tag:blogger.com,1999:blog-58035184732701554342024-03-21T13:02:37.255-07:00My World and Welcome to ItBretthttp://www.blogger.com/profile/11094579354565486061noreply@blogger.comBlogger17125tag:blogger.com,1999:blog-5803518473270155434.post-55380765954206899812015-01-16T16:55:00.000-08:002015-02-18T16:44:19.394-08:00Who is Larry Doby?<div class="separator" style="clear: both; text-align: center;">
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In a departure from my normal investment-related posts, I am asking today, "Who is Larry Doby"?<br />
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I am willing to guess that <u>at least</u> 90% of the readers of this blog have no idea who the man is (pronounced "dough - be"). On the other hand, I am also willing to bet that nearly all of the readers of this blog know the name Jackie Robinson. <br />
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I first became aware of Larry Doby about 24 years ago while attending a dinner held in his honor in New York City. You might ask why I would attend the dinner of a person I hadn't known prior to the invitation - but that will become evident as I write. Once I learned about the man and what he had accomplished, I was more than a bit perplexed that I did not know of him - and I guess there is a lesson in that.<br />
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In life, Larry Doby was the second African-American to play Major League baseball. The first, of course, was Jackie Robinson. Mr. Doby followed Jackie Robinson by only 10 weeks, debuting with the Cleveland Indians on July 5th, 1947.<br />
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While all due credit is given to Jackie Robinson for breaking the color barrier in American sports, Larry Doby never seems to be mentioned in this regard, yet we know he suffered with and endured the same trials as Mr. Robinson. Had Mr. Doby a short-lived career, or one that was unremarkable, the lack of recognition might be understandable. However, Larry Doby went on to have a career that spanned 13-years and included seven All Star appearances (Jackie Robinson was an All Star six times).<br />
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In fact, the careers of the two men were very similar. While Jackie Robinson had a higher career batting average (.311 versus .283) and was a better base runner, Larry Doby had more home runs (253 to 137), RBI's (970 to 734) and a higher slugging percentage (.490 to .474). <br />
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Jackie Robinson was deservedly elected to the Baseball Hall of Fame by the Baseball Writers of America in 1962. He was named on over 77% of their ballots. Larry Doby, however, failed to be elected by the BBWAA, never appearing on more than 3.4% of their ballots. Two men, playing the same game at the same time, both achieving success, but with two different legacies. <br />
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Now, let me ask a second question. Who was the second African American to coach in the Majors? The answer, is the same as to my first question, Larry Doby (baseball fans will know that Frank Robinson was the first).<br />
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So, being second in America is sometimes almost the same as never having been there. With our incessant focus on the headlines, the details often get overlooked. While we love to celebrate our heroes, we often neglect to celebrate men and women who are equally "heroic".<br />
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So whether it is Monday's Martin Luther King Jr holiday, or tonight's release of the movie "American Sniper" (which celebrates the heroics of US Navy Seal Chris Kyle), let us also consider those whose names we don't know -- because like Larry Doby, they too are heroes and truly deserve our respect.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiqopPLlczQvxs-etkx50vBveHVomo9maSbuJyEup67gLcMawfBieAX26Zs0Z2YNJyDDwvd3H0WNEDBgrJyiwP6gOQOVXUOZXB4CyR3rhpZnVqY4mkQMvTKG0CKxdCTIBPmgZRtrBEoNx0/s1600/Larry+Doby.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiqopPLlczQvxs-etkx50vBveHVomo9maSbuJyEup67gLcMawfBieAX26Zs0Z2YNJyDDwvd3H0WNEDBgrJyiwP6gOQOVXUOZXB4CyR3rhpZnVqY4mkQMvTKG0CKxdCTIBPmgZRtrBEoNx0/s1600/Larry+Doby.jpg" height="320" width="271" /></a></div>
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Post scripts:<br />
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Larry Doby did have a few firsts. He was the FIRST African American to hit a home run in the World Series, and along with Satchel Page, the first African American to win a World Series championship.<br />
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And finally, in 1998, Mr. Doby received deserved recognition when the Veterans committee voted him into the Baseball Hall of Fame.<br />
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Bretthttp://www.blogger.com/profile/11094579354565486061noreply@blogger.com0tag:blogger.com,1999:blog-5803518473270155434.post-3797205305364663612015-01-12T16:22:00.003-08:002015-01-17T22:14:06.854-08:00Private Equity: Past, Present and Future<div class="MsoNormal">
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<b><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEggG1C0ecFD3AAHdO8f4otI1rRxDLWGFHTu45wABCN1SoHAjZ6UVhRAjv1Q8bUVE0y_OTAa3tUYUKMf0Uz_qQQ2ptLtc9y4jZCFqupN1sC1zM0Ejs8Bs67vvkSH8STEiqmwuc_yqToqQT4/s1600/PE+Funding+1.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEggG1C0ecFD3AAHdO8f4otI1rRxDLWGFHTu45wABCN1SoHAjZ6UVhRAjv1Q8bUVE0y_OTAa3tUYUKMf0Uz_qQQ2ptLtc9y4jZCFqupN1sC1zM0Ejs8Bs67vvkSH8STEiqmwuc_yqToqQT4/s1600/PE+Funding+1.jpg" height="181" width="400" /></a></b></div>
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<i><span style="font-family: "Times New Roman",serif; font-size: 9.0pt;">Source: Bain &
Company</span></i></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">The Private
Equity industry has grown and morphed over the nearly seven decades of its
formal existence. From primarily Venture
Capital-related funds at the outset, to Buyout strategies (and a levered
sub-segment); Secondaries; Fund of Funds; Distressed, Infrastructure; and Real
Estate, private equity has typically taken on the dynamics of the macro
environment around it, reacting to interest rate levels, spreads and the tax
code to take advantage of conditions as they have presented themselves. In this note, we will look at the development
of the industry and its major sub-segments over time and also provide our
insight as to what we think the years ahead might look like.<o:p></o:p></span></div>
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<b><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">Background<o:p></o:p></span></b></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">The current view
of what constitutes the private equity industry today most likely began to take
shape in the late 1940’s when organized, professional management firms with the
sole purpose of funding private companies were established. However, for decades before this, private market
transactions were not at all uncommon.<o:p></o:p></span></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-ansi-language: EN-US; mso-bidi-font-size: 11.0pt; mso-bidi-language: AR-SA; mso-fareast-font-family: Calibri; mso-fareast-language: EN-US; mso-fareast-theme-font: minor-latin;">The first major U.S. transaction was the notable buyout of the Carnegie Steel Company in 1901 by J.P.
Morgan & Company for $480 million. After
the deal closed, J.P. </span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;">Morgan famously quoted,
“Congratulations Mr. Carnegie, you are the richest man in the world”, a fact of
which Andrew Carnegie was supposedly embarrassed.</span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;"> </span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;">At the time, the $480 million transaction
value equated to over 2% of US GDP.</span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;">
</span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;">Today, a similarly sized transaction would have to weigh in at nearly $355
billion.</span></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">Private
acquisition activity continued apace until the early 1930’s when the Glass
Steagal Act (technically the Banking Act of 1933) forced a separation of the
activities of commercial and investment banks and hampered the further
development of the US merchant banking industry. The act essentially left private acquisition
activity as the preserve of wealthy individuals and families.<o:p></o:p></span></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">After World War
II, what are widely considered the first two modern venture capital firms were
formed. In 1946, American Research and
Development Corporation was founded by Georges Doriot with the goal of
encouraging investment in businesses run by returning soldiers. In the same year, J.H. Whitney & Company
was founded by John Hay “Jock” Whitney to provide capital and services to small
and mid-market growth companies. Based
in New Canaan, CT, J.H. Whitney & Company is still in business today.<o:p></o:p></span></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">In 1958, the
Small Business Investment Act was passed which aided in the financing and
management of smaller enterprises.
Specifically, this act provided certain firms access to federal funds
which could be levered at a rate of 4:1 against privately raised investment monies. Though helpful, the industry still remained
on the fringes of most investors’ radar.<o:p></o:p></span></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">Beginning in the
1960’s and continuing through the 70’s, the foundation upon which today’s
industry is based was laid. In the
1960’s private equity activity was predominantly centered around venture
capital firms who focused on providing funding to start and expand companies,
many of whom were in technology-related fields.
It was also during this period that the current Limited Partnership
structure for private equity funds was introduced: <o:p></o:p></span></div>
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<li>Limited Partners putting up the
money</li>
<li>General Partners identifying and
acquiring investments and running the day-to-day business</li>
<li>A compensation structure comprised
of a management fee plus a percentage of the profits</li>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">In 1973, the National
Venture Capital Association was founded to serve as the industry’s trade
group. However, the stock market crash
of the time quickly put a damper on fund raising and it wasn’t until 1978 that asset
gathering normalized.<o:p></o:p></span></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-ansi-language: EN-US; mso-bidi-font-size: 11.0pt; mso-bidi-language: AR-SA; mso-fareast-font-family: Calibri; mso-fareast-language: EN-US; mso-fareast-theme-font: minor-latin;">Buyouts are now the
largest segment within the private equity world, with the leveraged sub-segment
often commanding much of the attention. The
first generally acknowledged leveraged buyouts were the acquisitions of
Pan-Atlantic Steamship Company and Waterman Steamship Corporation in 1955 by
McLean Industries. McLean borrowed $42
million and raised $7 million through the issuance of preferred stock. Upon closure of the deal, McLean used $20
million of the target’s cash and assets to retire some of the borrowings. This deal became a blueprint for many of the
leveraged buyouts of the 1980’s and later.</span><br />
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-ansi-language: EN-US; mso-bidi-font-size: 11.0pt; mso-bidi-language: AR-SA; mso-fareast-font-family: Calibri; mso-fareast-language: EN-US; mso-fareast-theme-font: minor-latin;"> </span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;">In the mid-1960’s,
Henry Kravis, Jerome Kohlberg and George Roberts, then employees of Bear
Stearns, began targeting the acquisition of family businesses that were facing
succession issues.</span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;"> </span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;">These companies were
generally too small to take public and their founders did not care to sell out
to competitors.</span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;"> </span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;">It wasn’t until 1976
that Kohlberg, Kravis and Roberts left Bear Stearns to form what we know today
as KKR.</span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;"> </span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;">About the same time (1974),
Thomas H. Lee founded a new investment firm bearing his name to focus on
acquiring more mature companies in leveraged buyouts.</span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;"> </span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;">Both firms have gone on to great successes.</span></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">The passage of
the Employee Retirement Income Security Act of 1974 (ERISA) initially stunted
industry growth as corporate pension funds were prohibited from owning what were
deemed to be “risky” investments in private companies. Largely as a result, industry-wide fund
raising fell to $10 million in 1975. In
1978, restrictions were relaxed and fund raising climbed quickly from $39
million in 1977 to $570 million, solidifying private equity as an important
asset class with a significant following.
Other regulatory events late in the decade also supported the growth of
the industry, most notably the capital gains tax rate reductions of 1979
(39.875% to 28%) and 1981 (28% to 20%). <o:p></o:p></span></div>
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<b><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">Boom and Bust Cycles – a more recent history<o:p></o:p></span></b></div>
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<i><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">The Stars Align.
The First Big Boom (1982 – 1990) <o:p></o:p></span></i></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">Along with the capital
gains rate tax changes, 1981 saw the peaking of interest rates. Further fuel was thrown on the fire by investment
bank Drexel Burnham Lambert, which essentially created the Junk bond market,
allowing many middle market firms to borrow while bypassing the banks. The issuance of high yield debt climbed from
$1.5 billion in 1982 to $15 billion in 1984 and was almost entirely
underwritten by Drexel. Bank lending as
a percentage of corporate credit fell from just under 60% at the beginning of
the decade, to 15% by its end. Further
spurring the growth of leveraged buyouts was the Tax Reform Act of 1986 which
provided strong incentives for corporations to substitute debt for equity
financing (the curtailment of non-debt tax shields such as the investment tax
credit and depreciation allowances were two such incentives). And, as if this weren’t enough, the stock
market soared. Accordingly, the levered
portion of the private equity industry boomed with commitments climbing nearly
10-fold from $2.4 billion in 1980 to $21.9 billion in 1989. In total, it is estimated that more than 2,000
levered deals with a value in excess of $250 million were consummated. As volume increased, new, niche areas also began
to develop a following including secondary market purchases and
industry-specific funds.<o:p></o:p></span></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">The venture segment
saw numerous new firms enter the market, though capital managed by them grew only
slightly as this area was not buffeted as greatly by the favorable events in
the debt markets. Instead, the segment gradually
went through a shakeout with the best models rising to the top.<o:p></o:p></span></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-ansi-language: EN-US; mso-bidi-font-size: 11.0pt; mso-bidi-language: AR-SA; mso-fareast-font-family: Calibri; mso-fareast-language: EN-US; mso-fareast-theme-font: minor-latin;">It should also be
noted that this decade coincided with the arrival of the “corporate raider” that
used many of the same financing structures as private equity firms, but typically
acted as hostile investors in public companies.
Michael Milken’s bankers at Drexel Burnham supported many of </span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;">these hostile
investors through the funding of blind pools which enabled the transactions.</span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;"> </span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;">Levered private equity funds were often
lumped in with the raiders – at least in the public’s eye.</span>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">At the time, public
companies being taken private accounted for about ½ of all transaction value
and large mature industries, like retail and manufacturing, made up the bulk of
transactions. Subsequent to the junk bond collapse, these public to private
deals fell to less than 10% of total value and middle market buyouts of
non-publicly traded firms accounted for the bulk of deals (the public to private
relationship currently stands at a more normalized level of approximately 46%
of deal value).<o:p></o:p></span></div>
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<i><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">The LBO Bust (1990 – 1992)<o:p></o:p></span></i></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">As with any
boom, excesses appeared and a number of buyouts fell into bankruptcy, including
those of the Campeau Corporation. Campeau
was a Canadian Real Estate company which acquired Allied and Federated
department stores in the US in the late 1980’s and was one of the first, large
levered bankruptcies of the decade. By
1991, 26 of the 83 large deals completed between 1985 and 1989 had defaulted with
18 entering Chapter 11 bankruptcy proceedings.
LBO volume dropped by over 90% to under $10 billion. At the same time, Drexel Burnham Lambert was
tainted by the charge of insider trading against one of its managing directors,
Dennis Levine. Levine pled guilty and in
turn implicated one of his partners, Ivan Boesky. Boesky in turn, agreed to cooperate with the
SEC regarding his dealings with Michael Milken.
The SEC initiated an investigation of the firm which dragged on for more
than two years with Drexel finally pleading “no contest” to six felonies and
agreeing to pay a fine of $650 million.
During this time, junk bond activity slowed dramatically and funding
declined. <o:p></o:p></span></div>
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<i><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">Venture Capital and Technology. The Second Boom (1993 – 2000)<o:p></o:p></span></i><br />
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<i><span style="font-family: "Times New Roman",serif; font-size: 9.0pt;">Source:
National Venture Capital Association<o:p></o:p></span></i></div>
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<i><span style="font-family: "Times New Roman",serif; font-size: 9.0pt;">Source:
Bain & Company<o:p></o:p></span></i></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">During the
second boom, both venture capital and levered investments experienced a
re-birth, with the former leading the way.
Private equity commitments overall climbed from roughly $20 billion in
1992 to $240 billion in 2000. Venture
commitments climbed from less than $5 billion to over $100 billion. The overall industry also managed to separate
itself from the taint associated with the 1980’s corporate raiders by
emphasizing the growth and development of acquired companies to the point where
such investors were often welcomed by managements (investments in capital
expenditures and management incentives became more common place during this
time). Risk was moderated as less
leverage was employed in the buyout sector (from 85% - 90% of purchase price in
the 1980’s to 20% to 40% in the 1990’s).
Driving much of the deal activity was the new found interest in the
internet, which drove a frenzy in start-ups and in some cases created new
riches overnight. The vast majority of venture deals were completed in the
Technology Software and Services space, setting the stage for the subsequent
bust.</span></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;"> <o:p></o:p></span><i><span style="font-family: "Times New Roman",serif; font-size: 9.0pt;">Source:
National Venture Capital Association</span></i></div>
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<i><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">What Goes Up, Must Come Down. The Internet Bubble Bursts (2000 – 2003)<o:p></o:p></span></i></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">As a large
percentage of the “dot.com” investments were premised solely on the unlimited
potential of the internet rather than a solid business model, many ran into
cash flow issues and the dominoes were set in motion, leading to a large number
of write-offs across technology and telecom-related investments. By mid-2003, private equity fund raising was
at less than half the peak level.
Leveraged buyout firms collapsed with a number of high profile shake-outs
including Hick Muse Tate & Furst and Forstmann Little & Company. <o:p></o:p></span></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">The bust ended
up forcing a greater level of due diligence upon investors and resulted in more
controls being placed on investment partnerships. Bank loans again became a more prevalent form
of deal financing.<o:p></o:p></span></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">Driven by surging
primary market volumes and regulations that increased capital set asides, many banks
and insurers made strategic decisions to exit from in-house private equity
operations. Secondary market transactions
(where one fund buys the private investments of another) grew from under 3% of
commitments to over 5% of the total, joining venture and buyouts as a viable segment
in the private equity world.<o:p></o:p></span></div>
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<i><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">Thank You Messrs. Greenspan and Bernanke. The Third Boom (2003 – 2008)<o:p></o:p></span></i></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-ansi-language: EN-US; mso-bidi-font-size: 11.0pt; mso-bidi-language: AR-SA; mso-fareast-font-family: Calibri; mso-fareast-language: EN-US; mso-fareast-theme-font: minor-latin;">In the aftermath of
the internet bust, seeds were also planted for the industry’s revival. Lower policy rates and a relaxation of
lending standards set the stage for some of the largest private equity transactions
to date. Unlike the boom of the late
1980’s which was fueled by the junk bond market, this boom benefited from the
growth of syndicated bank debt – more than 50% of the LBO’s funded in 2006 were
funded by bank loans. The syndication process
itself resulted in market imbalances which then contributed to the subsequent
bust. First, as the loans did not remain
on the originating bank’s books, there was the likelihood that the diligence
conducted in making the </span><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-ansi-language: EN-US; mso-bidi-font-size: 11.0pt; mso-bidi-language: AR-SA; mso-fareast-font-family: Calibri; mso-fareast-language: EN-US; mso-fareast-theme-font: minor-latin;">loans was relaxed. Second, a
number of the deals were funded with debt that had weak covenants
(“cov-lite”). Further, regulatory
changes (the imposition of Sarbanes Oxley), helped the buyout industry convince
public companies that life as a private firm might be preferable while the same
legislation hurt the IPO dreams of many venture firms. As a result, more of the venture deals ended
up being done with strategic buyers (a purchaser in the same industry as the
company) and secondary volumes grew, comprising over 20% of total transaction
value. The “Greenspan Put”, as it came
to be known, convinced industry players and investors that the environment
would not change and overall risk taking appetite increased. Funding volume hit a peak of just under $700
billion in both 2007 & 2008.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiApCIMf-Wyb7ICxYjldsF6TTL_c_a_Xy0Iklp3EEkaXxZzLAYdNHfUuXtE5NladKT8TzYK4v9RA8rTRsCKm5z1mKyvpSIB_M_TBSAcLnbrFROys1v8briJACzIik0VGdIxYpGd5Q9NHaw/s1600/PE+Funding+3.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiApCIMf-Wyb7ICxYjldsF6TTL_c_a_Xy0Iklp3EEkaXxZzLAYdNHfUuXtE5NladKT8TzYK4v9RA8rTRsCKm5z1mKyvpSIB_M_TBSAcLnbrFROys1v8briJACzIik0VGdIxYpGd5Q9NHaw/s1600/PE+Funding+3.jpg" height="286" width="640" /></a></div>
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<i><span style="font-family: "Times New Roman",serif; font-size: 9.0pt;">Source:
Bain & Company<o:p></o:p></span></i></div>
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<i><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">A Different Kind of Exit <o:p></o:p></span></i></div>
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<span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;">Toward the end
of the third boom, an exit of sorts was seen by some of the larger private
equity firms, though not in the usual context of selling portfolio firms.</span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;"> </span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;">In 2007</span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;"> the Blackstone group filed for an IPO with the SEC and proceeded
with a sale to the public (12.3% stake).</span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;">
</span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;">In the same year, the Carlyle Group also sold an interest in the
management company (7.5% interest).</span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;"> </span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;">In
January of 2008, Silver Lake Partners followed suit with a 9.9% sale of its
management company to CalPERS.</span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;"> </span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;">To the
cynical, this might seem like a backdoor way to raise liquidity for partners at
a time when the size of their investments limited strategic sales and when the
weakening market environment limited the IPO door.</span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;"> </span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;">It was promoted by the sellers as a way to
spread the riches of private equity to a wider audience of investors.</span><span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;"> </span></div>
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<i><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">Yet Another Bubble Bursts<o:p></o:p></span></i></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">Low interest
rates, no-money down mortgages and new residential mortgage financing vehicles
led to an unprecedented run in the US housing market from the early part of the
decade and into 2007. As this bubble
inevitably burst, its repercussions were felt world-wide. From the failure of a Bear Stearns hedge fund
during the summer of 2007 to the failure of Lehman Brothers a year later, the
credit markets froze and spreads widened to record levels. Globally, stock markets fell by more than 40%
and as might be expected, the leveraged finance markets came to a standstill,
with deal activity troughing at $134 billion in 2008. Only the Distressed and Turnaround funds saw notable
increases in fund raising in 2007 and 2008.<o:p></o:p></span></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhPMdfhifPqvP4cm7ZimmUqX6j7oXMRBAYpcJETI_Q3qHXXnXbwLpQSuv14-dTCf8dHRMQ3LSDZGZULqv58OabRU4oSt1qWUyw1Ie9j7uqS3V9EZxx37ePwY2gmANpbI6EBo-o0P1kzzL0/s1600/PE+Funding+Distressed.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhPMdfhifPqvP4cm7ZimmUqX6j7oXMRBAYpcJETI_Q3qHXXnXbwLpQSuv14-dTCf8dHRMQ3LSDZGZULqv58OabRU4oSt1qWUyw1Ie9j7uqS3V9EZxx37ePwY2gmANpbI6EBo-o0P1kzzL0/s1600/PE+Funding+Distressed.jpg" height="286" width="640" /></a></div>
<span style="font-family: 'Times New Roman', serif; font-size: 12pt; text-align: justify;"> </span><i style="text-align: justify;"><span style="font-family: "Times New Roman",serif; font-size: 9.0pt;">Source:
Probitas Partners</span></i></div>
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<i><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">A Slow and Steady Recovery<o:p></o:p></span></i></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">It wasn’t until after
more than a year of unprecedented intervention by US and other western central banks
that confidence was secured and funding activity picked up. From a trough of $296 billion in 2010, funding
rose slowly to reach $461 billion in 2013 (2014 activity through August is on a
similar pace).<o:p></o:p></span></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjneZEh0MhlTuu7ohd25jHjDA_jPLm-A5M99fKpvEWKu_vhc_-z5QJu4rZfG6TfEFLCXyDZq3GRSyiDaL6gawo8KoQ7Va2L0bB89hTR1q6sJUQA944Ncqdhq6gvNMR1dAyLDrZ_-FoHkuc/s1600/PE+Funding+4.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjneZEh0MhlTuu7ohd25jHjDA_jPLm-A5M99fKpvEWKu_vhc_-z5QJu4rZfG6TfEFLCXyDZq3GRSyiDaL6gawo8KoQ7Va2L0bB89hTR1q6sJUQA944Ncqdhq6gvNMR1dAyLDrZ_-FoHkuc/s1600/PE+Funding+4.jpg" height="286" width="640" /></a></div>
<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;"><br /></span></div>
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<i><span style="font-family: "Times New Roman",serif; font-size: 9.0pt;">Source:
Bain & Company<o:p></o:p></span></i></div>
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<b><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">The Present<o:p></o:p></span></b></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">The private
equity industry is led by buyout strategies which comprised 37% of the capital
raised last year. Tangible asset
strategies (Real Estate, Infrastructure and Natural Resources) made up an
additional 31% of the total, while distressed, venture capital and other
strategies comprised the remaining commitments.<o:p></o:p></span></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj3GKuil0atYy1npqZ2ab-NjmS8QvhcYXdO1PwCkp_HXjTP_SIImFMBSDEFn1M6OyN32jCiCZ0KxE8U422-kjhjjvFSkNYIzDlZnOWkRs-ccFLxXwIT3WDTkLiDSSHQZKPzA7GVW3Zsc1A/s1600/PE+Capital+Raise.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj3GKuil0atYy1npqZ2ab-NjmS8QvhcYXdO1PwCkp_HXjTP_SIImFMBSDEFn1M6OyN32jCiCZ0KxE8U422-kjhjjvFSkNYIzDlZnOWkRs-ccFLxXwIT3WDTkLiDSSHQZKPzA7GVW3Zsc1A/s1600/PE+Capital+Raise.jpg" height="286" width="640" /></a></div>
<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;"><br /></span></div>
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<i><span style="font-family: "Times New Roman",serif; font-size: 9.0pt;">Source:
Preqin Global Private Equity Report 2014<o:p></o:p></span></i></div>
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<b><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">The Future<o:p></o:p></span></b></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">While nothing is
ever certain, the history of private equity has shown how the industry attempts
to take advantage of (or is effected by) the tax, regulatory, interest rate and
stock market environments. Given our
reading of the tea leaves, we think the following factors will drive and shape
the industry in the decade ahead:<o:p></o:p></span></div>
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<div class="MsoListParagraphCxSpFirst" style="mso-list: l1 level1 lfo1; text-align: justify; text-indent: -.25in;">
<br />
<ul>
<li>Increased regulatory and operational
scrutiny</li>
<li>Diminished interest in hedge funds</li>
<li>Greater demand for private equity in
the alternatives space</li>
<li>A battle between mega-firms and
smaller, boutique style managers for investor monies</li>
<li>A headwind for buyout and other private
equity strategies employing leverage</li>
</ul>
</div>
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<i><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">Increased regulatory and operational scrutiny</span></i><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">
is a near certainty. Following on the heels
of the financial crisis, investors have stretched in search of new
opportunities as interest rates and spreads fell to historic lows. Perhaps because of this, alternative asset
categories have become more prevalent and regulators, accordingly, don’t want
to drop the ball again. The following
areas will be under watch in the private equity realm:<o:p></o:p></span></div>
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<br /></div>
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<br />
<ul>
<li>Expense allocation between the funds
of a given manager</li>
<li>The asset valuation policies of these
funds</li>
<li>The co-investment policies of the
manager</li>
<li>Fee transparency</li>
<li>Form PF and marketing material scrutiny</li>
<li>An increased push by investors to
outsource (and upgrade) manager operational capabilities</li>
</ul>
</div>
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<br /></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">On balance, increased
scrutiny should bode well for the growth of the industry. While it will increase the costs of doing
business, greater oversight will also allow investors not currently in the
segment to feel more comfortable about future commitments. At the same time, many service firms
specializing in providing non-investment services such as Fund Administration
and Compliance Outsourcing will help limit smaller managers’ cost increases
while providing them with best in class services.<o:p></o:p></span></div>
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<br /></div>
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<i><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">A diminished interest in Hedge Funds</span></i><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">
is quite possible. Following a number of
years of less than stellar results and a well-publicized decision by CalPERS,
the largest public fund in the United States, and PFZW, the $150 billion Dutch Healthcare system, to divest from the category, we put
a high probability on the following:<o:p></o:p></span></div>
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<br /></div>
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<br />
<ul>
<li>The potential for “follow on” moves
(away from hedge funds) by smaller plan sponsors</li>
<li>A move away from the higher
expenses associated with fund of fund programs and toward direct placement by
those committed to the category, a continuation of a trend that is already
underway</li>
<li>An opportunity for other
alternative categories such as Private Equity to gain share </li>
</ul>
</div>
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</div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;"><br /></span></div>
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<i><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">The fact that we are likely to be in a low return
environment for traditional asset classes</span></i><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;"> (see our
white paper, <i>“Forecasting Return
Expectations”</i>) and investors have already taken on more risk in the quest
for return, means <i>many are now more likely
to consider investing in what may be “new” asset classes to them</i>. With private equity allocations across large
plans currently at 7% of assets, there is still room for the segment to gain
share. Also, given the generally
fulfilled return expectations to date, private equity would seem to be a
natural fit for many. </span></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;"><br /></span>
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjhb8rXx7ioyBKwgGjyUGeTwyKKjLJXvFR8o4KhBBJBQPAfgfZ8CiR72WsdcEPUVMYJDRPbH5FHCvp-aj4pYvTX-xOOEiz-xQT_LGp-HUqLaJaBjU4NTJSk_Rb37r3FvVzexyE0G1hdpPY/s1600/PE+Perception.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjhb8rXx7ioyBKwgGjyUGeTwyKKjLJXvFR8o4KhBBJBQPAfgfZ8CiR72WsdcEPUVMYJDRPbH5FHCvp-aj4pYvTX-xOOEiz-xQT_LGp-HUqLaJaBjU4NTJSk_Rb37r3FvVzexyE0G1hdpPY/s1600/PE+Perception.jpg" height="130" width="320" /></a></div>
<br /></div>
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<i><span style="font-family: "Times New Roman",serif; font-size: 9.0pt;"><br /></span></i>
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhaaqypEy0GnWa5Cw7pc-O4mNFPQs2kZrhj50bVYVZvygxU_o23cmDxzJKAiFiOcuk2HevnOnuBtsfa0hw-fQjVFKDNHaMwDqwwGPtBAWs1saUt8-pinsUBikWv0OxrpkTgYdTkQeZHj3w/s1600/PE+IRR.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhaaqypEy0GnWa5Cw7pc-O4mNFPQs2kZrhj50bVYVZvygxU_o23cmDxzJKAiFiOcuk2HevnOnuBtsfa0hw-fQjVFKDNHaMwDqwwGPtBAWs1saUt8-pinsUBikWv0OxrpkTgYdTkQeZHj3w/s1600/PE+IRR.jpg" height="286" width="640" /></a></div>
<i><span style="font-family: "Times New Roman",serif; font-size: 9.0pt;"><br /></span></i>
<i><span style="font-family: "Times New Roman",serif; font-size: 9.0pt;">Source:
Bain & Company, Cambridge Associates<o:p></o:p></span></i></div>
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<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<i><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">However, within the industry, where investors focus is
still up in the air</span></i><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">.
We are currently seeing different behaviors by investors in terms of the
size of manager with whom they have comfort.
