Money is shooting out of the Fed and the ECB fire hoses at super-high pressure. The Fed upped the pressure with yesterday’s decision to leave interest rates at near-zero until the end of 2014 (past Ben Bernanke’s term expiry in January 2014) and its unequivocal QE commitment to buying assets whenever the economy needs an assist. The ECB expanded its money-output pressure with its €489 billion LTRO (Long-term Refinancing Operations) on December 21, 2011, with another slug upcoming in February.

Investors know money moves markets. They know they’re being pushed into high risk assets. They know others know. They’re hearing much more bullishness from officialdom in Europe and the US who want to build confidence and raise equity prices so that euro-banks can raise capital. They’re seeing many more bullish media commentators. They’re seeing stock prices rising. Their fear of a melt-up is rising.

Risk is substantial.
Yet, if you look at the 2 charts above you see risk .

The sky blue section on the left chart shows US-based bank reserve balances at the Fed from 2008 to the present. They rose from close to zero in 2008 to about $1.5 trillion today.

The turquoise line at the right shows Euro-based bank deposits at the ECB from 2009 to the present. They rose from close to zero in mid-2009 to €485 billion (or $630 billion) a couple of days ago – essentially equivalent to the ECB’s €489 LTRO which flowed back into the ECB.

In both cases these are funds the banking systems of both geographies are not lending. They are not lending to the real economy. But they are also not lending to one another.

Bank-to-bank non-lending.
Banks not lending to banks is important.

One thing banks know a lot better than the greatest outside expert will ever know is the quality of their assets. And as we’ve seen, they often misestimate even that.

A second thing banks know better than any outsider ever will is the quality of their competitors’ assets.

Banks not lending to banks says we do not trust your balance sheets. And then either they don’t lend. Or they lend on a fully-secured basis. Fear of banks by banks is the biggest message these charts are delivering.

Ben Bernanke knows this well. That’s why he looked so grim yesterday. That’s why he’s aiming the stream of his fire hose to the end of 2014 – whether you agree or disagree that this is the best or the worst way to lower risk.

‘Twas the most atypical of times…
Typically when better times arise, risks are receding.

Today we live on top of them like structures on the San Andreas fault.

All of which says these are times for the highly aware.

– John Allison

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I have always spent quality time trying to figure out The Next Big Thing – which usually turns out to be several Next Big Things.

For example, in the 80s and 90s the decline of inflation and its consequences; corporate restructuring and its consequences; the roll-out of the microprocessor and its consequences represented three Next Big Things, unrelated in their origins, but, when layered one on top of the other, had profound and generally positive effects on the world we experienced.

Important as Next Big Thing discoveries are, there are much less eye-popping Next Small Things – changes with narrower dimensions and impacts – but which nonetheless make the world a much-different place.

The all-volunteer military as a model.

To calibrate what a Next Small Thing might look like, think of the US military converting to an all-volunteer organization in 1973. There was controversy over replacing the draft; a commission (the 1970 Gates Commission) to investigate; a diversity of interests behind the all-volunteer concept from those wanting to end the Vietnam War by starving it of soldiers to Richard Nixon, then President, to Milton Friedman. Yet with the benefit of 40 years one can say that the high quality of the US’ military personnel and the military’s generally impactful performance in wars and skirmishes that followed, owed a lot to that decision to create a professional fighting force – all the more critical given the military’s much greater reliance, from the 80s onward, on sophisticated technologies and on highly trained people to run them.

The US auto industry fits the model.

Many Next Small Things are popping up all around us. One that has struck me is the revival of the US auto industry from – in 2 cases – near-death experiences.  The article quoted above by Dan Neil – in my view the world’s best auto reviewer and a Pulitzer-prize winner to boot – says it all. US cars are starting to look and feel exciting. They are starting to look and feel worldclass. Even the Detroit Auto Show was worth Neil’s going to it for the first time in 20 years. In addition, US auto executives (who hail from many nationalities) finally appear to have broken out of a decades-old bubble of complacency and product knuckleheadedness; are open to the world and their critics; and have visibly raised their standards.

As Neil puts it:

Detroit’s near-death has also resulted in something that’s hard to measure in the financials: a sort of collective gratitude. Gone from the executive corps is any sense of entitlement or notion of incumbency (did I mention I’ve been coming here for 20 years?). The bosses show up early for interviews and linger longer. Board-level bigwigs will scramble under a car to show you a suspension part.

