The Big Bond Bubble

Are bonds about to pop?

For 10 years we have expansionary monetary policies in developped countries, in Japan even for over 20 years!

Monetary expansion has driven government bond yields to historic lows

This monetary expansion has created a sequence of bubbles: real estate bubbles, commodity bubbles, and the mother of all bubbles in government bonds which is still here. The debt of the private sector which caused the financial crisis has just been shifted to the governments of the US, Europe, Japan and even China.

If we measure valuation of other asset classes such as equities or  real estate they appear cheap. Especially equities are in danger since companies are enjoying historically high profit margin, and profit margins are known to revert to their long term mean.

In my opinion, it is paramount to select reasonably priced stocks, not too much long term bonds, some cash and gold.

Weakest Currencies Deliver Best Returns

In today's FTfm on page 3 is an intersting article about a study on a market anomaly: Marsh, Dimson and Staunton have analyzed the effect of currency movements on stock and bond returns from 1900 until 2011. There findings:

Stocks and bonds of currencies which were weakest in the last 5 years, outperform (currency adjusted) in the subsequent 5 years. Stocks and bonds of currencies which were strong, underperform.

http://www.ft.com/intl/cms/s/0/941121c8-61f9-11e1-807f-00144feabdc0.html#axzz1oEDIBAke

The findings are also true for the time after Bretton Woods (1972 - 2011).

Explanation: Currency weakness increases export opportunities and competitiveness, which are not noticed immediately but over time. This contradicts market efficiency (equity prices should jump immediately and not over 5 years) and is another nail in the coffin of modern portfolio theory. However, it is a big argument for value investing. 

Implication on portfolio strategy: The belief of investors that emerging markets with strong currencies will out perform is to be doubted. It also explains why the German economy and the DAX have performed that well over the last 6 months. Since the study suggest that the movement has another 4.5 years to go, we should buy more DAX on dips.

Wall Street Psychos

A typical employee on the trading floor

The March/April 2012 issue of the CFA Magazine has a nice piece about psychopaths in the financial industry. The main trait of a psychopath is his lack of empathy and lack of responsibility for the consequences of his actions. There are studies which show that in the financial service industry, 10% of the employees are psychopaths compared to 1% in the general population.

Trading is a high paced business, firms hire and fire and don't have time to care about sensitive employees.
A Trader is also always a risk taker, since he earns money by entering risky positions. But from behavioral finance we know that we usually get overconfident, especially after a period without any losses. Some traders even become compulsive gamblers. It is only a matter of time unitl gamblers dig their hole by making losses. hiding them and accumulating them until it is too late. Most recent examples are the rogue traders at UBS or at Société Générale. But in every financial institute there are cases of employees getting fired because of hiding losses. Those traders only wake up when it is already too late!

In order to manage this risk, banks need to invest heavily in systems and procedures to keep traders in check: The task is complex since there are many different communication channels, systems, databases and application. But to do nothing is even more costly!

I guess I have to watch "American Psycho" this weekend (the picture above is from the movie).

BCA Research for March 2012

BCA Research March 2012 Bank Credit Analyst comes with following headlines:

• The structural problems in Europe remain unresolved, making another market
  riot likely later this year. Greece may well leave the euro within the next two
  years, and if it does, this could trigger the exodus of other countries.
• The U.S. housing sector appears to have bottomed and the labor market
  is improving. That said, the durability of the recovery is far from assured,
  especially if gasoline prices keep rising and the economy is hit by major fiscal
  tightening in 2013.
• Against this fragile backdrop, the Fed will keep rates at rock-bottom levels
  for the next few years. Other central banks have also turned much more
  accommodative, which will help support growth and risk assets.
• For now, we continue to recommend a modest overweight in equities and
  corporate bonds. However, given the fragility of the financial and economic
  environment, we will not hesitate to move back to a neutral or underweight
  stance if the situation in Europe flares up again or the U.S. economy begins to
  slow.