<o:p></o:p></span></div>
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<br /></div>
<div class="MsoListParagraphCxSpFirst" style="mso-list: l0 level1 lfo1; text-align: justify; text-indent: -.25in;">
<br />
<ul>
<li>The State of Wisconsin as well as Colorado
Fire & Police have explicitly announced an intention to invest more with
smaller managers where they feel interests are better aligned and where more opportunity to add alpha is possible</li>
</ul>
<ul>
<li>Los Angeles County ERS is also “looking
at smaller managers”</li>
</ul>
<ul>
<li>CalPERS and the State of Michigan have
already increased allocations with mega-firms citing the ease of oversight when
managing large pools of capital</li>
</ul>
</div>
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</div>
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<br /></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">Ultimately,
performance will likely determine which preference becomes dominant, though
both are likely to co-exist for the near term.<o:p></o:p></span></div>
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<br /></div>
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</div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">Finally, given today’s
historically low level of interest rates and credit spreads, along with the
increased use of leverage in recent transactions,<i> it will be more difficult for strategies dependent upon leverage to do
as well in the future as they have in the recent past</i>. In fact valuation levels are approaching the
last cycle’s peak.<o:p></o:p></span><br />
<br /></div>
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<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgI_RoWBcp7_9M3vaRlVeJOF9pF2V65vkH5X3pTB7r7OZc6_eafZYjF9LEzgjN8rsk9_FKY0E4frb-CjggXkpoGn36XZrVcOaYJPkMY5ujit_VZrh_-QsFzCao7YYnM7iV3VC-NPIVc_Ac/s1600/PE+LBO+Val.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgI_RoWBcp7_9M3vaRlVeJOF9pF2V65vkH5X3pTB7r7OZc6_eafZYjF9LEzgjN8rsk9_FKY0E4frb-CjggXkpoGn36XZrVcOaYJPkMY5ujit_VZrh_-QsFzCao7YYnM7iV3VC-NPIVc_Ac/s1600/PE+LBO+Val.jpg" height="284" width="640" /></a></div>
<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;"><br /></span></div>
<div class="MsoNormal" style="text-align: justify;">
<i><span style="font-family: "Times New Roman",serif; font-size: 9.0pt;">Source:
Bain & Company, S&P Capital IQ<o:p></o:p></span></i></div>
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<br /></div>
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<br /></div>
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<b><span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">Conclusion<o:p></o:p></span></b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
</div>
<div class="MsoNormal" style="text-align: justify;">
<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-bidi-font-size: 11.0pt;">At the end of
the day the future looks bright for most areas within the private equity
space. Investors are underweight the
asset class, private equity has historically met investor expectations and it is
looked upon favorably by current investors.
With a low return environment for traditional asset classes a high
probability, new sources of return will continue to be sought by plan sponsors. Private equity has every reason to be high on
most lists.<o:p></o:p></span></div>
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<span style="font-family: "Times New Roman",serif; font-size: 12.0pt; mso-ansi-language: EN-US; mso-bidi-font-size: 11.0pt; mso-bidi-language: AR-SA; mso-fareast-font-family: Calibri; mso-fareast-language: EN-US; mso-fareast-theme-font: minor-latin;"><br /></span></div>
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Bretthttp://www.blogger.com/profile/11094579354565486061noreply@blogger.com0tag:blogger.com,1999:blog-5803518473270155434.post-66356397851618992172014-08-14T10:52:00.000-07:002014-08-14T10:52:21.752-07:00It's All in the Math - Equity Returns over the Coming Decade (2 of 2)<br />
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<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-bidi-font-style: italic; mso-fareast-font-family: "Times New Roman";"><em>While
equity markets have more "moving pieces" than their fixed income
counterparts, their longer-term outcomes can likewise be broken down into a
handful of understandable and forecastable components. When approached in this
disciplined manner, we see that returns from nearly every major equity region in the coming
decade will be poor, with the UK faring better than most and the US
likely to struggle.</em> </span><span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";"><o:p></o:p></span></div>
<br />
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<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";">It is a given that there are only
two ways to make money from an equity - either you are paid a stream of
dividends, or the price another party is willing to pay you for your shares
differs from the price you paid (Dividend + Price Change). In general,
the Dividend component is readily observable and tends to be less volatile
while stock Price Changes are more volatile and, in the short-run, more
unpredictable.<o:p></o:p></span></div>
<br />
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<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";">To better understand the portion of
return due to Price Change, we can further decompose that piece into Earnings
Growth per share and the P/E Ratio (i.e. the price one is willing to pay for
each dollar's worth of those earnings). Both are somewhat volatile, but
less so than the overall Price Change itself. To simplify further, I
sub-divide the Earnings Growth component into Revenue Growth and the change in
the profitability of those Revenues (i.e. the Profit Margin). Taking all
this together then, if we know with near certainty just four variables:
Dividends, Revenue Growth, Profit Margins and the P/E Ratio, we know with certainty
the return from an equity (or equity index).<o:p></o:p></span></div>
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhPLdjfgilBPdFZlBGX8-0H-f6TgAnJZekMKO-FtPDi5m2ckEygKD-bnzXVHkS1-tcIfJKaxTBxVj0hBRGpvyU3P4f3mjd_POJDoaJ6cbsFIXt3-RU6nGBxkFNhYiwcZ2okJAsbDVMnbp8/s1600/Schematic.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhPLdjfgilBPdFZlBGX8-0H-f6TgAnJZekMKO-FtPDi5m2ckEygKD-bnzXVHkS1-tcIfJKaxTBxVj0hBRGpvyU3P4f3mjd_POJDoaJ6cbsFIXt3-RU6nGBxkFNhYiwcZ2okJAsbDVMnbp8/s1600/Schematic.png" height="225" width="400" /></a></div>
<br />
<br />
<br />
<br />
<br />
<br />
<br />
<br />
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<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";">Fortunately, for the purpose of our
analysis, two of these components are relatively stable over a period as long
as a decade (Dividend Yield and Revenue Growth), while valuation and
profitability are more volatile -- and it is this change in the P/E Ratio and
Margins that ultimately drives returns. Thus a sensitivity analysis
featuring these two unknowns is called for.</span></div>
<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";"></span><div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";"> </span></div>
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<b><span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";">Some Background</span></b><span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";"><o:p></o:p></span></div>
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<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";">Equity earnings tend to be cyclical
over time (see chart) and gauging market value on a single, spot observation
can be mis-leading -- especially when earnings are well above, or well below,
their trend. As of June 30th, the P/E Ratio on trailing, reported earnings of
the S&P 500 index was 18.2x, just above the longer-term norm of 17.1x
(the median valuation since Dec 1959). One might therefore conclude
that the market is slightly overvalued. What is left out of such a simplistic
analysis is that the earnings part of that calculation is not at its norm, but
rather closer to a cyclical high.</span></div>
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<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";"><o:p></o:p></span> </div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjNXh2fh29b-eAOKBkg25BLF2hCRPxo6DMpKJLkSlY-7Hfl3o4T5efiUgIeK1MALU2y4U0keBuN4c3QYKSwMUr4iQb7LevsPjtCVQL8Fqj3YXVLW79fkb4ptbOZOt5FpmamNInLYrZWF10/s1600/Trend+EPS.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjNXh2fh29b-eAOKBkg25BLF2hCRPxo6DMpKJLkSlY-7Hfl3o4T5efiUgIeK1MALU2y4U0keBuN4c3QYKSwMUr4iQb7LevsPjtCVQL8Fqj3YXVLW79fkb4ptbOZOt5FpmamNInLYrZWF10/s1600/Trend+EPS.png" height="225" width="400" /></a></div>
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<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";">Instances such as this occur
when margins are historically high, even as they are understood to be
generally mean-reverting. Today, margins in the US and Japan are closer
to one of these cyclical peaks, while those in the UK and Europe are
not.<o:p></o:p></span></div>
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<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";"><o:p><span style="font-family: "Times New Roman","serif"; font-size: 12pt; line-height: 107%; mso-ansi-language: EN-US; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US;"></span></o:p></span> </div>
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<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";"><o:p><span style="font-family: "Times New Roman","serif"; font-size: 12pt; line-height: 107%; mso-ansi-language: EN-US; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US;">When
valuation is compared to reported earnings per share, and the cycle is not
taken into account, valuation (as measured by the PE Ratio) tends to be more
volatile. When the index price level is measured against trend EPS (that
is, assuming a constant "normalized" margin), valuation extremes tend
to disappear and a more stable relationship is observed.</span></o:p></span></div>
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<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";"><o:p><span style="font-family: "Times New Roman","serif"; font-size: 12pt; line-height: 107%; mso-ansi-language: EN-US; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US;"></span></o:p></span> </div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi6kRB8dHsIyn65ow4dh8pwxpz4GQNuvAQjb2GIFrrHuCtU67QQA9idLM4fSNsTpEqOcs2dlq1gN1jSsoTTBxryJ4oezS30fLAoKjpEU4zSNrb4oLraifXXNHjnmqkrhUiNg2RV1p_Qo2s/s1600/Trend+PE.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi6kRB8dHsIyn65ow4dh8pwxpz4GQNuvAQjb2GIFrrHuCtU67QQA9idLM4fSNsTpEqOcs2dlq1gN1jSsoTTBxryJ4oezS30fLAoKjpEU4zSNrb4oLraifXXNHjnmqkrhUiNg2RV1p_Qo2s/s1600/Trend+PE.png" height="225" width="400" /></a></div>
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<span style="font-family: "Times New Roman","serif"; font-size: 12pt; line-height: 107%; mso-ansi-language: EN-US; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US;"><div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
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<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";"></span> </div>
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<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";"></span> </div>
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<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";">Thus, a valuation analysis which
adjusts for the margin's deviation from its norm and which assumes dividend
growth in line with earnings (as long as the current payout ratio is near
longer-term norms), revenue growth in line with historical trends (typically
that of nominal GDP) and a valuation component (P/E ratio) that returns to its
long-run median over a period of ten-years should provide a decent assessment
of where returns are headed as cycles run their course. Those who
disagree with my assumptions of a return to normal margin can use the
accompanying sensitivity tables and observe returns under a range of margin and
P/E inputs - but refer to the above charts to understand what is in the
"normal" (i.e. likely) range of outcomes. I would direct
doubters back to "The Profitability Illusion" (posted to this blog
June 15, 2013) which discusses in some detail why
over 2 percentage points of the current S&P 500 margin is illusory and
unlikely to be sustained (all due to lower interest expense as opposed to better operational efficiency). In any case, the range of returns can be
illuminating and the dispersion of returns, not as wide as one might assume.<o:p></o:p></span></div>
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<span style="font-family: "Times New Roman","serif"; font-size: 12pt; line-height: 107%; mso-ansi-language: EN-US; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US;"></span><br /></div>
<div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
<span style="font-family: "Times New Roman","serif"; font-size: 12pt; line-height: 107%; mso-ansi-language: EN-US; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US;"></span> </div>
<div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
<span style="font-family: "Times New Roman","serif"; font-size: 12pt; line-height: 107%; mso-ansi-language: EN-US; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US;">I turn first to the United States and use the
S&P 500 index as a proxy for US Equities. Over the past 50+ years, a
median valuation of 17.1x earnings is the norm (I choose to use a median as
opposed to an average because out-sized values can distort its calculation.
In full disclosure, the average P/E has been 17.6x). Margins have
averaged 6% for the past 50 years and have proven throughout to be mean
reverting. Today, though they stand near record highs of over 8% and in
this analysis it is assumed they will slowly return to the 6% average.</span></div>
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</div>
</span><div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";">For this exercise, we also assume
5.5% annual compounded nominal revenue growth (in line with historic norms) and
a 2.08% annual return from dividends (normalized current yield). Putting this
all together, our best guess return estimate for US Equities over the next 10
years is 2.0% per year. If you want to assume record margins continue,
you could up that expectation, but just to 5.0% (see table below). Under
no reasonable scenario, are double digit equity returns in sight.<o:p></o:p></span></div>
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<strong></strong><br /></div>
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<strong></strong> </div>
<div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
<strong>S&P 500 10-Year Return Estimation (5.5% Nominal Revenue Growth, 2.08% Annual Dividend, Various Margin and P/E Scenarios</strong></div>
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 427px;">
<colgroup><col style="mso-width-alt: 2121; mso-width-source: userset; width: 44pt;" width="58"></col>
<col style="mso-width-alt: 1792; mso-width-source: userset; width: 37pt;" width="49"></col>
<col span="5" style="width: 48pt;" width="64"></col>
<tbody>
<tr height="17" style="height: 12.75pt;">
<td class="xl91" height="17" style="background-color: #ffc000; border-color: windowtext; border-style: solid none none solid; border-width: 1pt 0px 0px 1pt; height: 12.75pt; width: 44pt;" width="58"><strong><span style="font-family: Arial; font-size: x-small;"> </span></strong></td>
<td class="xl83" style="background-color: #ffc000; border-color: windowtext; border-style: solid none none; border-width: 1pt 0px 0px; width: 37pt;" width="49"><span style="font-family: Arial; font-size: x-small;"> </span></td>
<td class="xl94" colspan="5" style="background-color: #ffc000; border-color: windowtext black windowtext windowtext; border-style: solid solid none none; border-width: 1pt 1pt 0px 0px; width: 240pt;" width="320"><strong><span style="font-family: Arial; font-size: x-small;">Normalized PE Ratio</span></strong></td>
</tr>
<tr height="16" style="height: 12pt;">
<td class="xl92" height="16" style="background-color: #ffc000; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt; height: 12pt;"><strong><span style="font-family: Arial; font-size: x-small;"> </span></strong></td>
<td align="right" class="xl87" style="background-color: #ffc000; border: 0px rgb(255, 192, 0);"><span style="color: #ffc000; font-family: Arial; font-size: x-small;">2.0%</span></td>
<td class="xl84" style="background-color: #ffc000; border: 0px windowtext;"><strong><span style="font-family: Arial; font-size: x-small;">13</span></strong></td>
<td class="xl84" style="background-color: #ffc000; border: 0px windowtext;"><strong><span style="font-family: Arial; font-size: x-small;">15</span></strong></td>
<td class="xl85" style="background-color: #ffc000; border: 0px rgb(0, 112, 192);"><strong><span style="color: #0070c0; font-family: Arial; font-size: x-small;">17</span></strong></td>
<td class="xl84" style="background-color: #ffc000; border: 0px windowtext;"><strong><span style="font-family: Arial; font-size: x-small;">19</span></strong></td>
<td class="xl86" style="background-color: #ffc000; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px;"><strong><span style="font-family: Arial; font-size: x-small;">21</span></strong></td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td class="xl93" height="76" rowspan="5" style="background-color: #ffc000; border-color: windowtext windowtext black; border-style: none none solid solid; border-width: 0px 0px 1pt 1pt; height: 57pt; width: 44pt;" width="58"><strong><span style="font-family: Arial; font-size: x-small;">Normalized Margin</span></strong></td>
<td align="right" class="xl88" style="background-color: #ffc000; border: 0px windowtext;"><strong><span style="font-family: Arial; font-size: x-small;">4.0%</span></strong></td>
<td align="right" class="xl66" style="background-color: transparent; border-color: windowtext; border-style: solid none none solid; border-width: 1pt 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">-4.5%</span></td>
<td align="right" class="xl67" style="background-color: transparent; border-color: windowtext; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">-3.1%</span></td>
<td align="right" class="xl67" style="background-color: transparent; border-color: windowtext; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">-1.9%</span></td>
<td align="right" class="xl67" style="background-color: transparent; border-color: windowtext; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">-0.9%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border-color: windowtext; border-style: solid solid none none; border-width: 1pt 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">0.1%</span></td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl88" height="15" style="background-color: #ffc000; border: 0px windowtext; height: 11.25pt;"><strong><span style="font-family: Arial; font-size: x-small;">5.0%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">-2.4%</span></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: windowtext; border-style: solid none none solid; border-width: 0.5pt 0px 0px 0.5pt;"><span style="font-family: Arial; font-size: x-small;">-1.0%</span></td>
<td align="right" class="xl75" style="background-color: transparent; border-color: windowtext; border-style: solid none none; border-width: 0.5pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">0.2%</span></td>
<td align="right" class="xl76" style="background-color: transparent; border-color: windowtext; border-style: solid solid none none; border-width: 0.5pt 0.5pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">1.3%</span></td>
<td align="right" class="xl70" style="background-color: transparent; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">2.3%</span></td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl89" height="15" style="background-color: #ffc000; border: 0px rgb(0, 112, 192); height: 11.25pt;"><strong><span style="color: #0070c0; font-family: Arial; font-size: x-small;">6.0%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">-0.6%</span></td>
<td align="right" class="xl77" style="background-color: transparent; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 0.5pt;"><span style="font-family: Arial; font-size: x-small;">0.8%</span></td>
<td align="right" class="xl82" style="background-color: transparent; border: 0px rgb(0, 112, 192);"><strong><span style="color: #0070c0; font-family: Arial; font-size: x-small;">2.0%</span></strong></td>
<td align="right" class="xl78" style="background-color: transparent; border-color: windowtext; border-style: none solid none none; border-width: 0px 0.5pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">3.2%</span></td>
<td align="right" class="xl70" style="background-color: transparent; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">4.2%</span></td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl88" height="15" style="background-color: #ffc000; border: 0px windowtext; height: 11.25pt;"><strong><span style="font-family: Arial; font-size: x-small;">7.0%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">0.9%</span></td>
<td align="right" class="xl79" style="background-color: transparent; border-color: windowtext; border-style: none none solid solid; border-width: 0px 0px 0.5pt 0.5pt;"><span style="font-family: Arial; font-size: x-small;">2.3%</span></td>
<td align="right" class="xl80" style="background-color: transparent; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 0.5pt;"><span style="font-family: Arial; font-size: x-small;">3.6%</span></td>
<td align="right" class="xl81" style="background-color: transparent; border-color: windowtext; border-style: none solid solid none; border-width: 0px 0.5pt 0.5pt 0px;"><span style="font-family: Arial; font-size: x-small;">4.7%</span></td>
<td align="right" class="xl70" style="background-color: transparent; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">5.8%</span></td>
</tr>
<tr height="16" style="height: 12pt;">
<td align="right" class="xl90" height="16" style="background-color: #ffc000; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt; height: 12pt;"><strong><span style="font-family: Arial; font-size: x-small;">8.0%</span></strong></td>
<td align="right" class="xl71" style="background-color: transparent; border-color: windowtext; border-style: none none solid solid; border-width: 0px 0px 1pt 1pt;"><span style="font-family: Arial; font-size: x-small;">2.2%</span></td>
<td align="right" class="xl72" style="background-color: transparent; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">3.7%</span></td>
<td align="right" class="xl72" style="background-color: transparent; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">5.0%</span></td>
<td align="right" class="xl72" style="background-color: transparent; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">6.1%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext; border-style: none solid solid none; border-width: 0px 1pt 1pt 0px;"><span style="font-family: Arial; font-size: x-small;">7.2%</span></td>
</tr>
</tbody></colgroup></table>
</o:p><div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
</div>
<div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";"></span> </div>
<div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";">Taking Japan next we conduct a
similar analysis, using the historically lower 3.0% margin levels and 3.0%
nominal revenue growth. Though Japanese valuation data is distorted
somewhat by 10+ years of a great bubble, we feel a normalized P/E ratio of
20.x, higher than that of the US, can be argued, though we show a range of
12.5x to 27.5x in the sensitivity below. Still, a 3.0% return is the most
likely annual outcome for the coming decade.<o:p></o:p></span></div>
<div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
</div>
<div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
<strong></strong> </div>
<div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
<strong>MSCI Japan 10-Year Return Estimation (3.0% Nominal Revenue Growth, 1.77% Annual Dividend, Various Margin and P/E Scenarios</strong></div>
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 425px;">
<colgroup><col style="mso-width-alt: 2048; mso-width-source: userset; width: 42pt;" width="56"></col>
<col style="mso-width-alt: 1792; mso-width-source: userset; width: 37pt;" width="49"></col>
<col span="5" style="width: 48pt;" width="64"></col>
<tbody>
<tr height="17" style="height: 12.75pt;">
<td class="xl72" height="17" style="background-color: #ffc000; border-color: windowtext; border-style: solid none none solid; border-width: 1pt 0px 0px 1pt; height: 12.75pt; width: 42pt;" width="56"><strong><span style="font-family: Arial; font-size: x-small;"> </span></strong></td>
<td class="xl67" style="background-color: #ffc000; border-color: windowtext; border-style: solid none none; border-width: 1pt 0px 0px; width: 37pt;" width="49"><span style="font-family: Arial; font-size: x-small;"> </span></td>
<td class="xl94" colspan="5" style="background-color: #ffc000; border-color: windowtext black windowtext windowtext; border-style: solid solid none none; border-width: 1pt 1pt 0px 0px; width: 240pt;" width="320"><strong><span style="font-family: Arial; font-size: x-small;">Normalized PE Ratio</span></strong></td>
</tr>
<tr height="16" style="height: 12pt;">
<td class="xl73" height="16" style="background-color: #ffc000; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt; height: 12pt;"><strong><span style="font-family: Arial; font-size: x-small;"> </span></strong></td>
<td align="right" class="xl68" style="background-color: #ffc000; border: 0px rgb(255, 192, 0);"><span style="color: #ffc000; font-family: Arial; font-size: x-small;">3.0%</span></td>
<td class="xl82" style="background-color: #ffc000; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><span style="font-family: Arial;"><span style="mso-spacerun: yes;"><span style="font-size: x-small;"> </span></span><span style="font-size: x-small;">12.5 </span></span></td>
<td class="xl82" style="background-color: #ffc000; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><span style="font-family: Arial;"><span style="mso-spacerun: yes;"><span style="font-size: x-small;"> </span></span><span style="font-size: x-small;">15.0 </span></span></td>
<td class="xl83" style="background-color: #ffc000; border-color: rgb(0, 112, 192) rgb(0, 112, 192) windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><strong><span style="font-family: Arial;"><span style="mso-spacerun: yes;"><span style="color: #0070c0; font-size: x-small;"> </span></span><span style="color: #0070c0; font-size: x-small;">20.0 </span></span></strong></td>
<td class="xl82" style="background-color: #ffc000; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><span style="font-family: Arial;"><span style="mso-spacerun: yes;"><span style="font-size: x-small;"> </span></span><span style="font-size: x-small;">25.0 </span></span></td>
<td class="xl84" style="background-color: #ffc000; border-color: windowtext; border-style: none solid solid none; border-width: 0px 1pt 1pt 0px;"><span style="font-family: Arial;"><span style="mso-spacerun: yes;"><span style="font-size: x-small;"> </span></span><span style="font-size: x-small;">27.5 </span></span></td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td class="xl93" height="76" rowspan="5" style="background-color: #ffc000; border-color: windowtext windowtext black; border-style: none none solid solid; border-width: 0px 0px 1pt 1pt; height: 57pt; width: 42pt;" width="56"><strong><span style="font-family: Arial; font-size: x-small;">Normalized Margin</span></strong></td>
<td align="right" class="xl69" style="background-color: #ffc000; border: 0px windowtext;"><strong><span style="font-family: Arial; font-size: x-small;">2.0%</span></strong></td>
<td align="right" class="xl66" style="background-color: transparent; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">-5.4%</span></td>
<td align="right" class="xl74" style="background-color: transparent; border: 0px windowtext;"><span style="font-family: Arial; font-size: x-small;">-3.7%</span></td>
<td align="right" class="xl74" style="background-color: transparent; border: 0px windowtext;"><span style="font-family: Arial; font-size: x-small;">-1.0%</span></td>
<td align="right" class="xl74" style="background-color: transparent; border: 0px windowtext;"><span style="font-family: Arial; font-size: x-small;">1.2%</span></td>
<td align="right" class="xl75" style="background-color: transparent; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">2.2%</span></td>
</tr>
<tr height="15" style="height: 11.25pt; mso-height-source: userset;">
<td align="right" class="xl69" height="15" style="background-color: #ffc000; border: 0px windowtext; height: 11.25pt;"><strong><span style="font-family: Arial; font-size: x-small;">2.5%</span></strong></td>
<td align="right" class="xl76" style="background-color: transparent; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">-3.3%</span></td>
<td align="right" class="xl85" style="background-color: transparent; border-color: windowtext; border-style: solid none none solid; border-width: 0.5pt 0px 0px 0.5pt;"><span style="font-family: Arial; font-size: x-small;">-1.6%</span></td>
<td align="right" class="xl86" style="background-color: transparent; border-color: windowtext; border-style: solid none none; border-width: 0.5pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">1.2%</span></td>
<td align="right" class="xl87" style="background-color: transparent; border-color: windowtext; border-style: solid solid none none; border-width: 0.5pt 0.5pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">3.5%</span></td>
<td align="right" class="xl77" style="background-color: transparent; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">4.4%</span></td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl70" height="15" style="background-color: #ffc000; border: 0px rgb(0, 112, 192); height: 11.25pt;"><strong><span style="color: #0070c0; font-family: Arial; font-size: x-small;">3.0%</span></strong></td>
<td align="right" class="xl76" style="background-color: transparent; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">-1.6%</span></td>
<td align="right" class="xl88" style="background-color: transparent; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 0.5pt;"><span style="font-family: Arial; font-size: x-small;">0.2%</span></td>
<td align="right" class="xl81" style="background-color: transparent; border: 0px rgb(0, 112, 192);"><span style="color: #0070c0; font-family: Arial; font-size: x-small;">3.0%</span></td>
<td align="right" class="xl89" style="background-color: transparent; border-color: windowtext; border-style: none solid none none; border-width: 0px 0.5pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">5.3%</span></td>
<td align="right" class="xl77" style="background-color: transparent; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">6.3%</span></td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl69" height="15" style="background-color: #ffc000; border: 0px windowtext; height: 11.25pt;"><strong><span style="font-family: Arial; font-size: x-small;">3.5%</span></strong></td>
<td align="right" class="xl76" style="background-color: transparent; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">-0.1%</span></td>
<td align="right" class="xl90" style="background-color: transparent; border-color: windowtext; border-style: none none solid solid; border-width: 0px 0px 0.5pt 0.5pt;"><span style="font-family: Arial; font-size: x-small;">1.7%</span></td>
<td align="right" class="xl91" style="background-color: transparent; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 0.5pt;"><span style="font-family: Arial; font-size: x-small;">4.6%</span></td>
<td align="right" class="xl92" style="background-color: transparent; border-color: windowtext; border-style: none solid solid none; border-width: 0px 0.5pt 0.5pt 0px;"><span style="font-family: Arial; font-size: x-small;">6.9%</span></td>
<td align="right" class="xl77" style="background-color: transparent; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">7.9%</span></td>
</tr>
<tr height="16" style="height: 12pt;">
<td align="right" class="xl71" height="16" style="background-color: #ffc000; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt; height: 12pt;"><strong><span style="font-family: Arial; font-size: x-small;">4.0%</span></strong></td>
<td align="right" class="xl78" style="background-color: transparent; border-color: windowtext; border-style: none none solid solid; border-width: 0px 0px 1pt 1pt;"><span style="font-family: Arial; font-size: x-small;">1.2%</span></td>
<td align="right" class="xl79" style="background-color: transparent; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">3.0%</span></td>
<td align="right" class="xl79" style="background-color: transparent; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">6.0%</span></td>
<td align="right" class="xl79" style="background-color: transparent; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">8.3%</span></td>
<td align="right" class="xl80" style="background-color: transparent; border-color: windowtext; border-style: none solid solid none; border-width: 0px 1pt 1pt 0px;"><span style="font-family: Arial; font-size: x-small;">9.4%</span></td>
</tr>
</tbody></colgroup></table>
</span><br />
<div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
</div>
<div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";"></span> </div>
<div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";">Moving on to the European markets
and the UK, we reach a somewhat happier, though still below historic,
level of return expectations. For the UK market we use similar
revenue (5.5%) and normalized margin assumptions (6.0%) as we do for the US.
