Contrarian Investing

Prof. Gerlach

Sacred Heart University

Deborah J. Weir, CFAAuthor, TIMING THE MARKET (Wiley, 2005)

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Fundamental Economics

As

Contrarian Investing

Because

Emotions Get In the Way

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Background

• SEC Registered to sell hedge funds

• MBA in finance: NYU Stern School of Business

• Stamford CFA Society, Past President

• Deutsche Bank/Scudder: United Technologies, Rockwell, Mayo Clinic

• Instructor: NY Institute of Finance

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We Will Forecast

GDP

Interest rates (up or down)

Direction of stock & bond markets

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Economic ForecastingTools

1) Yield curve shape

2) Quality spreads

3) Central bank actions

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Contrarian Tools?

• These tools are fundamental economic analysis

• People get caught up in emotion and overlook them

• It is always “different this time”

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Ground your thinking in solid economic analysis to rise above hysteria.

Old adage, “Keep your head while all about you are losing theirs.”

New adage:

Make money when all about you are losing theirs.

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1) Yield Curve ShapesPositive Slope (normal) Negative Slope (inverted)

http://stockcharts.com/freecharts/yieldcurve.html

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Curve Reflects Investor Expectations for Future Rates

• Investors stay short if they expect rates to increase

• Investors go long if they expect rates to decrease

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• Positive slope – increase risk: buy stocks, real estate, gold

• Negative slope – decrease risk: buy bonds or cash

• US Federal Reserve uses the shape of the yield curve to help forecast the economy

Asset Allocation Using Yield Curve Shapes

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Normal Curve, Normal Growth: Nov. 2004

Equities

Inverted Curve, Recession:March 2007

Fixed-income or Cash

Steep Curve, Inflation:

July 2009

Gold, Foreign Currencies, Real Estate

Economic Forecasting Theory

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Forecasting Practice

http://stockcharts.com/charts/YieldCurve.html

Click on the “animate” option to see how these two markets move:

The yield curve helps forecast the recent US investment cycle.

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Inverted Curve 2006 Forecast the financial crisis of 2007 – 2009 and the decline of the S&P 500

Index.

http://stockcharts.com/charts/YieldCurve.html

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Normal Curve 2009

http://stockcharts.com/charts/YieldCurve.html

Forecast strong stock market.

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Steep Curve 2010(3mo./10yr. Spread > 300 bp)

http://stockcharts.com/charts/YieldCurve.html

Forecast inflation expectations.

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Steep Curve 2009 - 2010

http://stockcharts.com/h-sc/ui

Inflation expectations weakened the US dollar.

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Steep Curve 2009 - 2012Inflation expectations increased the price of gold

http://finance.yahoo.com/q?s=GLD

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Steep Curve 2009 – 2011Inflation fears may end the decline in real estate.

http://www.dallasfed.org/microsites/research/econdata/housing-charts.pdf

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Inverted Curve

Forecasts recessions

• Lower stock market

• Higher bond prices (& lower yields)

• Lower inflation

• Stronger currency

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Ten-yr./Three-mo. Spread 1953–2012

http://www.clevelandfed.org/research/trends.cfm

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Stocks Inverse of BondsCurve forecast stock market losses, bond market gains.

http://stockcharts.com/charts/historical/

S&P 500 Index

30-yr

Bond

Price

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Federal Reserve Bank Uses the Yield Curve

http://www.clevelandfed.org/Research/Data/Yield_Curve/

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This Site Has Monthly UpdatesOctober 26, 2012Covering September 26, 2012–October 26, 2012

Highlights  October September

August3-month Treasury bill rate (percent) 0.10 0.11 0.10 10-year Treasury bond rate (percent) 1.79 1.81 1.76Yield curve slope (basis points) 169 170 166

Expected real GDP growth (percent) 0.6 0.6 0.6Old Formula: GDP = 1.87 + (.97 X spread)New Formula: GDP is weighted by the previous growth rates

Probability of recession in 1 year 8.2 8.1 8.5http://www.clevelandfed.org/Research/Data/Yield_Curve/

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Applications to Global Economies

