On the Situation in Cyprus...

Wading into an issue like the Cyprus bailout is a dangerous prospect, indeed.  We couldn’t help it, though, after receiving a breathless email this week from a family member warning that this was the first step in Western governments’ attempts to “confiscate” all of our deposits and wealth in general through outright theft.  Of course, this family member was responding to a breathless appearance by a pundit (who will remain nameless) on financial television this week warning Americans that we’re next in line.  Don’t get us wrong, there certainly are plenty of problems, politically and economically, to ruminate about in the US and, of course, Western Europe.  Financial repression, an age-old tactic, has been implemented to some extent judging by the consternation surrounding low interest rate regimes around the world.  Perhaps, governments will try to “inflate away” our debt over the long run.  Some view “Abenomics” Japan as some sort of variation on this theme.  Inflationary tactics have certainly been used before throughout history, though in a world with such a large demand deficit and a private sector still working to deleverage, we have our doubts that a massive bout of global, developed market inflation is in the cards anytime soon.  We tend to sympathize with those more worried about deflationary tendencies in the Western developed markets owing to the massive output gaps that still exist and the continued slack in many labor and capital markets.

Coming back to Cyprus, it quickly gets lost in the weeds (punditry) that Cyprus presented an incredibly unique situation, not applicable in any consistent way to the other countries of the Eurozone, or the United States for that matter.  The country is tiny.  Its population of 1.1 million is smaller than approximately 50 US metropolitan areas.  Yet, Cyprus had built up quite a business as an offshore banking and tax haven, with a particular gift for catering to billionaire and millionaire Russians with wealth they wanted to spirit out of the country for various reasons, some legitimate, many not-so-legitimate.  As a result, the size of the banking sector in Cyprus came out to several times the level of GDP.  The three major banks in Cyprus funded their balance sheets mostly through these deposits from offshore customers, not via the debt markets.  Cyprus banks made a common error, of course, which was investing in assets that failed the “money-good” test, namely a bunch of assets in the Greek isles that collapsed in value with the Greek economy.  When the proverbial chickens came home to roost, there was absolutely no way Cyprus was going to be able to handle the burden of recapitalizing its banks on its own due to the fact the size of the banks dwarfed the broader economy (due to the unique circumstances as an offshore tax haven).  Owing to the structure of the banks’ liabilities, there were fewer debt-holders to haircut or “bail-in.”  If burden-sharing of some sort were to take place under these unique conditions, higher-status depositors were going to come into focus.  Everybody in Europe knew the primary source for the massive deposits.  There wasn’t any way politicians around the rest of Europe were going to bailout Cypriot banks to protect Russian oligarchs.  On the flip side, the Russian (and other foreign) depositors knew there was risk in the system, yet made a major gamble that the European authorities would blink and make everyone whole in Cyprus.  

What happened next, of course, has fueled the breathless “confiscation” cries around the globe.  Cyprus, given orders to come up with several billion euros to help with the overall bailout package, announced that insured depositors under €100,000 would get haircut, along with the big-time offshore depositors.  Most likely, Cypriot authorities committed this unforced error in an attempt to placate these offshore customers, reducing their burdens so they presumably wouldn’t abandon Cyprus over the long-run and flee to other tax havens.  This obviously turned out to be a major error in judgment, causing massive hand-wringing and protest among their citizens, not to mention condemnation and disbelief among European authorities, who basically said, “Go back to the drawing board.”  Again, to reiterate, these troublesome issues were a direct outgrowth from Cyprus’ unique status as a banking haven and the Cyprus government’s uniquely ridiculous attempt to protect an offshore client base.  It certainly didn’t help that there didn’t seem to be a consistent guiding hand on the process from the rest of Europe.  It was never necessary to even consider haircutting insured depositors.  Very few if any serious observers believe that is type of depositor haircut policy is sitting on desks in Brussels, or Frankfurt, or London, or Washington DC waiting for implementation at the next sign of banking crisis.  As Martin Wolf of the Financial Times pointed out this week: 