For the continent, I discount both revenue growth and margins by 0.5%, in
line with historic observations. Again, under a broad range of valuation
and margin assumptions we see a most likely return for the UK of 5.7% and a
most likely return of 3.9% for the continent.<o:p></o:p></span></div>
<div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
</div>
<div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
<strong></strong> </div>
<div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
<strong>MSCI UK 10-Year Return Estimation (5.5% Nominal Revenue Growth, 3.95% Annual Dividend, Various Margin and P/E Scenarios)</strong></div>
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 431px;">
<colgroup><col style="mso-width-alt: 2157; mso-width-source: userset; width: 44pt;" width="59"></col>
<col style="mso-width-alt: 1901; mso-width-source: userset; width: 39pt;" width="52"></col>
<col span="5" style="width: 48pt;" width="64"></col>
<tbody>
<tr height="15" style="height: 11.25pt;">
<td class="xl88" height="15" style="background-color: #ffc000; border-color: windowtext; border-style: solid none none solid; border-width: 1pt 0px 0px 1pt; height: 11.25pt; width: 44pt;" width="59"><strong><span style="font-family: Arial; font-size: x-small;"> </span></strong></td>
<td class="xl83" style="background-color: #ffc000; border-color: windowtext; border-style: solid none none; border-width: 1pt 0px 0px; width: 39pt;" width="52"><span style="font-family: Arial; font-size: x-small;"> </span></td>
<td class="xl95" colspan="5" style="background-color: #ffc000; border-color: windowtext black windowtext windowtext; border-style: solid solid none none; border-width: 1pt 1pt 0px 0px; width: 240pt;" width="320"><strong><span style="font-family: Arial; font-size: x-small;">Normalized PE Ratio</span></strong></td>
</tr>
<tr height="16" style="height: 12pt;">
<td class="xl89" height="16" style="background-color: #ffc000; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt; height: 12pt;"><strong><span style="font-family: Arial; font-size: x-small;"> </span></strong></td>
<td align="right" class="xl84" style="background-color: #ffc000; border: 0px rgb(255, 192, 0);"><span style="color: #ffc000; font-family: Arial; font-size: x-small;">5.5%</span></td>
<td class="xl90" style="background-color: #ffc000; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><strong><span style="font-family: Arial; font-size: x-small;">10</span></strong></td>
<td class="xl90" style="background-color: #ffc000; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><strong><span style="font-family: Arial; font-size: x-small;">12</span></strong></td>
<td class="xl92" style="background-color: #ffc000; border-color: rgb(0, 112, 192) rgb(0, 112, 192) windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><strong><span style="color: #0070c0; font-family: Arial; font-size: x-small;">14</span></strong></td>
<td class="xl90" style="background-color: #ffc000; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><strong><span style="font-family: Arial; font-size: x-small;">16</span></strong></td>
<td class="xl91" style="background-color: #ffc000; border-color: windowtext; border-style: none solid solid none; border-width: 0px 1pt 1pt 0px;"><strong><span style="font-family: Arial; font-size: x-small;">18</span></strong></td>
</tr>
<tr height="15" style="height: 11.25pt; mso-height-source: userset;">
<td class="xl93" height="76" rowspan="5" style="background-color: #ffc000; border-color: windowtext windowtext black; border-style: none none solid solid; border-width: 0px 0px 1pt 1pt; height: 57pt; width: 44pt;" width="59"><strong><span style="font-family: Arial; font-size: x-small;">Normalized Margin</span></strong></td>
<td align="right" class="xl85" style="background-color: #ffc000; border: 0px windowtext;"><strong><span style="font-family: Arial; font-size: x-small;">4.0%</span></strong></td>
<td align="right" class="xl66" style="background-color: transparent; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">-1.7%</span></td>
<td align="right" class="xl67" style="background-color: transparent; border: 0px windowtext;"><span style="font-family: Arial; font-size: x-small;">0.1%</span></td>
<td align="right" class="xl67" style="background-color: transparent; border: 0px windowtext;"><span style="font-family: Arial; font-size: x-small;">1.6%</span></td>
<td align="right" class="xl67" style="background-color: transparent; border: 0px windowtext;"><span style="font-family: Arial; font-size: x-small;">2.9%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">4.1%</span></td>
</tr>
<tr height="15" style="height: 11.25pt; mso-height-source: userset;">
<td align="right" class="xl85" height="15" style="background-color: #ffc000; border: 0px windowtext; height: 11.25pt;"><strong><span style="font-family: Arial; font-size: x-small;">5.0%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">0.5%</span></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: windowtext; border-style: solid none none solid; border-width: 0.5pt 0px 0px 0.5pt;"><span style="font-family: Arial; font-size: x-small;">2.3%</span></td>
<td align="right" class="xl75" style="background-color: transparent; border-color: windowtext; border-style: solid none none; border-width: 0.5pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">3.8%</span></td>
<td align="right" class="xl76" style="background-color: transparent; border-color: windowtext; border-style: solid solid none none; border-width: 0.5pt 0.5pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">5.2%</span></td>
<td align="right" class="xl70" style="background-color: transparent; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">6.4%</span></td>
</tr>
<tr height="15" style="height: 11.25pt; mso-height-source: userset;">
<td align="right" class="xl86" height="15" style="background-color: #ffc000; border: 0px rgb(0, 112, 192); height: 11.25pt;"><strong><span style="color: #0070c0; font-family: Arial; font-size: x-small;">6.0%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">2.3%</span></td>
<td align="right" class="xl77" style="background-color: transparent; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 0.5pt;"><span style="font-family: Arial; font-size: x-small;">4.1%</span></td>
<td align="right" class="xl82" style="background-color: transparent; border: 0px rgb(0, 112, 192);"><strong><span style="color: #0070c0; font-family: Arial; font-size: x-small;">5.7%</span></strong></td>
<td align="right" class="xl78" style="background-color: transparent; border-color: windowtext; border-style: none solid none none; border-width: 0px 0.5pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">7.1%</span></td>
<td align="right" class="xl70" style="background-color: transparent; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">8.3%</span></td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl85" height="15" style="background-color: #ffc000; border: 0px windowtext; height: 11.25pt;"><strong><span style="font-family: Arial; font-size: x-small;">7.0%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">3.8%</span></td>
<td align="right" class="xl79" style="background-color: transparent; border-color: windowtext; border-style: none none solid solid; border-width: 0px 0px 0.5pt 0.5pt;"><span style="font-family: Arial; font-size: x-small;">5.7%</span></td>
<td align="right" class="xl80" style="background-color: transparent; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 0.5pt;"><span style="font-family: Arial; font-size: x-small;">7.3%</span></td>
<td align="right" class="xl81" style="background-color: transparent; border-color: windowtext; border-style: none solid solid none; border-width: 0px 0.5pt 0.5pt 0px;"><span style="font-family: Arial; font-size: x-small;">8.7%</span></td>
<td align="right" class="xl70" style="background-color: transparent; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">10.0%</span></td>
</tr>
<tr height="16" style="height: 12pt;">
<td align="right" class="xl87" height="16" style="background-color: #ffc000; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt; height: 12pt;"><strong><span style="font-family: Arial; font-size: x-small;">8.0%</span></strong></td>
<td align="right" class="xl71" style="background-color: transparent; border-color: windowtext; border-style: none none solid solid; border-width: 0px 0px 1pt 1pt;"><span style="font-family: Arial; font-size: x-small;">5.2%</span></td>
<td align="right" class="xl72" style="background-color: transparent; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">7.1%</span></td>
<td align="right" class="xl72" style="background-color: transparent; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">8.7%</span></td>
<td align="right" class="xl72" style="background-color: transparent; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">10.1%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext; border-style: none solid solid none; border-width: 0px 1pt 1pt 0px;"><span style="font-family: Arial; font-size: x-small;">11.4%</span></td>
</tr>
</tbody></colgroup></table>
<div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
</div>
<div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
</div>
<div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
<strong></strong> </div>
<div class="MsoNormal" style="line-height: normal; margin: 0in 0in 8pt; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto;">
<strong>MSCI Europe ex UK 10-Year Return Estimation (5.0% Nominal Revenue Growth, 3.71% Annual Dividend, Various Margin and P/E Scenarios)</strong> </div>
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 429px;">
<colgroup><col style="mso-width-alt: 2121; mso-width-source: userset; width: 44pt;" width="58"></col>
<col style="mso-width-alt: 1865; mso-width-source: userset; width: 38pt;" width="51"></col>
<col span="5" style="width: 48pt;" width="64"></col>
<tbody>
<tr height="15" style="height: 11.25pt;">
<td class="xl85" height="15" style="background-color: #ffc000; border-color: windowtext; border-style: solid none none solid; border-width: 1pt 0px 0px 1pt; height: 11.25pt; width: 44pt;" width="58"><strong><span style="font-family: Arial; font-size: x-small;"> </span></strong></td>
<td class="xl83" style="background-color: #ffc000; border-color: windowtext; border-style: solid none none; border-width: 1pt 0px 0px; width: 38pt;" width="51"><span style="font-family: Arial; font-size: x-small;"> </span></td>
<td class="xl95" colspan="5" style="background-color: #ffc000; border-color: windowtext black windowtext windowtext; border-style: solid solid none none; border-width: 1pt 1pt 0px 0px; width: 240pt;" width="320"><strong><span style="font-family: Arial; font-size: x-small;">Normalized PE Ratio</span></strong></td>
</tr>
<tr height="16" style="height: 12pt;">
<td class="xl86" height="16" style="background-color: #ffc000; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt; height: 12pt;"><strong><span style="font-family: Arial; font-size: x-small;"> </span></strong></td>
<td align="right" class="xl84" style="background-color: #ffc000; border: 0px rgb(255, 192, 0);"><span style="color: #ffc000; font-family: Arial; font-size: x-small;">4.0%</span></td>
<td class="xl87" style="background-color: #ffc000; border: 0px windowtext;"><strong><span style="font-family: Arial; font-size: x-small;">10</span></strong></td>
<td class="xl87" style="background-color: #ffc000; border: 0px windowtext;"><strong><span style="font-family: Arial; font-size: x-small;">12</span></strong></td>
<td class="xl91" style="background-color: #ffc000; border: 0px rgb(0, 112, 192);"><strong><span style="color: #0070c0; font-family: Arial; font-size: x-small;">14</span></strong></td>
<td class="xl87" style="background-color: #ffc000; border: 0px windowtext;"><strong><span style="font-family: Arial; font-size: x-small;">16</span></strong></td>
<td class="xl88" style="background-color: #ffc000; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px;"><strong><span style="font-family: Arial; font-size: x-small;">18</span></strong></td>
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<td align="right" class="xl89" style="background-color: #ffc000; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px;"><strong><span style="font-family: Arial; font-size: x-small;">3.5%</span></strong></td>
<td align="right" class="xl66" style="background-color: transparent; border-color: windowtext; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">-3.8%</span></td>
<td align="right" class="xl67" style="background-color: transparent; border-color: windowtext; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">-2.1%</span></td>
<td align="right" class="xl67" style="background-color: transparent; border-color: windowtext; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">-0.6%</span></td>
<td align="right" class="xl67" style="background-color: transparent; border-color: windowtext; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">0.7%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border-color: windowtext; border-style: solid solid none none; border-width: 1pt 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">1.9%</span></td>
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<td align="right" class="xl89" height="15" style="background-color: #ffc000; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px; height: 11.25pt;"><strong><span style="font-family: Arial; font-size: x-small;">4.5%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px windowtext;"><span style="font-family: Arial; font-size: x-small;">-1.4%</span></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: windowtext; border-style: solid none none solid; border-width: 0.5pt 0px 0px 0.5pt;"><span style="font-family: Arial; font-size: x-small;">0.3%</span></td>
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<td align="right" class="xl76" style="background-color: transparent; border-color: windowtext; border-style: solid solid none none; border-width: 0.5pt 0.5pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">3.2%</span></td>
<td align="right" class="xl70" style="background-color: transparent; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">4.4%</span></td>
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<td align="right" class="xl92" height="15" style="background-color: #ffc000; border-color: rgb(0, 112, 192) windowtext rgb(0, 112, 192) rgb(0, 112, 192); border-style: none solid none none; border-width: 0px 1pt 0px 0px; height: 11.25pt;"><strong><span style="color: #0070c0; font-family: Arial; font-size: x-small;">5.5%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px windowtext;"><span style="font-family: Arial; font-size: x-small;">0.5%</span></td>
<td align="right" class="xl77" style="background-color: transparent; border-color: windowtext; border-style: none none none solid; border-width: 0px 0px 0px 0.5pt;"><span style="font-family: Arial; font-size: x-small;">2.3%</span></td>
<td align="right" class="xl82" style="background-color: transparent; border: 0px rgb(0, 112, 192);"><strong><span style="color: #0070c0; font-family: Arial; font-size: x-small;">3.9%</span></strong></td>
<td align="right" class="xl78" style="background-color: transparent; border-color: windowtext; border-style: none solid none none; border-width: 0px 0.5pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">5.3%</span></td>
<td align="right" class="xl70" style="background-color: transparent; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">6.5%</span></td>
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<td align="right" class="xl89" height="15" style="background-color: #ffc000; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px; height: 11.25pt;"><strong><span style="font-family: Arial; font-size: x-small;">6.5%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px windowtext;"><span style="font-family: Arial; font-size: x-small;">2.2%</span></td>
<td align="right" class="xl79" style="background-color: transparent; border-color: windowtext; border-style: none none solid solid; border-width: 0px 0px 0.5pt 0.5pt;"><span style="font-family: Arial; font-size: x-small;">4.0%</span></td>
<td align="right" class="xl80" style="background-color: transparent; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 0.5pt;"><span style="font-family: Arial; font-size: x-small;">5.6%</span></td>
<td align="right" class="xl81" style="background-color: transparent; border-color: windowtext; border-style: none solid solid none; border-width: 0px 0.5pt 0.5pt 0px;"><span style="font-family: Arial; font-size: x-small;">7.0%</span></td>
<td align="right" class="xl70" style="background-color: transparent; border-color: windowtext; border-style: none solid none none; border-width: 0px 1pt 0px 0px;"><span style="font-family: Arial; font-size: x-small;">8.2%</span></td>
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<td align="right" class="xl90" height="16" style="background-color: #ffc000; border-color: windowtext; border-style: none solid solid none; border-width: 0px 1pt 1pt 0px; height: 12pt;"><strong><span style="font-family: Arial; font-size: x-small;">7.5%</span></strong></td>
<td align="right" class="xl71" style="background-color: transparent; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">3.6%</span></td>
<td align="right" class="xl72" style="background-color: transparent; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">5.5%</span></td>
<td align="right" class="xl72" style="background-color: transparent; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">7.1%</span></td>
<td align="right" class="xl72" style="background-color: transparent; border-color: windowtext; border-style: none none solid; border-width: 0px 0px 1pt;"><span style="font-family: Arial; font-size: x-small;">8.5%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext; border-style: none solid solid none; border-width: 0px 1pt 1pt 0px;"><span style="font-family: Arial; font-size: x-small;">9.7%</span></td>
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<b style="mso-bidi-font-weight: normal;"><span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";">CONCLUSION <o:p></o:p></span></b></div>
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<span style="font-family: "Times New Roman","serif"; font-size: 12pt; line-height: 107%; mso-ansi-language: EN-US; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US;">It is almost certain that returns from the major
developed equity markets are quite likely to remain in single digits - from somewhere
near 2.0% compounded in the US to under 6% compounded in the UK – for the
decade ahead. This realization, combined with similar fixed income expectations
is that most plan sponsors will have great difficulty achieving their projected
return assumptions of over 7.5%, even under the most optimistic of market
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<span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";">Obviously a new perspective on
managing and allocating funds is called for. This is why my July blog post, “</span><span style="font-family: "Times New Roman","serif"; font-size: 12pt;">The Task of Capital Allocators”</span><span style="font-family: "Times New Roman","serif"; font-size: 12pt; mso-fareast-font-family: "Times New Roman";"> is so important for every Plan Sponsor to consider.<o:p></o:p></span></div>
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Bretthttp://www.blogger.com/profile/11094579354565486061noreply@blogger.com0tag:blogger.com,1999:blog-5803518473270155434.post-47461709356679031112014-08-04T11:03:00.001-07:002014-08-04T14:23:42.316-07:00It's All in the Math - Fixed Income Returns for the Decade Ahead (1 of 2)<em>It is becoming a more common belief that equity and bond market returns are likely to be lower than normal in the years ahead. If proven out, this will have negative implications for the many retirement plans that have target return assumptions based off of historical norms. Shortfalls in returns will require additional contributions - either out of corporate profits (for private plans), or out of the pockets of taxpayers (for public plans). Expected blended return expectations remain above 7.5% for most plans. Returns from traditional fixed income and equity markets will not reach this level and a rethinking of expectations and asset allocations will be necessary. </em><br />
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Using models I originally developed in the late 1990’s, we can arrive at accurate return projections for both fixed income and global equity market over the coming decade. </div>
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Starting with fixed income markets. A bond is a fairly straight forward instrument with returns accruing to just four factors: the price paid, the coupon payments received, the reinvestment of those coupons and the ultimate return of principal. Taking each in turn, we know the price paid. We also know the coupon payments as they are contractual in nature. The reinvestment return of these coupons is unknown; however, as I will demonstrate, even an immediate, radical move in interest rates will not dramatically change the overall return of a bond over its lifetime. Finally, while return of principal to a single bond may be uncertain, when looking at the broader market of bonds of similar ratings, historical experience can provide a reasonable guide as to default and recovery rates. Putting these together, estimating long-term bond returns is a very straight forward process.<o:p></o:p></div>
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At July 30th, you could buy a ten-year US government note with a maturity of May 15, 2024 for a price of $99.49. That note will pay a semi-annual coupon at an annual rate of 2.50%. At maturity, an investor will receive $100 and along the way, twice yearly coupon payments of $1.25 (per $100 value). While we do not know the rate at which those coupons will be reinvested, even if we assume rates rise by 500 basis points before the first coupon payment is received (to 7.56% across all maturities), the total annualized return from this note will rise only to 2.85% over the ten year period. Conversely, if rates fell to zero and an investor received no return at all on the coupons, the ten year total annualized return on this note falls only to 2.29%. Thus, assuming no default, one can not expect anything other than a return of between 2.29% and 2.85% from buying a ten-year US government note today. Another way of looking at this is, assuming no risk of default, the best approximation of the long-term return on a bond is probably just its current yield (on the UST, currently 2.56%). Of course, the road to that compounded annual return need not be smooth. Outsized returns or losses in a near-year, will cause out-year returns in the other direction as the result is mathematically determined.<o:p></o:p></div>
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DEVELOPED MARKET SOVEREIGN DEBT</div>
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Looking at other developed government bond markets (G-7 plus Australia and Spain), we note 10-year yields between 0.53% (Japan) and 3.43% (Australia). Assuming no risk of default, these again are the best estimate for annualized local currency returns over the coming decade. </div>
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<span style="line-height: 107%;"><span style="font-size: x-small;">Source: Bloomberg</span></span></div>
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Of course, given the recent experience of certain governments (Argentina, Greece), zero chance of default might not be the best assumption. If one wanted to insure themselves against default risk, we can look to the Credit Default Swap market to gauge the costs of protection. Higher yielding markets such as Spain and Italy currently have annual “insurance” costs of 1.15% and 1.56%, respectively. Perceived “safe” markets like the US and Germany have lower insurance costs of 0.25% and 0.42%, respectively. Calculating the “net” return with insurance, we see a lower expectation for ten-year returns of between 2.87% (Australia) at the high end and -0.26% (Japan) at the low end. Needless to say, developed market sovereign returns of 1% - 3% are not going to get plans to their return targets.</div>
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INVESTMENT GRADE, HIGH YIELD AND EMERGING MARKETS</div>
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Of course, government markets are not the only fixed income game in town. Lower rated corporate credits, mortgage securities and the like broaden an investor’s opportunity set and we have seen dramatic evidence of plans reaching for yield over the past couple of years. Still, like the sovereign bond markets, the current yield on these instruments, less an assumed default and recovery rate, makes for the best long-term expectations of their likely returns. </div>
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While there are many segments within the broader fixed income universe, for the purposes of this posting, I have chosen to project returns for US High Yield, European High Yield, Emerging Market USD/EUR-Pay Sovereign and US Investment Grade segments – all fairly liquid markets. Current Yields and Spreads (versus governments) are shown below.<o:p></o:p></div>
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<b><span style="font-size: xx-small;">US High Yield<o:p></o:p></span></b></div>
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<b><span style="font-size: xx-small;">Euro High Yield<o:p></o:p></span></b></div>
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<b><span style="font-size: xx-small;">EM Sovereign<o:p></o:p></span></b></div>
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<b><span style="font-size: xx-small;">US Inv Grade<o:p></o:p></span></b></div>
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<b><span style="font-size: xx-small;">Current Spread<o:p></o:p></span></b></div>
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<span style="font-size: xx-small;">3.75</span></div>
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<span style="font-size: xx-small;">4.49</span></div>
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<span style="font-size: xx-small;">5.05</span></div>
</td><td style="border-color: currentColor windowtext windowtext currentColor; border-style: none solid solid none; border-width: medium 1pt 1pt medium; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt; width: 93.5pt;" valign="top" width="125"><div align="center" class="MsoNormal" style="margin-bottom: 0pt; text-align: center;">
<span style="font-size: xx-small;">1.45</span></div>
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<b><span style="font-size: xx-small;">Historic Spread (Median)<o:p></o:p></span></b></div>
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<span style="font-size: xx-small;">5.34</span></div>
</td><td style="border-color: currentColor windowtext windowtext currentColor; border-style: none solid solid none; border-width: medium 1pt 1pt medium; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt; width: 93.5pt;" valign="top" width="125"><div align="center" class="MsoNormal" style="margin-bottom: 0pt; text-align: center;">
<span style="font-size: xx-small;">5.89</span></div>
</td><td style="border-color: currentColor windowtext windowtext currentColor; border-style: none solid solid none; border-width: medium 1pt 1pt medium; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt; width: 93.5pt;" valign="top" width="125"><div align="center" class="MsoNormal" style="margin-bottom: 0pt; text-align: center;">
<span style="font-size: xx-small;">4.78</span></div>
</td><td style="border-color: currentColor windowtext windowtext currentColor; border-style: none solid solid none; border-width: medium 1pt 1pt medium; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt; width: 93.5pt;" valign="top" width="125"><div align="center" class="MsoNormal" style="margin-bottom: 0pt; text-align: center;">
<span style="font-size: xx-small;">1.97</span></div>
</td></tr>
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<b><span style="font-size: xx-small;">Current YTM</span></b></div>
</td><td style="border-color: currentColor windowtext windowtext currentColor; border-style: none solid solid none; border-width: medium 1pt 1pt medium; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt; width: 93.5pt;" valign="top" width="125"><div align="center" class="MsoNormal" style="margin-bottom: 0pt; text-align: center;">
<span style="font-size: xx-small;">5.90</span></div>
</td><td style="border-color: currentColor windowtext windowtext currentColor; border-style: none solid solid none; border-width: medium 1pt 1pt medium; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt; width: 93.5pt;" valign="top" width="125"><div align="center" class="MsoNormal" style="margin-bottom: 0pt; text-align: center;">
<span style="font-size: xx-small;">4.49</span></div>
</td><td style="border-color: currentColor windowtext windowtext currentColor; border-style: none solid solid none; border-width: medium 1pt 1pt medium; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt; width: 93.5pt;" valign="top" width="125"><div align="center" class="MsoNormal" style="margin-bottom: 0pt; text-align: center;">
<span style="font-size: xx-small;">6.84</span></div>
</td><td style="border-color: currentColor windowtext windowtext currentColor; border-style: none solid solid none; border-width: medium 1pt 1pt medium; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt; width: 93.5pt;" valign="top" width="125"><div align="center" class="MsoNormal" style="margin-bottom: 0pt; text-align: center;">
<span style="font-size: xx-small;">4.65</span></div>
</td></tr>
</tbody></table>
<div class="MsoNormal">
<span style="font-size: 9pt; line-height: 107%;"><span style="font-size: x-small;">Source: BofA Merrill Lynch, Brett Gallagher Calculations<o:p></o:p></span></span></div>
<div class="MsoNormal">
<span style="font-size: 9pt; line-height: 107%;"><br /></span></div>
<div class="MsoNormal">
Once again, assuming no default, Current Yield to Maturity is our best guess at the long-term return from the various fixed income segments (between 4.5% and 7.0% in this example). However, as there is some realistic level of default expected in each of these riskier pools, building a sensitivity analysis around the historic default level and recovery rates makes sense (detailed in the tables below). <o:p></o:p></div>
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<br /></div>
<div class="MsoNormal">
For reasonable default and recovery assumptions, I turned to data gathered by Moody’s Investors Service which has compiled cumulative 10-year default percentages across a number of markets and ratings classes for the 10-year periods ending 1970 - 2013 and also used their observed historical recovery percentages. <br />
<br />
I have converted the cumulative default figures into annual ones (shown in parenthesis below). For the sensitivity analysis, I use the Worst, 25th Percentile, Median, 75th Percentile and Best Case historical experiences - though I would expect the 25th to 75th percentile range to capture the most likely outcomes. Because of the longer history of the US data, I use that experience for other speculative markets as well (note: using a common data set with an inception date of 1983, European High Yield and EM Sovereign Debt actually have lower default rates than the US Universe over the common period – thus my assumptions may be slightly conservative). For recovery rates, the sovereign experience has been better than corporates by about 10 percentage points and is also reflected in the sensitivities.</div>
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<br /></div>
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<strong>10-Year Cumulative (Annual Equivalent) Default Rates (1970 - 2013)</strong></div>
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<br /></div>
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<b>Investment Grade</b></div>
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<b>US HY, Euro HY, EM Sovereign<o:p></o:p></b></div>
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<b>Worst Case <o:p></o:p></b></div>
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10.33% (0.97%)<o:p></o:p></div>
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45.88% (3.85%)<o:p></o:p></div>
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<b>25<sup><span style="font-size: x-small;">th</span></sup> Percentile <o:p></o:p></b></div>
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5.91% (0.58%)<o:p></o:p></div>
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38.93% (3.34%)<o:p></o:p></div>
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<b>Median <o:p></o:p></b></div>
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4.89% (0.48%)<o:p></o:p></div>
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32.33% (2.84%)<o:p></o:p></div>
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<b>75<sup><span style="font-size: x-small;">th</span></sup> Percentile <o:p></o:p></b></div>
</td><td style="border-color: currentColor windowtext windowtext currentColor; border-style: none solid solid none; border-width: medium 1pt 1pt medium; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt; width: 155.85pt;" valign="top" width="208"><div align="center" class="MsoNormal" style="margin-bottom: 0pt; text-align: center;">
3.63% (0.36%)<o:p></o:p></div>
</td><td style="border-color: currentColor windowtext windowtext currentColor; border-style: none solid solid none; border-width: medium 1pt 1pt medium; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt; width: 155.85pt;" valign="top" width="208"><div align="center" class="MsoNormal" style="margin-bottom: 0pt; text-align: center;">
18.80% (1.74%)<o:p></o:p></div>
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<b>Best Case <o:p></o:p></b></div>
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1.26% (0.13%)<o:p></o:p></div>
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0.37% (0.04%)<span style="font-size: xx-small;"><o:p></o:p></span></div>
</td></tr>
</tbody></table>
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</div>
<div class="MsoNormal">
<span style="line-height: 107%;"><span style="font-size: x-small;">Source: Moody’s, Brett Gallagher</span><span style="font-size: 9pt;"><o:p></o:p></span></span></div>
<div class="MsoNormal">
<span style="font-size: 9pt; line-height: 107%;"><br /></span><br />
Using a plausible range of default and recovery assumptions, we are now able to construct a narrow range of likely outcomes for nearly any fixed income segment we desire. While the returns due to risk assets appear relatively attractive when compared with developed sovereign markets, the range of returns are far below historic experience and most investors assumed return assumptions. </div>
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<br /></div>
<div class="MsoNormal">
<o:p></o:p><br /></div>
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<b>US High Yield Debt – Yield to Maturity 5.90%, Median 10-year Cumulative Default 32.3%</b><br />
<strong></strong><br />
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 447px;">
<colgroup><col style="mso-width-alt: 1536; mso-width-source: userset; width: 32pt;" width="42"></col>
<col style="mso-width-alt: 2486; mso-width-source: userset; width: 51pt;" width="68"></col>
<col style="mso-width-alt: 2962; mso-width-source: userset; width: 61pt;" width="81"></col>
<col span="4" style="width: 48pt;" width="64"></col>
<tbody>
<tr height="20" style="height: 15pt;">
<td class="xl68" height="20" style="background-color: transparent; border: 0px black; height: 15pt; width: 32pt;" width="42"></td>
<td style="background-color: transparent; border: 0px black; width: 51pt;" width="68"></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 61pt;" width="81"><strong><span style="font-family: Calibri;">Annualized Default Rates</span></strong></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 48pt;" width="64"></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 48pt;" width="64"></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 48pt;" width="64"></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 48pt;" width="64"></td>
</tr>
<tr height="21" style="height: 15.75pt; mso-height-source: userset;">
<td class="xl76" height="162" rowspan="8" style="background-color: transparent; border: 0px black; height: 121.5pt;"><strong><span style="font-family: Calibri;">Recovery Rate</span></strong></td>
<td align="right" class="xl71" style="background-color: transparent; border: 0px white;"><span style="color: white; font-family: Calibri;">4.31%</span></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px black;"><strong><span style="font-family: Calibri;">0.04%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px black;"><strong><span style="font-family: Calibri;">1.74%</span></strong></td>
<td align="right" class="xl70" style="background-color: transparent; border: 0px red;"><strong><span style="color: red; font-family: Calibri;">2.84%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px black;"><strong><span style="font-family: Calibri;">3.34%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px black;"><strong><span style="font-family: Calibri;">3.85%</span></strong></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">30.0%</span></strong></td>
<td align="right" class="xl72" style="background-color: transparent; border-color: windowtext black black windowtext; border-style: solid none none solid; border-width: 1pt 0px 0px 1pt;"><span style="font-family: Calibri;">5.76%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Calibri;">4.74%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Calibri;">4.12%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Calibri;">3.84%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Calibri;">3.57%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">35.0%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">5.76%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.80%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.22%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">3.96%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">3.70%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">37.5%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">5.76%</span></td>
<td align="right" class="xl78" style="background-color: transparent; border-color: windowtext black black windowtext; border-style: solid none none solid; border-width: 0.5pt 0px 0px 0.5pt;"><span style="font-family: Calibri;">4.83%</span></td>
<td align="right" class="xl79" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 0.5pt 0px 0px;"><span style="font-family: Calibri;">4.27%</span></td>
<td align="right" class="xl80" style="background-color: transparent; border-color: windowtext windowtext black black; border-style: solid solid none none; border-width: 0.5pt 0.5pt 0px 0px;"><span style="font-family: Calibri;">4.02%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">3.77%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl67" height="20" style="background-color: transparent; border: 0px red; height: 15pt;"><strong><span style="color: red; font-family: Calibri;">40.0%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">5.76%</span></td>
<td align="right" class="xl81" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 0.5pt;"><span style="font-family: Calibri;">4.86%</span></td>
<td align="right" class="xl70" style="background-color: transparent; border: 0px red;"><strong><span style="color: red; font-family: Calibri;">4.31%</span></strong></td>
<td align="right" class="xl82" style="background-color: transparent; border-color: black windowtext black black; border-style: none solid none none; border-width: 0px 0.5pt 0px 0px;"><span style="font-family: Calibri;">4.08%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">3.84%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">42.5%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">5.76%</span></td>
<td align="right" class="xl83" style="background-color: transparent; border-color: black black windowtext windowtext; border-style: none none solid solid; border-width: 0px 0px 0.5pt 0.5pt;"><span style="font-family: Calibri;">4.89%</span></td>
<td align="right" class="xl84" style="background-color: transparent; border-color: black black windowtext; border-style: none none solid; border-width: 0px 0px 0.5pt;"><span style="font-family: Calibri;">4.36%</span></td>
<td align="right" class="xl85" style="background-color: transparent; border-color: black windowtext windowtext black; border-style: none solid solid none; border-width: 0px 0.5pt 0.5pt 0px;"><span style="font-family: Calibri;">4.13%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">3.90%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">45.0%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">5.76%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.92%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.41%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.19%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">3.97%</span></td>
</tr>
<tr height="21" style="height: 15.75pt;">
<td align="right" class="xl66" height="21" style="background-color: transparent; border: 0px black; height: 15.75pt;"><strong><span style="font-family: Calibri;">50.0%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">5.76%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.98%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.51%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.31%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.10%</span></td>
</tr>
</tbody></colgroup></table>
<strong></strong> </div>
<div class="MsoNormal">
<b></b><br />
<b>European High Yield Debt – Current Yield 4.49%, Median 10-year Cumulative Default 32.3%<o:p></o:p></b></div>
<div class="MsoNormal">
</div>
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 447px;">
<colgroup><col style="mso-width-alt: 1536; mso-width-source: userset; width: 32pt;" width="42"></col>
<col style="mso-width-alt: 2486; mso-width-source: userset; width: 51pt;" width="68"></col>
<col style="mso-width-alt: 2962; mso-width-source: userset; width: 61pt;" width="81"></col>
<col span="4" style="width: 48pt;" width="64"></col>
<tbody>
<tr height="20" style="height: 15pt;">
<td class="xl68" height="20" style="background-color: transparent; border: 0px black; height: 15pt; width: 32pt;" width="42"></td>
<td style="background-color: transparent; border: 0px black; width: 51pt;" width="68"></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 61pt;" width="81"><strong><span style="font-family: Calibri;">Annualized Default Rates</span></strong></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 48pt;" width="64"></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 48pt;" width="64"></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 48pt;" width="64"></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 48pt;" width="64"></td>
</tr>
<tr height="21" style="height: 15.75pt; mso-height-source: userset;">
<td class="xl76" height="162" rowspan="8" style="background-color: transparent; border: 0px black; height: 121.5pt;"><strong><span style="font-family: Calibri;">Recovery Rate</span></strong></td>
<td align="right" class="xl71" style="background-color: transparent; border: 0px white;"><span style="color: white; font-family: Calibri;">2.93%</span></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px black;"><strong><span style="font-family: Calibri;">0.04%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px black;"><strong><span style="font-family: Calibri;">1.74%</span></strong></td>
<td align="right" class="xl70" style="background-color: transparent; border: 0px red;"><strong><span style="color: red; font-family: Calibri;">2.84%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px black;"><strong><span style="font-family: Calibri;">3.34%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px black;"><strong><span style="font-family: Calibri;">3.85%</span></strong></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">30.0%</span></strong></td>
<td align="right" class="xl72" style="background-color: transparent; border-color: windowtext black black windowtext; border-style: solid none none solid; border-width: 1pt 0px 0px 1pt;"><span style="font-family: Calibri;">4.42%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Calibri;">3.36%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Calibri;">2.72%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Calibri;">2.44%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Calibri;">2.15%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">35.0%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">4.42%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">3.43%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">2.83%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">2.56%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">2.30%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">37.5%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">4.42%</span></td>
<td align="right" class="xl78" style="background-color: transparent; border-color: windowtext black black windowtext; border-style: solid none none solid; border-width: 0.5pt 0px 0px 0.5pt;"><span style="font-family: Calibri;">3.46%</span></td>
<td align="right" class="xl79" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 0.5pt 0px 0px;"><span style="font-family: Calibri;">2.88%</span></td>
<td align="right" class="xl80" style="background-color: transparent; border-color: windowtext windowtext black black; border-style: solid solid none none; border-width: 0.5pt 0.5pt 0px 0px;"><span style="font-family: Calibri;">2.63%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">2.37%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl67" height="20" style="background-color: transparent; border: 0px red; height: 15pt;"><strong><span style="color: red; font-family: Calibri;">40.0%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">4.42%</span></td>