• BRIC

• PIIGS

• Managed economies limit the use but still can indicate the direction of growth

• 2011 indicators were negative

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Outlook for the BRICshttp://www.economist.com/news/economic-and-financial-indicators/21567095-

trade-exchange-rates-budget-balances-and-interest-rates%20%20

Country 3-month 10-year BP SpreadBrazil 7.10% 9.57% +274Russia 7.66% 7.36% - 30India 8.18% 8.21% + 3China 3.80% 3.19% - 61

Given these spreads, what’s your forecast:

GDP

Interest rates (up or down)

Inflation

Currency

Direction of stock & bond markets

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Outlook for PIIGS

Country 3-month 10-year BP Spread

*Portugal0.19% 7.89% +770

Italy 0.90% 4.84% +394

*Ireland 0.19% 4.58% +439

Greece 0.19% 16.08% +1589

Spain 0.19% 5.74% +555

http://www.economist.com/news/economic-and-financial-indicators/21567095-trade-exchange-rates-budget-balances-and-interest-rates%20%20

•No information for Portugal or Ireland in 2011

Given these spreads, what’s your forecast:GDPInterest rates (up or down)InflationCurrencyDirection of stock & bond markets

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2) Quality spreads

• Forecasts trouble in emerging markets (1998 Russian bond default)

• Forecasts trouble in developed markets (1987 S&L crisis, 2008 crisis)

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Merrill-Lynch High-yield

Index Constrained Less the Ten-year US Treasury Note:

(sometimes not available & no history)

http://online.wsj.com/mdc/public/page/2_3022-bondbnchmrk.html

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http://online.wsj.com/mdc/public/page/2_3022-bondbnchmrk.html

Wall St. Journal Publishes High-yield Index

Nov. 2011

Nov. 2012 = 4.87%

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Other SourcesFederal Reserve Bank of St. Louis (two-day lag)

Gives previous five days for easy comparison

http://research.stlouisfed.org/fred2/series/BAMLH0A0HYM2

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You Can Get the Spread in Real Time

Good for trading options during the day…

High-yield ETF (JNK) – Ten-year yieldhttp://finance.yahoo.com/q?s=JNK&ql=0 http://finance.yahoo.com/q?s=%5ETNX

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Is This Stock Market Recovery Sustainable?

S&P October 1 - Nov. 23, 2012

1340

13601380

14001420

14401460

1480

10/1

/201

2

10/8

/201

2

10/1

5/20

12

10/2

2/20

12

10/2

9/20

12

11/5

/201

2

11/1

2/20

12

11/1

9/20

12

S&P

•Fiscal Cliff

•Greek Default

•Global Slowdown

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Bull Market Confirmed by Quality Spreads

Merrill-Lynch High Yield Less the Ten Year Note

Quality Spread Oct. 1 - Nov. 23, 2012

3.84

4.24.44.64.8

55.25.4

10/1

/201

2

10/8

/201

2

10/1

5/20

12

10/2

2/20

12

10/2

9/20

12

11/5

/201

2

11/1

2/20

12

11/1

9/20

12

%

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3) Central Bank Actions

• Open Market Operations

• Money Supply

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Federal Reserve Open Market Operations

• Normal repurchase agreements = $3.25 billion daily prior to 9/11

• September 11, 2001 = $35 billionhttp://www.ny.frb.org/markets/omo/dmm/temp.cfm

What is the Fed doing today? Tightening? Easing?

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Federal Reserve Controls Money Supply and the Shape of the Yield Curve

http://www.dallasfed.org/assets/documents/research/econdata/us-charts.pdf

Financial Crisis

Market Turn

QE2

QE3Turn

Turn?

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Global Economic ForecastingTools

1) Yield curve shape

2) Quality spreads

3) Central bank actions

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Fixed-income Is a Good Data Set for Forecasting Economies and Markets

Large Data Set (Eight Times the Volume of Equities)

Depicts Investors’ Actions Rather Than Opinions

Forward-looking; No Reliance on Historical Financial Statements

Low Turnover and Transactions Costs

Government influence on the shape of the yield curve works for you; not fighting City Hall

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UpdatesBlog:http://timingthemarket.blogspot.com/

Twitter.com: @debweir

Voices of New York Institute of Finance Faculty: http://www.nyif.com/blog.html

Email DebWeir@WealthStrategies.bz

Contrarian Investing

Prof. Gerlach

Sacred Heart University

Deborah J. Weir, CFAAuthor, TIMING THE MARKET (Wiley, 2005)