One could conclude that the action over Cyprus tells us little about the monetary area. After all, the island is unique because of the size of its banking liabilities, the unpopularity of its banks’ creditors and the borderline insolvency of its state. Or one could believe it is a template, but only for other countries with similarly weak states. Or you could see it as a template for all eurozone states, except when there is a financial crisis of 2008 dimensions. Finally, an observer could believe Cyprus is a template for all eurozone states in all circumstances. Which of these readings is right? Nobody knows. But it is probably the first or the second. A consensus on the principle that creditors, not taxpayers, should pay if a bank becomes insolvent does not yet exist across the eurozone. Does anybody imagine the German government would not rescue Deutsche Bank if it were in trouble? Of course it would.

So, as it pertains to “confiscation”, we tend to side with the Martin Wolfs of the world in believing that insured depositors in western countries need not worry at all that governments are coming after their cash stuffed in banks.  Furthermore, we tend to find some of the commentary out there whipping up the frenzy on financial channels and on certain financial blogs and websites as ill-informed at best, and deliberately manipulative and pernicious at worst.  These breathless proclamations don’t serve anybody well.  In many cases, we’re probably watching people talk their own books of business.  Maybe they want to sell more newsletters.  Or, maybe their portfolios are positioned for crisis and Armageddon.  Whatever the case, they’re probably best ignored.

What, however, does this mini-crisis and kerfuffle say about the state of European politics and the overall structure of the European Union?  It says a lot.  First, it reconfirms that admitting marginal European countries like Cyprus was probably an error in judgment from the get-go.  There’s very little that can be done about this now, though we’re amazed that expansion talk continues.  Second, and most importantly at this juncture, it shows again that the structure of the EU, a currency union without political/fiscal union, lends itself to unforced error after unforced error after unforced error.  As observers around the globe have watched Europe lurch from one crisis to the next over the past three years, one can’t help but be amazed by the communication inconsistency that rears its ugly head every time trouble crops up.  These communication problems have a habit of taking marginal issues and blowing them up into hand-wringing crises, or taking big issues and blowing them up into existential hurricanes.  This, of course, is a direct result of the fact that the Eurozone by current design consists of numerous leaders and very few followers.  With its diffuse power structures and combination of essentially sovereign states within a broader, loose political structure, the current situation is not unlike the US Articles of Confederation that preceded our current form of government under the US Constitution.  There are too many voices out there in the wilderness.  Neither individual citizens, nor corporate leaders, nor investors know who to listen to or who to trust.  Conflicting proclamations and information are the norm.  On any given issues, it’s not unfathomable to hear simultaneously from Angela Merkel, Francois Hollande, Mario Draghi, and umpteen other officials, all of whom have roughly similar power and standing within the Eurozone.  Oftentimes, they’re pushing completely different agendas.  This week, Eurogroup head and Dutch Finance Minister Dijssellbloem caused problems by stating that this template of haircutting depositors could be seen as a template of sorts.  He was quickly and rightfully criticized by Eurozone leaders, but not before damage was done and the aforementioned conspiracy theories on confiscation were flamed.  This was apparent even last summer in the midst of what many consider to be the Eurozone’s biggest policy success in terms of quelling the financial turmoil, Draghi’s assertion in a magazine interview that the ECB would do “whatever it takes” to preserve the monetary union.  Within an hour of the news hitting the market tape, officials from Germany and elsewhere were either disputing the statement or offering counter-positions muddying the water.  Markets continued to rally, but in an uneasy state.  The lead-in to the official ECB rate decision and news conference following the news of the statement was a time of incredible uncertainty.  Contrast these exercises in communication futility with the United States.  Surely, there are times when a Fed Governor or Representative or Senator can ruffle some feathers.  But when the going gets rough, most know to focus on three or four folks: the President, the Speaker, the Senate Majority Leader, and/or the head of the Federal Reserve.  As witnessed at the depth of the ’08 crisis, American economic policymakers can act quickly and decisively.  Americans know to focus their attention quickly on one power center: Washington.  We’ve had a few unforced errors.  But, if a Governor of Texas or California comes out criticizing Federal Reserve action, very few pay it a bit of attention.