The potential for something big.

A true revival – not some PR-spun, flash-in-the-pan, now-you-see-it, now-you-don’t revival – would have real consequences not just within the industry but across the economy. Cars are now the most sophisticated piece of technology consumers own. They are a hybrid of mechanical, power-propulsion, and computer technologies plus others such as aerodynamics. Technological changes under the hood, in the drive-train and braking mechanics, and on the dashboard, are proceeding at a faster pace than personal computers whose innovations are just limping forward.

In addition, the machine called the car is linked to the energy infrastructure – gasoline and electricity – and innovations both in the internal combustion engine and battery power will have big effects on transportation energy usage at a time when the US – for reason of other Next Small Things happening in oil and natural gas discovery and distribution. The auto industry also feeds many companies, so its higher-quality output means the standard is raised for its supplier infrastructure across the world.

The auguries are good.

Whether a turnaround in US autos turns into a true Next Small Thing or goes into the dustbin of Next Small Flameouts remains to be seen.

The auto business is a tough business – cyclical, fashion-oriented, highly competitive globally, capital-intensive. Its power to attract the best and the brightest is untested.

But if we were Ancient Romans going to the priestess of the god of transportation asking for an augury on the future of the US auto industry the omens would probably look good – based not on chicken entrails but on the kind of real facts people like Dan Neil can see.

Don’t lose sight of Next Small Things.

Even more important than whether the auto industry turns out to be a real Next Small Thing, is making it one’s business to look at the less visible Next Small Things – not just at their Next Big Thing cousins. In fact, just when it’s hard to identify Next Big Things is usually when there is an abundance of Next Small Things struggling to be born.

– John Allison

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Point 1 – they often know less than they think they do – was illustrated in an extreme way by the Fed’s just-released transcripts of its closed-door 2006 meetings. Time and again, most of its participants most of the time expressed serene confidence in the staying power of the economic expansion and the relative unimportance of housing excesses. See the left chart. This is not an isolated instance where those-in-charge just don’t know or sense what’s around the corner. It happens with regularity. The phenomenon is exacerbated by the credulity with which most of us listen to what the authorities tell us.

Point 2 – they can’t say all they might want to say or know they could say – is on display almost every day, particularly in these times of financial stress. For example, in the Financial Times’ article entitled “Draghi hails ‘tentative’ stabilization” and in his press conference, Draghi is a cheerleader – one day before S&P downgrades France, Italy, Austria and Slovakia and before Greek debt talks sideswipe an iceberg. Even though the truth shall set you free, Draghi cannot tell any truth that undercuts people’s belief in the ECB’s power to control events. He is locked into a confidence game he must play.

Point 3 – that vigorous central-bank actions always have big impacts – is demonstrated by the chart on the right. That chart compares the price of the S&P 500 Index with the Euro Stoxx 50 index for the past month and a half (Dec 1, 2011 to Jan 12, 2012). The two indexes moved up together from December 19 (see the vertical cobalt line) – the date when it became increasingly clear that European banks would be taking up the ECB’s new 3-year liquidity facility in size on December 21 – which they did at €489 billion. While people are looking for all sorts of reasons for advancing stock markets look no further than the simple adage that markets love money and lots of money moves markets.

We could all have a great lunch discussing the subtleties and qualifiers to the above-three points. On balance, their validity is ignored at one’s peril – which of course stops no one from ignoring them.

– John Allison

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Remember Silly Putty? Looked like real putty. Felt like real putty. But unlike real putty, when rolled up into a ball and thrown onto a hard surface, it didn’t go splat! It bounced way up like an India rubber ball!

Wondrous as Silly Putty was, there is nothing more wondrous in the adult world than sovereign debt. This is especially true of sovereign debt that governments can sell to captive domestic markets – like Japanese debt – represented by the red line in the chart below. Sovereign debt is different.

On January 1, Paul Krugman wrote an article titled “Nobody Understands Debt”¹ that explains the difference – between the regular debt you and I owe versus the debt government owes – a difference about as wide as that between putty and Silly Putty.

The difference.