<td align="right" class="xl81" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 0.5pt;"><span style="font-family: Calibri;">3.49%</span></td>
<td align="right" class="xl70" style="background-color: transparent; border: 0px red;"><strong><span style="color: red; font-family: Calibri;">2.93%</span></strong></td>
<td align="right" class="xl82" style="background-color: transparent; border-color: black windowtext black black; border-style: none solid none none; border-width: 0px 0.5pt 0px 0px;"><span style="font-family: Calibri;">2.69%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">2.44%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">42.5%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">4.42%</span></td>
<td align="right" class="xl83" style="background-color: transparent; border-color: black black windowtext windowtext; border-style: none none solid solid; border-width: 0px 0px 0.5pt 0.5pt;"><span style="font-family: Calibri;">3.53%</span></td>
<td align="right" class="xl84" style="background-color: transparent; border-color: black black windowtext; border-style: none none solid; border-width: 0px 0px 0.5pt;"><span style="font-family: Calibri;">2.99%</span></td>
<td align="right" class="xl85" style="background-color: transparent; border-color: black windowtext windowtext black; border-style: none solid solid none; border-width: 0px 0.5pt 0.5pt 0px;"><span style="font-family: Calibri;">2.75%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">2.52%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">45.0%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">4.42%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">3.56%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">3.04%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">2.81%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">2.59%</span></td>
</tr>
<tr height="21" style="height: 15.75pt;">
<td align="right" class="xl66" height="21" style="background-color: transparent; border: 0px black; height: 15.75pt;"><strong><span style="font-family: Calibri;">50.0%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">4.42%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">3.62%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">3.14%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">2.93%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">2.73%</span></td>
</tr>
</tbody></colgroup></table>
<strong></strong><br />
<div class="MsoNormal">
<b><br /></b> <b>US Investment Grade (Baa) – Current Yield 4.65%, Median 10-year Cumulative Default 4.89%<o:p></o:p></b></div>
<div class="MsoNormal">
<b> </b></div>
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 447px;">
<colgroup><col style="mso-width-alt: 1536; mso-width-source: userset; width: 32pt;" width="42"></col>
<col style="mso-width-alt: 2486; mso-width-source: userset; width: 51pt;" width="68"></col>
<col style="mso-width-alt: 2962; mso-width-source: userset; width: 61pt;" width="81"></col>
<col span="4" style="width: 48pt;" width="64"></col>
<tbody>
<tr height="20" style="height: 15pt;">
<td class="xl68" height="20" style="background-color: transparent; border: 0px black; height: 15pt; width: 32pt;" width="42"></td>
<td style="background-color: transparent; border: 0px black; width: 51pt;" width="68"></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 61pt;" width="81"><strong><span style="font-family: Calibri;">Annualized Default Rates</span></strong></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 48pt;" width="64"></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 48pt;" width="64"></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 48pt;" width="64"></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 48pt;" width="64"></td>
</tr>
<tr height="21" style="height: 15.75pt; mso-height-source: userset;">
<td class="xl76" height="162" rowspan="8" style="background-color: transparent; border: 0px black; height: 121.5pt;"><strong><span style="font-family: Calibri;">Recovery Rate</span></strong></td>
<td align="right" class="xl71" style="background-color: transparent; border: 0px white;"><span style="color: white; font-family: Calibri;">3.09%</span></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px black;"><strong><span style="font-family: Calibri;">0.04%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px black;"><strong><span style="font-family: Calibri;">0.19%</span></strong></td>
<td align="right" class="xl70" style="background-color: transparent; border: 0px red;"><strong><span style="color: red; font-family: Calibri;">0.23%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px black;"><strong><span style="font-family: Calibri;">0.34%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px black;"><strong><span style="font-family: Calibri;">0.52%</span></strong></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">30.0%</span></strong></td>
<td align="right" class="xl72" style="background-color: transparent; border-color: windowtext black black windowtext; border-style: solid none none solid; border-width: 1pt 0px 0px 1pt;"><span style="font-family: Calibri;">4.57%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Calibri;">4.47%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Calibri;">4.45%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Calibri;">4.38%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Calibri;">4.27%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">35.0%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">4.57%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.48%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.46%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.39%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.29%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">37.5%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">4.57%</span></td>
<td align="right" class="xl78" style="background-color: transparent; border-color: windowtext black black windowtext; border-style: solid none none solid; border-width: 0.5pt 0px 0px 0.5pt;"><span style="font-family: Calibri;">4.49%</span></td>
<td align="right" class="xl79" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 0.5pt 0px 0px;"><span style="font-family: Calibri;">4.46%</span></td>
<td align="right" class="xl80" style="background-color: transparent; border-color: windowtext windowtext black black; border-style: solid solid none none; border-width: 0.5pt 0.5pt 0px 0px;"><span style="font-family: Calibri;">4.40%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.30%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl67" height="20" style="background-color: transparent; border: 0px red; height: 15pt;"><strong><span style="color: red; font-family: Calibri;">40.0%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">4.57%</span></td>
<td align="right" class="xl81" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 0.5pt;"><span style="font-family: Calibri;">4.49%</span></td>
<td align="right" class="xl70" style="background-color: transparent; border: 0px red;"><strong><span style="color: red; font-family: Calibri;">4.47%</span></strong></td>
<td align="right" class="xl82" style="background-color: transparent; border-color: black windowtext black black; border-style: none solid none none; border-width: 0px 0.5pt 0px 0px;"><span style="font-family: Calibri;">4.40%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.31%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">42.5%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">4.57%</span></td>
<td align="right" class="xl83" style="background-color: transparent; border-color: black black windowtext windowtext; border-style: none none solid solid; border-width: 0px 0px 0.5pt 0.5pt;"><span style="font-family: Calibri;">4.49%</span></td>
<td align="right" class="xl84" style="background-color: transparent; border-color: black black windowtext; border-style: none none solid; border-width: 0px 0px 0.5pt;"><span style="font-family: Calibri;">4.47%</span></td>
<td align="right" class="xl85" style="background-color: transparent; border-color: black windowtext windowtext black; border-style: none solid solid none; border-width: 0px 0.5pt 0.5pt 0px;"><span style="font-family: Calibri;">4.41%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.31%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">45.0%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">4.57%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.50%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.47%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.42%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.32%</span></td>
</tr>
<tr height="21" style="height: 15.75pt;">
<td align="right" class="xl66" height="21" style="background-color: transparent; border: 0px black; height: 15.75pt;"><strong><span style="font-family: Calibri;">50.0%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">4.58%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.50%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.48%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.43%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.34%</span></td>
</tr>
</tbody></colgroup></table>
<strong></strong><br />
<div class="MsoNormal">
<b><br /></b> <b>EM Sovereign (USD/EUR Pay) – Current Yield 6.84%, Median 10-year Cumulative Default 32.3%<o:p></o:p></b></div>
<div class="MsoNormal">
</div>
<div class="MsoNormal">
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 447px;">
<colgroup><col style="mso-width-alt: 1536; mso-width-source: userset; width: 32pt;" width="42"></col>
<col style="mso-width-alt: 2486; mso-width-source: userset; width: 51pt;" width="68"></col>
<col style="mso-width-alt: 2962; mso-width-source: userset; width: 61pt;" width="81"></col>
<col span="4" style="width: 48pt;" width="64"></col>
<tbody>
<tr height="20" style="height: 15pt;">
<td class="xl68" height="20" style="background-color: transparent; border: 0px black; height: 15pt; width: 32pt;" width="42"></td>
<td style="background-color: transparent; border: 0px black; width: 51pt;" width="68"></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 61pt;" width="81"><strong><span style="font-family: Calibri;">Annualized Default Rates</span></strong></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 48pt;" width="64"></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 48pt;" width="64"></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 48pt;" width="64"></td>
<td class="xl75" style="background-color: transparent; border: 0px black; width: 48pt;" width="64"></td>
</tr>
<tr height="21" style="height: 15.75pt; mso-height-source: userset;">
<td class="xl76" height="162" rowspan="8" style="background-color: transparent; border: 0px black; height: 121.5pt;"><strong><span style="font-family: Calibri;">Recovery Rate</span></strong></td>
<td align="right" class="xl71" style="background-color: transparent; border: 0px white;"><span style="color: white; font-family: Calibri;">5.21%</span></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px black;"><strong><span style="font-family: Calibri;">0.04%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px black;"><strong><span style="font-family: Calibri;">1.74%</span></strong></td>
<td align="right" class="xl70" style="background-color: transparent; border: 0px red;"><strong><span style="color: red; font-family: Calibri;">2.84%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px black;"><strong><span style="font-family: Calibri;">3.34%</span></strong></td>
<td align="right" class="xl69" style="background-color: transparent; border: 0px black;"><strong><span style="font-family: Calibri;">3.85%</span></strong></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">40.0%</span></strong></td>
<td align="right" class="xl72" style="background-color: transparent; border-color: windowtext black black windowtext; border-style: solid none none solid; border-width: 1pt 0px 0px 1pt;"><span style="font-family: Calibri;">6.64%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Calibri;">5.75%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Calibri;">5.21%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Calibri;">4.98%</span></td>
<td align="right" class="xl73" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 1pt 0px 0px;"><span style="font-family: Calibri;">4.74%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">45.0%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">6.64%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">5.81%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">5.31%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">5.09%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.87%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">47.5%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">6.64%</span></td>
<td align="right" class="xl78" style="background-color: transparent; border-color: windowtext black black windowtext; border-style: solid none none solid; border-width: 0.5pt 0px 0px 0.5pt;"><span style="font-family: Calibri;">5.84%</span></td>
<td align="right" class="xl79" style="background-color: transparent; border-color: windowtext black black; border-style: solid none none; border-width: 0.5pt 0px 0px;"><span style="font-family: Calibri;">5.35%</span></td>
<td align="right" class="xl80" style="background-color: transparent; border-color: windowtext windowtext black black; border-style: solid solid none none; border-width: 0.5pt 0.5pt 0px 0px;"><span style="font-family: Calibri;">5.14%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">4.93%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl67" height="20" style="background-color: transparent; border: 0px red; height: 15pt;"><strong><span style="color: red; font-family: Calibri;">50.0%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">6.64%</span></td>
<td align="right" class="xl81" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 0.5pt;"><span style="font-family: Calibri;">5.87%</span></td>
<td align="right" class="xl70" style="background-color: transparent; border: 0px red;"><strong><span style="color: red; font-family: Calibri;">5.40%</span></strong></td>
<td align="right" class="xl82" style="background-color: transparent; border-color: black windowtext black black; border-style: none solid none none; border-width: 0px 0.5pt 0px 0px;"><span style="font-family: Calibri;">5.20%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">5.00%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">52.5%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">6.64%</span></td>
<td align="right" class="xl83" style="background-color: transparent; border-color: black black windowtext windowtext; border-style: none none solid solid; border-width: 0px 0px 0.5pt 0.5pt;"><span style="font-family: Calibri;">5.89%</span></td>
<td align="right" class="xl84" style="background-color: transparent; border-color: black black windowtext; border-style: none none solid; border-width: 0px 0px 0.5pt;"><span style="font-family: Calibri;">5.45%</span></td>
<td align="right" class="xl85" style="background-color: transparent; border-color: black windowtext windowtext black; border-style: none solid solid none; border-width: 0px 0.5pt 0.5pt 0px;"><span style="font-family: Calibri;">5.25%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">5.06%</span></td>
</tr>
<tr height="20" style="height: 15pt;">
<td align="right" class="xl66" height="20" style="background-color: transparent; border: 0px black; height: 15pt;"><strong><span style="font-family: Calibri;">55.0%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">6.64%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">5.92%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">5.49%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">5.31%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">5.12%</span></td>
</tr>
<tr height="21" style="height: 15.75pt;">
<td align="right" class="xl66" height="21" style="background-color: transparent; border: 0px black; height: 15.75pt;"><strong><span style="font-family: Calibri;">60.0%</span></strong></td>
<td align="right" class="xl74" style="background-color: transparent; border-color: black black black windowtext; border-style: none none none solid; border-width: 0px 0px 0px 1pt;"><span style="font-family: Calibri;">6.64%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">5.98%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">5.59%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">5.42%</span></td>
<td align="right" class="xl68" style="background-color: transparent; border: 0px black;"><span style="font-family: Calibri;">5.25%</span></td>
</tr>
</tbody></colgroup></table>
</div>
<div class="MsoNormal">
</div>
<div class="MsoNormal">
</div>
<div class="MsoNormal">
In my next post, I turn to global equity markets.</div>
<br />Bretthttp://www.blogger.com/profile/11094579354565486061noreply@blogger.com0tag:blogger.com,1999:blog-5803518473270155434.post-39629078482305167132014-07-30T10:07:00.000-07:002014-07-31T08:18:09.928-07:00The Task of Capital AllocatorsI had mentioned previously that I have been furiously at work on a new venture and that I would shortly have some news to report. Today, I'd like to let you know what I have been up to.<br />
<br />
For the past six months, I have been consulting with the Nile Capital Group, a private equity firm based in Los Angeles that provides capital and expertise to small and emerging asset managers. As part of my work with them, I engaged in a study with a former colleague, Pranay Gupta, most recently the Chief Investment Officer for Lombard Odier in Hong Kong.<br />
<br />
Pranay and I analyzed literally millions upon millions pieces of data (manipulating more than 20 million data points in all), examining monthly returns and the growth in Assets under Management (AUM) for over 50,000 US mutual funds - current and closed. Portions of the full study can be obtained by interested consultants and institutional plan sponsors by contacting Nile directly. <br />
<br />
For my blog readers, I can share with you some of our findings. Certain of these findings support prior research, while others are quite new - and I think illuminating.<br />
<br />
<strong>1. Larger funds are benchmark huggers.</strong> <em>This is certainly not news to most investors, and whether the result is due to structural reasons (the strategies are too big and their trades influence the markets) or business ones ("we've succeed, so now let's not get fired") is of little consequence. Statistically, you are likely to earn near-benchmark returns if you invest with a larger manager.</em><br />
<br />
<strong>2. Small funds are the best performers.</strong> <em>However, I must offer a caveat - they are also the worst. Thus, if you don't have the resources for, or skill in, manager selection, you need to hire someone to do it for you or should otherwise index.</em><br />
<em></em><br />
<strong>3. There is a relationship between performance and a manager's ability to grow assets.</strong> <em>This conclusion may seem obvious, but there is more to it than most know. Interestingly, the best performers are not the fastest growers - and the fastest growers are not the best performers. Factors beyond performance strongly influence a manager's business success. Also, it should be noted that once performance falls below the median, there is little distinction in asset gathering ability between funds.</em><br />
<em></em><br />
<ul>
<li><strong>The fastest growing decile of managers have a performance rank somewhere in the middle of the second quartile.</strong> <em>In other words, you don't have to be great to grow. Good is good enough.</em></li>
</ul>
<strong></strong><br />
<ul>
<li><strong>The best performing managers fall near the top of the second quartile in asset gathering ability</strong>. <em>Again, there is more to growth success than performance. It is also true that performance has become a less important, though still positive, driver of asset growth since 2006.</em></li>
</ul>
<em></em><br />
<strong>4. As noted previously, the top asset gatherers (on average) are mid-second quartile performers. However, over the three years following their success, they become, in aggregate, only slightly better than a median performer</strong>.<br />
<br />
<br />
<strong>Connecting the Dots</strong><br />
<br />
If you want better than index performance, you need to find the right small manager in each asset class you are considering. Assuming you select the right manager, this manager's success will result in a growth in their AUM and a diminuation of your alpha over time. You will then have to go through the selection process again. In the meantime, the manager has created a highly-valued annuity business.<br />
<br />
The work of the plan sponsor includes helping their plans achieve a certain assumed rate of return through asset allocation and manager selection. Depending upon the plan's return assumption and the returns actually realized, the employer may have to increase the annual amount contributed on behalf of employees should returns fall short. <br />
<br />
Today, most US defined benefit pension plans are underfunded and will either need to achieve better returns, or increase their funding amounts. With taxpayers already strapped, the pursuit of higher returns matters more than ever. Unfortunately, and as I will show in my annual long-term asset class return forecasts next month, almost all plans will fail to meet their assumed rate of returns in the coming decade (the National Association of State Retirement Administrators has reported that the average assumed rate of return for State plans is currently 7.72% - US Corporate assumptions are close, albeit slightly lower).<br />
<br />
Thus, it becomes ever more important to find new asset vehicles to help achieve these goals. One area plan sponsors should consider is not only investing <em>with</em> the best small managers, but also investing <em>in</em> the best small managers.<br />
<br />
<em>Also, in the interests of full disclosure, since May 1, 2014 I have been employed by Nile Capital Group and may continue in a similar role in the future. This blog post is not a solicitation on behalf of any product, current or future, that may be offered by them. The purpose of this blog is solely to convey the findings of the Gallagher/Gupta study and to suggest a potential course of exploration for plan sponsors, whether pursued on their own or through any other party.</em>Bretthttp://www.blogger.com/profile/11094579354565486061noreply@blogger.com0tag:blogger.com,1999:blog-5803518473270155434.post-89916452074086110282014-06-28T15:35:00.001-07:002014-07-08T10:30:42.951-07:00Caveat EmptorRegular readers of this blog and of my previous ramblings know that I am a skeptic when it comes to the reliability of government statistics. Such figures are important to investors trying to understand the true state of the economy in which they are investing and, unfortunately, today are so manipulated (even by the government's own admission) as to be increasingly useless.<br />
<br />
In the September 2013 post to this blog, "Lies, Damn Lies and Statistics", I took a look at the United States' monthly jobs report and noted how seasonal adjustments applied to the figures have gotten bigger over time and how the adjustment is almost always larger than the underlying number itself. When the seasonal adjustment is stripped away and the underlying figures are smoothed, the health of the jobs economy can be quite different from what is reported as truth each month. Similarly, while penning the quarterly CIO Letter at Artio Global Investors/Julius Baer, the figure that bothered me the most was the CPI, the Consumer Price Index, which I argued was no longer a price index with any relevance to the pocketbook of consumers. Changes in the way the index has been constructed over time (including the 40% weight given to housing, of which 3/4 is based on a survey question asking homeowners what they think they could rent their house for) leaves the current release unrecognizable and not comparable to historic readings.<br />
<br />
Today, though, I'd like to talk about GDP, Gross Domestic Product, or the value of goods and services produced within the borders of a given country. And for this, we will look overseas. GDP per capita is often used as a measure of a society's standard of living and changes in GDP are looked at to measure the health of an economy. Therefore, you might agree, it would be a useful number for investors to know.<br />
<br />
As reported by the Wall Street Journal on June 9th, Italy, the UK and Ireland will be changing the way they calculate GDP. Going forward, they will included the "value" of the illegal economy -- i.e. drugs, prostitution, etc.. As a result, GDP will be larger, not because the economy has improved, but rather because the illicit portions of it will now be counted. Debt to GDP figures will depict greater economic "health" as the denominator in the equation is increased. In other words, links to the past will change.<br />
<br />
Granted, one can argue whether legal or illegal, such activities are truly a part of the economy and their inclusion is overdue. Fair enough. However, when measuring illegal activity, assumptions have to be made. Lots of assumptions - many more than in the reported economy. And to the extent the underlying activities are large relative to the size of the economy, the assumptions used can distort the true state of being. So let's look at how these numbers will be computed and adjusted.<br />
<br />
<strong>Drugs</strong><br />
<br />
In the UK, the trade in six substances will be added to GDP - heroin, powder cocaine, crack, ecstasy, amphetamines and marijuana. And here's where the math gets interesting. According to a UK crime survey, the number of heroin users climbed to 38,000 in 2009 from 36,000 in 2003 (assumption #1). The purity of the heroin has climbed to 43% from 33%, yet its price has fallen by 31% (assumptions #2 and #3). So to measure the value of heroin in GDP, you take the base year (2003) sales of GBP 1.349 million and multiply by the increase in users (38,000 divided by 36,000) and then by the increase in price to get a base-level value of product sold. Then you further multiply by the 2003 purity level and divide by the 2009 purity level to get the total value of heroin consumed (the purity adjustment is the hedonic, or quality adjustment, so prevalent in many economic statistics compiled today).<br />
<br />
GBP 1.349 * (2009 heroin users/2003 heroin users) * price * (2003 purity/2009 purity)<br />
<br />
You are not done yet. Now you have to account for imported heroin and subtract that out of the total number as GDP is only value produced <em>within</em> a country's borders. So based on another set of calculations using UK Border agency seizures and a UN estimate of the imported price level, this figure is calculated. The total value of heroin to the UK economy is thus "exactly" GBP 536 million.<br />
<br />
The value of the largest drug, crack, weighs in at GBP 2.9 billion - or as the Wall Street Journal points out, more than the GBP 2.5 billion in profits from Barclays, the nations largest bank and employer of approximately 60,000 Britons.<br />
<br />
<strong>Prostitution</strong><br />
<br />
To measure prostitution, the measurements get a little more complex. A 2004 survey estimated there were 58,000 prostitutes at work in the UK. Since then, the population of men in the country older than 16 years has increased by 5%, so it is assumed the number of prostitutes has kept pace. Using data from the Netherlands, it is further assumed each prostitute sees 25 clients each week and that in 2004 the price was GBP 55 per visit. Lap dance prices in the country have climbed by 22% since then (and we know this how?), so it is assumed so has the price received by prostitutes. These figures must then be adjusted by the purchases prostitutes make in the course of doing business as GDP only measures final sales, not intermediate sales (for example, if the Brown Forman company sells a bottle of Jack Daniels to my local liquor store and the liquor store then sells that bottle to me, only my purchase is included in calculating the value of GDP). So, when a prostitute buys a condom it is not included in the value of GDP. However, when a private person buys a condom, it is. So total condom sales must be adjusted downward based on an assumption between professional and personal useage. The same holds true for hotel rooms and any other consumables used in the provision of the prostitute's service.<br />
<br />
<strong>Is there a point to all this?</strong><br />
<br />
The point I am making is that economic statistics are important and their estimation is hard enough. When multiple assumptions are then mixed in, and the size of the underlying segment changed is large relative to the whole, the value of the resulting number has to be questioned - especially when making comparisons with previous measures of the same. Unfortunately, many economic series including jobs, inflation and GDP are now all suspect.<br />
<br />
Happy July 4th<br />
<br />
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Bretthttp://www.blogger.com/profile/11094579354565486061noreply@blogger.com0tag:blogger.com,1999:blog-5803518473270155434.post-27191842479366944782014-05-04T16:41:00.000-07:002014-06-28T15:36:38.162-07:00Not So Random Thoughts<i>It has been a busy few months, not that the volume of postings to this blog (zero) is indicative. However, in the next few weeks, I will be able to share news regarding a new venture about which I am very excited and shortly thereafter release a white paper that I hope will cause many readers to reconsider the way they view the typical investment opportunity set. But, until then, a lot has transpired in the global economy and I wanted to share with you some of what I think to be the most interesting and significant insights out there today.</i><br />
<i><br /></i>
<span style="font-family: inherit;"><i><br /></i>
THE RISK TRADE IS ON. BUT FOR HOW LONG?</span><br />
<span style="font-family: inherit;"><i><br /></i>
Plan sponsors and investors in general have become somewhat frustrated by the returns available from "low risk" investments such as cash and high grade bonds. As a result they have progressively taken on greater amounts of risk in the quest for higher returns. That is all well-and-good, but the question becomes whether and when they may have over reached and set themselves up for potential disappointment.</span><br />
<span style="font-family: inherit;"><br /></span><span style="font-family: inherit;">Consider:</span><br />
<span style="font-family: inherit;"><br /></span>
<br />
<ul>
<li><span style="font-family: inherit;">US Households now hold the largest percentage of their financial assets in risk assets (stocks, corporate bonds and mutual funds) since Q3 2000. At 34.9% of total, holdings in these risk assets is just short of the 60-year high of 38.4% reached in Q1 2000 </span><a href="http://www.thereformedbroker.com/2014/04/29/america-is-all-in" style="font-family: inherit;">(blog)</a><span style="font-family: inherit;">.</span></li>
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<li><span style="font-family: inherit;">Spain, just a couple years ago, seemed on the verge of imploding. This past month the Kingdom of Spain was able to issue notes that traded BELOW those of the US Government. Two years ago, they paid more than 7 percentage points more than Uncle Sam </span><a href="http://www.bloomberg.com/news/2014-04-04/spain-s-five-year-yield-drops-below-america-s.html" style="font-family: inherit;">(article)</a><span style="font-family: inherit;">. Even Greece has been able to issue bonds at a yield of 5% in spite of the fact that their finances (Debt/GDP) and employment situation are in worse shape than when the crisis began </span><a href="http://larrylarry1.wordpress.com/2014/04/12/beware-of-greeks-bearing-debts-2/" style="font-family: inherit;">(blog)</a><span style="font-family: inherit;">.</span></li>
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<li><span style="font-family: inherit;">And even the riskiest markets are becoming more expensive. Last year we saw investors gobble up offerings from Nigeria, Ghana, Mozambique and Zambia. The interest rate spread on Eurobonds issued by such frontier markets has fallen to below 400 basis points versus US Treasuries while the gap between JP Morgan's Emerging Market Bond Index and Frontier bond markets narrowed to a record 68 basis points this past month </span><a href="http://www.economist.com/news/finance-and-economics/21600132-money-leaving-emerging-markets-riskier-bets-investment-frontier-wedge" style="font-family: inherit;">(article)</a><span style="font-family: inherit;">. </span></li>
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<span style="font-family: inherit;">Issuers have flooded the markets:</span></div>
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<span style="font-family: inherit;">And "safe" assets have been shunned:</span></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiRXKrxtfJSot0-lO38gYsOAqbFLPf7cbmV2Zu4Wr-oPBkTxfVXzN5_1iWdi2WA8KQrqc09YnNBRX8g7vqjlwQ2c-YtkP6N_64UAtzibbuuLNZEMoE9-1xICP9mb1ulOV7n5Sa7jTspV14/s1600/ust.png" imageanchor="1" style="clear: left; display: inline !important; margin-bottom: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiRXKrxtfJSot0-lO38gYsOAqbFLPf7cbmV2Zu4Wr-oPBkTxfVXzN5_1iWdi2WA8KQrqc09YnNBRX8g7vqjlwQ2c-YtkP6N_64UAtzibbuuLNZEMoE9-1xICP9mb1ulOV7n5Sa7jTspV14/s1600/ust.png" height="206" width="400" /></span></a></div>
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<span style="font-family: inherit;">Which raises the question of whether we've gone too far. I don't believe we are there yet, but the caution lights are on and a reduction in risk is advised. In a recent speech, Federal Reserve Governor Jeremy Stein cited the work of Harvard professors Robin Greenwood and Samuel Harrison who developed a credit-based early warning measure - simply the ratio of the volume of non-investment to investment grade issuance (rather than the more typical relative price measure, the comparison of spreads). At prior stress points, this ratio reached extreme levels. Though we are not quite there today, we are in the neighborhood</span> <a href="http://www.houseofdebt.org/2014/04/17/are-we-headed-for-a-credit-market-crash.html">(blog)</a>. <span style="font-family: inherit;">. </span></div>
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<span style="font-family: inherit;">STILL, THE SEARCH FOR RETURN CONTINUES</span><br />
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<span style="font-family: inherit;">Traditional asset classes are getting pricey when measured against historical norms, whether we're looking at stock P/E ratios, bond yields or credit spreads. So perhaps it's not surprising that hedge fund assets have reached new record highs as investors seek alternatives. Hedge Fund tracking firm HFR noted that Assets Under Management at hedge funds reached new highs in each of the past seven quarters and that hedge funds now managed in excess of $2.7 trillion <a href="http://blogs.wsj.com/moneybeat/2014/04/21/hedge-fund-assets-hit-new-record-in-first-quarter-again/">(article)</a>. Yet, at the same time, hedge funds as a group posted their worst Q1 results in six years, and over the past 12 months, hedge funds were up just 8.53% compared to the S&P 500, up 19.32%. Since the beginning of 2011, the HRF Equity Hedge Index (long/short funds) has actually lost more than 7% while the S&P is up 59% <a href="http://www.businessweek.com/articles/2014-04-16/hedge-funds-post-worst-first-quarter-results-since-2008">(article)</a>. Defenders of the industry will note that the word "hedge" implies they should lag in an up market because of the downside protection offered when things turn bad. We will see, but investors should be very comfortable with the strategies employed by their managers and understand how they have performed in tough periods in the past, because the testing of the "hedge" may be forthcoming. </span><br />
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<span style="font-family: inherit;"><br /></span>WITH LITTLE HELP FROM EARNINGS<br />
<span style="font-family: inherit;"><br />Over time, earnings drive stock prices - or so we have been led to believe. In the short-run, this isn't necessarily the case as the value one places upon each dollar of earnings (the P/E ratio) can fluctuate based on expectations for the future or on current levels of risk tolerance (see above). However, if earnings growth really is the longer-term fundamental link to equity performance, one might begin to get a little nervous. From the last earnings peak (Q2 2007) through the first quarter of this year, we have seen the second weakest earnings cycle in more than 50 years. Previous cycles have averaged 6.0% compounded annual growth as measured from peak-to-peak. Currently, we are on track for just 2.6% annualized - and though well below the norm in terms of magnitude, in terms of duration, this cycle is just about average.</span><br />
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<span style="font-family: inherit;"><br /></span><span style="font-family: inherit;">ROOKIE MISTAKES?</span><br />
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As interest rates hover near record lows, corporate treasurers have been quick to take advantage and lock-in the attractive funding costs. Corporate debt levels have climbed, even as interest costs have fallen. At the same time, the US Government has decided to issue its first-ever floating rate notes (FRN's). Instead of locking in today's low rates, taxpayer interest costs will fluctuate in line with the market. As rates rise, so will interest costs. Should rates fall, costs may go down, though that benefit is limited as we are already close to the zero floor. It seems to be a one-side trade and not one in the taxpayer interest.</span><br />
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Not to be outdone by the Treasury Department, the Federal Reserve has been lengthening the maturity of the Treasuries it holds in its portfolio. The $2.3 trillion portfolio now shows bonds with a maturity of more than 10 years comprising 26% of holdings (versus 18% just four years ago). Maturities of between five and ten years account for 37% of holdings versus 26% as recently as 2010. Short-term notes (91 days to one year) were 23% of holdings prior to 2008. Today they are zero. This means, the Fed has taken on more interest rate risk just as rates trade near historic lows.</span><br />
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<span style="font-family: inherit;">It appears the US Government (and by extension, taxpayers) have taken the opposite side of the bet from Corporate America.</span><br />
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THE DARK SIDE OF QE?<br />
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Supporters of the Federal Reserves' massive quantitative easing programs (aka QE1, 2 and 3), when confronted with the question of why things haven't worked out better, say "it wasn't big enough" - an argument that could be made no matter the size of the program or the outcome.<br />
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If you want to see what big does, however, just look at the Bank of Japan and their impact on the Japanese government bond market. The JGB market is larger in size than even the US Treasury market. In spite of the smaller economy, the BoJ holds nearly the same amount of its own government debt as does the Fed. So what can go wrong? In reality, plenty. The BoJ is, essentially, the Japanese bond market, having pushed all other players to the sideline. For the first time in 13 years, the benchmark 10-year bond went untraded - not one single trade - for more than a day. Overall trading volume is down nearly 70% from the same period last year. When a central bank intervenes in a public market, prices are naturally distorted - in this case pushing yields lower than might be expected. Given the lack of liquidity in the market, traders and investors worry what happens when the big buyer tries to catch his breath. The answer is that yields can spike dramatically in a short period of time, leaving bond investors with large losses <a href="http://www.gulf-times.com/eco.-bus.%20news/256/details/388487/japan-bond-market-liquidity-dries-up-as-boj-holding-crosses-%C2%A5200tn">(article)</a>. Better to sit on the sidelines or go elsewhere seems to be the result.</div>
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<span style="font-family: inherit;"><br /></span>Meanwhile, savers are penalized while debtors reap the benefits of cheap money. As discussed in a previous posting, "Winners and Losers (Nov 17, 2013), while the low interest rate policies have bailed out the banks, boosted the stock market and real estate, those with money on deposit have lost ground to inflation. Richard Barrington, an analyst at Moneyrates.com, estimates that U.S. savers have lost $758 billion since the crisis began due to the erosion of purchasing power from the difference in interest earned and inflation <a href="http://www.marketwatch.com/story/whats-that-fishy-smell-the-fed-corrupt-policies-2014-04-23">(article)</a>. The McKinsey study cited in my earlier posting looked at the cost by estimating what savers could have earned had rates been in a more normal rate state relative to the level of inflation. In either case, the costs are not insignificant.<br />
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<span style="font-family: inherit;">HAVE I PAID MY FAIR SHARE YET?</span><br />
<span style="font-family: inherit;"><br /></span><span style="font-family: inherit;">And how can we let April 15th go by without commenting on taxes? By this year's tax deadline, Americans as a group paid roughly $3 trillion in federal taxes and $1.5 trillion in state taxes, an amount greater than they will spend on the necessities of life - food, clothing and shelter <a href="http://dailycaller.com/2014/04/07/tax-freedom-day-falls-three-days-later-this-year/">(article)</a>. </span></div>
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<span style="font-family: inherit;"><br />And, as the tax take has climbed, wealthier Americans continue to shoulder a larger portion of the federal tax burden. According to the Tax Policy Center, the top 1% of earners, who take home 17% of all income, now pay 29.3% of all taxes <a href="http://online.wsj.com/news/articles/SB10001424052702304117904579499561359467786?mod=WSJ_hp_LEFTWhatsNewsCollection&mg=reno64-wsj">(article)</a>. </span><br />
<span style="font-family: inherit;"><br /></span><span style="font-family: inherit;">Many will argue that this is fair, or that the "rich" should do even more. But just who are these 1% er's? According to a study by Thomas Hirschl of Cornell and Mark R. Rank of Washington University, 12% of the population will find themselves in the top 1 percent of the income distribution for at least one year during their career. 39% of Americans will spend at least a year in the top 5 percent and more than half will spend at least a year in the top 10%. An astounding 73% will spend a year in the top 20 percent of the distribution. So rather than thinking of the top group as a fixed bastion of fat cats who deserve to be flayed annually, perhaps we should remember it is most people who dream the dream and often get pretty close, only to fail to stay there that are supposedly not paying their fair share <a href="http://www.nytimes.com/2014/04/20/opinion/sunday/from-rags-to-riches-to-rags.html?smid=fb-share&_r=2">(article</a>).</span></div>
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<span style="font-family: inherit;">But at least we're not the Europeans (yet). The chart below from the consultancy of Ernst & Young shows the number of days of work it takes for citizens of a given country to pay their respective tax burden:</span></div>
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WHAT TO DO?<br />
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To those readers who agree that the topics raised about are potentially troublesome, the question of what to do next remains paramount. With traditional asset classes historically expensive, economic growth below trend, the unknown consequences of Central Bank interventions yet to be felt and aggressive return hurdles to be met, we all have our work cut out.<br />
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I hope to offer at least one alternative in my coming white paper. Please stay posted.<br />
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Bretthttp://www.blogger.com/profile/11094579354565486061noreply@blogger.com0tag:blogger.com,1999:blog-5803518473270155434.post-47847484646832215972014-02-28T12:15:00.000-08:002014-03-20T11:55:09.678-07:00The Other Olympics<div class="MsoNormal">
<i>What do the United States and the United Kingdom have in common, economically, with Argentina, Pakistan, Uganda, Venezuela, Greece and North Korea? Answer: they have all become less free over the past 20 years.</i></div>
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I am writing this note a bit later in the month than I
normally do and will ascribe the delay to Olympic Fever. Well, perhaps that’s an exaggeration, but I
have to admit that I find something compelling about watching men and women fly
down a hill, unprotected, at speeds greater than I than I am allowed on the
freeway. However, now that the athletic competition
is over, I can turn my attention to the more important global competition, the
Economic Olympics.<o:p></o:p></div>
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Every day of every year, companies and individuals compete
economically. Most are looking to
enhance their own quality of life. Some
do better than others. Some do worse. Some
of the outcome is due to the effort put forth. Some of the outcome is due to the skills of
the competing parties. And some is due
to the environment in which they operate.
