains in total earnings.

The record level of current corporate profits is also borne by the very high level of corporate profits as a share of nominal GDP, which has never been this high ever. The chart below, using data from the BEA, of corporate profits as a share of nominal GDP clearly shows this.

Where Will the Growth Come From?

There is some truth to the claim that the current record level of corporate profits, whether in absolute dollar terms or as a share of the GDP, does not mean that earnings have to necessarily come down. But earnings don’t grow forever either as current consensus expectations of double-digit growth next year and beyond seem to imply. 

After all, earnings in the aggregate can grow only through two avenues – revenue growth and/or margin expansion.

Revenue growth is strongly correlated with ‘nominal’ GDP growth. If the growth outlook for the global economy is positive or improving, then it’s reasonable to expect corporate revenues to do better as well. But the global economic growth outlook is at best stable, definitely not improving as the recent estimate cuts by the IMF shows.

The U.S. economic outlook has certainly stabilized and GDP growth in Q4 is expected to be modestly better than Q3’s growth pace. The expectation is for growth to materially improve in 2014, with consensus GDP growth estimates north of +3% for 2014 and even higher the following year. Europe isn’t expected to become an engine of global growth any time soon, but the region’s recession has ended and its vitals appear to be stabilizing. The magic of Abenomics is expected to revitalize Japan, but it’s nothing more than a hope at this stage. In the emerging world, sentiment on China has improved, but India, Brazil, Turkey and other former high flyers appear to be struggling.

All in all, this isn’t a picture to get overly excited about. But with almost 60% of the S&P 500 revenues coming from the domestic market, the expected GDP ramp up next year should have a positive effect on corporate revenues, which are expected to increase by +4.2% in 2004. But in order to reach the expected +11.8% total earnings growth in 2014, we need a fair amount of expansion in net margins to compliment the +4.2% revenue growth.

Can Margins Continue to Expand?

The two charts show net margins (total income/total revenues) for the S&P 500, on a quarterly and trailing 4-quarter basis. For both charts, the data through 2013 Q2 represents actual results, while the same for Q3 and beyond represent net margins implied by current consensus estimates for earnings and revenues.

The chart below shows net margins the same data for a longer time span on a calendar year basis – from 2003 through 2014.

As you can see margins have come a long way from the 2009 bottom and by some measures have already peaked out.

Margins follow a cyclical pattern. As the above chart shows, they expand as the economy comes out of a recession and companies use existing resources in labor and capital to drive business. But eventually capacity constraints kick in, forcing companies to spend more for incremental business. Input costs increase and they have hire more employees to produce more products and services. At that stage, margins start to contract again.

We may not be at the contraction stage yet, but given the current record level of margins and how far removed we are from the last cyclical bottom, we probably don’t have lot of room for expansion. The best-case outcome on the margins front will be for stabilization at current levels; meaning that companies are able to hold the line on expenses and keep margins steady. We will need to buy into fairly optimistic assumptions about productivity improvements for current consensus margin expansion expectations to pan out.

So What Gives?

What all of this boils down to is that current consensus earnings estimates are high and they need to come down – and come down quite a bit. I don’t subscribe to the view held by some stock market bears that earnings growth will turn negative. But I don’t buy into the perennial growth story either.

So what’s the big deal if estimates for Q4 come down in the coming days and weeks? After all, estimates have been coming down consistently for more than a year and the stock market has not only ignored the earnings downtrend, but actually scaled new heights.

A big reason for investors’ disregard of negative estimate revisions has been that they always looked forward to a growth ramp up down the road. In their drive to push stocks to all-time highs in the recent past, investors have been hoping for substantial growth to eventually resume. The starting point of this expected growth ramp-up kept getting delayed quarter after quarter. The hope currently is that Q4 will be the starting point of such growth.

Guidance has overwhelmingly been negative over the last few quarters. But if current Q4 expectations have to hold, then we will need to see a change on the guidance front; we need to see more companies either guide higher or reaffirm current consensus expectations. Anything short of that will result in a replay of the by-now familiar negative estimate revisions trend that we have been seeing in recent quarters.

Will investors delay the hoped-for earnings growth recovery again this time or finally realize that the period of double-digit earnings growth is perhaps behind us for good? Hard to tell at this stage, but we will find out soon enough.

My sense is that markets can buck trends in aggregate earnings for some time, as they have been doing lately. But expecting the trend to continue indefinitely may not be realistic.