For regular debtors – say a family with a mortgage –debt is owed to someone else, like a bank. Debt has to be paid back. Debt has a term – a time limit. Debt has minimum payments of principal and interest – debt service. And debt can be foreclosed if not paid to that “someone else”.

For sovereign debtors that sell only to their own societies there is no “someone else”. Their debt is owed by society to itself. There is no term. The government can keep issuing and refinancing debt till the cows come home. There is minimum debt service – but, through the power to tax – government can usually tax what it needs to meet that debt service. And a government can’t be foreclosed on because there are no assets to seize and governments are typically hard-to-impossible to sue.

And even more.

Krugman’s is an Economics 101 point. He’s correct. Sovereign debt is different from regular debt. In fact Krugman doesn’t go far enough on the difference.

For one thing, governments can coerce people, explicitly or implicitly, to buy their debt. For example, the Europeans have always done this, especially with government-controlled banks. Governments do it in most parts of the world which is why these societies’ banking systems are the biggest buyers of sovereign debt.

Sovereign debt’s difference with regular debt also lies in the fact that a country’s central bank can effect policies that lower the interest costs on that debt whereas if regular debtors have a mortgage with a commercial bank, they have no personal central bank working on their behalf to lower their monthly interest payments.

So let’s accept that sovereign debt is different. Should we have more of it? Less of it? Is that even the best question to be asking?

The Krugmans and the anti-Krugmans.

To the Krugmans we should, and can afford, to have more of it. Tax a bit more and the government can afford to pay more debt service and therefore borrow more. Borrow more and it can stimulate the economy more. Stimulate the economy more and unemployment goes down.

To the anti-Krugmans we should and can have less government debt. Taxing more hurts economic growth. Hurting economic growth more than negates any benefits from stimulation. Backfiring stimulation raises unemployment. Higher unemployment, lower economic growth, and higher government debt lowers confidence in the quality of that debt and eventually raises its rate of interest.

A better idea.

But there’s an even better question to be battling over: does the ease with which governments can issue debt tend to misallocate economic resources, which in turn leads to lower long-run economic growth and lower long-run faith in the stock market – the most sensitive forward-looking indicator of confidence in the wealth-producing power of a society?

If you look again at the chart of Japan for the past 17 years it certainly suggests a “yes” answer.

The red line is government debt. It’s up steadily. The green line is real GDP. It’s in a long choppy downtrend. The blue line is the Nikkei 225 Index. It’s in the same downtrend as GDP. Japan is much more than a high-taxes-slow-growth story. It’s a society where the totality of assets that support economic growth (GDP) and future wealth-producing confidence (the Nikkei) are not anywhere near optimal. And this despite the fact that Japan is one of the most educated, orderly and inventive societies in the world.

You say. I say.

Well, you say, that’s fine and dandy but you’ve proved nothing. All you’ve shown is that rising government debt has been associated with poor GDP and stock-market performance in one country. There is no evidence that rising government debt caused poor GDP and stock-market performance.

I understand. But let me ask you this: in retrospect, now that we know what we know, was easy-to-get debt behind the subprime housing bubble in the US in the 2000-07 period? I think we’d all agree “yes.” Was the availability of that debt, and its issuance, a causal factor in subprime housing assets being built that never should have – from a social and economic resource allocation standpoint? I think we’d still say “yes.” So was that not an instance – in the private sector – where too-easy debt creation led to a big misallocation of resources?

Well, “yes”, you say. But that’s an example where debt creation was channeled into a very specific industry. Government debt permeates the economy far more broadly and therefore it’s impossible to know for sure whether it has the misallocating effect you speak of.

And so…

That’s why God invented economists. To spend decades of quality time sifting through to some kind of proof. In the meantime humble investors like me have to hope they ask the right questions and that their provisional guesses are mostly on the mark. Proof will always elude us. But roughly-right judgments can provide lots of value while we wait.

— John Allison

¹ Krugman, Paul. “Nobody Understands Debt.” The New York Times. January 1, 2012.

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Experience is about pattern-recognition. You see patterns – patterns of behavior, for example – and you learn. And to the degree investing is based on experience it too is learning from patterns, recognizing them later on, and applying them. Investment patterns can be very complex like the patterns you have to discern in order to recognize a company that is engaged in fraud, something I have done more than a few times. Or patterns can be simple in appearance like the patterns of a stock price which can be represented in a line graph.

A love affair with price patterns.