It is the last of these that I look at in this month’s post.<o:p></o:p></div>
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About 15 years ago, I first came across the Wall Street
Journal and Heritage Foundation’s annual Index of Economic Freedom and was immediately
hooked. This year’s release marks the 20<sup>th</sup> anniversary of the index. The concept of
Economic Freedom and the construction of the index made intuitive sense to
me. As described by the authors, Economic
Freedom is a condition where individuals are free to work, produce, consume,
and invest in any way they please. It also describes a situation where governments
allow labor, capital and goods to move freely, and where they refrain from the coercion
or constraint of liberty. In measuring
economic freedom, the <i>Index</i> analyzes countries’ commitment to
the rule of law, principles of limited government, regulatory efficiency, and
open markets – what they refer to as the “four pillars”.<o:p></o:p></div>
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Each pillar is comprised of two to three sub-categories
which themselves are comprised of a variety of quantitative and qualitative
measures. The four pillars and the ten
sub-categories are:<o:p></o:p></div>
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of Law</span></a></span><span style="color: #2e74b5; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman"; mso-themecolor: accent1; mso-themeshade: 191;"> </span>(property rights, freedom
from corruption);<o:p></o:p></li>
<li class="MsoNormal" style="background: #F7FCFD; color: #545454; line-height: 15.0pt; mso-list: l0 level1 lfo1; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto; tab-stops: list .5in;"><span style="color: windowtext;"><a href="http://www.heritage.org/index/limited-government"><span style="color: #006898; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman"; text-decoration: none; text-underline: none;">Limited
Government</span></a></span> (fiscal freedom, government spending);<o:p></o:p></li>
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<span style="color: #545454; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman";">Each of the ten economic freedoms within these categories
is graded on a scale of 0 to 100. A country’s overall score is derived by
averaging these ten economic freedoms, with equal weight being given to each (</span><a href="http://www.heritage.org/index/about">http://www.heritage.org/index/about</a><span style="color: #545454; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman";">).<o:p></o:p></span></div>
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<span style="color: #545454; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman";">This year, 186 countries were included in the study and
179 received scores. While the
difference in ranks should not be taken as a precise measure of guaranteed
success (really, what is the difference between a score of 73.2 and 76.1?),
countries can more easily be delineated into one of five broad classifications:
Free (currently 6 countries), Mostly Free (28), Moderately Free (56), Mostly
Unfree (61) and Repressed (27). In
addition to the broad classifications, I have always been interested in how
countries have moved within the rankings.
I would find more comfort starting a business in a country, for example,
that moved from 100 to 60, than in one that fell from 20 to 40.<o:p></o:p></span></div>
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<span style="color: #545454; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman";">This year, only six countries are considered truly
Free. They are (in order) Hong Kong,
Singapore, Australia, Switzerland, New Zealand and Canada. Hong Kong has remained the most free country
since the inception of the study. On the other hand, the United States’ score
has now fallen in each of the past seven years; and while it was ranked as high as
number five just six years ago, it is currently number 12. The country, though, still remains Mostly Free.<o:p></o:p></span></div>
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<span style="color: #545454; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman";">With that in mind, I look to summarize the winners and
losers over the past 20 years. During
this time, the general level of global economic freedom has increased, though
it has not been consistent over time or across countries. In addition, the size of the scored universe
has increased meaning many countries have fallen in the rankings simply because
new countries have entered, even though absolute scores may have
increased. It is also harder to move up in the rankings when you already have a
high freedom score and rank and it is easier to improve when you have a low
rank and score. With all these moving
parts in mind, I have looked at winners and losers in a couple of different
ways. Note that this specific analysis
of the data has not been endorsed by the authors and is mine entirely. I would direct you to their complete study to
see their conclusions. That said, allow
me to present my winners and losers.<o:p></o:p></span></div>
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<b><span style="color: #545454; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman";">The Winners<o:p></o:p></span></b></div>
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<span style="color: #545454; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman";">Only five countries moved up in the rankings during both
the periods 1995 – 2004 and 2004 – 2014.
They are Bulgaria, Canada, Chile, Hungary and Sweden. In all of these
cases, the absolute scores improved in both periods. I consider these countries all Gold Medalists.<o:p></o:p></span></div>
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<span style="color: #545454; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman";">If, instead, I measure winners and rank countries by
percentage improvement in score over the full period (and then eliminate any
whose scores declined in the most recent 10-year period or which are not currently considered
Moderately Free or better) I am left with 21 names – Romania, Albania, Poland,
Bulgaria, Botswana, Hungary, Madagascar, Sweden, Peru, Malta, Ghana, Canada,
Uruguay, Australia, Chile, Jordan, the Slovak Republic, the Philippines, Mexico,
Singapore and Hong Kong. All are
interesting and comprise my Silver and Bronze Medalist lists.<o:p></o:p></span></div>
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<b><span style="color: #545454; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman";">The Losers<o:p></o:p></span></b></div>
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<span style="color: #545454; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman";">A much larger group of countries fell in the rankings
during both periods, though as mentioned earlier, in many cases a fall in the
absolute rank was due to an expansion of the number of countries scored in the
study (up from 101 in 1995 to 155 in 2004 to 178 today). Excluding those whose absolute score today is higher than it was in 1995, we are left with 27 countries who lost ground during both periods (the <b>bolded</b> countries are the larger and more investible). They are Argentina, Belize, Costa Rica, Ecuador, El Salvador,
<b>France</b>, <b>Greece</b>,
Guatemala, Guinea, <b>Italy</b>, Morocco, North Korea, Oman, Pakistan, Panama, Sierra
Leone, Sri Lanka, Swaziland, <b>Thailand</b>, The Bahamas, Tunisia, Uganda,
the Ukraine, the <b>United Kingdom</b>, the
<b>United States</b>, Venezuela and Zimbabwe. <o:p></o:p></span></div>
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<span style="color: #545454; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman";">A smaller list of eight countries saw raw scores decline in both periods. They were Argentina, Ecuador, Greece, Guinea, Panama, Venezuela and Thailand. Of these, only Thailand and Panama remain in the Mostly Free category. These are consistently bad players.</span></div>
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<span style="color: #545454; line-height: 15pt;">The countries whose score declined by the greatest
percentage (and by at least 10%) over the past ten years include North Korea, Bolivia, Venezuela, the Central African Republic, Argentina, Turkmenistan, Equatorial Guinea, Cuba, Chad, Mauritania, Algeria, Trinidad and Tobago, Ecuador and Belize – on nobody’s list of economic paragons and,
for the most part, not investible countries.</span><span style="color: #545454; line-height: 15pt;"> </span></div>
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<span style="color: #545454; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman";">Of the larger and more liquid countries, deterioration in
Freedom scores of at least 5% over the past ten years were seen in Brazil,
the Ukraine, South Africa, Greece, Ireland, Italy and Egypt. Of these seven countries, only Ireland (solidly)
and Italy (though just barely) remain in the Mostly Free category. This should be disconcerting to those looking
to start businesses or those who have large operations in these countries.<o:p></o:p></span></div>
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<span style="color: #545454; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman";">Economic Freedom scores are not, by themselves, an investment
strategy. Instead, they can be used as a risk measure and as a caution for companies with large investments in the less free regions. Also they should serve as
a wake up call for policy makers not in the Free or Mostly Free categories, or in those countries not moving up quickly from the lower ranks.<o:p></o:p></span></div>
Bretthttp://www.blogger.com/profile/11094579354565486061noreply@blogger.com0tag:blogger.com,1999:blog-5803518473270155434.post-45969613101564648402014-01-26T14:16:00.002-08:002014-06-28T19:08:00.929-07:00I Dream of Gini<div class="MsoNormal">
<i>Some who talk about inequality would like you to think they are talking about the plight of the poor. In fact, the inequality gap tells you nothing about the life of those at the bottom of the income distribution. Not understanding this can lead to dangerous policies which hurt the entire society, and perhaps the poor the most. </i><br />
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In just the past few weeks, a ground swell of discussion regarding income inequality and its inherent evils has been heard. The leader of the world's largest economy, US President Barrack Obama, as well as the moral leader of 1.2 billion Catholics, Pope Francis, have led the charge. </div>
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Very quickly, US Media outlets picked up on the theme, praising
both men whilst deploring the inequality problem. Expect increasing chatter on this topic later
in the month after the President delivers his State of the Union Address.<o:p></o:p></div>
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Before we get too far along, however, let me beg you to hold
your applause. What these gentlemen did (intentionally
or not) was to equate income inequality with the plight of the
unfortunate. In fact, the two are not
related and not understanding this will lead to the adoption of precisely the
wrong economic policies. Allow me
to explain.<o:p></o:p></div>
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Just because the income gap between two people or groups is
large or has grown, really tells us nothing about whether the gap is inherently
good or bad or about the fate of each group.
Take the two person world of Oprah Winfrey (the highest paid celebrity of 2013) and Brett Gallagher. The income gap is incomprehensible, I can assure you. In a case like this one, any policy that focuses on a meaningful redistribution of wealth away from Ms. Winfrey would reduce both our incentives to work - a sub-optimal result for any society. A slightly larger hypothetical might be the distribution of income at a successful hedge or private equity fund where the top partners walk away with a lion's share of the income, but where everyone does pretty well. <br />
<b><i><br /></i></b>
<b><i>What some who talk about inequality want you to think is they are addressing
the plight of the poorest</i></b>. As
the preceding hypotheticals show, <b><i>the inequality gap itself tells you nothing
about the life of those at the bottom of the distribution</i></b>. Any policy that focuses directly on reducing the gap, rather than growing the pie is likely to produce perverse results.<o:p></o:p></div>
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<b>Measuring Inequality</b><br />
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Before we can discuss inequality, we must measure it – a problem in and of itself. The most commonly cited measure is the Gini Coefficient (sounds like "Jeanie").
The GC for any economy ranges from 0 (a perfectly equal distribution of income where the bottom 5% of the population make 5% of the income, the bottom 20% make 20%, and so on) to 1 (one person makes all the money). Many pundits use results drawn from the
GC to support redistribution conclusions – and they are wrong to do so. Again, not only is inequality not an issue, but I would also guess the majority of its adopters also don’t
understand the limitations of the Gini.<br />
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The mathematical formula for the calculation of this number
is complex and would make little intuitive sense to most of us. However, the concept itself is relatively easy to grasp. Perfect equality, or a Gini equal to 0, is
represented in the graph below by the straight line drawn at a 45 degree
angle (where 5% of the people earn 5% of the income, etc). In no society have we ever seen such a
distribution. Typically, the
more realistic distribution is represented by a saucer-shaped line, drawn
with an increasing slope, called the Lorenz Curve, below.
Such a depiction measures a situation where the lowest earners earn less
a share of the income than their share of the population and the highest
earners earn a greater share of the income than their representation in the
economy. The Gini Coefficient is the
ratio of the area between the two lines (shaded Grey) and the total income (the sum of the Grey and Blue areas). The greater the inequality, the bigger the Gini Coefficient.</div>
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While this calculation may be a convenient way of capturing
in one number the distribution of income in an economy, it does have numerous
shortfalls that do not lend themselves to support many of the conclusions pundits have drawn.</div>
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First and foremost, the most oft cited measures of the GC do not take
taxation into account. Nor do they
consider transfer payments received by the poorest. When such figures are included, the
differences in spending power within a given economy decreases universally.<o:p></o:p></div>
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Secondly, there are situations where a GC can rise (a
supposedly a less equal income distribution), but where the ratio of incomes
between the lowest and highest wage earners actually narrows. What causes the GC to decline in such cases
has more to do with the way income is spread amongst the middle portion of wage
earners than just the spread between the highest and lowest.<o:p></o:p></div>
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<table class="wikitable" style="background-color: #f9f9f9; border-collapse: collapse; border: 1px solid rgb(170, 170, 170); color: black; font-family: sans-serif; font-size: 13px; line-height: 19.200000762939453px; margin: 1em 1em 1em 0px;"><caption style="font-weight: bold;">Different income distributions<br />with the same Gini Index</caption><tbody>
<tr><th style="background-color: #f2f2f2; border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">Household<br />
Group</th><th style="background-color: #f2f2f2; border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">Country A<br />
Annual<br />
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Annual<br />
Income ($)</th></tr>
<tr><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">1</td><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">20,000</td><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">9,000</td></tr>
<tr><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">2</td><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">30,000</td><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">40,000</td></tr>
<tr><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">3</td><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">40,000</td><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">48,000</td></tr>
<tr><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">4</td><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">50,000</td><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">48,000</td></tr>
<tr><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">5</td><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">60,000</td><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">55,000</td></tr>
<tr><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">Total Income</td><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">$200,000</td><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;">$200,000</td></tr>
<tr><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em;">Gini</td><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;"><b>0.2</b></td><td style="border: 1px solid rgb(170, 170, 170); padding: 0.2em; text-align: center;"><b>0.2</b></td></tr>
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Also, we can also look to the real-world example of China,
where over the past two decades, between 400 and 600 million have been moved out
of poverty (depending upon who you believe), yet where the GC has steadily increased. In this case, the rising “inequality” of income
has in-arguably been a very good thing. Conversely, one might note in the preceding graphs for Greece and the US, "inequality" decreased during the recent economic troubles, yet few would argue that the poor were better off.<o:p></o:p></div>
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We can also show a homegrown example from the United
States (1979 through 2010) where the GC rose from 0.40 to 0.47 (i.e. incomes became less
“equal”), but where the lowest wage earners actually saw their incomes
increase, even after adjusting for the drag of inflation. In fact, those earning more than $100,000 (measured in 2010 dollars) rose from 11.5% of the population to 20.5% while those earning less than $35,000 fell from 38.6% of the population to 36.6% (those earning less than $15,000 fell from 14.6% to 13.1%). In other words the US poor are better off than
they were 30 years previously, even as the gap between them and the “rich” grew. Unless envy is one’s true concern, anything which
allows you to increase your quality of life should be viewed as a good thing –
even if your neighbor’s quality of life improved more.<o:p></o:p><br />
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The following chart shows the progression of incomes in the United States, by quartile, over this time period. Note, that these figures are pre-tax and pre-transfers, so the gap in disposable incomes is not as great as first appears. What it does show, however, is that income growth for the poorest 50% of Americans has been anemic and that, not the gap, is the issue that must be addressed.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhy0xIC6-gGrFbXQTyf_tbJ_bqzvOviEd_i9CKUWZasIXH5XAS8W5WaDd5QEfufaI4PduUI48PePo3Mt6lZd611s9ey6q9_vWUTkXKczCkHHMtPmE84u7eVGEgOEm8DPOhIhLyh5LHa6uU/s1600/income+dist.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhy0xIC6-gGrFbXQTyf_tbJ_bqzvOviEd_i9CKUWZasIXH5XAS8W5WaDd5QEfufaI4PduUI48PePo3Mt6lZd611s9ey6q9_vWUTkXKczCkHHMtPmE84u7eVGEgOEm8DPOhIhLyh5LHa6uU/s1600/income+dist.png" height="206" width="400" /></a></div>
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While I acknowledge that a dramatic difference between the “haves”
and “have nots” can create stress within a society, I would also argue that it
would be naïve for the government to proffer policies to address the “gap”
itself, rather than trying to pursue policies that increase economic growth which
lift all its citizens to a better life style.
Most would agree that we are not really better off as a society if we
all have less. So, when a political figure or media pundit calls for
reducing inequality, an informed person should consider three things:</div>
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<li><span style="font-size: 7pt; text-indent: -0.25in;"> </span><span style="text-indent: -0.25in;">Are they really talking about the plight of the poor or are they just upset by the gap?</span></li>
<li><span style="font-size: 7pt; text-indent: -0.25in;"> </span><span style="text-indent: -0.25in;">How do they measure the inequality they are talking
about?</span><span style="text-indent: -0.25in;"> </span><span style="text-indent: -0.25in;">Are they literally measuring the
difference between one sizeable segment of the population and another or are
they looking at 500 CEO’s and comparing their income to that of the average worker
(and then offering prescriptions that reach well beyond these “Fortunate 500”)?</span></li>
<li><span style="font-size: 7pt; text-indent: -0.25in;"> </span><span style="text-indent: -0.25in;">Do the policies they put forth directly address
the plight of the poor, or are they simply redistribution efforts which are
unlikely to increase the economy’s overall wealth?</span></li>
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I am deeply worried that policies proposed in the name of helping
the poor climb up the economic ladder (i.e. a sharp rise in the minimum wage - see Bill Gates comments <a href="http://www.cnsnews.com/news/article/susan-jones/bill-gates-raising-minimum-wage-does-cause-job-destruction"><b>here</b></a>), will in reality result in anti-growth
policies that will hurt us all. An
honest debate about the plight of the poorest among us, does not seem to be in the cards.<o:p></o:p></div>
Bretthttp://www.blogger.com/profile/11094579354565486061noreply@blogger.com1tag:blogger.com,1999:blog-5803518473270155434.post-74181049108904528372013-12-16T14:21:00.000-08:002013-12-17T12:21:30.376-08:00'Tis the Season(ality)As we embark upon the holiday season, I wanted to take a moment to update a data set which relates to the seasonal performance of the S&P 500 industry groups. The history runs monthly from January 1990 through November 2013 - nearly 24 years and 23 industry groupings. <br />
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While using seasonal tendencies alone is not a robust investment strategy, it does add an interesting aspect to to the discussion. I believe such analysis has the most relevancy when combined with relative valuation work (i.e. an industry group entering a seasonally strong/weak period is more likely to show its tendency if also supported by relative under/over valuation measures). <br />
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I also believe that many analysts make an easy mistake when discussing seasonality by choosing to comment on <i><b>average</b></i> relative performance. The danger of using an average is that one or two very strong, or very weak observations can skew the general tendency. For example, although the average relative performance in April of the Autos & Components sector is 4.91% better than that of the index (one of the strongest monthly outcomes), it has only outperformed in 13 of the 24 Aprils - just one observation away from a coin toss. <br />
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Therefore, to help overcome the tendency of averages to skew results, I prefer to rely on median performances and the absolute number of periods in which a sector has done better than the market. Below I display the monthly median relative performance (blue) followed by the number of months in which the Auto & Components sector outperformed (yellow) the S&P 500. There is very little seasonal tendency in this sector, save some weakness in May.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEieMEROfg69lG5tjFpFsCGeFCj-IYRrGCKNu5NOKwh6BWdlLCiGA_zxHChNjaw4vMFKAza1ngdEKtNcELnr1FNwCZs_k_9cpAYlv-mlfZVEW3zfq25ZiBWptYW8A1iaNwHztv86PjOGC2Y/s1600/Auto+2.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="206" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEieMEROfg69lG5tjFpFsCGeFCj-IYRrGCKNu5NOKwh6BWdlLCiGA_zxHChNjaw4vMFKAza1ngdEKtNcELnr1FNwCZs_k_9cpAYlv-mlfZVEW3zfq25ZiBWptYW8A1iaNwHztv86PjOGC2Y/s400/Auto+2.png" width="400" /></a></div>
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After examining 276 industry months (23 industries across 12 months), only 14 industries show performance consistency of 75% or greater in a given month. In five of these instances we find industries which have outperformed, and another nine which have underperformed similarly.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhnq13JfKm3lJZi9pqrmeGNpBKmialYtRJs3QU2DAAzx4uJGZ_T_atjlmiNrpen-v-0eXYi0lhZBJSIDkv-GYleEUTk8nLsddg5tb9eoriOX98eVUILqF_DdXmO2Ol5nEJKEoX4B9xgTow/s1600/Seasonality.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="206" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhnq13JfKm3lJZi9pqrmeGNpBKmialYtRJs3QU2DAAzx4uJGZ_T_atjlmiNrpen-v-0eXYi0lhZBJSIDkv-GYleEUTk8nLsddg5tb9eoriOX98eVUILqF_DdXmO2Ol5nEJKEoX4B9xgTow/s400/Seasonality.png" width="400" /></a></div>
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The most seasonal sector would appear to be Capital Goods which appears three times (consistently strong in November and December and consistently weak in October). The strongest seasonals though, would appear to be Software & Services in June (outperform 75% of the time, by a median of 2.19%) and Transportation in October (75% and 2.34%). The weakest seasonal would be Food & Staples Retailers which tend to underperform in April 75% of the time by a median of 2.17%.<br />
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Seasonality is just a beginning and not an investment strategy in and of itself. For those who would like to see the complete data file and graph set to combine with their own valuation work, please drop me an email and I will be happy to provide the full results.<br />
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Best Wishes to all for a Very Merry Christmas and a Happy New Year.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjjrYtBdLFhYq-McOtgJLiQ8zblw-rfCaEoJLgaOCu7EzhxDNX1tPgU-O2BYenkLpSzOE2uO8ciW-IPxAemquJHA6qQMGli4KhEOeLPxUjOqm09Pjeur8aP2_kqP3Dj1EMf_EpcRZVKZn8/s1600/christmas-1386607701hIP.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="263" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjjrYtBdLFhYq-McOtgJLiQ8zblw-rfCaEoJLgaOCu7EzhxDNX1tPgU-O2BYenkLpSzOE2uO8ciW-IPxAemquJHA6qQMGli4KhEOeLPxUjOqm09Pjeur8aP2_kqP3Dj1EMf_EpcRZVKZn8/s400/christmas-1386607701hIP.jpg" width="400" /></a></div>
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<br />Bretthttp://www.blogger.com/profile/11094579354565486061noreply@blogger.com0tag:blogger.com,1999:blog-5803518473270155434.post-86447587561229343112013-11-17T16:43:00.000-08:002013-11-23T09:18:01.592-08:00Winners and Losers<div class="separator" style="clear: both; text-align: justify;">
<i style="text-align: left;"><span style="font-family: inherit;">Consumers have not made the necessary adjustments to again become the motor of economic growth in the United States. While progress in debt reduction has been seen in certain areas, well-intentioned, but mis-guided policies have created problems in others. Overall, the consumer is only marginally stronger than they were in the midst of the crisis.</span></i></div>
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<i><span style="font-family: inherit;">Jobs and Income growth will be key to any consumer revival, but to date have been substandard, while the will to work seems to have eroded. Without stronger jobs and income growth, we can not have consumption growth. Unfortunately, incomes have been in a secular decline for more than a half-century, though the accumulation of debt during this period has hidden the direct link between incomes and consumption. The days of debt-driven consumption are over and greater leverage and an easy monetary policy are not a salvation for Main Street.</span></i></div>
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<i><span style="font-family: inherit;">In addition to the poor numbers, the quality of jobs added in this expansion has been substandard, and heavily reliant on part-timers. This too, has depressed incomes. It would seem regulation had a hand in this as well as in the difficulty that start-ups, the usual driver of jobs, are having.</span></i></div>
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<i><span style="font-family: inherit;">There have been winners - namely those with the where-with-all to take advantage of the Federal Reserve's Quantitative Easing (QE) policies - borrowers, stock market investors and banks head the list. US non-financial corporations have responded naturally to the incentives put before them, but could be in danger should they not be careful as the quality of debt seems to be in decline as its quantity increases.</span></i></div>
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<span style="font-family: inherit;">The topics I will touch upon this month - debt, income, jobs and consumption are all complex and inter-related. Any one of them could be its own post; the four together could easily become a 100+ page white paper. However, not wishing to subject anyone to that kind of mess, especially before the holidays, I will be a bit more brief on detail than usual - though I will link to the larger studies should one wish to jump in with both feet.</span></div>
<span style="font-family: inherit;"><br /></span><span style="font-family: inherit;"><b><br /></b></span><br />
<span style="font-family: inherit;"><b>Where to Begin - The Consumer</b></span><br />
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">In most countries, the consumer is the largest single economic entity in the economy with spending accounting for somewhere between 50% and 70% of annual GDP. Canada and the US are at the upper end of that range, while China is an outlier at the bottom end. Thus any discussion around the prospects for economic growth must start with, and focus on, households, their behavior and their potential.</span><br />
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<span style="font-family: inherit;"><b>Consumption as Percent of GDP</b></span><br />
<span style="font-family: inherit;">Canada 70.2%</span><br />
<span style="font-family: inherit;">United States 68.6%</span><br />
<span style="font-family: inherit;">Hong Kong 65.0%</span><br />
<span style="font-family: inherit;">Japan 60.9%</span><br />
<span style="font-family: inherit;">India 56.8%</span><br />
<span style="font-family: inherit;">Euro Area 56.3%</span><br />
<span style="font-family: inherit;">Australia 53.9%</span><br />
<span style="font-family: inherit;">China 36.6%</span><br />
<span style="font-family: inherit; font-size: x-small;"><i>Sources: Federal Reserve Board, Bureau of Economic Analysis, Statistics Canada, Asia Development Bank, Eurostat </i> </span><br />
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<span style="font-family: inherit;">The US Government's policy response (and that of many other developed countries) has been to attempt to re-kindle the moribund shopper, so far to little avail. Policies from "Cash for Clunkers", to HARP to an unprecedented entry by the Federal Reserve into the market for Treasury and Mortgage securities have attempted this, albeit through various channels. However, for those who took more than one or two introductory Economics classes, the weaker than normal economic response should not have caught them by surprise, yet that is what it seems to have done to policy makers - even as a handful of market commentators shouted caution.</span><br />
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<li><i style="font-family: inherit;"><span style="background-color: white; line-height: 1.4em;">"when an economy is excessively over-indebted and dis-inflationary factors force central banks to cut overnight interest rates to as close to zero as possible, central bank policy is powerless to further move inflation or growth metrics. The periods between 1927 and 1939 in the U.S. (and elsewhere), and from 1989 to the present in Japan, are clear examples of the impotence of central bank policy actions during periods of over-indebtedness" - Lacy H. Hunt, Ph.D. (</span></i><a href="http://www.caseyresearch.com/articles/federal-reserve-policy-failures-are-mounting" style="background-color: white; font-family: inherit; line-height: 1.4em;">http://www.caseyresearch.com/articles/federal-reserve-policy-failures-are-mounting</a>)<span style="font-family: inherit;"> </span></li>
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<span style="font-family: inherit;">Let's start my analysis with a simple law of gravity - and it's not "what goes up must come down". Rather, it is an economic law of gravity, namely that "one can only spend over time what they earn over time". Empirically, this is demonstrated in the chart and table below.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhWM5OogYqaSTPvNQJ-yILNlmPS-Kgbda9h99pDTUNcngYk2nNKPYK_8qnhmznn4ih0wZM1KWY94AqZBBGylpeQzfYxpYCta43yfSIur26GG-K3Wq-TWzkiXpRABe5SJBRDYmSrZvKnSYw/s1600/DPI+&+Outlays.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" height="225" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhWM5OogYqaSTPvNQJ-yILNlmPS-Kgbda9h99pDTUNcngYk2nNKPYK_8qnhmznn4ih0wZM1KWY94AqZBBGylpeQzfYxpYCta43yfSIur26GG-K3Wq-TWzkiXpRABe5SJBRDYmSrZvKnSYw/s400/DPI+&+Outlays.png" width="400" /></span></a></div>
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<b>Compound Annual Growth Rates over Various Time Periods to Dec 2012</b><br />
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<span style="font-family: inherit; font-size: x-small;"><b> 5 Years 10 Years 20 Years 30 Years 40 Years 50 Years</b></span><br />
<span style="font-family: inherit; font-size: x-small;"><b>Personal Income 2.8% 4.2% 4.8% 5.5% 6.7% 7.0%</b></span><br />
<span style="font-family: inherit;"><b><span style="font-size: x-small;">Pers Consumption Exp 2.7% 4.2% 5.0% 4.7% 6.9% 7.1%</span></b></span>
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<span style="font-family: inherit; font-size: x-small;">Side Notes: </span><br />
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<li><span style="font-size: x-small;">income growth has been in secular decline for much of the past half-century</span></li>
<li><span style="font-size: x-small;">over longer periods, income and consumption growth are strongly linked</span></li>
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While over longer periods, spending and income are clearly linked, they can diverge over shorter time frames. Comparing nominal levels of spending to income as I do in the following chart, one can see how spending began to grow relatively faster than incomes from the mid 1970's until its reversal over the years 2005 - 2007.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg9b-SEwUkSeRo2ep-KkDsxSoa92WIGYBP3ZtHES1ynbZSPneIj7WKzAZk9QA8rBlysCIVxuhddI7gxl4NMu1J4EphdtmVKNA0V5QHzJrNy8-NJOCqaVDsGBhTjq2fIYLeVQpk6MWHTC3U/s1600/Spend+v+Income.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" height="225" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg9b-SEwUkSeRo2ep-KkDsxSoa92WIGYBP3ZtHES1ynbZSPneIj7WKzAZk9QA8rBlysCIVxuhddI7gxl4NMu1J4EphdtmVKNA0V5QHzJrNy8-NJOCqaVDsGBhTjq2fIYLeVQpk6MWHTC3U/s400/Spend+v+Income.png" width="400" /></span></a></div>
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<span style="font-family: inherit;">These short-term divergences, where one can spend more than they earn, are related to borrowing behavior. Unsurprisingly, the period from 1975 described above, coincided with a build-up in household debt, while the period since 2007 has coincided with a partial rebuilding of consumer balance sheets. This kind of borrowing activity accelerated spending beyond income growth for a period of time, but as borrowed amounts must be repaid at some point in the future (and out of income), it had the effect of stemming current growth -- and this is where policy makers have gotten it wrong by trying to recreate the same dynamic, but from a much more difficult, and unsustainable, starting point.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg3SSEV09JEIRdchwMWtC___VsNay_HyZSshgpLzoy6f1FVnP5ylEWoBVzRjrdwdDG59G9VcDGQyc6WAVSkC_167j7CoLd0PwMeJLyfSBCTpUZC2DjAl2OiBB9QExWXunBHfLgeif-7i0o/s1600/Household+Debt+%25+Income.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" height="225" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg3SSEV09JEIRdchwMWtC___VsNay_HyZSshgpLzoy6f1FVnP5ylEWoBVzRjrdwdDG59G9VcDGQyc6WAVSkC_167j7CoLd0PwMeJLyfSBCTpUZC2DjAl2OiBB9QExWXunBHfLgeif-7i0o/s400/Household+Debt+%25+Income.png" width="400" /></span></a></div>
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<span style="font-family: inherit;">Economic and Fiscal policies that attempt to rekindle spending by encouraging an increase in an already large debt pile, were doomed to fail. Consumer debt had risen to record highs in both nominal and relative (to income) terms, fueled mainly by the residential mortgage market. A necessary part of any re-balancing requires consumers to first reduce debt and strengthen their personal balance sheets before they can safely come back to the shopping aisle. Policy makers did not act as if they understood this. The debt adjustment continues as it must, but is being hampered by Government policies which encourage debt accumulation.</span><br />