The Eurozone still has a long way to go in deciding what it wants to be when it grows up, at least from a political perspective.  As it stands now, the continuing danger from Europe remains a situation where poor communication and divergent voices lead the area to stumble unintentionally into problems with major systemic consequences.  In the US, a major municipal bankruptcy or a state financial problem need not become an existential problem.  In Europe, a problem like Cyprus that could have been nipped in the bud relatively quickly and painlessly becomes an absolute nightmare within days, requiring much more time and effort than should have ever been expended.  Until Europe either learns how to speak with one voice within the current edifice, or to create institutions that force it to speak with one voice, Cyprus type problems are going to continue to plague the currency union and drive fear and confusion.  Do Europeans have the will to take these steps over coming years?  We have our doubts.  

MSCI World Value vs. Growth: A History of Lumpy Relative Performance

It’s been a Sisyphean task promoting a global equity style of investing over the past several years.  When one sits down and examines the performance history for the MSCI World Value Index vs. the MSCI World Growth Index, it becomes apparent that the current underperformance streak is notable in several respects.  Fortunately, streaks have tended to revert over time and the rebounds have tended to offset, or more than offset, the prior underperformance periods.  Looking at the numbers for the two indices since inception in 1974 reveals some interesting dynamics in the continual tug of war between global growth and value investors.

Before we begin examining the numbers, let’s use MSCI’s own words to define the methodology behind choosing value and growth stocks for these indices:

MSCI Global Value & Growth Indices categorize value and growth securities using clear and consistent sets of attributes and a rigorous methodological framework. Style characteristics are defined using eight historical and forward looking variables (three for value and five for growth).

Each security in an underlying MSCI index is given an overall style characteristic derived from its value and growth scores and is then placed into either a value or a growth index (or is partially allocated to both). Ultimately, the adjusted market capitalization of each constituent of the underlying index is fully represented in the combination of the value index and the growth index, with no "double counting".

Msci.com

Here are the yearly performance numbers for the MSCI World Growth and Value Indices:

Using simple returns (dividends excluded), the MSCI World Value Index has outperformed the Growth Index over the past 38 years by nearly 0.90% per annum: 8.19% per year versus 7.30%.  The annualized numbers, however, mask a “lumpiness” and “streakiness” to returns that is surprising to many investors.  Over the 38 year time frame, Growth has actually outperformed Value in 20 of the years.  The average differential is 0.63% per year, but the median differential is -0.17% indicating Value outperformance tends to be skewed to the big upside performance differentials.  The biggest year of outperformance for the MSCI World Value Index was 2000.  The differential was +24.82%.  This followed on the heels of a massive underperformance streak for value, which we’ll address further below.  The biggest negative year for Value relative to Growth occurred in 1998; Value underperformed by 18.5%.  Calculating the standard deviation for the yearly differentials gives us another frame of reference for “lumpiness.”  At 7.99%, very high relative to the average differential of 0.63%, we see that performance in individual years tends to be very wide.

Under and outperformance tends to be streaky.  The current yearly streak of Value underperformance exceeds anything ever observed in the history of the data series, though.  Value has underperformed Growth for the past six years, 2007 through 2012.  Prior to the current period, the longest yearly streak of underperformance stood at three years.  During the current streak (through the end of 2012), cumulative performance for the Value Index stands at -21.63% vs. +3.21% for the Growth Index, a cumulative deficit of 24.84%.  This represents the second largest cumulative deficit.  The biggest deficit belongs to the years surrounding the tech/equity bubble in the late 1990s when growth stocks went on a massive performance rip to the upside.  Though growth “only” outperformed value for three years (1997 through 1999), the cumulative outperformance for growth totaled 50.81% over those three years, dwarfing the cumulative deficit witnessed during the current streak.  Needless to say, the late 1990s represented a big-time period of frustration for those in the value space.  It was very hard for value investors to stick to their guns.  