The investment business over 50 years has been very interested in simple price patterns and their ups and downs. Its interest has been in the ups and downs (volatility); in the relative volatility of one price versus another (IBM’s price versus the S&P 500’s price); and in the correlation or non-correlation of the ups and downs between two or more prices (correlations: how much the ups of IBM move with the ups of China Mobile, and the downs with the downs; or non-correlations: how much the ups of IBM move with the downs of China Mobile and the downs of IBM with the ups of China Mobile).

No time limit on correlations.

One last thing: correlations and non-correlations can, but don’t have to, last a long time. The correlation or non-correlation of IBM’s and China Mobile’s prices could last for years or could switch back and forth on a weekly basis.

The euro, gold & the S&P 500: the new pattern-switching phenomenon

Which leads me to the point: I am noticing more and more price patterns whose duration is shortening. Take the chart below which shows 3 price patterns: the euro, the ETF for Gold and the ETF for the S&P 500. It shows the past 12 months. August 2011 is represented by the two vertical blue lines. As you can see from December 2010 through July the euro (the white line) was somewhat correlated with gold (the yellow line) through about August, though the euro was more volatile than gold. However, the euro and gold were very little correlated to the S&P 500 until the end of August. Then in September all three suddenly correlated closely, though gold’s volatility increased relative to the other two.

Switching is speeding up. Computers have taken over.

The problem for price-pattern-watchers who are looking for price patterns they can learn from is that: a) patterns are switching faster against other patterns than ever before and b) patterns don’t last the way they used to. A correlation today becomes a non-correlation tomorrow at an ever faster pace. Or so it seems. Because we don’t know if the future will change that. As a result, detecting pattern switches is becoming a tough job – which is why it’s being done by computers, which is why computer-driven algorithmic trading accounts for 50-70% of daily stock market volume.

Know your environment to take advantage of it.

Why should you care if you’re not in the business of recognizing changes in price correlations and non-correlations? Because it helps to know what’s going on in the marketplace even if your only objective is exploiting the ups and downs of prices for your own fundamental purposes.

– John Allison

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We listened directly to the President of the ECB’s press conference this morning; took notes; checked what we heard for one simple reason:

In the worldwide press there have been so many false rumors over the past few months of developments that might happen that don’t happen; of intents that don’t exist; of interpretations that can’t possibly be true, that anyone who aims to understand what is truly going on in these momentous times must go to the source. Must.

The gist of what Draghi said was this. “No.” “Yes.” “Act.” – And if you read otherwise than what I say below assume it is conjecture, not fact.

No

To the related cluster of questions which fantasists on both sides of the Atlantic believe have to be answered “yes”– Will the ECB buy new-issue government bonds directly? Will the ECB buy new-issue government bonds (as Draghi supposedly hinted with his famous “sequencing” remark) after EU governments effect a Treaty change? Will the ECB do so indirectly through a device like lending to the IMF? Will the ECB seek to target government bond yields? Is deflation around the corner and will the ECB therefore buy government bonds to fight deflation? Or will the ECB become a bazooka-wielding Fed? – the answer was “no.” Just to be clear, he used the word “no”. He justified “no”, as you would expect, by citing Article 123 of the charter creating the ECB that forbids it from funding government debt. He justified submitting to Article 123 as obeying the law, pure and simple.

But he went further. Even more vital than adhering to the letter of the law, was respecting the spirit of the law. He and the ECB had a duty to be faithful to that spirit. His multiple references to fidelity to the spirit of the law came – deliberately or not – right on the heels of Angela Merkel’s slap-down yesterday of those in the EU she accused of wanting to resort to “tricks” (her words) to effect Treaty changes.

Yes

To the question – Will the ECB help European banks with their serious funding problems? – the answer was a resounding “yes” backed up by these actions: 1) a cut in rates from 1.25% to 1.00%; 2) an extension of unlimited funding for acceptable bank collateral to three years; 3) a reduction in the quality of acceptable collateral; 4) and a drop in reserve requirements.

Act

To the question – What will it take to solve the crisis of confidence in the euro? – the answer was clear: European states must act now. They must formulate an ironclad and enforceable mechanism for assuring that budgets stay within strict parameters and that government debt levels fall to acceptable levels. Period.