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<span style="font-family: inherit;">Below, we can see that credit card debt (most of the revolving credit) has indeed corrected (down nearly $200 Billion from its December 2008 peak), as has mortgage debt (down $1.3 Trillion from its January 2008 peak). Unfortunately, this has been partially offset by booms in student loan debt (up more than $550 Billion since December 2008) and auto loan borrowings (up $127 Billion since December 2010). In short, total consumer credit has only partially adjusted, now resting near 2003 (relative to income) or 2005 (in absolute) levels.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgPBoQcgXQm_EJKsAUdSax3rx9M0SZhpIIbsUxDzBgGHoKJgA0Q5Zj9Gg9b6HZStstmBkCviHsH39wdZQr9iCdIlUSAo5KnmRNPaDEAmzjXsTEXN8HDzP3LwmyGtTw-hYyek-BDIIolaCk/s1600/Total+Consumer+Revolving+Debt.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" height="240" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgPBoQcgXQm_EJKsAUdSax3rx9M0SZhpIIbsUxDzBgGHoKJgA0Q5Zj9Gg9b6HZStstmBkCviHsH39wdZQr9iCdIlUSAo5KnmRNPaDEAmzjXsTEXN8HDzP3LwmyGtTw-hYyek-BDIIolaCk/s400/Total+Consumer+Revolving+Debt.png" width="400" /></span></a></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjbcPqQAlLNWbyWOOylmd8h9Ioc_mJxthzpnOtColumFSrgjo45M-9Eo6pYRg3jlpGIWYC93HTeoSaPMtzpMdPAUshk6jjg-B3A9ZR2XwzvCF49Z9_L2NJFvgTeqCzPY_ET1xU55RdAxTw/s1600/Mortgage+Debt.png" imageanchor="1" style="clear: left; display: inline !important; margin-bottom: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" height="240" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjbcPqQAlLNWbyWOOylmd8h9Ioc_mJxthzpnOtColumFSrgjo45M-9Eo6pYRg3jlpGIWYC93HTeoSaPMtzpMdPAUshk6jjg-B3A9ZR2XwzvCF49Z9_L2NJFvgTeqCzPY_ET1xU55RdAxTw/s400/Mortgage+Debt.png" width="400" /></span></a><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhVMDCq-I0UIXzX7eBWiFfKP_QNyM9V6mW5V41FHlqXWhErcBgyAptRJMVUKRuY6aui6Ue1J_rThPgu4_ybWCZZaFr4sPSqEYcplq-6o-WGgyyCIrZxbDzhixQ5-Ula0bfnqh7ZlccgPa0/s1600/Student+Loan+Debt.png" imageanchor="1" style="clear: left; display: inline !important; margin-bottom: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" height="240" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhVMDCq-I0UIXzX7eBWiFfKP_QNyM9V6mW5V41FHlqXWhErcBgyAptRJMVUKRuY6aui6Ue1J_rThPgu4_ybWCZZaFr4sPSqEYcplq-6o-WGgyyCIrZxbDzhixQ5-Ula0bfnqh7ZlccgPa0/s400/Student+Loan+Debt.png" width="400" /></span></a><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg8pzKCDn6nHUsPVhn0whbnt9z5u3C5pgR-lKMVYNkc8S9S_MRqmhVsULernDgexoDu5I9Dvsq_YYu5ABIk1Vrie2AZWOEmgjw9XYH-lYX8bInoXe-rBfN7kRM5wCTJItDow-8AlTtK6qo/s1600/Total+Household+Debt.png" imageanchor="1" style="clear: left; display: inline !important; margin-bottom: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" height="225" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg8pzKCDn6nHUsPVhn0whbnt9z5u3C5pgR-lKMVYNkc8S9S_MRqmhVsULernDgexoDu5I9Dvsq_YYu5ABIk1Vrie2AZWOEmgjw9XYH-lYX8bInoXe-rBfN7kRM5wCTJItDow-8AlTtK6qo/s400/Total+Household+Debt.png" width="400" /></span></a><br />
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<span style="font-family: inherit;">The best way to speed the adjustment would have been to focus on policies that could accelerate repayment - and the best way to do that would have been to spur jobs and income growth. While much lip service has been paid to these goals, the record is, unfortunately, dismal. </span><br />
<span style="font-family: inherit;"><br /></span><span style="font-family: inherit;"> Let's look at a few facts relating to job creation over the past few years:</span><br />
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<li><span style="font-family: inherit;">The percentage of the US population that works has fallen dramatically. A record 91.5 million Americans are now "not in the labor force" - <i>Bureau of Labor Statistics</i></span></li>
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<li><span style="font-family: inherit;">Of those "not in the labor force", a record number indicate that they have no interest in finding a job, even if one were offered -<span style="background-color: white;"> </span><span style="background-color: white;">As a share of all
those “not in the labor force,” the number of people who want a job has been
generally declining since the early 1980's. Three decades ago, more than 10%
wanted a job; more recently, that number dipped below 6% <i>- </i></span><i style="background-color: white;">Regis Barnichon and Andrew Figura, </i><span style="background-color: white;"><i>" </i></span><i style="background-color: white;"><div style="display: inline !important;">
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<i style="font-family: inherit;"><i>Declining Labor Force Attachment and </i></i></div>
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</i>and Participation" </div>
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<a href="http://research.barcelonagse.eu/tmp/working_papers/728.pdf" style="background-color: transparent;">http://research.barcelonagse.eu/tmp/working_papers/728.pdf</a></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgzFOBoacrg143Nua-krQKpDt59ns-1kpnhrkkyyfpznytHG6FRfZdy73fdoej-apynN5uQofPvAtQANL0wW-qBC3E8TP-WUn6qijNrb0HU66TufiHIs5WsabCKljodO-675n3WvueNfis/s1600/Want+a+Job.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" height="266" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgzFOBoacrg143Nua-krQKpDt59ns-1kpnhrkkyyfpznytHG6FRfZdy73fdoej-apynN5uQofPvAtQANL0wW-qBC3E8TP-WUn6qijNrb0HU66TufiHIs5WsabCKljodO-675n3WvueNfis/s400/Want+a+Job.jpg" width="400" /></span></a></div>
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<li><span style="font-family: inherit;">The labor force participation rate is at an 25 year low - <i>Bureau of Labor Statistics. </i></span></li>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjONuRsghJOJI6uflJ_wAYvAxuNTgEE6Uck_TAptdFZ7MSTW5JHFqyjiZcrOk5m8PDld_3HjaJU89VS0dLayVWOLghvSrgVjBINI4R9H24gHz60xusaSG896SIY6yKNg_NDzpvJOwNFvH0/s1600/Participation.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" height="225" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjONuRsghJOJI6uflJ_wAYvAxuNTgEE6Uck_TAptdFZ7MSTW5JHFqyjiZcrOk5m8PDld_3HjaJU89VS0dLayVWOLghvSrgVjBINI4R9H24gHz60xusaSG896SIY6yKNg_NDzpvJOwNFvH0/s400/Participation.png" width="400" /></span></a></div>
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<li><span style="font-family: inherit;">For younger people, this rate is at a 40-year low as the employment rate of persons aged 21 to 25 has fallen from 84% to 72% since 2000 - <i>Georgetown University Center on Education, "Failure to Launch" </i><a href="http://cew.georgetown.edu/failuretolaunch/">http://cew.georgetown.edu/failuretolaunch/</a></span></li>
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<li><span style="font-family: inherit;">Of the jobs created since "recovery" began, a large number have been part time in nature. The increase this time around though, was much larger than seen in previous recovery periods and remains above previous highs many months later - <i>Bureau of Labor Statistics</i></span></li>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjY6Qf7YvIbGLdLGulamx-RuB34roZkxpAmciZ1rz6_Lfok0Q3Fn6XnPx9TJeSRBhIptpCspyKWnyxhXbUPipa6Tu6O3y4AFhljvFnAgPw9bMmmhyphenhyphenopS4HbM0DmTjyYDKbVKe1EeAVP0k8/s1600/Part+Time.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" height="225" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjY6Qf7YvIbGLdLGulamx-RuB34roZkxpAmciZ1rz6_Lfok0Q3Fn6XnPx9TJeSRBhIptpCspyKWnyxhXbUPipa6Tu6O3y4AFhljvFnAgPw9bMmmhyphenhyphenopS4HbM0DmTjyYDKbVKe1EeAVP0k8/s400/Part+Time.png" width="400" /></span></a></div>
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<li><span style="font-family: inherit;">Young workers are now 30 years old when they first earn a median-wage income, up from 26 years old in 1980 - <i>Georgetown University Center on Education, "Failure to Launch"</i></span></li>
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<li><span style="font-family: inherit;">Start ups (firms 5 years or younger), which have historically accounted for all NET jobs growth, are having difficulties (<i><a href="http://www.economist.com/news/business/21587778-americas-engines-growth-are-misfiring-badly-not-open-business">http://www.economist.com/news/business/21587778-americas-engines-growth-are-misfiring-badly-not-open-business</a>)</i></span></li>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEikAKm6HnbbbWY-WWM9eYA2kBHwnrsuVv2aRLqspFhXkN71v8Mtd7rR-JznOyp84yccMD4nakPWUNB9AlvLwmX4RYJSDRtq1Ji4N6ngYU1VLitlPNC74gEN6yrV_Dy0ME2qvgmy4p_el1A/s1600/Excess+reserves.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-family: inherit;"><br /></span></a></div>
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<li><span style="font-family: inherit;">the average number of jobs created by start ups has fallen from the historical average of 7 to less than 5 today</span></li>
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<li><span style="background-color: white; font-family: inherit;">over the period 2009-11 the Obama
administration issued 106 new regulations each expected to have an economic
impact of at least $100 million a year</span></li>
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<li><span style="background-color: white;"><span style="font-family: inherit;">In 2011—the last
year for which Commerce Department data is available, 35% of firms operating in the U.S. were
five years old or less. That compares with 40% in 2007.</span></span></li>
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<li><span style="background-color: white;"><span style="font-family: inherit;">The Labor Department's establishment birthrate/deathrate, a proxy for the pace of
new-business formations and failures, shows that for the first time (other than a brief moment in 2001), more companies folded, than have been formed.</span></span></li>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhqjqI_agtDHGrbGeK4NEULqDjh-CnGgaPMzMsKjE-qjCJ1-DmE8zOtvYmy8EOMam8NsQE7zdJZhx7LL2gDs9-aZGZLehDneQij8rPGJ52ITsRU8fGOi9B1mzpRDn6B7LQ8wjkqpeZGNGI/s1600/establishment+birth+rate.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="247" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhqjqI_agtDHGrbGeK4NEULqDjh-CnGgaPMzMsKjE-qjCJ1-DmE8zOtvYmy8EOMam8NsQE7zdJZhx7LL2gDs9-aZGZLehDneQij8rPGJ52ITsRU8fGOi9B1mzpRDn6B7LQ8wjkqpeZGNGI/s400/establishment+birth+rate.png" width="400" /></a></div>
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<span style="font-family: inherit;">It would seem clear that US Households, as a group, are not having a good go of it, and, until debt is reduced further, will continue to sputter. So if US Households are not making much progress, has the massive amount of money and time invested by our leaders benefited anyone? </span><br />
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<span style="font-family: inherit;"><b>The Winners </b></span><br />
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Corporations, who's investment comprises about 16% of annual GDP, have seen profits climb to 80+ year highs as a percentage of National Income.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh1S_yPPhc_zFpGsbalAr5HWxQ2aPQUe5y1vi3frni0L-HZvAa8FU-CjMk8z64NGdGjWaE94CCFvJpgdbO8e7nd7ixKdrakdnUiOost3k_fs2OqqKZ5hyphenhyphensdpNOfLuXLynr52LMl5_QWtVE/s1600/corp+profits.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" height="240" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh1S_yPPhc_zFpGsbalAr5HWxQ2aPQUe5y1vi3frni0L-HZvAa8FU-CjMk8z64NGdGjWaE94CCFvJpgdbO8e7nd7ixKdrakdnUiOost3k_fs2OqqKZ5hyphenhyphensdpNOfLuXLynr52LMl5_QWtVE/s400/corp+profits.png" width="400" /></span></a></div>
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They have also rationally responded to the ultra-low interest rates and increased their borrowing. After dipping briefly during the crisis, business debt levels have jumped to record highs since the Fed's QE policy was put in place. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhXL_kZ98Ot67hUfOwgjyXYZiu8OaNvtrtRxp7Syz6dGVaVLNeqlpDIfXml-j-J_sQONGs5AHCBBEpbL5iR33FpRlIlTqLgrrZEpgZCHyzsZBGoIySepzisDTGE7_4OT5EgVQkcQdrdYqU/s1600/Non+Financial+Debt.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" height="225" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhXL_kZ98Ot67hUfOwgjyXYZiu8OaNvtrtRxp7Syz6dGVaVLNeqlpDIfXml-j-J_sQONGs5AHCBBEpbL5iR33FpRlIlTqLgrrZEpgZCHyzsZBGoIySepzisDTGE7_4OT5EgVQkcQdrdYqU/s400/Non+Financial+Debt.png" width="400" /></span></a></div>
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<span style="font-family: inherit;">More recently, however, a larger amount of that borrowing has been done at a lower-quality standard and will need to be watched.</span><br />
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<li style="line-height: 18px;"><span style="font-family: inherit;">Many companies have been able to increase their borrowing from exuberant markets. More than $225 billion of "covenant-lite" loans, or loans that come with fewer protections for lenders, have been sold so far this year, according to S&P Capital IQ. That figure eclipses the $100 billion issued in 2007 and means a majority of new leveraged loans, 55%, are “cov-lite” ht<a href="http://www.ft.com/intl/cms/s/0/f151df3a-3a6f-11e3-9243-00144feab7de.html#axzz2kjbS3Zqz">tp://www.ft.com/intl/cms/s/0/f151df3a-3a6f-11e3-9243-00144feab7de.html#axzz2kjbS3Zqz</a></span></li>
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<li><span style="font-family: inherit;"><span style="line-height: 18px;">Already the amount of indebtedness in leveraged buyouts</span><span style="line-height: 18px;"> is creeping up. </span><span style="line-height: 18px;">The average amount of debt used to finance LBO's has jumped from a low of 3.69 times earnings in 2009 to an average 5.37 so far this year, according to data from S&P Capital IQ. At the height of the LBO boom, the average leverage was 6.05x </span><a href="http://www.ft.com/intl/cms/s/0/f151df3a-3a6f-11e3-9243-00144feab7de.html?siteedition=intl#ixzz2kjeFYnhR" style="line-height: 18px;">http://www.ft.com/intl/cms/s/0/f151df3a-3a6f-11e3-9243-00144feab7de.html?siteedition=intl#ixzz2kjeFYnhR</a></span></li>
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<li><span style="font-family: inherit;"><span style="background-color: white; line-height: 18px;">Like the rest of the leveraged loan market, CLO's have enjoyed buoyant demand</span><span style="background-color: white; line-height: 18px;">. At least $55.41 billion of the vehicles have been sold this year – the highest amount since the $88.94 billion issued in 2007. </span><a href="http://www.ft.com/intl/cms/s/0/f151df3a-3a6f-11e3-9243-00144feab7de.html?siteedition=intl#ixzz2kjeFYnhR" style="line-height: 18px;">http://www.ft.com/intl/cms/s/0/f151df3a-3a6f-11e3-9243-00144feab7de.html?siteedition=intl#ixzz2kjeFYnhR</a></span></li>
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<li><span style="font-family: inherit;">IPO growth has re-accelerated to near previous peaks <a href="http://online.wsj.com/news/articles/SB10001424052702303843104579174282457849984?mod=WSJ_hps_LEFTTopStories" style="line-height: 18px;">http://online.wsj.com/news/articles/SB10001424052702303843104579174282457849984?mod=WSJ_hps_LEFTTopStories</a></span></li>
</ul>
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<span style="font-family: inherit;"><br />Most importantly, however, little of the record borrowing has flowed into new investment (and thereby GDP). On a nominal basis, corporate investment has only recently recovered to previous peaks and as a percent of GDP remains near historical lows - even though overall debt levels are at a record.</span></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjKo5jNtiPvor_rjNqjWsAf62CjsuQ-sKe3Zy4Nret4fdWS4yC8FphhZ7_nHd6bt5TVZRQZgmdwhdohL_d9Qorx171EtynWcdtnqe21_ALCipQ8UVt4Ww6KbX_r1CnCktT1jcVJUqDl748/s1600/GPDI+%25.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" height="225" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjKo5jNtiPvor_rjNqjWsAf62CjsuQ-sKe3Zy4Nret4fdWS4yC8FphhZ7_nHd6bt5TVZRQZgmdwhdohL_d9Qorx171EtynWcdtnqe21_ALCipQ8UVt4Ww6KbX_r1CnCktT1jcVJUqDl748/s400/GPDI+%25.png" width="400" /></span></a></div>
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<span style="font-family: inherit;">Instead, much of the borrowing has been used to financially craft earnings growth via buybacks and suppressed interest expenses (see my previous post, "The Profitability Illusion") - and while this may have been great for shareholders, it has not been a positive for the economy.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiYoiZ4D5XrrxY47SSL1JTWhX-AKRH2r6xrCjd4Ps3fyQKkCC58MfqXKg0yO400FAWlYmaXwhTL50diV0Zs2iqGySo9w1Hti-gK0CiWZo7wk8Ib5xeJPXK2EPT2c3BxoLCFMjvlMwaSLv8/s1600/Corp+Investment.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" height="387" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiYoiZ4D5XrrxY47SSL1JTWhX-AKRH2r6xrCjd4Ps3fyQKkCC58MfqXKg0yO400FAWlYmaXwhTL50diV0Zs2iqGySo9w1Hti-gK0CiWZo7wk8Ib5xeJPXK2EPT2c3BxoLCFMjvlMwaSLv8/s400/Corp+Investment.png" width="400" /></span></a></div>
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<a href="http://www.economist.com/news/finance-and-economics/21587213-new-book-explains-why-business-investment-has-been-low-profits-prophet"><span style="font-family: inherit;">http://www.economist.com/news/finance-and-economics/21587213-n<span style="font-family: inherit;">ew-book-explains-why-business-investment-has-been-low-profits-prophet</span></span></a><br />
<span style="font-family: inherit;"><br /></span>
<span style="background-color: white;"><span style="font-family: inherit;">In fact, companies which
heavily repurchase their own shares have seen their stock prices outperform the
overall market over both short and long time frames, according to Andrew Wilkinson, the Chief Economic strategist at Miller Tabak &
Co. The S&P 500 Buyback Index, which measures <span style="background-position: initial initial; background-repeat: initial initial;">the 100 stocks with the highest
buyback ratios, has surged 40% this year, compared with a 24% rally for the
S&P 500</span></span></span><br />
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<span style="font-family: inherit;">The Government is the third player in the market and has stepped up in a big way, both in its fiscal and monetary policy response. Trillion dollar deficits were incurred. Yet, because this borrowing has not visibly flowed into the real economy, consumers have not been able to take advantage to sufficiently clean up their balance sheets. Instead, the financial markets have benefited, as has a small group of favored industries -- notably automobiles and banking. Some other favored players (clean energy, et</span><span style="font-family: inherit;">c) have received subsidies or grants, but also failed to produce jobs.</span><br />
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">Many policies, about which I won't debate the merits or intentions, have also failed to stimulate activity on Main Street. Lets take a look at some of the unintended consequences of these actions.</span><br />
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">The Federal Reserves QE program, which today purchases $85 billion in fixed income securities each month creates reserves which banks have left on deposit with the Fed. The Wall Street Journal notes that of the $2.365 trillion in reserves at the Fed, only $59 billion are required to be held there. The remainder of roughly $2.3 trillion, called "excess reserves" receive a payment of 25 basis points annually. While this may not seem like much, it represents a transfer from the Fed to Banks of $5.75 billion each year. Since the Fed is required to remit profits to the US Treasury every year, this reduction in Treasury profits could be construed as a "back-door" transfer from tax payers to the nation's banks. <a href="http://online.wsj.com/news/articles/SB10001424052702304069604579153290395722608?mod=WSJ_Opinion_MIDDLETopOpinion">http://online.wsj.com/news/articles/SB10001424052702304069604579153290395722608?mod=WSJ_Opinion_MIDDLETopOpinion</a></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEikAKm6HnbbbWY-WWM9eYA2kBHwnrsuVv2aRLqspFhXkN71v8Mtd7rR-JznOyp84yccMD4nakPWUNB9AlvLwmX4RYJSDRtq1Ji4N6ngYU1VLitlPNC74gEN6yrV_Dy0ME2qvgmy4p_el1A/s1600/Excess+reserves.png" imageanchor="1" style="clear: left; margin-bottom: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" height="240" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEikAKm6HnbbbWY-WWM9eYA2kBHwnrsuVv2aRLqspFhXkN71v8Mtd7rR-JznOyp84yccMD4nakPWUNB9AlvLwmX4RYJSDRtq1Ji4N6ngYU1VLitlPNC74gEN6yrV_Dy0ME2qvgmy4p_el1A/s400/Excess+reserves.png" width="400" /></span></a><br />
<span style="font-family: inherit;"><br /></span><span style="background-color: white;"><span style="font-family: inherit;">In addition, one could say that borrowers were also net winners as they have been able to issue debt at below unfettered rates, while savers have foregone interest income. A McKinsey Global Institutes study <span style="font-family: inherit;">attempted to quantify this effect and found that Government
borrowers were the biggest winners, with the US, UK and Euro Zone governments saving $1.6 trillion due to below normal interest rates. Non-financial
companies also fared well, saving $710 billion in debt service payments. The big losers were were households who forgave $630 billion in net interest income in the United States, the euro zone and Britain, as interest rates for savers
plunged. </span></span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhChwZxfNy4GVMuy_ge_vLWOlpuSE3Q49fiGPQUlLrx4sedG-7ZfA2IDq6ChVhTsLZLzZBq41ofb59zjt_7PpFo0WEi6iPQuuFBw-08XfWgTzQ8EctGeku5E1qjEQKossI8LhRUoL0139E/s1600/Interest+Distribution.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="225" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhChwZxfNy4GVMuy_ge_vLWOlpuSE3Q49fiGPQUlLrx4sedG-7ZfA2IDq6ChVhTsLZLzZBq41ofb59zjt_7PpFo0WEi6iPQuuFBw-08XfWgTzQ8EctGeku5E1qjEQKossI8LhRUoL0139E/s400/Interest+Distribution.png" width="400" /></a></div>
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<span style="background-color: white;"><span style="font-family: inherit;"><span style="font-size: 11pt;">(</span></span></span><a href="http://www.mckinsey.com/Insights/Economic_Studies/QE_and_ultra_low_interest_rates_Distributional_effects_and_risks">http://www.mckinsey.com/Insights/Economic_Studies/QE_and_ultra_low_interest_rates_Distributional_effects_and_risks</a><span style="font-size: 15px;">)</span><br />
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<span style="font-family: inherit;">Another winner of recent policies have been those most involved in the stock market. As Bianco Research shows quite clearly in the chart below, when QE policies were in place, the stock market tended to do well. On days when we were in between QE events, the markets declined. This is a very large sample size and the results seem to speak for themselves - if you had money to invest in the stock market, you did well. If you didn't and were dependent upon wage or interest income, you struggled. Or as Michael Cembalest, Chairman of Market and Investment
Strategy for J.P. Morgan Asset Management noted, all of the gains in the S&P 500 since January 2009 have come in weeks during which the Fed actively bought securities. In the weeks during which the Fed did not act, the markets declined. </span><br />
(<a href="http://www.forbes.com/sites/robertlenzner/2013/10/17/dont-fight-the-fed-because-100-of-stock-market-gains-since-2009-occurred-in-the-weeks-the-fed-was-buying-bonds/" style="font-family: inherit;">http://www.forbes.com/sites/robertlenzner/2013/10/17/dont-fight-the-fed-because-100-of-stock-market-gains-since-2009-occurred-in-the-weeks-the-fed-was-buying-bonds/</a>)<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjwCnMaU9KmMht9QFNb_dWOtbNo_LBUfiYrVWR2BzxfnvbxO9fwvaux6D3LjuKWbzz4RIdGGPRYFL4FT9O6Ht2ow1DY44ukJxNxu9K6AQ6mEtMWa4rO28goAAuLP_DpDROne8cYGBhjyiE/s1600/QE.gif" imageanchor="1" style="clear: left; margin-bottom: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" height="300" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjwCnMaU9KmMht9QFNb_dWOtbNo_LBUfiYrVWR2BzxfnvbxO9fwvaux6D3LjuKWbzz4RIdGGPRYFL4FT9O6Ht2ow1DY44ukJxNxu9K6AQ6mEtMWa4rO28goAAuLP_DpDROne8cYGBhjyiE/s400/QE.gif" width="400" /></span></a><br />
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<span style="font-family: inherit;">Life was even better for those who used leverage, and another area where certain consumers chose to incur debt was in the stock market. Margin debt today sits near record levels (shown below as a percent of total market capitalization) - and we must ask, are we just trading off near-term risk reduction at the expense of building problems down the road? </span>Matt King, a credit strategist at Citigroup commented that "it strikes me that one of the things we're doing is suppressing at-the-money risk and then adding to tail risks". (<span style="line-height: 18px;"><a href="http://www.ft.com/cms/s/0/b92f9434-4c9a-11e3-804b-00144feabdc0.html#ixzz2kjdGLojE" style="-webkit-font-smoothing: antialiased; color: #003399; text-decoration: none;">http://www.ft.com/cms/s/0/b92f9434-4c9a-11e3-804b-00144feabdc0.html#ixzz2kjdGLojE</a>). In plain english, Mr. King is saying that current actions seem to be trying to support markets today, while building up future risks should something go wrong. I fully agree.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiBcy8pKOfZjBLo-_Q96t9641A7n6Pc0tacdH43ISQmNPASUqaNXFc4mXuzasBbxeYd34o6BsACLdZetRt0lnJ7XzDXW3IEw3yJRzFaRvhp3pnwbrazCAR__TQfHk5B-tyeT1_iE3dr3zE/s1600/Margin+Debt.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" height="300" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiBcy8pKOfZjBLo-_Q96t9641A7n6Pc0tacdH43ISQmNPASUqaNXFc4mXuzasBbxeYd34o6BsACLdZetRt0lnJ7XzDXW3IEw3yJRzFaRvhp3pnwbrazCAR__TQfHk5B-tyeT1_iE3dr3zE/s400/Margin+Debt.jpg" width="400" /></span></a></div>
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<span style="font-family: inherit;"><span style="font-family: inherit;">The belief that QE policies will continue has driven a wall of cash, more than $275 billion through late October, into US listed mutual funds and ETF's accroding to TrimTabs Investment Research. That's the most for one year since 2000's $324 billion - which is, of course, the year the tech bubble burst. About 1/6 of this year's total came in October alone. TrimTabs notes that the net total of $45.5 billion through October 25th is the fifth highest monthly inflow on record (the two biggest months were January ($66.3 billion) and July ($55.3 billion). (</span></span><a href="http://blogs.marketwatch.com/thetell/2013/10/29/277-billion-into-stock-funds-so-far-this-year-highest-since-2000/?link=sfmw" style="line-height: 1.5em;">http://blogs.marketwatch.com/thetell/2013/10/29/277-billion-into-stock-funds-so-far-this-year-highest-since-2000/?link=sfmw</a><span style="background-color: white; line-height: 1.5em;">).</span><br />
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<span style="font-family: inherit;"><span style="font-family: inherit;">In this post, I have attem</span>pted to show that the real economy - defined as consumer spending and corporate investment has struggled. In addition, and despite great efforts to heal the economy, the consumer is still not in a position to act as a sustainable source of economic growth. Corporations, who have visibly benefited from current policies have, however, not contributed to economic growth (via hiring or investment) as they normally do, but instead have rationally used the artificial conditions put in place by the Fed to increase leverage, buy back shares, craft earnings and boost share prices. In addition, the quality of more recent borrowings has become questionable and could be a problem in the making. The winners have been the financial markets and those who are able to participate in them as well as the banks and governments.</span><br />
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<span style="font-family: inherit;">To close, I would suggest you read in its entirety, the following Wall Street Journal Op Ed, that was recently penned by Andrew<span style="font-family: inherit;"> </span><span style="border: 0px; color: #333333; line-height: 21px; margin: 0px; outline: 0px; padding: 0px; vertical-align: baseline;">Huszar, a senior fellow at Rutgers Business School, and a former Morgan Stanley managing director. In 2009-10, Mr. Huszar was asked to manage the Federal Reserve's $1.25 trillion agency mortgage-backed security purchase program. This Op Ed is Mr. Huszar's apology for the failure of the program he managed. (</span></span><span style="font-family: inherit;"><a href="http://online.wsj.com/news/articles/SB10001424052702303763804579183680751473884">http://online.wsj.com/news/articles/SB10001424052702303763804579183680751473884</a>).</span><br />
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<span style="font-family: inherit;">Happy Thanksgiving to all your families.</span><br />
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Bretthttp://www.blogger.com/profile/11094579354565486061noreply@blogger.com0tag:blogger.com,1999:blog-5803518473270155434.post-74692095380324916152013-10-01T19:16:00.004-07:002013-10-03T05:09:51.693-07:00Not All Debt is Created EqualToday is Day 1 of the US Government shutdown. In spite of the 24/7 media hoopla, this is, in fact, the 16th shutdown of the Federal Government since 1976. Shutdowns have ranged from 1 to 21 days in duration, with an average of 6.5 and a median of 3 days.<br />
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Much has been made of the approach of this event and the supposedly "horrific"implications if we don't borrow more to keep the government open. Lost in the coverage, however, is the fact that the United States (as well as most other developed countries) have a bigger problem which is no closer to being addressed. It's not a Democratic problem, nor a Republican one. Not a Labor issue nor a Tory one -- nor a Christian Democrat, nor a Social Democrat, nor a Green Party one. In fact, it is not a political problem at all. It is a generational one that will unfortunately be passed along to our children and theirs. Simply put,<i><b> governments everywhere have spent AND promised to spend much more than can possibly be generated by their economies without impinging upon growth</b></i>. </div>
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I have written on this issue at least annually since 2004 and don't wish to rehash the problem in its entirety. However, to quickly review, there are three aspects of any debt situation that one must examine to determine whether a threat exists. Unfortunately, the most important aspect is the one that is least analyzed.</div>
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Certainly, the amount of debt (relative to a country's size) is important. Below I show the situation of the G-7 countries, plus Spain. Not one is a shining example of fiscal prudence, though the US is the best of a weak bunch, while Japan and Italy have been most profligate over longer periods of time. </div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiS4-WJYCI0HFlZnFcU4fUbzpYNCtfCQYi0XGFjqkWNypi7BZOmLn4xmIs-UjHWRz1Oo6AWdRmoe9ius_2kq-J7WEW8L-4UclJj2NYqciMR17QAHaD1nd1pe9B_OwSY5COA7EqIXrWuiyA/s1600/Debt+%25+GDP.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="227" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiS4-WJYCI0HFlZnFcU4fUbzpYNCtfCQYi0XGFjqkWNypi7BZOmLn4xmIs-UjHWRz1Oo6AWdRmoe9ius_2kq-J7WEW8L-4UclJj2NYqciMR17QAHaD1nd1pe9B_OwSY5COA7EqIXrWuiyA/s400/Debt+%25+GDP.png" width="400" /></a></div>
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Historically, as debt as a percentage of GDP closes in on 90%, it has been observed that a country's subsequent growth slows (the best discussion of this effect is detailed in the book "This Time is Different" by Reinhart and Rogoff. Subsequent criticism of their findings by a group at the University of Massachusetts, Amherst is oft-quoted to dispute the conclusions of R&R. However, this criticism tells me more about the critics than R&R - they like to read headlines and executive summaries and not the nitty-gritty. For those who do read further, it is clear that the R&R conclusions remain valid).</div>
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Secondly, how quickly the debt pile growing, the annual fiscal deficit, tells us whether the problem is being addressed or worsening. Ideally, you must see the deficit growing more slowly than nominal GDP so that the ratio of debt to GDP can fall. Here, some countries (Germany, Canada and, oddly, Italy) seem to be making progress, while others appear hopelessly lost (Japan).</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjLzyocNki_uJLy0vD2nEle1YSLsTVKteDEDzzhgOmtkrkGmm_pX1X9WMGsI1ynOhm0gQofltVBAFQDN1uaY5A8o0FjnXvW_yWDZsk6C7zyTs0VWjLjXL7msFJiQPbuD1hQtS4d6v9xMmA/s1600/Fiscal+Deficit.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="227" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjLzyocNki_uJLy0vD2nEle1YSLsTVKteDEDzzhgOmtkrkGmm_pX1X9WMGsI1ynOhm0gQofltVBAFQDN1uaY5A8o0FjnXvW_yWDZsk6C7zyTs0VWjLjXL7msFJiQPbuD1hQtS4d6v9xMmA/s400/Fiscal+Deficit.png" width="400" /></a></div>
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Thirdly, and rarely discussed, is the cost of the debt. Having lots of debt, but not having to pay any interest on it is an interesting concept. In fact, this is the state of most countries in the world today. Historically low borrowing costs have allowed governments (and companies and households) to borrow more and more, without having to pay out greater amounts of their incomes. However, as an economy begins to grow and interest rates rise, debt service costs will likewise rise. Newly incurred debt (each year's fiscal deficit) as well as previously borrowed amounts that are coming due must all be financed at the new (higher) current rate. Thus entities with high fiscal deficits and those with shorter maturities are the most vulnerable to having success (a growing economy) short circuit itself. </div>
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Consider for a second the US Government. With a fiscal deficit at over 4% of GDP, a little more than 5% of its total debt pile is priced anew each year (deficit/debt). In addition, nearly 1/3 of previously borrowed amounts will mature in the next 18 months, and nearly half in the next three years. The US is therefore one of the countries most at risk to interest rate movements (along with Canada, Spain and Japan), while only the UK seems to have taken true advantage of the lower interest rate environment, locking in rates for years to come. </div>
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<b>Debt Maturity Profiles for G-7 plus Spain (% of debt maturing within time frame)</b></div>
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<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 584px;"><colgroup><col style="width: 54pt;" width="72"></col><col span="8" style="width: 48pt;" width="64"></col></colgroup><tbody>
<tr height="20" style="height: 15pt;"><td height="20" style="height: 15pt; width: 54pt;" width="72"></td><td class="xl65" style="width: 48pt;" width="64"><b><span style="font-size: x-small;"> Can</span></b></td><td class="xl65" style="width: 48pt;" width="64"><b><span style="font-size: x-small;"> USA</span></b></td><td class="xl65" style="width: 48pt;" width="64"><b><span style="font-size: x-small;"> Spain</span></b></td><td class="xl65" style="width: 48pt;" width="64"><b><span style="font-size: x-small;"> Japan</span></b></td><td class="xl65" style="width: 48pt;" width="64"><b><span style="font-size: x-small;"> Germany</span></b></td><td class="xl65" style="width: 48pt;" width="64"><b><span style="font-size: x-small;"> France </span></b></td><td class="xl65" style="width: 48pt;" width="64"><b><span style="font-size: x-small;"> Italy</span></b></td><td class="xl65" style="width: 48pt;" width="64"><b><span style="font-size: x-small;"> UK</span></b></td></tr>
<tr height="20" style="height: 15pt;"><td class="xl69" height="20" style="height: 15pt;"><b><span style="font-size: x-small;">0 - 18 Mos</span></b></td><td align="right" class="xl67"><span style="font-size: x-small;">45%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">32%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">30%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">31%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">25%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">23%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">23%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">11%</span></td></tr>
<tr height="20" style="height: 15pt;"><td class="xl69" height="20" style="height: 15pt;"><b><span style="font-size: x-small;">18 - 36 Mos</span></b></td><td align="right" class="xl67"><span style="font-size: x-small;">17%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">17%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">18%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">14%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">16%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">15%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">14%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">6%</span></td></tr>
<tr height="20" style="height: 15pt;"><td class="xl69" height="20" style="height: 15pt;"><b><span style="font-size: x-small;">3 - 5 Yr</span></b></td><td align="right" class="xl67"><span style="font-size: x-small;">10%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">17%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">16%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">15%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">17%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">14%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">15%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">12%</span></td></tr>
<tr height="20" style="height: 15pt;"><td class="xl69" height="20" style="height: 15pt;"><b><span style="font-size: x-small;">5 - 10 Yr</span></b></td><td align="right" class="xl67"><span style="font-size: x-small;">12%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">22%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">19%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">20%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">26%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">29%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">26%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">23%</span></td></tr>