What’s the good news for Value investors, especially those frustrated with the current period of underperformance?  Streaks of underperformance have been followed by streaks of outperformance.  And, in every case since the inception of the indices that the Value Index has underperformed the Growth Index for two or more years consecutively, the subsequent outperformance streak has produced cumulative excess returns that offset the losses felt during the prior underperformance period.  For instance, as mentioned, during the three years of the late 90s bull run, the MSCI World Value Index rose 48.79% vs. 99.59% for the World Growth Index, a deficit of 50.81%.  Over the next seven years, 2000 through year-end 2006, Value rose 33.56% vs. -20.44% for the Growth Index, a cumulative performance differential of 53.99%.  Compound out the yearly performance over those ten years and Value handily outperformed Growth from year-end 1996 to year-end 2006, 98.71% vs. 58.80% for Growth.  While the value investor experienced significant frustration, the investor was ultimately vindicated.  This type of “through the cycle” outperformance has occurred in every case since 1974.  The lesson: no matter how infuriating the underperformance streaks for value, it pays to stick with the strategy.  

So far this year, the MSCI World Value Index is outperforming the Growth Index by 0.63%.  There’s a long way to go for global value to erase the recent deficit.  If history is a guide though, value investing’s time in the sun may be approaching.  We’ll leave you with a chart showing the ratio of the MSCI World Value Index price to the MSCI World Growth Index showing just has much relative performance has oscillated over the past 16 or so years.

IronHorse Capital

2013: A Positive Year?

Since February ended on a positive note for the S&P 500, we’ve come across a number of stories discussing S&P 500 performance during years in which both January and February closed in positive territory.  In nearly all of the stories, it’s mentioned that the S&P 500 has never ended in negative territory for the year when this has occurred.  There have been 26 instances since 1945 where both January and February exhibited positive performance.  Based on our calculations, excluding dividends and using only price appreciation, there have actually been 25 positive years, and one very slightly negative year.  On a price appreciation basis, 2011 ended essentially flat, down 0.03%.  Still, it’s an impressive record overall.

Most of the stories, however, failed to discuss the nature of the performance for the remainder of the year after the January/February positive run.  Was performance run of the mill relative to other years for the other months?  Were most gains for the entire year achieved during January and February?  Should investors feel comfortable investing after January/February runs?  

Looking at performance for the final 10 months during these January/February episodes, we found that performance for the remainder of the year was exceptionally strong, especially compared to the final 10 months of years in which either January or February (or both) came in negative.  Let’s move on to the data. 

As mentioned, there have been 26 years since 1945 in which both January and February were positive.  Here is a table showing the years of occurrence, the cumulative performance for January and February in those years, and the cumulative performance for the 10 months following in those years:

Year	Jan to Feb Return	Mar to Dec Return	YR Return (Simple Return)
2013	6.20%	????	????
2012	8.59%	4.43%	13.406%
2011	5.53%	-5.25%	-0.003%
2006	2.59%	10.75%	13.619%
2004	2.97%	5.85%	8.993%
1998	8.13%	17.14%	26.669%
1997	6.76%	22.71%	31.008%
1996	3.98%	15.66%	20.264%
1995	6.12%	26.37%	34.111%
1993	1.76%	5.20%	7.055%
1991	11.16%	13.63%	26.307%
1988	8.39%	3.70%	12.401%
1987	17.36%	-13.06%	2.028%
1986	7.40%	6.72%	14.620%
1985	8.34%	16.61%	26.333%
1983	5.28%	11.39%	17.271%
1975	19.01%	10.54%	31.549%
1972	4.39%	10.77%	15.633%
1971	4.99%	5.52%	10.787%
1967	8.03%	11.17%	20.092%
1964	3.71%	8.93%	12.970%
1961	9.17%	12.78%	23.129%
1955	2.17%	23.72%	26.404%
1954	5.40%	37.59%	45.022%
1951	6.71%	9.04%	16.349%
1950	2.56%	18.64%	21.680%
1945	7.68%	21.40%	30.723%

The first fact of note from the table: of the 26 years exhibiting positive performance in both January and February, there were only two instances in which the S&P 500 posted a negative performance number for the final ten months, 2011 and 1987.  The summer and fall months of 2011 were negatively affected by the European debt crisis and the sovereign ratings downgrade for US debt.  Of course, 1987 was the year of the October stock market crash.  Even with the devastating crash, the S&P 500 only posted a negative 13% number for the final 10 months, relatively tame compared to many other episodes in market history.  Moreover, 1987 produced one of our favorite fun facts: the S&P 500 was actually up for full year 1987 despite the crash.