220 Stocks To Sell Now

No matter where the market is headed, one fact is obvious: You should not buy and hold stocks unless they offer good prospects for profit. I can help you weed out many of the ones that don’t make the grade. That is because my company, Zacks Investment Research, is releasing to the public its list of 220 Stocks to Sell Now.

These Strong Sells are sinister portfolio killers because many have good fundamentals and seem like good buys.   But something important has happened to each of them that greatly lowers their odds of success. Historically, such stocks perform 6 times worse than the market.

I invite you to examine this list for free and make sure no stock you own or are considering is on it. Today you are welcome to see it and other time-sensitive Zacks information at no charge and with no obligation to purchase anything.

See Zacks’ “220 Stocks to Sell Now” list for Free.

Best,

Sheraz Mian

Sheraz Mian is the Director of Research for Zacks and manages its award-winning Focus List portfolio.

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Outside the Box and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA, SIPC, through which securities may be offered . MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop.

Things That Make You Go Hmmm – An Empty Forest Full of Trees

 

By Grant Williams  

ca·tas·tro·phe

n.

1. A great, often sudden calamity.

2. A complete failure; a fiasco.

3. The concluding action of a drama, especially a classical tragedy, following the climax and containing a resolution of the plot.

In 1710, philosopher George Berkeley formulated a proposition in his work “A Treatise Concerning the Principles of Human Knowledge,” which would inspire a philosophical discussion that continues to this day — three centuries later.

Berkeley wrote:

But, say you, surely there is nothing easier than for me to imagine trees, for instance, in a park … and nobody by to perceive them…. The objects of sense exist only when they are perceived; the trees therefore are in the garden … no longer than while there is somebody by to perceive them.

Twenty years later, William Fossett took Berkeley’s baton and ran with it:

Tease apart the threads [of the natural world] and the pattern vanishes. The design is in how the cloth-maker arranges the threads: this way and that, as fashion dictates…. To say something is meaningful is to say that that is how we arrange it so; how we comprehend it to be, and what is comprehended by you or I may not be by a cat, for example. If a tree falls in a park and there is no-one to hand, it is silent and invisible and nameless. And if we were to vanish, there would be no tree at all; any meaning would vanish along with us. Other than what the cats make of it all, of course.

But it wasn’t until June 1883 that the magazine The Chautauquan posed the question more or less in the familiar form we know today:

If a tree were to fall on an island where there were no human beings would there be any sound?

The Chautauqaun answered — rather too emphatically, I thought — “No. Sound is the sensation excited in the ear when the air or other medium is set in motion.” But that implies a more scientific perception of the question than the philosophical one which has intrigued thinkers through the centuries.

It was from that example that the modern-day form of the question was finally settled upon:

“If a tree falls in the forest and nobody is there to hear it, does it make a sound?”

Now, rather than take the path followed by a million tortured souls and try to answer the question, I am going to pose my own question of a similar nature and see if I can stimulate a philosophical debate that will endure through the centuries, as George Berkeley did way back in the 18th century.

If “through the centuries” is reaching a little, would you all mind doing me a favour and just pretending to discuss it until I’ve left the room?

Much obliged.

OK… so all that remains is for you to click here for some appropriate mood music, and off we jolly well go…

“If something bad happens but nobody reacts badly to it, did nothing bad happen?”

Deep, huh? Not what you come here for, I know, but bear with me for a moment.

I recently read an article that bemoaned the level of volatility that besets the modern world, and the piece got me thinking: how volatile is the investment world, really?

To continue reading this article from Things That Make You Go Hmmm… – a free weekly newsletter by Grant Williams, a highly respected financial expert and current portfolio and strategy advisor at Vulpes Investment Management in Singapore – please click here.

Things That Make You Go Hmmm…An Empty Forest Full of Trees

 

By Grant Williams  

ca·tas·tro·phe

n.

1. A great, often sudden calamity.

2. A complete failure; a fiasco.

3. The concluding action of a drama, especially a classical tragedy, following the climax and containing a resolution of the plot.

In 1710, philosopher George Berkeley formulated a proposition in his work “A Treatise Concerning the Principles of Human Knowledge,” which would inspire a philosophical discussion that continues to this day — three centuries later.

Berkeley wrote:

But, say you, surely there is nothing easier than for me to imagine trees, for instance, in a park … and nobody by to perceive them…. The objects of sense exist only when they are perceived; the trees therefore are in the garden … no longer than while there is somebody by to perceive them.