Only real, verifiable, fact-based action will work, provided two conditions are met. One: that action be legitimately taken through a credible legal (parliamentary/constitutional) process within each country. Two: that action be taken fast.

Read his lips?

Believe what he says. Believe what you want to think he says or what he doesn’t say but you think he intends to do. We all have a choice.

One thing: there are many interests – from governments to senior bureaucrats to financial institutions to media on both sides of the Atlantic – that have both financial and fantasy reasons for believing what they’d like to believe about the ECB and its intentions.

As I told a friend at dinner last night: “people don’t follow their objective interest. They follow the fantasy of what they believe is their objective interest. Sometimes the two coincide. Sometimes they don’t”

When it comes to Mario Draghi I am in the “read his lips” camp. For whomever is not, this might be a time for a rethink.

– John Allison

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See it below. It shows the S&P 500 over 5 days. Two of those days – Monday and Wednesday, November 28^th and 30^th – are the days to note. On Monday the S&P was up 2.9%; on Wednesday, 4.3%. Big moves.

Behold a pattern.

On both days a similar pattern occurred. 1) A piece of dramatic or dramatizable news emerged. 2) Futures rose dramatically the nights before. 3) The bulk of the gain and volume happened in the first hour – the high-volatility spike in price you see at the start of November 28^th and 30^th where the arrows point. 4) The rest of the day was mostly spent going sideways on a low-volatility, very low volume ledge. 5) The ledge remained till the end of the day (November 28^th ) or spiked up a little (November 30^th).

Chart Source: Bloomberg

Repeated many times.

Although I’m showing 2 recent days I’ve seen this pattern many times over the past year.

Interestingly, the dramatic or dramatizable news that triggers it is usually a hope or rumor that later proves false or insubstantial. Often the hope or rumor comes from the same media sources.

For example on Sunday there were two hopes/rumors:

One: that the European Union would somehow circumvent the need for a lengthy treaty change by implementing bilateral agreements that would bypass parliamentary approvals or referendums.

Two: that the IMF – perennial rescue favorite – would buy sovereign bonds, possibly funded by the ECB.

Neither event occurred. Both were officially denied.

Inseparable from the “risk-on”, “risk-off” world.

But while these rumors and hopes were alive they became, or were used, as market-moving news items. In today’s markets billions of dollars are ready to press a “risk-on” button (“get aggressive”) or a “risk-off” button (“get defensive”). The news on Sunday pressed the “risk on” button. Those pressing it bought futures Sunday night and in the pre-market hours of Monday.

On Monday at 9:30 a.m. it is very likely that the upward spike of the S&P 500 in the first hour was driven by the many hedge funds with short positions, particularly those with low conviction, that had to cover when they saw how far futures had risen in the hours before. It is also likely that futures buyers from the night before unloaded their positions (bought on margin) and booked their profits.

Then, the ledge.

After that the market went on this unusual ledge. Buyers and sellers traded shares within a couple of tenths of one percent of the high reached in the morning. There were no pullbacks, no advances, no to-ing, no fro-ing – just a flat line with low volatility and low volume – all indicating that ledge buyers and sellers are in some special class, perhaps most of them computers.

You might say that Wednesday was a bit different. The trigger was real, not a hope or rumor. Central banks announced new terms (lower interest rates) for their currency-swap arrangements. This is true, though it bears pointing out that these swap arrangements have been in existence for several years and that the swap action set in motion a large hope that it augured bigger things to come – like the old favorite – the ECB going to its tool shed and pulling out the proverbial bazooka.  Also, China cut bank reserve requirements half a percent. Real for sure. But lots of hope too that China can stimulate with inflation still high.

So what?

So what does all this mean? Why even bother knowing?

What it means is that what is powering the market more often than not is not the usual crowd of buyers and sellers we typically imagine lining up to buy or sell a little piece of America or the world. Rather it is players playing a different game with different motivations, tools, and time horizons than even ordinary investment professionals, let alone ordinary mortals, are used to.

And why bother knowing? After all, if you’re buying or selling and you know what you want and at what price, why do you care what the crowd or the computers are doing at the stock-market bazaar? True enough. But as a general rule it is by far the better part of wisdom to know something of the games others are playing with whom you must consort. At worst it can’t hurt. At best, it helps one not fall for narratives one can all too easily believe the market is transmitting.