Now for some summary statistics that show the strength of the cumulative performance for the final 10 months, both in years with positive performance in both January and February and years without:

	Jan/Feb Both Positive	Jan/Feb (other)
Average	12.00%	4.57%
Median	10.97%	4.04%
St. Dev	10.08%	16.18%
Min	-13.06%	-32.12%
Max	37.59%	51.70%

As you can see above, average and median performance was much higher over the final 10 months for “positive” years compared to years with either a negative Jan. or Feb.  Dispersion or volatility of the returns is also much lower as indicated by the standard deviation, minimum, and maximum summary statistics.  

Is there a statistical relationship between strong January/February returns and returns the remainder of the year?  There’s a very weak statistical relationship.  The R-squared between them is a paltry 0.08.  Correlation is -0.298 indicating that there is a negative statistical relationship between the two (i.e. higher cumulative Jan/Feb returns mean lower Mar to Dec returns), but again the strength of the relationship is weak.  In layman’s language, just because the first two months are positive in a big way doesn’t mean the final 10 months are going to come in below average relative to the other 25 years, or vice versa.

What can we take away from the exercise?  There appear to be reasons for optimism the rest of this year.  Cumulative performance for January and February this year came in at 6.2%, slightly below, but close to in-line with the average over the other 26 episodes of 6.8%.  There are certainly going to be bumps in the road over the course of any year, but the historical record for performance in years with positive January and February performance is consistently strong.  March is off to a good start.  Let’s hope the remainder of 2013 doesn’t prove to be the very rare exception.

Sequester Sideshow

March Madness has arrived early.  The much debated and huffed-about sequester begins today barring some unforeseen action by Congress and the President.  Suffice to say, this has been one of the most overwrought political situations we’ve observed in quite a while.  We find the sequester and the debate surrounding the sequester fascinating, not because of the nitty-gritty embedded policy details or the fireworks between all the politicians and pundits, but because it presents another example of many policymakers and political activists missing the forest for the trees.  So much time and energy is spent in the US bemoaning discretionary government spending as a whole.  Interests on both the right and left have their pet projects and initiatives. Each side fights tooth and nail for its own interests and demonizes the other side’s wants, whether defense spending, welfare moms, research, general government services, or a number of other programs.  The cacophony is overwhelming.  All the while, the true hundred pound gorillas in the room—entitlements—are forgotten, perhaps conveniently considering Medicare, Medicaid, and Social Security are “third-rail” political issues.  The simple fact of the matter is that both defense and non-defense discretionary spending are not big problems from a long-term budgetary standpoint.  It’s the entitlement programs that are problematic, especially health care entitlements.  Let’s take a look at some numbers.  

First, here is a backward-looking chart showing federal spending as a percentage of GDP in four major categories, Defense, Nondefense Discretionary, Social Security, and Medicare.   

Source: American Prospect and Congressional Budget Office

As seen above, defense spending as a percentage of GDP has declined materially over time.  Granted, the Vietnam War affected the numbers at the outset of the timeframe.  Still, the War on Terror has been a significant event spending wise, yet defense spending as a percentage of GDP is only back to the late-1980s/early-1990s levels.  Nondefense discretionary, which basically includes all government spending ex-defense that doesn’t fall into the entitlement buckets, has risen since 2000, with a notable bump during the Great Recession years as both the Bush and Obama administrations responded to the economic crisis.  This figure has been in decline over the past few years, however, and has remained comfortably within the long-term range.  After leveling off, Social Security expenditures have begun creeping higher again as a percentage of GDP.  Medicare expenditures as a % of GDP have consistently crept higher.  Of course, as the Baby Boomers retire in increasing numbers, the entitlement numbers will begin to grow quickly as we’ll observe later.  Looking at these numbers, nothing in the defense or non-defense discretionary realm looks particularly egregious relative to historical precedent.  