Twenty years later, William Fossett took Berkeley’s baton and ran with it:

Tease apart the threads [of the natural world] and the pattern vanishes. The design is in how the cloth-maker arranges the threads: this way and that, as fashion dictates…. To say something is meaningful is to say that that is how we arrange it so; how we comprehend it to be, and what is comprehended by you or I may not be by a cat, for example. If a tree falls in a park and there is no-one to hand, it is silent and invisible and nameless. And if we were to vanish, there would be no tree at all; any meaning would vanish along with us. Other than what the cats make of it all, of course.

But it wasn’t until June 1883 that the magazine The Chautauquan posed the question more or less in the familiar form we know today:

If a tree were to fall on an island where there were no human beings would there be any sound?

The Chautauqaun answered — rather too emphatically, I thought — “No. Sound is the sensation excited in the ear when the air or other medium is set in motion.” But that implies a more scientific perception of the question than the philosophical one which has intrigued thinkers through the centuries.

It was from that example that the modern-day form of the question was finally settled upon:

“If a tree falls in the forest and nobody is there to hear it, does it make a sound?”

Now, rather than take the path followed by a million tortured souls and try to answer the question, I am going to pose my own question of a similar nature and see if I can stimulate a philosophical debate that will endure through the centuries, as George Berkeley did way back in the 18th century.

If “through the centuries” is reaching a little, would you all mind doing me a favour and just pretending to discuss it until I’ve left the room?

Much obliged.

OK… so all that remains is for you to click here for some appropriate mood music, and off we jolly well go…

“If something bad happens but nobody reacts badly to it, did nothing bad happen?”

Deep, huh? Not what you come here for, I know, but bear with me for a moment.

I recently read an article that bemoaned the level of volatility that besets the modern world, and the piece got me thinking: how volatile is the investment world, really?

To continue reading this article from Things That Make You Go Hmmm… – a free weekly newsletter by Grant Williams, a highly respected financial expert and current portfolio and strategy advisor at Vulpes Investment Management in Singapore – please click here.

Thoughts from the Frontline: The Damage to the US Brand

 

There is no doubt that the image – what I will refer to in this letter as the “brand” – of the United States has been damaged in the past month. But what are the actual costs? And what does it matter to the average citizen? Can the US recover its tarnished image and go on about business as usual? Is the recent dysfunction in Washington DC now behind us, or is it destined to become part of a bleaker landscape? In this week’s letter we try to answer those questions and more, as I step firmly into politically incorrect territory and offer a little advice to my junior senator from Texas. If nothing else, we will look at the problems we face in a different light.

An Exorbitant Privilege

The term exorbitant privilege refers to the alleged benefit the United States receives due to the US dollar’s being the international reserve currency. The term was coined in the 1960s by Valéry Giscard d’Estaing (not Charles de Gaulle, as many think), then the French Minister of Finance, later President of France, and an early and major proponent of a United States of Europe. This was prior to the gold window’s being shut by Nixon. Giscard saw the Bretton Woods monetary system not simply as a way to balance international payments but as something that was giving the United States a significant advantage in the world. He was right.

Under Bretton Woods, the US would never face a balance of payments crisis, because it purchased imports in its own currency. That exorbitant privilege could not redound to a country whose currency had only a regional reserve currency role, but in the postwar era the US dollar reigned supreme around the world.

Academically, the exorbitant privilege literature analyzes two empiric puzzles, the position and the income puzzle. The position puzzle consists of the difference between the (negative) U.S. net international investment position (NIIP) and the accumulated U.S. current account deficits, the former being much smaller than the latter. The income puzzle consists of the fact that despite a deeply negative NIIP, the U.S. income balance is positive, i.e. despite having much more liabilities than assets, earned income is higher than interest expenses. (Wikipedia)

What that means in practical terms is that the United States can purchase more with its currency than it produces and sells. In theory those accounts should balance. But the world’s reserve currency, for all intent and purposes, becomes a product. The world needs dollars in order to conduct its trade. Today, if someone in Peru wants to buy something from Thailand, they first convert their local currency into US dollars and then purchase the product with those dollars. Those dollars eventually wind up at the Central Bank of Thailand, which includes them in its reserve balance. When someone in Thailand wants to purchase an imported product, their bank accesses those dollars, which may go anywhere in the world that will take the US dollar, which is to say pretty much anywhere.