<tr height="20" style="height: 15pt;"><td class="xl69" height="20" style="height: 15pt;"><b><span style="font-size: x-small;">+10 Yr</span></b></td><td align="right" class="xl67"><span style="font-size: x-small;">16%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">12%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">17%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">20%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">16%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">19%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">22%</span></td><td align="right" class="xl67"><span style="font-size: x-small;">47%</span></td></tr>
<tr height="20" style="height: 15pt;"><td class="xl69" height="20" style="height: 15pt;"></td><td class="xl66"></td><td class="xl66"></td><td></td><td class="xl66"></td><td class="xl66"></td><td></td><td class="xl66"></td><td class="xl66"></td></tr>
<tr height="20" style="height: 15pt;"><td class="xl69" height="20" style="height: 15pt;"><b><span style="font-size: x-small;">< 3 Year</span></b></td><td align="right" class="xl68"><span style="font-size: x-small;">62%</span></td><td align="right" class="xl68"><span style="font-size: x-small;">49%</span></td><td align="right" class="xl68"><span style="font-size: x-small;">48%</span></td><td align="right" class="xl68"><span style="font-size: x-small;">45%</span></td><td align="right" class="xl68"><span style="font-size: x-small;">41%</span></td><td align="right" class="xl68"><span style="font-size: x-small;">38%</span></td><td align="right" class="xl68"><span style="font-size: x-small;">37%</span></td><td align="right" class="xl68"><span style="font-size: x-small;">17%</span></td></tr>
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Consider the following two examples. </div>
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The coupon rate on all US government debt that matures in the next 36 months is 1.08%. If the government wanted to lock in today's low rates for the next ten years, the cost of borrowing would rise to 2.61% on this piece of the debt (the current 10-year yield), while any new debt incurred would also be charged a rate of 2.61%. Overall annual interest expense would increase by $141 billion under this scenario (assuming interest rates do not rise over this period and deficits run at 4.1% of GDP for the next 3 years). However, if rates were to normalize (3.92% is the average 10-year bond yield since 2000), interest costs would soar by $243.5 billion. To put this into perspective, total individual income tax receipts for the US were $1.27 trillion in the 12 months through this August. Additional debt service costs would equate to 19.2% of individual income taxes currently collected under even a modest increase in interest costs.</div>
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The same analysis applied to the United Kingdom reveals a much different outcome. The coupon rate on all UK government debt that matures in the next 36 months is 3.04%. If the government wanted to lock in today's low rates for the next ten years, the cost of borrowing would actually FALL to 2.72% on this piece of the debt (the current 10-year yield), while any new debt incurred would also be charged a rate of 2.72%. Overall annual interest expense would increase by GBP 7.665 billion under this scenario (assuming interest rates do not rise over this period and deficits run at 6.5% of GDP for the next 3 years). However, if rates were to normalize (4.10% is the average 10-year bond yield since 2000), interest costs would grow by a larger GBP 15.1 billion. To put this into perspective, total individual income tax receipts for the UK were GBP 194.8 billion in the 12 months through this August. Additional debt service costs would equate to just 7.75% of individual income and wealth taxes currently collected.</div>
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Whilst the study of the size and on-going fiscal situation of countries is important, a potentially even more important aspect - interest rate sensitivity is being ignored. In a rising rate environment, the United States and a number of other highly levered countries are in danger of suffocating on their own debt, while the UK - a country with a larger debt pile and a bigger fiscal deficit would fare much better. </div>
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So while the US debates the government shut down and the Japanese Abe-nomics and the Germans try to form a new ruling coalition and the Spanish, Greeks, Italians and Portuguese debate austerity versus growth, the bigger picture goes un-addressed to the detriment of future generations nearly everywhere.</div>
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Bretthttp://www.blogger.com/profile/11094579354565486061noreply@blogger.com0tag:blogger.com,1999:blog-5803518473270155434.post-29756072049429647372013-09-08T11:13:00.000-07:002013-09-08T12:17:19.766-07:00"Lies, Damn Lies and Statistics"The title to this short posting was popularized by Mark Twain, though it's true origin is open to debate. Whether Mr. Twain or another is to be credited, I can think of no better description of the monthly government employment numbers which elicit so much attention from investors.<br />
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Last Friday, the government report that 169,000 new jobs were created in August, slightly below the expectations of economists and the average figures over the past year. Markets interpreted such weakness to mean that the Federal Reserve would be unlikely begin its tapering of bond purchases in September as rumored.<br />
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Now for the truth. According to the Bureau of Labor Statistics, the economy added 378,000 new jobs in August, but this number was "seasonally adjusted" downward to the reported figure of 169,000. "Well then, that's good, you say. The economy is stronger than we thought". No, not so fast. Last month when the government reported 104,000 new jobs (seasonally adjusted, of course), the economy really lost 1,186,000.<br />
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Confused? Allow me to clarify. The reason the government looks to adjust the monthly numbers is precisely so we don't all become schizophrenic as we see jobs swing from one million lost one month, to nearly 400,000 created the next. Precisely because there is a seasonality to hiring (for example retailers hire many temporary employees in the months before Christmas, only to let them go in January and college students flood the job market early in the summer, but then leave to go back to school in the fall), the government tries to make one month's figures more comparable to previous months by creating the adjustment. And it is this adjusted number to which the world so frenetically reacts. But the question remains, should we ascribe such certainty to a figure which is really just an (educated) guess?<br />
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The size of the monthly adjustments are huge. In fact, the median monthly adjustment (using data from January 1940 to the present), is more than 75% of the actual figure - and in the last decade, the adjustment has been bigger than the actual number in nearly 50% of the months.<br />
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I would also note, since the 1960's, the size of the adjustment (on a percentage basis) has grown as have the number of months where the adjustment is bigger than the actual figure. Usually when you've had practice doing something over and over, you get better. The government seems to be getting worse.<br />
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<b> 70's 80's 90's 00's </b><br />
<b>Pct of Months Where Adjustment > Actual </b> 23% 29% 36% 48%<br />
<b>Median Size of Monthly Adjustment Relative to Actual</b> 63% 69% 80% 97%<br />
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With such a margin for error, why do investors focus so intently on these monthly numbers? I argue, that they shouldn't.<br />
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If one really wants to understand the state of the labor market, a better way to use these figures is to look at a 12 month moving average of the unadjusted jobs created. By using a full year, seasonality is fairly scrubbed away and one does not need to rely on the accuracy (or lack thereof) of government adjusters.<br />
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When we do this we find:<br />
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<li>job creation remains anemic compared to historical norms (even moreso when thought of relative to the size of the economy and population)</li>
<li>job creation is disappointing given the historic magnitude of the job losses that preceded the recovery</li>
<li>job creation is disappointing given the amount of government spending that was employed to accelerate the recovery</li>
<li>the monthly rate of job creation has not changed in the past two years</li>
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So, there really is no reason for the Fed to change their view of the economy as a result of Friday's numbers. The economy remains weak and is getting little better on the jobs front. Of course, any single monthly number can be used to justify any course the Fed decides to take, but from a fundamental perspective, the jobs picture has simply not changed.Bretthttp://www.blogger.com/profile/11094579354565486061noreply@blogger.com1tag:blogger.com,1999:blog-5803518473270155434.post-77722570404758908112013-08-17T14:56:00.000-07:002013-08-26T11:42:27.184-07:00It's the Great Rotation, Charlie Brown<div class="MsoNormal">
In the 1966 animated movie, “It’s the Great Pumpkin, Charlie
Brown”, Linus van Pelt sits in the pumpkin patch on Halloween evening, waiting
for the Great Pumpkin to arrive while his friends trick or treat from door to
door gathering candy and popcorn balls.
Unfortunately, for Linus, the Great Pumpkin never shows.<o:p></o:p></div>
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Today, there’s lots of talk about “The Great Rotation” – an
idea that as the economy recovers, rates will rise, investors will abandon
bonds and equities will soar based on a better economy and better earnings. Like Linus, investors who believe in this real
world coming, will be disappointed.<o:p></o:p></div>
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Over the past year, the S&P 500 is up by more than 20%
while earnings per share have climbed only 4.2% (even less excluding financial
stocks). Thus, investors have already been
factoring in improvement into their willingness to pay more for each dollar’s
worth of today’s earnings.<o:p></o:p></div>
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The flaw in their thinking is twofold:<span style="font-family: Symbol; text-indent: -0.25in;"><span style="font-family: 'Times New Roman'; font-size: 7pt;"> </span></span><span style="font-family: Symbol; text-indent: -0.25in;"><span style="font-family: 'Times New Roman'; font-size: 7pt;"> </span></span></div>
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<li><span style="text-indent: -0.25in;">First, stocks tend to do better when rates are falling,
than when they are rising</span></li>
<li><span style="text-indent: -0.25in;">Secondly, there are two “components” to earnings
– operating and financing, and rising rates will dramatically challenge the
second of these</span></li>
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When we think of how a company works, we assume without much
afterthought, that it does better when the economy does better. However, let’s examine this a little bit more.<o:p></o:p></div>
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A company makes its widgets, or provides a service, which
they sell for a certain amount. However,
there was a cost to manufacturing and selling that widget or service – materials,
electricity, labor, marketing, etc. The
difference between these costs and the sales price is the operating profit – or
what we think of as “the business”.<o:p></o:p></div>
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There is, however, a second, less considered component to
earnings, and that is the financial component.
In order to make their widgets, the company had to invest in plant,
property and equipment. Usually, they
will have to sell equity or borrow money to fund this investment. Whether they choose to issue equity or bonds,
borrow from the bank, set the term of the borrowing, etc. is a financial
decision every bit as important as the decisions made in manufacturing its
product.<o:p></o:p></div>
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Over the past few years, many companies reacted to the Fed's decision to artificially lower interest rates (Quantitative Easing) by borrowing to fund their investments. As evidence of this, we can see how debt outstanding as a percentage of assets has risen since QE was introduced in 2008.</div>
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Even when accounting for the cash that has built up on
balance sheets (borrowing for future purposes), leverage has still increased. This is most clearly see if we subtract cash
retained on the balance sheet from the total debt amount (giving us Net Debt)
and express that as a percent of assets.
Such an exercise shows a rise in leverage over recent years to 14.2% of
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Interestingly, however, the overall cost of this borrowing
has not grown, even as the amount borrowed has.
At the end of 2012, interest expense fell to 1.78% of sales from a
15-year average of 3.88% (and note it had never been below even 3% of sales
until 2009).<o:p></o:p></div>
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So let’s say a company sells it widget for $100, and its
cost of materials, labor, etc was $90.
Then their operating, or business, margin is 10 cents on the
dollar. Now, let’s subtract the costs of
borrowing, currently 1.78 cents. So the
bottom line profits are 8.2 cents for every dollar of goods sold. If, however, the cost of borrowing were
closer to “normal” (3.88% of sales), the bottom line would be more like 6.1
cents. In other words, you could expect
earnings to fall roughly 25% even though the “business” environment hasn’t
changed at all.<o:p></o:p></div>
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Yet another aspect of financial management relating to the
low rate environment engendered by QE is the option many companies have followed
to borrow at low interest rates for the purpose of buying back stock. Remember, there are two ways to grow EPS,
grow the earnings or shrink the number of shares. Buoyed by QE, companies have opted to buy
back shares, allowing EPS to grow faster than earnings overall (in some
instances, outright earnings declines have been “converted” into EPS gains
through a shrinkage of the share base). <o:p></o:p></div>
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For the market as a whole (the S&P 500 index), In each
of the past five years, operating income per share, has grown faster than overall
operating income – evidence of a share base shrinkage (A positive numbers in the chart below indicate share buy backs. A negative number, share issuance). As rates rise, this practice of borrowing to
repurchase shares will diminish and the ability to manufacture EPS growth will be
further challenged.</div>
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Prima facie evidence that such financial machinations are
still alive and well, surfaced earlier this week when Carl Icahn tweeted about
acquiring a large stake in Apple Computer.
Icahn stated that Apple didn’t even need to grow its business for its
share price to climb from $525 to $625 per share - they could simply borrow
money at 3% and buyback shares that were more dear. So whilst this financial maneuver is still viable,
investors will be pressed to continue it should the cost of borrowing
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<b>In simple terms, any
rise in interest rates will bring an end to the ability companies have had to
manage the financial component of their businesses, even as the economy
improves and helps their operating business.<o:p></o:p></b></div>
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There is one final element to managing the “financial”
component of earnings that has nothing to do with interest rates. It has to do with taxes. As tax
rates have come down over the years and as US companies do more business in
lower tax jurisdictions, the effective taxes they have paid have fallen. In other words, they get to keep more of the
money they earned – another boost to the “non-business” side of earnings. <o:p></o:p></div>
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Looked at from an economy-wide perspective (using the
National Income and Product Account data from the US Bureau of Economic
Analysis), the effective tax rate paid by US companies has fallen dramatically,
especially in the past decade. For the
most recent 12 months, companies have paid out a little more than 18% of their
earnings as taxes. That’s down from a
50-year average of roughly 34% - a reduction of almost 50%. To put this into some perspective. If today’s effective tax rate of 18% were to
return to the 25% rate which was the norm as recently as 2002 – 2006, the net
margin would decline from 8.1% to 7.4% – corresponding to an earnings decline
of just over 8.5%.<o:p></o:p></div>
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Unlike interest expense and share buybacks, I don’t
necessarily think this is a trend that is going to reverse soon, but by the
same token, I don’t see much room for improvement, especially as debt-laden Governments,
worldwide, look to increase their revenue base.<o:p></o:p></div>
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So Linus and equity bulls, whilst I admire your faith and
convictions, evidence would seem to be against the arrival of The Great
Rotation.<o:p></o:p></div>
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<span style="font-family: "Calibri","sans-serif"; font-size: 11.0pt; line-height: 107%; mso-ansi-language: EN-US; mso-ascii-theme-font: minor-latin; mso-bidi-font-family: "Times New Roman"; mso-bidi-language: AR-SA; mso-bidi-theme-font: minor-bidi; mso-fareast-font-family: Calibri; mso-fareast-language: EN-US; mso-fareast-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><br /></span>Bretthttp://www.blogger.com/profile/11094579354565486061noreply@blogger.com0tag:blogger.com,1999:blog-5803518473270155434.post-75570475168148015122013-08-01T16:20:00.000-07:002013-08-04T17:31:54.926-07:00Brace Yourself for Mediocre Returns - Part 2, The Equity Edition<i>While equity markets have more "moving pieces" than their fixed income counterparts, their longer-term outcomes can likewise be broken down into a handful of understandable and forecastable components. When approached in this manner, we see that returns from US and Japanese equity markets in the coming decade are likely to be poor, while returns from the currently "troubled" markets of Europe are likely to be substantially better.</i><br />
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It is a given that there are only two ways to make money from an equity - either you are paid a stream of dividends, or the price another party is willing to pay you for your shares differs from the price you paid (Dividend + Price Change). In general, the Dividend component is readily observable and tends to be less volatile while stock Price Changes are more volatile and, in the short-run, more unpredictable.<br />
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To better understand the portion of return due to Price Change, we can further decompose that piece into Earnings Growth per share and the price one is willing to pay for each dollar's worth of those earnings (i.e. the P/E Ratio). Both are somewhat volatile, but less so than the overall Price Change itself. To simplify further, I like to sub-divide the Earnings Growth component into Revenue Growth and the change in the profitability of those Revenues (i.e. the Profit Margin). Taking all this together then, if we know with certainty just four variables: Dividends, Revenue Growth, Profit Margins and the P/E Ratio, we will know with certainty the return from an equity (or equity index).<br />
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Fortunately, two of these components are relatively stable over a period as long as a decade (Dividends and Revenue Growth), while valuation and profitability are more volatile -- and it is this change in Margins and the P/E Ratio that ultimately drives returns. Thus a sensitivity analysis featuring these two unknowns is called for.<br />
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Equity earnings tend to be cyclical over time (see chart) and gauging market value on a single, spot observation can be mis-leading -- especially when earnings are well above, or well below, their trend. As of June 30th, the P/E Ratio on trailing, reported earnings of the S&P 500 index was 15.5x, below the longer-term norm of 17.0x (the median valuation since Dec 1959). Based on this, one might conclude that the market is cheaply-valued. What is left out of such a simplistic analysis is that the earnings part of that calculation is not at the norm, but rather a cyclical high.<br />
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Instances such as this tend to occur when margins are well above their norms, even as they are understood to be generally mean-reverting. Today, S&P 500 margins are near one of these cyclical peaks. The chart below was first published in my initial blog posting, "The Profitability Illusion" (June 15th), and depicts year-end S&P 500 net margins over the past 15 years.<br />
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A longer-term chart using a different set of data, the National Income and Product Accounts from the Bureau of Economic Analysis, which details economy wide profits, delivers much the same message (note how current margins appear to have broken out of their long-term channel. I showed in "The Profitability Illusion" how this is largely due to the low interest rates engendered by the Fed's QE policies).<br />
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Thus, a valuation analysis which adjusts for the margin's deviation from its norm and which assumes dividend growth in line with earnings (as long as the current payout ratio is near longer-term norms), revenue growth in line with historical trends (typically that of nominal GDP) and a valuation component (P/E ratio) that returns to its long-run median over a period of ten-years should provide a decent assessment of where returns are headed as cycles run their course. Those who disagree with my assumptions of a return to normal margin can use the accompanying sensitivity tables and observe returns under a range of margin and P/E inputs. However, I would direct doubters back to "The Profitability Illusion" which discusses in some detail why over 2 percentage points of the current S&P 500 margin is illusory and unlikely to be sustained. In any case, the range of returns can be illuminating and the dispersion of returns, not as wide as one might assume.<br />
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I turn first to the United States and use the S&P 500 index as a proxy for US Equities. Over the past 50+ years, a median valuation of 17.0x earnings is the norm (I choose to use a median as opposed to an average because out-sized values can distort its calculation. In full disclosure, the average P/E has been 17.6x). Margins have averaged 6% for the past 50 years and have proven throughout to be mean reverting. Today, though they stand near record highs of over 8% and in this analysis it is assumed they will slowly return to the 6% average.<br />
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For this exercise, we also assume 5.5% annual compounded nominal revenue growth (in line with historic norms) and a 2.14% annual return from dividends (the current yield). Putting this all together, our best guess return estimate for US Equities over the next 10 years is 3.9% per year. If you want to assume record margins continue, you could up that expectation (see table below), but just to 6.8%. Under no reasonable scenario, are double digit equity returns in sight.<br />
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<b>S&P 500 10-Year Return Estimation (5.5% Nominal Revenue Growth, 2.14% Annual Dividend Return, Various Margin and P/E Scenarios)</b><br />
<br />
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 391px;">
<colgroup><col style="mso-width-alt: 2596; mso-width-source: userset; width: 53pt;" width="71"></col>
<col span="5" style="width: 48pt;" width="64"></col>
</colgroup><tbody>
<tr height="16" style="height: 12.0pt;">
<td align="right" class="xl86" height="16" style="height: 12.0pt; width: 53pt;" width="71"><br /></td>
<td class="xl80" style="width: 48pt;" width="64"> <br />
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 391px;">
<colgroup><col style="mso-width-alt: 2596; mso-width-source: userset; width: 53pt;" width="71"></col>
<col span="5" style="width: 48pt;" width="64"></col>
</colgroup><tbody>
<tr height="16" style="height: 12.0pt;">
<td align="right" class="xl86" height="16" style="height: 12.0pt; width: 53pt;" width="71"> </td>
<td class="xl80" style="width: 48pt;" width="64"><b> 13x </b></td><td class="xl80" style="width: 48pt;" width="64"><b> 15x</b></td>
<td class="xl81" style="width: 48pt;" width="64"><b> <span style="color: blue;">17x</span></b></td>
<td class="xl80" style="width: 48pt;" width="64"><b> 19x </b></td>
<td class="xl82" style="width: 48pt;" width="64"><b> 21x</b></td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl83" height="15" style="height: 11.25pt;"><b>4.0%</b></td>
<td align="right" class="xl73">-2.8%</td>
<td align="right" class="xl74">-1.4%</td>
<td align="right" class="xl75">-0.2%</td>
<td align="right" class="xl74">0.9%</td>
<td align="right" class="xl76">1.9%</td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl83" height="15" style="height: 11.25pt;"><b>5.0%</b></td>
<td align="right" class="xl77">-0.6%</td>
<td align="right" class="xl66">0.8%</td>
<td align="right" class="xl67">2.0%</td>
<td align="right" class="xl66">3.1%</td>
<td align="right" class="xl68">4.1%</td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl84" height="15" style="height: 11.25pt;"><b><span style="color: blue;">6.0%</span></b></td>
<td align="right" class="xl78">1.2%</td>
<td align="right" class="xl67">2.6%</td>
<td align="right" class="xl67"><span style="color: blue;"><b>3.9%</b></span></td>
<td align="right" class="xl67">5.0%</td>
<td align="right" class="xl69">6.0%</td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl83" height="15" style="height: 11.25pt;"><b>7.0%</b></td>
<td align="right" class="xl77">2.7%</td>
<td align="right" class="xl66">4.1%</td>
<td align="right" class="xl67">5.4%</td>
<td align="right" class="xl66">6.6%</td>
<td align="right" class="xl68">7.6%</td>
</tr>
<tr height="16" style="height: 12.0pt;">
<td align="right" class="xl85" height="16" style="height: 12.0pt;"><b>8.0%</b></td>
<td align="right" class="xl79">4.1%</td>
<td align="right" class="xl70">5.5%</td>
<td align="right" class="xl71">6.8%</td>
<td align="right" class="xl70">8.0%</td>
<td align="right" class="xl72">9.1%</td>
</tr>
</tbody></table>
</td><td class="xl80" style="width: 48pt;" width="64"><br /></td><td class="xl81" style="width: 48pt;" width="64"><br /></td><td class="xl80" style="width: 48pt;" width="64"><br /></td><td class="xl82" style="width: 48pt;" width="64"><br /></td></tr>
</tbody></table>
<br />
Taking Japan next we conduct a similar analysis, though using the historically lower 3.0% margin levels and nominal revenue growth. Though Japanese valuation data is distorted somewhat by 10+ years of a great bubble, we feel a normalized P/E ratio of 20.x, higher than that of the US, can be argued, though we show a range of 12.5x to 27.5x in the sensitivity below.<br />
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<div>
<b>MSCI Japan 10-Year Return Estimation (3.0% Nominal Revenue Growth, 1.77% Annual Dividend Return, Various Margin and P/E Scenarios)</b><br />
<div>
<br /></div>
<div>
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 387px;">
<colgroup><col style="mso-width-alt: 2450; mso-width-source: userset; width: 50pt;" width="67"></col>
<col span="5" style="width: 48pt;" width="64"></col>
</colgroup><tbody>
<tr height="16" style="height: 12.0pt;">
<td align="right" class="xl86" height="16" style="height: 12.0pt; width: 50pt;" width="67"><br /></td>
<td class="xl83" style="width: 48pt;" width="64"> <b>12.5x</b></td>
<td class="xl83" style="width: 48pt;" width="64"><b> 15.0x</b></td>
<td class="xl84" style="width: 48pt;" width="64"><b> <span style="color: blue;">20.0x</span></b></td>
<td class="xl83" style="width: 48pt;" width="64"><b> 25.0x</b></td>
<td class="xl85" style="width: 48pt;" width="64"><b> 27.5x</b></td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl67" height="15" style="height: 11.25pt;"><b>2.0%</b></td>
<td align="right" class="xl66">-5.7%</td>
<td align="right" class="xl77">-4.0%</td>
<td align="right" class="xl78">-1.2%</td>
<td align="right" class="xl77">0.9%</td>
<td align="right" class="xl79">1.9%</td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl67" height="15" style="height: 11.25pt;"><b>2.5%</b></td>
<td align="right" class="xl80">-3.6%</td>
<td align="right" class="xl68">-1.9%</td>
<td align="right" class="xl69">0.9%</td>
<td align="right" class="xl68">3.2%</td>
<td align="right" class="xl70">4.2%</td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl71" height="15" style="height: 11.25pt;"><span style="color: blue;"><b>3.0%</b></span></td>
<td align="right" class="xl81">-1.9%</td>
<td align="right" class="xl69">-0.1%</td>
<td align="right" class="xl69"><span style="background-color: white;"><span style="color: blue;"><b>2.8%</b></span></span></td>
<td align="right" class="xl69">5.0%</td>
<td align="right" class="xl72">6.0%</td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl67" height="15" style="height: 11.25pt;"><b>3.5%</b></td>
<td align="right" class="xl80">-0.4%</td>
<td align="right" class="xl68">1.4%</td>
<td align="right" class="xl69">4.3%</td>
<td align="right" class="xl68">6.7%</td>
<td align="right" class="xl70">7.7%</td>
</tr>
<tr height="16" style="height: 12.0pt;">
<td align="right" class="xl73" height="16" style="height: 12.0pt;"><b>4.0%</b></td>
<td align="right" class="xl82">0.9%</td>
<td align="right" class="xl74">2.8%</td>
<td align="right" class="xl75">5.7%</td>
<td align="right" class="xl74">8.1%</td>
<td align="right" class="xl76">9.1%</td>
</tr>
</tbody></table>
</div>
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<br />
Moving on to the European markets and the UK, we reach a somewhat happier, though still below historic, level of return. For the UK market we use similar revenue (5.5%) and normalized margin assumptions (6.0%) as we do for the US. For the continent, I discount both revenue growth and margins by 0.5%, in line with historic observations. Again, under a broad range of valuation and margin assumptions we see the following:<br />
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<b>MSCI United Kingdom 10-Year Return Estimation (5.5% Nominal Revenue Growth, 3.95% Annual Dividend Return, Various Margin and P/E Scenarios)</b><br />
<b><br /></b>
<br />
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 384px;">
<colgroup><col span="6" style="width: 48pt;" width="64"></col>
</colgroup><tbody>
<tr height="16" style="height: 12.0pt;">
<td align="right" class="xl86" height="16" style="height: 12.0pt; width: 48pt;" width="64"><br /></td>
<td class="xl80" style="width: 48pt;" width="64"> <b>10x</b></td>
<td class="xl80" style="width: 48pt;" width="64"><b> 12x</b></td>
<td class="xl81" style="width: 48pt;" width="64"><b> <span style="color: blue;">14x</span></b></td>
<td class="xl80" style="width: 48pt;" width="64"><b> 16x</b></td>
<td class="xl82" style="width: 48pt;" width="64"><b> 18x</b></td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl83" height="15" style="height: 11.25pt;"><b>4.0%</b></td>
<td align="right" class="xl73">0.8%</td>
<td align="right" class="xl74">2.6%</td>
<td align="right" class="xl75">4.1%</td>
<td align="right" class="xl74">5.5%</td>
<td align="right" class="xl76">6.7%</td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl83" height="15" style="height: 11.25pt;"><b>5.0%</b></td>
<td align="right" class="xl77">3.0%</td>
<td align="right" class="xl66">4.8%</td>
<td align="right" class="xl67">6.4%</td>
<td align="right" class="xl66">7.8%</td>
<td align="right" class="xl68">9.0%</td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl84" height="15" style="height: 11.25pt;"><span style="color: blue;"><b>6.0%</b></span></td>
<td align="right" class="xl78">4.8%</td>
<td align="right" class="xl67">6.7%</td>
<td align="right" class="xl67"><span style="color: blue;"><b>8.3%</b></span></td>
<td align="right" class="xl67">9.7%</td>
<td align="right" class="xl69">10.9%</td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl83" height="15" style="height: 11.25pt;"><b>7.0%</b></td>
<td align="right" class="xl77">6.4%</td>
<td align="right" class="xl66">8.3%</td>
<td align="right" class="xl67">9.9%</td>
<td align="right" class="xl66">11.3%</td>
<td align="right" class="xl68">12.6%</td>
</tr>
<tr height="16" style="height: 12.0pt;">
<td align="right" class="xl85" height="16" style="height: 12.0pt;"><b>8.0%</b></td>
<td align="right" class="xl79">7.8%</td>
<td align="right" class="xl70">9.7%</td>
<td align="right" class="xl71">11.3%</td>
<td align="right" class="xl70">12.8%</td>
<td align="right" class="xl72">14.0%</td>
</tr>
</tbody></table>
</div>
<div>
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<div>
<b>MSCI Europe (ex-UK) 10-Year Return Estimation (5.0% Nominal Revenue Growth, 3.71% Annual Dividend Return, Various Margin and P/E Scenarios)</b></div>
<div>
<br /></div>
<div>
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 384px;">
<colgroup><col span="6" style="width: 48pt;" width="64"></col>
</colgroup><tbody>
<tr height="16" style="height: 12.0pt;">
<td align="right" class="xl86" height="16" style="height: 12.0pt; width: 48pt;" width="64"><br /></td>
<td class="xl80" style="width: 48pt;" width="64"> <b>10x</b></td>
<td class="xl80" style="width: 48pt;" width="64"><b> 12x</b></td>
<td class="xl81" style="width: 48pt;" width="64"><b> <span style="color: blue;">14x</span></b></td>
<td class="xl80" style="width: 48pt;" width="64"><b> 16x</b></td>
<td class="xl82" style="width: 48pt;" width="64"><b> 18x</b></td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl83" height="15" style="height: 11.25pt;"><b>3.5%</b></td>
<td align="right" class="xl73">-0.2%</td>
<td align="right" class="xl74">1.6%</td>
<td align="right" class="xl75">3.1%</td>
<td align="right" class="xl74">4.4%</td>
<td align="right" class="xl76">5.6%</td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl83" height="15" style="height: 11.25pt;"><b>4.5%</b></td>
<td align="right" class="xl77">2.2%</td>
<td align="right" class="xl66">4.1%</td>
<td align="right" class="xl67">5.6%</td>
<td align="right" class="xl66">7.0%</td>
<td align="right" class="xl68">8.2%</td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl84" height="15" style="height: 11.25pt;"><span style="color: blue;"><b>5.5%</b></span></td>
<td align="right" class="xl78">4.2%</td>
<td align="right" class="xl67">6.1%</td>
<td align="right" class="xl67"><b><span style="color: blue;">7.7%</span></b></td>
<td align="right" class="xl67">9.1%</td>
<td align="right" class="xl69">10.3%</td>
</tr>
<tr height="15" style="height: 11.25pt;">
<td align="right" class="xl83" height="15" style="height: 11.25pt;"><b>6.5%</b></td>
<td align="right" class="xl77">5.9%</td>
<td align="right" class="xl66">7.8%</td>
<td align="right" class="xl67">9.4%</td>
<td align="right" class="xl66">10.8%</td>
<td align="right" class="xl68">12.1%</td>
</tr>
<tr height="16" style="height: 12.0pt;">
<td align="right" class="xl85" height="16" style="height: 12.0pt;"><b>7.5%</b></td>
<td align="right" class="xl79">7.4%</td>
<td align="right" class="xl70">9.3%</td>
<td align="right" class="xl71">11.0%</td>
<td align="right" class="xl70">12.4%</td>
<td align="right" class="xl72">13.7%</td>
</tr>
</tbody></table>
</div>
<div>
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 384px;">
<colgroup><col span="6" style="width: 48pt;" width="64"></col>
</colgroup><tbody>
<tr height="16" style="height: 12.0pt;">
<td align="right" class="xl86" height="16" style="height: 12.0pt; width: 48pt;" width="64"><br /></td>
<td class="xl80" style="width: 48pt;" width="64"> </td><td class="xl80" style="width: 48pt;" width="64"><br /></td><td class="xl81" style="width: 48pt;" width="64"><br /></td><td class="xl80" style="width: 48pt;" width="64"><br /></td><td class="xl82" style="width: 48pt;" width="64"><br /></td></tr>
</tbody></table>
</div>
<div>
My conclusion is that long-term returns from the major developed equity markets are quite likely to remain in single digits -- and below 5% in both the US and Japan. This realization, combined with those in Part 1 (which looked at fixed income markets) is that most plan sponsors will have great difficulty achieving their projected return assumptions, even under the most optimistic of market conditions. Obviously a new perspective on managing funds is called for. In coming posts, I will make some suggestions.<br />
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<b>Sources Used:</b> Bloomberg, Zack's Research System, Bureau of Economic Analysis, MSCI Barra, Brett Gallagher</div>
Bretthttp://www.blogger.com/profile/11094579354565486061noreply@blogger.com0tag:blogger.com,1999:blog-5803518473270155434.post-61830338697583019122013-07-27T23:12:00.000-07:002013-09-08T12:18:44.419-07:00Brace Yourself for Mediocre Returns, Part 1 of 2<div class="separator" style="clear: both; text-align: center;">
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<i>While Wall Street
analysts debate the next market turn, far too little effort is being put into
understanding the longer-term outcomes likely from various asset
classes. Though this is a more precise
and, arguably more important, exercise than the one they choose to pursue, it
remains a neglected area of research.