– John Allison

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IN EUROPE:

On the one side, you have the Germans & Co. i.e. their northern soul mates – Holland, Finland, Austria.

Their solution to the European crisis is sharp as a knife’s edge.

One: this is a debt crisis.
Two: the only way out is for debtors (Greece, Portugal, Ireland, Italy, Spain etc.) to pay their debts.
Three: austerity is the only way to generate the money to do this.
Four: once austerity succeeds, debtor countries will have access to bond markets at reasonable rates.
Five: Germans & Co. will help out debtors interimly by contributing to the EFSF (aka the European Financial Stability Fund) which will buy debtors’ bonds the private market won’t buy.
Six: Germans & Co. will help one debtor – Greece – restructure its debts.
Seven: under no circumstances will they support using the ECB as lender or helper of last resort because that would pervert the ECB’s role as keeper of price stability.

Follow their 7-point plan and everything will work out.  Pain will yield gain.

So say Angela Merkel; Wolfgang Schauble (German Finance Minister); Jens Weidmann (President of the Bundesbank); Guido Westerwelle (German Foreign Minister); and assorted other prominent Germans, Dutch and Finns who have been out speaking the past couple of weeks.

On the other side, you have the French & Latins – Belgium, Italy, Spain, Greece etc.

Their tune is plaintive, exasperated but as simple as one clear note of a bird’s song.

”Use the ECB.” Use it the way the Americans use their Fed and the British their Bank of England. Have it issue infinite gobs of digitized money; buy infinite amounts of assets; and bring back private buyers who are fleeing the European sovereign and bank debt marketplace as we speak.

Follow their one-note plan and everything will work out. No pain. All gain – at least until the moment eventually arrives when the debt the ECB bought has to be disgorged. But “eventually” is almost “forever” during times like these when every day seems like an eternity.

So say Nicolas Sarkozy; José Luis Zapatero (Prime Minister of Spain); Jean-Claude Juncker (President of the EU); and assorted others like David Cameron (Prime Minister of England) and Tim Geithner (US Treasury Secretary).

And then in the middle is the ECB, aka European Central Bank.

The ECB has a simple script that it repeats like a schoolboy reciting the school prayer.

One: its job is to maintain the purchasing value of the euro through low inflation just like the Bundesbank did for Germany.
Two: it will help solvent banks that have liquidity problems. It will not help insolvent banks.
Three: it will not finance governments.
Four: it will not be a lender of last resort.
Five: its credibility is all about sticking to these principles.

The ECB sees itself as an anchor of stability in Europe. If it does its job, and the European politicians do theirs, everything will be OK. The problem is: the European politicians are not doing theirs. They’re trying to foist tough decisions onto the ECB that are not the ECB’s to make. The ECB won’t play ball.

So say Jean-Claude Trichet (just-retired ECB President); Mario Draghi (current ECB Chief); and assorted members of the ECB’s Governing Council.

MEANWHILE IN THE INVESTMENT WORLD…

A majority of smart money believes the Germans and ECB will cave…

When the going gets rough they will chuck their principles. They’re playing a game of chicken, talking out of both sides of their mouths – tough talk to get politicians in Greece, Italy and elsewhere to implement austerity. But under their breath, unspoken readiness is to be sugar-daddies-in-chief when duty calls.

…While a minority of smart money believes the opposite: that the Germans and ECB will stand firm.

The Germans will stand firm because their population has zero tolerance for any more financial commitments to debtors. The ECB will stand firm a) because it’s “son of Bundesbank”; and b) because to imitate the Fed or Bank of England would crush its identity in the eyes of its German and northern-country sponsors just as the US would crush its identity if, in making some international agreement, it scrapped its Constitution to get the deal done.

EUROPE: THE MOVIE

If this were a Hitchcock movie… you’d be feeling the tension rising. You’d be waiting for the dénouement. The suspense would be killing you. But this is a slow-mo reality movie. The actors are writing the script. And you – you have to wait each day for the next episode. The interesting thing is: you already know whodunit. In fact, you already know, amidst this incredibly complex plot, that it all boils down to two characters – the ECB, and the Germans. Will they change their stripes when tension reaches the breaking point? If they do, what relief! If they don’t, will chaos ensue? You wish you could fast-forward and peek ahead.