Other currencies can also function as reserve currencies if there is sufficient trade between countries. The euro, the Canadian dollar, the Aussie dollar, and the yen are examples; but the US dollar is the 800-pound gorilla.

There have been other global reserve currencies. The British pound sterling served as a global currency prior to the ascendance of the dollar. In most ways, we in the US act as if our dollar will always be the world’s reserve currency. History suggests, however, that reserve currencies come and go. The US dollar will remain the dominant reserve currency only as long as we respect the responsibility that comes with our exorbitant privilege.

That privilege allows US citizens to purchase goods and services at prices somewhat lower than those people in the rest of the world must pay. We can produce electronic fiat dollars, and the rest of the world accepts them because they need them to in order to trade with each other. And they do so because they trust the dollar more than they do any other currency that is readily available. You can take those dollars and come to the United States and purchase all manner of goods, including real estate and stocks. Just this week a Chinese company spent $600 million to buy a building in New York City. Such transactions happen all the time.

And there is one other item those dollars are used to pay for: US Treasury bonds. We buy oil and all manner of goods with our electronic dollars, and those dollars typically end up on the reserve balance sheets of other central banks, which buy our government bonds. It’s hard to quantify the exact amount, but these transactions significantly lower the cost of borrowing for the US government. On a $16 trillion debt, every basis point (1/10 of 1%) means a saving of $16 billion annually. So 5 basis points would be $80 billion a year. There are credible estimates that the savings are well in excess of $100 billion a year. Thus, as the debt grows, the savings also grow! That also means the total debt compounds at a lower rate.

Just as an aside, $80-$100 billion a year will buy a lot of healthcare. Hold that thought as we continue to look at currency trading and reserve currency status.

A Friction-Free World?

Let’s return to our example of trade between Peru and Thailand. There is presumably little reason for a furniture manufacturer in Thailand to take Peruvian money (which is called the nuevo sol). Let’s assume this piece of furniture sells for 32,300 Thai baht or about $1000. So the buyer in Peru takes 2,764 nuevo sols, buys 1,000 US dollars, sends them to Thailand, and voila! his teak table comes in on the next boat.

Except that it isn’t quite that simple, as anyone who has done a substantial foreign transaction knows. You have to go to your local bank, which probably goes to its correspondent intermediary bank, which in turn deals with a large international investment bank, which then sends the money on to an intermediary in Thailand and then to a local Thai bank. At every step along the way there is a “toll” charged. While much smaller than it was a few decades ago, those tolls – that “friction” – can add up to a sizable sum. Depending on whom you ask and what you count, the total amount of currency traded per day is as much as $4 trillion, and just a few “pips” taken out to grease the skids tally up to a rather tidy sum.

(For the curious, a “pip” stands for “percentage in point” and is the smallest increment of trade in foreign exchange [FX] currency trading. In the FX market, prices are quoted to the fourth decimal point. For example, if a bar of soap in the drugstore is priced at $1.20, in the FX market the same bar of soap would be quoted at 1.2000. The change in that fourth decimal point is called 1 pip and is equal to 1/100th of 1%.)

Currently, there are only about seven currencies that are traded in serious amounts, although theoretically every currency is trading in some manner. When I was traveling around Africa, I would often come across a street in a city where currencies were being traded. The rates were much better than you could get at the local bank. Going with an “official” rate often means suffering a real loss in local buying power, and thus the spreads on some currencies are much wider than on others. No one wants to get stuck with an Argentine peso for very long outside of Argentina, and even inside Argentina the locals exchange money into pesos only when they need local currency. When I was last there, using a credit card cost anywhere between 10-15% more (if a local establishment took credit cards at all), because the store would have to cash in at the official rate rather than the street rate.

And while the “friction,” or transaction cost, of trading a euro for a dollar and vice versa is a much smaller percentage, it is there. And thus the need for dollars to grease the wheels. To trade goods between Peru and Thailand, intermediaries usually have to find dollars.

But the key word in that sentence is usually. This week, London and Hong Kong agreed to begin trading in Chinese renminbi. The “extra” friction once incurred in converting to the US dollar will disappear, and the cost of doing direct transactions will fall. This absolutely makes sense for the two countries, and over time it will make sense on an ever-larger scale. Currencies are increasingly becoming mere electronic blips. For young traders, sitting at an FX desk is just another computer game, but if they are good at it, they get paid real money. Killing pips can be more profitable than killing zombies ever was.