So, what does the future look like on the discretionary side?  Judging by the rhetoric, we’re absolutely doomed because of all that out of control discretionary government spending.  Actually, not so much.  Here are a couple of charts that show the projected trajectory of defense and non-defense discretionary spending after the passage of the Budget Control Act.  As you can see, even before the sequester cuts kick in, both defense and nondefense discretionary spending were slated to decline over the next 10 years as a percentage of GDP to levels below the lowest levels observed since World War II.  To repeat, discretionary and nondiscretionary government spending were already set to decline below the lowest levels witnessed in the past 50 or 60 years relative to GDP.  Both are already below the trailing 30-year averages.

Source: Bipartisan Policy Center and Congressional Budget Office

Source: Bipartisan Policy Center and Congressional Budget Office

So what’s the bugaboo that that keeps budget analysts up at night if discretionary spending is under control?  Mandatory entitlement spending.  First, a side note.  Obviously, projecting figures out to 2040 or 2050 is always a dangerous exercise, especially considering we have a hard enough time making predictions a quarter or two ahead of time when it comes to economic growth, policy, and other factors.  One thing we can see coming with relative accuracy is demographic waves.  We know with a decent degree of accuracy how many folks will retire over the next 30 or 40 years and what they’re owed pension-wise.  Life expectancy projections will probably turn out reasonably accurate as well.  On the other hand, the growth trajectory of health care spending is a major wild-card.  The health-care related entitlement programs are expected to account for the bulk of budgetary problems moving forward.  Most projections show health care costs increasing at a similar pace over the coming decades as observed over recent decades.  Of course, health care costs have outpaced CPI handily for years.  Many people attack long-term entitlement spending projections on these grounds, perhaps rightfully, arguing that natural market forces will dampen health-care inflation and that the numbers will ultimately come in better than expected.  So OK, let’s assume there’s a not-insignificant chance that health care inflation declines; isn’t it still prudent to consider the worst or “worser” case scenarios?  If health care inflation moderates a good bit, that’s gravy.  If not, we’re adequately prepared.  As it stands now, using the lesser-case projections, entitlement spending is projected to explode over the next few decades:

Source: Heritage Foundation and Congressional Budget Office

As seen above, under the less optimistic cost scenarios, and under assumptions that current entitlement policy remains intact, entitlement spending alone will eat 100% of Federal revenues within approximately 30 years.  Assuming that we can bring health care cost inflation under some semblance of control, US demographics and other factors still suggest that entitlement spending will eat a significant amount of governmental financial resources over coming decades.  The US government will increasingly become a “retirement program with a…large army,” as described by writer Paul Waldman.

What’s the bottom line?  Though it remains the focal point for a lot of activists and loudmouths on the left and right, government discretionary spending, both defense and non-defense, is a minor irritant at worst and a non-factor at best.  Are there inefficiencies throughout government?  Most certainly.  But, Congress and the President could decide today to cut every single dollar of nondefense discretionary spending today from the budget, for instance, and would eliminate less than half of the budget deficit projected for this year.  As we’ve seen, under current policy, discretionary spending is moving towards low levels not seen for a few generations.  The sequester debate no matter the side you’re on is small potatoes compared to the larger debates we need to have moving forward about entitlement spending.  Current Washington games are an annoying sideshow and distraction.  Dealing with entitlements will require incredibly tough discussions between younger and older generations about benefit levels to retirees, payments to providers, eligibility ages, means testing, public health, and a number of other issues.  Somehow, Americans across generations are going to have to shed the tendency to exhibit “not in my backyard syndrome.”  Unless these issues are addressed sooner rather than later, and unless they’re addressed honestly without band-aid, can-kicking solutions, there won’t be any room for guns or butter in the budget, only dentures and dialysis machines.