– John Allison

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The charts’ patterns are roughly the same, despite describing vastly different entities: an internet film service; a US broker-dealer; a Belgian bank; and an Italian sovereign bond. Human minds are not made to anticipate the kinds of discontinuities depicted here. They are made to believe that what happened yesterday is connected to what will happen today. Human minds have a built-in continuity bias.

Netflix Inc. (NFLX) US Equity – Daily 5/17/2011 – 11/17/2011

MF Global Holdings Ltd (MFGLQ US) US Equity – Daily 5/17/2011 – 11/17/2011

Dexia SA (DEX) BB Equity – Daily 5/17/2011 – 11/17/2011

10-Year Italian Bond EI586386 Corp (BTPS 4 ¾ 09/01/21) – Daily 5/17/2011 – 11/17/2011

Chart Source: Bloomberg

In the investment industry, and in business in general, there is no reward for anticipating and preparing for discontinuity. If you do, and you’re wrong, you look like an idiot. If you don’t, you’re safe because you’re part of the vast majority that didn’t prepare.

However, not preparing for discontinuity doesn’t eliminate its occurrence.  Suppose that today we are in an era of unusually frequent discontinuities. At what point does the frequency of discontinuities place a greater responsibility on intelligent minds to prepare for them? At what point in such an era does not preparing for them morph from being the safe play into dangerous passivity?

– John Allison

© 2011 UNIO Holdings, LLC.

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-  The S&P 500′s earnings have been rocketing upward since January 2010.
-  The S&P 500 is statistically cheap on a price/earnings (P/E) basis.
-  Consensus prospects for its earnings over the next 1-3 years are for an upward trajectory.
-  Bonds look like a poor investment alternative.

Rocketing earnings

The chart below shows a blue line – the S&P 500′s earnings. These earnings fell from late 2007 to the end of 2009, from about $90 to almost $45. Down 50%+.The S&P 500 – the white line – fell with them. Then from 2010 to the present, earnings (the blue line) rocketed, from about $45 to $95. Up 100%+.

Statistically cheap

The S&P 500 index – the white line rose in line with those earnings. It began rising, as it usually does, ahead of the earnings – in March 2009. But then in the first half of 2011 the S&P (white line) went sideways. As it did the blue line (earnings) kept going up.  In July 2011 the white line (S&P 500) went down. The blue line (earnings) continued going up. By early October, the S&P 500 (white line) was about 1100. Earnings (blue line) were about $92. The P/E ratio – the green line – was 12x (1100 divided by $92). The historical P/E ratio is 14 ½ x. So at 12x in early October the S&P was cheap on the numbers.

Consensus earnings prospects strong

Looking ahead, the consensus expects S&P 500 earnings to rise: from $95 to $104 in the next 12 months; from $95 to $109 over the next 24; and from $95 to $121 over the next 36 months. At its price on Tuesday of 1275 the S&P 500's P/E was 12x earnings based on the next 12 months’ earnings; 11.7x based on the next 24; and 10.5x based on the next 36 – all statistically cheap P/Es.

Poor Bond alternative

The US 10-year Treasury yields about 2%. The S&P 500's dividend yield is about 2%. With the S&P 500, you get a 10-year Treasury yield plus the upside (or downside) of S&P 500 earnings from companies that as a group have pretty strong balance sheets.

The second question I was asked was: why not buy the S&P 500? I was silent. No advice given outside a professional setting.

The third and final question was: “what's wrong with this beautiful S&P 500 picture?” I limited myself to the following. “The S&P 500's profit margin hit about 14 1/2% in early 2007. It hit 14% in October 2011 after all the earnings announcements. From here on out it would seem the S&P 500's earnings gains will have to come more from revenue growth and less from margin expansion growth. Will that revenue growth materialize? Will margins strengthen or at least hold their own? What impact will the internal dynamics of the US' economy, Europe's and China's have on these questions?”

I left my interlocutor. There is no free lunch.

Next time, his turn to answer. My treat.

— John Allison

© 2011 UNIO Holdings, LLC.

UNIO® and the UNIO® Logo are registered trademarks of UNIO Holdings, LLC.

The information contained in this communication is proprietary to UNIO Holdings, LLC. Reproduction or retransmission of this information, in whole or in part, is prohibited without the prior written consent of UNIO Holdings, LLC. This information does not constitute investment advice.