The dollar is the world’s reserve currency because it is a no-brainer trade. You don’t have to think about your risk. If you take a ruble, you need to think about your risk and maybe buy some insurance. You ask yourself if you can trust Putin with your money. Even today, if you begin to stockpile renminbi, what can you do with them? You need to find something to import from China. There is risk to that trade. Not as large a risk as in the past, but more than if you deal in dollars.

Unless we damage our brand. Unless we start making that 27-year-old trader sitting at an investment bank in London think for a fraction of a second before he hits the button. He is in the business of killing pips, and if you increase his cost, even by 1/1000, the difference shows up in his bonus.

You scoff? Then why did credit default swaps on the US Treasury market rise over the last month? If you are buying US Treasury bonds, you are by definition seeking to avoid risk. You want zero risk, and last week the world markets decided – while watching CNN, CNBC, Bloomberg, and Al Jazeera, and reading the running commentary in the Wall Street Journal and the Financial Times, on Reuters, and in gods-know-how-many blogs – that there was indeed some small risk, and so they wanted to be paid more for holding Treasuries.

The world looked at the US, and unlike in the dozens of debt-ceiling games of chicken our politicians have played in the past, this time the fight at the edge of the cliff made the rest of the world nervous. In the past, you “knew” that the adults were playing a serious game over budgets, but there was always the sure sense that they would do the right thing and not risk the brand.

You can call it media spin or whatever you like, but this time there was a real sense that the adults had left the room. I totally understand why it happened, but the reaction from around the world was akin to watching your parents fighting and not being sure what would happen. I mean, you get used to your parents quarreling from time to time, but when they threaten to shut down the marriage and blow up the house, you might start to worry.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

© 2013 Mauldin Economics. All Rights Reserved.
Thoughts from the Frontline is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.

Please write to subscribers@mauldineconomics.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.MauldinEconomics.com.

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Thoughts From the Frontline and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President and registered representative of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.

Thoughts from the Frontline: The Damage to the US Brand

 

There is no doubt that the image – what I will refer to in this letter as the “brand” – of the United States has been damaged in the past month. But what are the actual costs? And what does it matter to the average citizen? Can the US recover its tarnished image and go on about business as usual? Is the recent dysfunction in Washington DC now behind us, or is it destined to become part of a bleaker landscape? In this week’s letter we try to answer those questions and more, as I step firmly into politically incorrect territory and offer a little advice to my junior senator from Texas. If nothing else, we will look at the problems we face in a different light.

An Exorbitant Privilege

The term exorbitant privilege refers to the alleged benefit the United States receives due to the US dollar’s being the international reserve currency. The term was coined in the 1960s by Valéry Giscard d’Estaing (not Charles de Gaulle, as many think), then the French Minister of Finance, later President of France, and an early and major proponent of a United States of Europe. This was prior to the gold window’s being shut by Nixon. Giscard saw the Bretton Woods monetary system not simply as a way to balance international payments but as something that was giving the United States a significant advantage in the world. He was right.

Under Bretton Woods, the US would never face a balance of payments crisis, because it purchased imports in its own currency. That exorbitant privilege could not redound to a country whose currency had only a regional reserve currency role, but in the postwar era the US dollar reigned supreme around the world.

Academically, the exorbitant privilege literature analyzes two empiric puzzles, the position and the income puzzle. The position puzzle consists of the difference between the (negative) U.S. net international investment position (NIIP) and the accumulated U.S. current account deficits, the former being much smaller than the latter. The income puzzle consists of the fact that despite a deeply negative NIIP, the U.S. income balance is positive, i.e. despite having much more liabilities than assets, earned income is higher than interest expenses. (Wikipedia)

What that means in practical terms is that the United States can purchase more with its currency than it produces and sells. In theory those accounts should balance. But the world’s reserve currency, for all intent and purposes, becomes a product. The world needs dollars in order to conduct its trade. Today, if someone in Peru wants to buy something from Thailand, they first convert their local currency into US dollars and then purchase the product with those dollars. Those dollars eventually wind up at the Central Bank of Thailand, which includes them in its reserve balance. When someone in Thailand wants to purchase an imported product, their bank accesses those dollars, which may go anywhere in the world that will take the US dollar, which is to say pretty much anywhere.

Other currencies can also function as reserve currencies if there is sufficient trade between countries. The euro, the Canadian dollar, the Aussie dollar, and the yen are examples; but the US dollar is the 800-pound gorilla.

There have been other global reserve currencies. The British pound sterling served as a global currency prior to the ascendance of the dollar. In most ways, we in the US act as if our dollar will always be the world’s reserve currency. History suggests, however, that reserve currencies come and go. The US dollar will remain the dominant reserve currency only as long as we respect the responsibility that comes with our exorbitant privilege.

That privilege allows US citizens to purchase goods and services at prices somewhat lower than those people in the rest of the world must pay. We can produce electronic fiat dollars, and the rest of the world accepts them because they need them to in order to trade with each other. And they do so because they trust the dollar more than they do any other currency that is readily available. You can take those dollars and come to the United States and purchase all manner of goods, including real estate and stocks. Just this week a Chinese company spent $600 million to buy a building in New York City. Such transactions happen all the time.

And there is one other item those dollars are used to pay for: US Treasury bonds. We buy oil and all manner of goods with our electronic dollars, and those dollars typically end up on the reserve balance sheets of other central banks, which buy our government bonds. It’s hard to quantify the exact amount, but these transactions significantly lower the cost of borrowing for the US government. On a $16 trillion debt, every basis point (1/10 of 1%) means a saving of $16 billion annually. So 5 basis points would be $80 billion a year. There are credible estimates that the savings are well in excess of $100 billion a year. Thus, as the debt grows, the savings also grow! That also means the total debt compounds at a lower rate.

Just as an aside, $80-$100 billion a year will buy a lot of healthcare. Hold that thought as we continue to look at currency trading and reserve currency status.

A Friction-Free World?

Let’s return to our example of trade between Peru and Thailand. There is presumably little reason for a furniture manufacturer in Thailand to take Peruvian money (which is called the nuevo sol). Let’s assume this piece of furniture sells for 32,300 Thai baht or about $1000. So the buyer in Peru takes 2,764 nuevo sols, buys 1,000 US dollars, sends them to Thailand, and voila! his teak table comes in on the next boat.

Except that it isn’t quite that simple, as anyone who has done a substantial foreign transaction knows. You have to go to your local bank, which probably goes to its correspondent intermediary bank, which in turn deals with a large international investment bank, which then sends the money on to an intermediary in Thailand and then to a local Thai bank. At every step along the way there is a “toll” charged. While much smaller than it was a few decades ago, those tolls – that “friction” – can add up to a sizable sum. Depending on whom you ask and what you count, the total amount of currency traded per day is as much as $4 trillion, and just a few “pips” taken out to grease the skids tally up to a rather tidy sum.

(For the curious, a “pip” stands for “percentage in point” and is the smallest increment of trade in foreign exchange [FX] currency trading. In the FX market, prices are quoted to the fourth decimal point. For example, if a bar of soap in the drugstore is priced at $1.20, in the FX market the same bar of soap would be quoted at 1.2000. The change in that fourth decimal point is called 1 pip and is equal to 1/100th of 1%.)

Currently, there are only about seven currencies that are traded in serious amounts, although theoretically every currency is trading in some manner. When I was traveling around Africa, I would often come across a street in a city where currencies were being traded. The rates were much better than you could get at the local bank. Going with an “official” rate often means suffering a real loss in local buying power, and thus the spreads on some currencies are much wider than on others. No one wants to get stuck with an Argentine peso for very long outside of Argentina, and even inside Argentina the locals exchange money into pesos only when they need local currency. When I was last there, using a credit card cost anywhere between 10-15% more (if a local establishment took credit cards at all), because the store would have to cash in at the official rate rather than the street rate.

And while the “friction,” or transaction cost, of trading a euro for a dollar and vice versa is a much smaller percentage, it is there. And thus the need for dollars to grease the wheels. To trade goods between Peru and Thailand, intermediaries usually have to find dollars.

But the key word in that sentence is usually. This week, London and Hong Kong agreed to begin trading in Chinese renminbi. The “extra” friction once incurred in converting to the US dollar will disappear, and the cost of doing direct transactions will fall. This absolutely makes sense for the two countries, and over time it will make sense on an ever-larger scale. Currencies are increasingly becoming mere electronic blips. For young traders, sitting at an FX desk is just another computer game, but if they are good at it, they get paid real money. Killing pips can be more profitable than killing zombies ever was.

The dollar is the world’s reserve currency because it is a no-brainer trade. You don’t have to think about your risk. If you take a ruble, you need to think about your risk and maybe buy some insurance. You ask yourself if you can trust Putin with your money. Even today, if you begin to stockpile renminbi, what can you do with them? You need to find something to import from China. There is risk to that trade. Not as large a risk as in the past, but more than if you deal in dollars.

Unless we damage our brand. Unless we start making that 27-year-old trader sitting at an investment bank in London think for a fraction of a second before he hits the button. He is in the business of killing pips, and if you increase his cost, even by 1/1000, the difference shows up in his bonus.

You scoff? Then why did credit default swaps on the US Treasury market rise over the last month? If you are buying US Treasury bonds, you are by definition seeking to avoid risk. You want zero risk, and last week the world markets decided – while watching CNN, CNBC, Bloomberg, and Al Jazeera, and reading the running commentary in the Wall Street Journal and the Financial Times, on Reuters, and in gods-know-how-many blogs – that there was indeed some small risk, and so they wanted to be paid more for holding Treasuries.

The world looked at the US, and unlike in the dozens of debt-ceiling games of chicken our politicians have played in the past, this time the fight at the edge of the cliff made the rest of the world nervous. In the past, you “knew” that the adults were playing a serious game over budgets, but there was always the sure sense that they would do the right thing and not risk the brand.

You can call it media spin or whatever you like, but this time there was a real sense that the adults had left the room. I totally understand why it happened, but the reaction from around the world was akin to watching your parents fighting and not being sure what would happen. I mean, you get used to your parents quarreling from time to time, but when they threaten to shut down the marriage and blow up the house, you might start to worry.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

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Things That Make You Go Hmmm…Chekhov’s Gun

 

By: Grant Williams

During my recent hiatus a number of things happened which I suspect will be the subject of feverish debate amongst the chattering classes (myself included) for months if not years to come.

Amidst it all was a bald, bearded man of a certain age, who had transformed himself from a lifelong academic into a feared and almost mythical leader, becoming in the process the focus of the world as he stared down all kinds of trouble in the name of protecting his “family”.

This man did whatever he felt was necessary in order to further his agenda; and though it meant making many enemies, he dared look straight into the eyes of both his detractors and those who would defy him, and he never blinked.

He did what had to be done.

But lately he had been trying to find a way out. He didn’t want the responsibility anymore, and he felt as though it was time to quit and leave the empire to whoever was bold enough to seize it.

Sure, he tried to quit, but that wasn’t something he could just do on a whim. Loose ends needed to be tied up, and promises had to be made good and powerful people placated.

For anyone who doesn’t know the outcome of this tale, don’t worry that I might ruin the ending … because that outcome hasn’t been written yet. The best we can do is just guess at how it all plays out.

Wait? What? Oh… Breaking Bad? Nooooo… I wasn’t talking about Walter White, I was talking about Ben Bernanke. Except, he DID blink…

Yes, whilst I was away the Fed announced to the world that, although they had done all the hard work to convince the world that the Dreaded Taper was a done deal that allowed both bond and equity markets to price in a reduction in the amount of asset purchases being made every month by Bernanke (or, as he has become known in financial circles, “Buysenberg”), when it came to crunch time, the Fed didn’t have the guts to pull the trigger. To use the English phrase, “they bottled it”.

Now, any self-respecting drug lord central bank head (hell, any parent) knows that, in order to maintain respect, in order to continue to be feared, you MUST be prepared to follow through with your threats, even if you don’t necessarily want to. That’s just how the world works. You don’t threaten to rain down badness on people and then shy away. If you do that, your credibility is gone and your reputation is in tatters.

In this world, reputation is everything.

In the months leading up to the September FOMC meeting, the world was put on standby for a change in Fed policy, a process that had been innocuously labelled a “taper” by the Fed (check out the video interview with Elliot Management’s Paul Singer in this week’s videos section for an erudite — and I am willing to bet 100% accurate — assessment of how that phrase came to be chosen); and, as the Fed have come to expect in recent years, their preparatory jawboning was working its customary magic.

Source: NY Times

Between May 22, when Bernanke first uttered the T-word, to September 12th, on the eve of the FOMC decision, confidence in the Fed’s beginning their taper climbed relentlessly higher, reaching 67% right before the hammer was supposed to fall.

But a funny thing happened on the way to the forum: the Fed pulled a Cassius Clay and shook up the world….

To continue reading this article from Things That Make You Go Hmmm… – a free weekly newsletter by Grant Williams, a highly respected financial expert and current portfolio and strategy advisor at Vulpes Investment Management in Singapore – please click here.