The bad news is that even under the most optimistic default and recovery
scenarios, returns from nearly every fixed income segment will barely breach 4%
in the coming decade. Investment-grade
segments will struggle to return to reach a “3-handle”. Equity returns will be better, but that’s a
relative comparison, and returns from most developed equity markets will struggle
to crack 5%, with European markets faring somewhat better. </i></div>
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In my previous posting, I identified a little talked about
risk to corporate earnings – the substantial prop to margins provided by the
Fed-created low interest rate environment.
While it is important to understand that this risk exists and its
magnitude, it does little to identify when the risk becomes a market
issue. It is in this regard, Investors and Wall
Street Analysts spend untold hours and countless dollars in their efforts to
forecast short-term market returns. Yet in spite of these efforts,
in nearly 30 years in this industry, I have yet to meet anyone who has been able to do
this successfully and consistently – this author included. At the same time, I have seen more than a
handful of practitioners who have been able to fairly accurately determine
long-term returns from various fixed income and equity markets. It is ironic then that despite these
long-term forecasts being both more accurate and ultimately more important to
investors such as endowments, foundations and corporate pension committees,
greater efforts continue to be devoted to analysis based on short term market
twists and turns.</div>
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<o:p></o:p></div>
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This posting and the next are for those willing to look
beyond the coming quarter. Using a model
I originally developed in the late 1990’s, I provide what I believe to be
reasonably accurate return projections for fixed income and global equity
market over the coming decade, along with the methodology for doing so. Since its introduction, this approach has quite
accurately called market outcomes.<o:p></o:p></div>
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Let’s start with fixed income markets. As you know, a bond is a fairly simple
instrument with returns accruing to just four factors: the price paid, the coupon
payments received, the reinvestment of those coupons and the ultimate return of
principal. Taking each in turn, we know the
price paid. We also know the coupon
payment as it is contractual in nature.
The reinvestment return of these coupons is unknown; however, as I will
demonstrate below, even an immediate, radical move in interest rates will not dramatically
change the overall return of a bond over its lifetime. Finally, while return of principal to a
single bond may be uncertain, when looking at the broader market of bonds of
similar ratings, historical experience can provide a reasonable guide as to
default and recovery rates. Putting
these together, estimating long-term bond returns is a very straight forward
process.<o:p></o:p></div>
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Let’s use ten-year US Treasury notes as an example. At July 21<sup>st</sup>, you could buy a
ten-year government security with a maturity of May 15, 2023 for a price of $93.64. That note will pay a semi-annual coupon at an
annual rate of 1.75%. At maturity, an
investor will receive $100 and along the way, twice yearly coupon payments of $0.875
(per $100 value). While we do not know
the rate at which those coupons will be reinvested, even if we assume rates
rise by 500 basis points before the first coupon payment is received (to 7.48% across
all maturities), the total annualized return from this note will rise only to
2.96% over the ten year period. Conversely,
if rates fell to zero and an investor received no return at all on the coupons,
the ten year total annualized return on this note falls only to 2.29%. Thus, assuming no default, one can not
realistically expect anything other than a return of between 2.29% and 2.96% from
buying a ten-year US government note today.
Another way of looking at this is, assuming no risk of default, the best
approximation of the long-term return on a bond is probably just its current
yield (on the UST, currently 2.48%).<o:p></o:p></div>
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Looking at other developed government bond markets (G-7 plus
Australia and Spain), we note the 10-year yields between 0.78% (Japan) and
4.60% (Spain). Assuming no risk of
default, these again are the best estimate for ten-year local currency
returns. </div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjFsdV8O3NxVlnsfHXgUkJlbxPMedExQwEx7NJwhPmpzaRCTUrdy2bWU0If7H8JX0EgliMp8JmHoYBjbCwttwbJpO2WatbMnafnZP4O-fLf753KLKs6p9CfexaWs5kfWdhtGtqpmgOK6ak/s1600/Gross+Yields.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" height="226" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjFsdV8O3NxVlnsfHXgUkJlbxPMedExQwEx7NJwhPmpzaRCTUrdy2bWU0If7H8JX0EgliMp8JmHoYBjbCwttwbJpO2WatbMnafnZP4O-fLf753KLKs6p9CfexaWs5kfWdhtGtqpmgOK6ak/s400/Gross+Yields.png" width="400" /></a></div>
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<span style="font-size: 9pt; line-height: 107%;">Source:
Bloomberg</span></div>
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Of course, given the recent experience of Greece and
on-going concern across the Eurozone, zero chance of default might not be the
best assumption. If one wanted to insure
themselves against default risk, we can look to the Credit Default Swap market
to gauge the costs. Higher yielding
markets such as Spain and Italy currently have annual “insurance” costs of
3.06% and 3.08%, respectively. Perceived
“safe” markets like the US and Germany have lower insurance costs of 0.41% and
0.65%, respectively. Calculating the
“net” return with insurance, we see an expectation for ten-year returns between
2.90% (Australia) at the high end and -0.46% (Japan) at the low end.<o:p></o:p></div>
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Government markets are not the only fixed income
game in town. Lower rated corporate
credits, mortgage securities and the like broaden an investor’s opportunity
set. Still, like the sovereign bond
markets, the current yield on these instruments, less an assumed default and
recovery rate, makes for the best long-term expectations of their likely
returns. However, since default and
recovery rates are uncertain, it is best to examine these markets using
scenario analysis, tweaking each of these two variables.</div>
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<o:p></o:p></div>
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While there are many segments within the broader fixed
income universe, for the purposes of this posting, I have chosen to project
returns for US High Yield, European High Yield, Emerging Market Foreign-Pay Sovereign
and US Investment Grade segments – all fairly liquid markets. Current Yields and Spreads are shown below.<o:p></o:p></div>
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<b><span style="font-size: x-small;">US
High Yield<o:p></o:p></span></b></div>
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<b><span style="font-size: x-small;">Euro
High Yield<o:p></o:p></span></b></div>
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<b><span style="font-size: x-small;">EM
Sovereign<o:p></o:p></span></b></div>
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<b><span style="font-size: x-small;">US
Inv Grade<o:p></o:p></span></b></div>
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<b><span style="font-size: x-small;">Current Spread<o:p></o:p></span></b></div>
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<span style="font-size: x-small;">4.45<o:p></o:p></span></div>
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<span style="font-size: x-small;">5.28<o:p></o:p></span></div>
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<span style="font-size: x-small;">5.06<o:p></o:p></span></div>
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<span style="font-size: x-small;">2.05<o:p></o:p></span></div>
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<b><span style="font-size: x-small;">Historic Spread<o:p></o:p></span></b></div>
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<span style="font-size: x-small;">5.24<o:p></o:p></span></div>
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<span style="font-size: x-small;">6.42<o:p></o:p></span></div>
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<span style="font-size: x-small;">4.30<o:p></o:p></span></div>
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<span style="font-size: x-small;">1.95<o:p></o:p></span></div>
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<b><span style="font-size: x-small;">Current Yield<o:p></o:p></span></b></div>
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<span style="font-size: x-small;">6.01<o:p></o:p></span></div>
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<span style="font-size: x-small;">5.85<o:p></o:p></span></div>
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<span style="font-size: x-small;">7.66<o:p></o:p></span></div>
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<span style="font-size: x-small;">3.87<o:p></o:p></span></div>
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<span style="font-size: 9.0pt; line-height: 107%;">Source: BofA
Merrill Lynch, Brett Gallagher Calculations<o:p></o:p></span></div>
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Once again, assuming no default, Current Yield is our best
guess at the long-term return from the various fixed income segments. However, as there is some realistic level of
default expected in each of these riskier pools, building a sensitivity
analysis around the historic default level and recovery rates makes sense and
is detailed in the tables below. <o:p></o:p></div>
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For this analysis, I have turned to data gathered by Moody’s
Investors Service which examines cumulative 10-year default percentages
beginning annually in 1970. I then
convert this cumulative figure into an annual one and plug the median default experience
(noted by red font), the worst 10-year default experience, the
best 10-year default experience and the 25<sup>th</sup> and 75<sup>th</sup>
percentile default experience. Because
of the longer history of the US data, I use that experience for other speculative
markets as well (note: using a common data set with an inception date of 1983, European
High Yield and EM Sovereign Debt actually have lower default rates than the US
Universe over the common period – in the case of sovereign debt, about half
that of US Corporates, though the range of outcomes is also wider). <o:p></o:p></div>
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Default rates are calculated using Moody’s study of Cumulative
10-Year default rates over the period 1970 to 2010. Following the cumulative default outcomes, in
parenthesis, I show the annual equivalent default that results in the
cumulative figure and that is used in the sensitivity tables below.<o:p></o:p></div>
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<b>Baa-Rated<o:p></o:p></b></div>
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<b>US,
Euro, EM Sovereign<o:p></o:p></b></div>
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<b>Worst Case <o:p></o:p></b></div>
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10.34% (1.10%)<o:p></o:p></div>
</td>
<td style="border-bottom: solid windowtext 1.0pt; border-left: none; border-right: solid windowtext 1.0pt; border-top: none; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt 0in 5.4pt; width: 155.85pt;" valign="top" width="208"><div align="center" class="MsoNormal" style="margin-bottom: 0.0001pt; text-align: center;">
43.60% (5.65%)<o:p></o:p></div>
</td>
</tr>
<tr>
<td style="border-top: none; border: solid windowtext 1.0pt; mso-border-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt 0in 5.4pt; width: 155.8pt;" valign="top" width="208"><div class="MsoNormal" style="margin-bottom: 0.0001pt;">
<b>25<sup>th</sup> Percentile <o:p></o:p></b></div>
</td>
<td style="border-bottom: solid windowtext 1.0pt; border-left: none; border-right: solid windowtext 1.0pt; border-top: none; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt 0in 5.4pt; width: 155.85pt;" valign="top" width="208"><div align="center" class="MsoNormal" style="margin-bottom: 0.0001pt; text-align: center;">
5.87% (0.61%)<o:p></o:p></div>
</td>
<td style="border-bottom: solid windowtext 1.0pt; border-left: none; border-right: solid windowtext 1.0pt; border-top: none; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt 0in 5.4pt; width: 155.85pt;" valign="top" width="208"><div align="center" class="MsoNormal" style="margin-bottom: 0.0001pt; text-align: center;">
38.53% (4.80%)<o:p></o:p></div>
</td>
</tr>
<tr>
<td style="border-top: none; border: solid windowtext 1.0pt; mso-border-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt 0in 5.4pt; width: 155.8pt;" valign="top" width="208"><div class="MsoNormal" style="margin-bottom: 0.0001pt;">
<b>Median <o:p></o:p></b></div>
</td>
<td style="border-bottom: solid windowtext 1.0pt; border-left: none; border-right: solid windowtext 1.0pt; border-top: none; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt 0in 5.4pt; width: 155.85pt;" valign="top" width="208"><div align="center" class="MsoNormal" style="margin-bottom: 0.0001pt; text-align: center;">
4.74% (0.50%)<o:p></o:p></div>
</td>
<td style="border-bottom: solid windowtext 1.0pt; border-left: none; border-right: solid windowtext 1.0pt; border-top: none; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt 0in 5.4pt; width: 155.85pt;" valign="top" width="208"><div align="center" class="MsoNormal" style="margin-bottom: 0.0001pt; text-align: center;">
33.15% (4.00%)<o:p></o:p></div>
</td>
</tr>
<tr>
<td style="border-top: none; border: solid windowtext 1.0pt; mso-border-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt 0in 5.4pt; width: 155.8pt;" valign="top" width="208"><div class="MsoNormal" style="margin-bottom: 0.0001pt;">
<b>75<sup>th</sup> Percentile <o:p></o:p></b></div>
</td>
<td style="border-bottom: solid windowtext 1.0pt; border-left: none; border-right: solid windowtext 1.0pt; border-top: none; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt 0in 5.4pt; width: 155.85pt;" valign="top" width="208"><div align="center" class="MsoNormal" style="margin-bottom: 0.0001pt; text-align: center;">
3.76% (0.38%)<o:p></o:p></div>
</td>
<td style="border-bottom: solid windowtext 1.0pt; border-left: none; border-right: solid windowtext 1.0pt; border-top: none; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt 0in 5.4pt; width: 155.85pt;" valign="top" width="208"><div align="center" class="MsoNormal" style="margin-bottom: 0.0001pt; text-align: center;">
19.88% (2.20%)<o:p></o:p></div>
</td>
</tr>
<tr>
<td style="border-top: none; border: solid windowtext 1.0pt; mso-border-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt 0in 5.4pt; width: 155.8pt;" valign="top" width="208"><div class="MsoNormal" style="margin-bottom: 0.0001pt;">
<b>Best Case <o:p></o:p></b></div>
</td>
<td style="border-bottom: solid windowtext 1.0pt; border-left: none; border-right: solid windowtext 1.0pt; border-top: none; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt 0in 5.4pt; width: 155.85pt;" valign="top" width="208"><div align="center" class="MsoNormal" style="margin-bottom: 0.0001pt; text-align: center;">
1.16% (0.11%)<o:p></o:p></div>
</td>
<td style="border-bottom: solid windowtext 1.0pt; border-left: none; border-right: solid windowtext 1.0pt; border-top: none; mso-border-alt: solid windowtext .5pt; mso-border-left-alt: solid windowtext .5pt; mso-border-top-alt: solid windowtext .5pt; padding: 0in 5.4pt 0in 5.4pt; width: 155.85pt;" valign="top" width="208"><div align="center" class="MsoNormal" style="margin-bottom: 0.0001pt; text-align: center;">
8.23% (0.85%)<span style="font-size: x-small;"><o:p></o:p></span></div>
</td>
</tr>
</tbody></table>
<div class="MsoNormal">
</div>
<div class="MsoNormal">
<span style="line-height: 107%;"><span style="font-size: x-small;">Source: Moody’s,
Brett Gallagher</span><span style="font-size: 9pt;"><o:p></o:p></span></span></div>
<div class="MsoNormal">
<span style="font-size: 9.0pt; line-height: 107%;"><br /></span></div>
<div class="MsoNormal">
<span style="font-size: 9.0pt; line-height: 107%;">* Users
familiar with Moody’s data may note that my model default assumptions, when converted to annual rates, are lower
than the annual average default rates over the period. As certain outsized years have the effect of
distorting the overall calculation of “average” and, as we are looking at a
10-year horizon, I feel the cumulative data, converted to an annualized figure,
is more relevant.<o:p></o:p></span></div>
<div class="MsoNormal">
<br /></div>
<div class="MsoNormal">
<b> </b>Using a wide range of default and recovery assumptions, we
are able to construct a narrow range of likely outcomes for nearly any fixed
income segment we desire. While the
returns due to risk assets appear relatively attractive when compared with developed
sovereign markets, the range of returns are far below historic experience and
most investors assumed return assumptions.</div>
<div class="MsoNormal">
<br /></div>
<div class="MsoNormal">
<o:p></o:p></div>
<div class="MsoNormal">
<b>US High Yield Debt –
Current Yield 6.01%, Median 33.1% 10-year Cumulative Default<o:p></o:p></b></div>
<div class="MsoNormal">
<b><br /></b></div>
<div class="MsoNormal">
<br />
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 469px;">
<colgroup><col style="mso-width-alt: 2486; mso-width-source: userset; width: 51pt;" width="68"></col>
<col style="mso-width-alt: 2962; mso-width-source: userset; width: 61pt;" width="81"></col>
<col span="5" style="width: 48pt;" width="64"></col>
</colgroup><tbody>
<tr height="20" style="height: 15.0pt;">
<td class="xl67" height="20" style="height: 15.0pt; width: 51pt;" width="68"></td>
<td style="width: 61pt;" width="81"></td>
<td class="xl75" colspan="5" style="width: 240pt;" width="320">Annualized Default
Rates</td>
</tr>
<tr height="21" style="height: 15.75pt;">
<td class="xl74" height="161" rowspan="8" style="height: 120.75pt;">Recovery Rate</td>
<td align="right" class="xl70"><br /></td>
<td align="right" class="xl68"><b>0.85%</b></td>
<td align="right" class="xl68"><b>2.20%</b></td>
<td align="right" class="xl69"><b><span style="color: blue;">4.00%</span></b></td>
<td align="right" class="xl68"><b>4.80%</b></td>
<td align="right" class="xl68"><b>5.65%</b></td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>20.0%</b></td>
<td align="right" class="xl71">5.31%</td>
<td align="right" class="xl72">4.43%</td>
<td align="right" class="xl72">3.30%</td>
<td align="right" class="xl72">2.83%</td>
<td align="right" class="xl72">2.34%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>25.0%</b></td>
<td align="right" class="xl73">5.34%</td>
<td align="right" class="xl67">4.50%</td>
<td align="right" class="xl67">3.45%</td>
<td align="right" class="xl67">3.00%</td>
<td align="right" class="xl67">2.54%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>30.0%</b></td>
<td align="right" class="xl73">5.37%</td>
<td align="right" class="xl67">4.58%</td>
<td align="right" class="xl67">3.59%</td>
<td align="right" class="xl67">3.18%</td>
<td align="right" class="xl67">2.75%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl66" height="20" style="height: 15.0pt;"><b><span style="color: blue;">35.0%</span></b></td>
<td align="right" class="xl73">5.40%</td>
<td align="right" class="xl67">4.66%</td>
<td align="right" class="xl69"><b><span style="color: blue;">3.74%</span></b></td>
<td align="right" class="xl67">3.35%</td>
<td align="right" class="xl67">2.95%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>40.0%</b></td>
<td align="right" class="xl73">5.43%</td>
<td align="right" class="xl67">4.73%</td>
<td align="right" class="xl67">3.88%</td>
<td align="right" class="xl67">3.52%</td>
<td align="right" class="xl67">3.15%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>45.0%</b></td>
<td align="right" class="xl73">5.46%</td>
<td align="right" class="xl67">4.81%</td>
<td align="right" class="xl67">4.01%</td>
<td align="right" class="xl67">3.68%</td>
<td align="right" class="xl67">3.35%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>50.0%</b></td>
<td align="right" class="xl73">5.49%</td>
<td align="right" class="xl67">4.89%</td>
<td align="right" class="xl67">4.15%</td>
<td align="right" class="xl67">3.85%</td>
<td align="right" class="xl67">3.54%</td>
</tr>
</tbody></table>
</div>
<div class="MsoNormal">
<br /></div>
<div class="MsoNormal">
<b><br /></b>
<b>European High Yield
Debt – Current Yield 5.85%, Median 33.1% 10-year Cumulative Default<o:p></o:p></b></div>
<div class="MsoNormal">
<br />
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 469px;">
<colgroup><col style="mso-width-alt: 2486; mso-width-source: userset; width: 51pt;" width="68"></col>
<col style="mso-width-alt: 2962; mso-width-source: userset; width: 61pt;" width="81"></col>
<col span="5" style="width: 48pt;" width="64"></col>
</colgroup><tbody>
<tr height="20" style="height: 15.0pt;">
<td class="xl67" height="20" style="height: 15.0pt; width: 51pt;" width="68"></td>
<td style="width: 61pt;" width="81"></td>
<td class="xl75" colspan="5" style="width: 240pt;" width="320">Annualized Default
Rates</td>
</tr>
<tr height="21" style="height: 15.75pt;">
<td class="xl74" height="161" rowspan="8" style="height: 120.75pt;">Recovery Rate</td>
<td align="right" class="xl70"><br /></td>
<td align="right" class="xl68"><b>0.85%</b></td>
<td align="right" class="xl68"><b>2.20%</b></td>
<td align="right" class="xl69"><b><span style="color: blue;">4.00%</span></b></td>
<td align="right" class="xl68"><b>4.80%</b></td>
<td align="right" class="xl68"><b>5.65%</b></td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>20.0%</b></td>
<td align="right" class="xl71">5.16%</td>
<td align="right" class="xl72">4.27%</td>
<td align="right" class="xl72">3.14%</td>
<td align="right" class="xl72">2.67%</td>
<td align="right" class="xl72">2.17%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>25.0%</b></td>
<td align="right" class="xl73">5.19%</td>
<td align="right" class="xl67">4.35%</td>
<td align="right" class="xl67">3.29%</td>
<td align="right" class="xl67">2.84%</td>
<td align="right" class="xl67">2.38%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>30.0%</b></td>
<td align="right" class="xl73">5.22%</td>
<td align="right" class="xl67">4.43%</td>
<td align="right" class="xl67">3.44%</td>
<td align="right" class="xl67">3.02%</td>
<td align="right" class="xl67">2.59%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl66" height="20" style="height: 15.0pt;"><b><span style="color: blue;">35.0%</span></b></td>
<td align="right" class="xl73">5.25%</td>
<td align="right" class="xl67">4.50%</td>
<td align="right" class="xl69"><b><span style="color: blue;">3.58%</span></b></td>
<td align="right" class="xl67">3.19%</td>
<td align="right" class="xl67">2.79%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>40.0%</b></td>
<td align="right" class="xl73">5.28%</td>
<td align="right" class="xl67">4.58%</td>
<td align="right" class="xl67">3.72%</td>
<td align="right" class="xl67">3.36%</td>
<td align="right" class="xl67">2.99%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>45.0%</b></td>
<td align="right" class="xl73">5.31%</td>
<td align="right" class="xl67">4.66%</td>
<td align="right" class="xl67">3.86%</td>
<td align="right" class="xl67">3.53%</td>
<td align="right" class="xl67">3.19%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>50.0%</b></td>
<td align="right" class="xl73">5.34%</td>
<td align="right" class="xl67">4.73%</td>
<td align="right" class="xl67">4.00%</td>
<td align="right" class="xl67">3.69%</td>
<td align="right" class="xl67">3.39%</td>
</tr>
</tbody></table>
</div>
<div class="MsoNormal">
<br /></div>
<div class="MsoNormal">
<b><br /></b>
<b>US Investment Grade
(BBB) – Current Yield 3.87%, Median 4.7% 10-year Cumulative Default<o:p></o:p></b></div>
<div class="MsoNormal">
<b> </b><br />
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 469px;">
<colgroup><col style="mso-width-alt: 2486; mso-width-source: userset; width: 51pt;" width="68"></col>
<col style="mso-width-alt: 2962; mso-width-source: userset; width: 61pt;" width="81"></col>
<col span="5" style="width: 48pt;" width="64"></col>
</colgroup><tbody>
<tr height="20" style="height: 15.0pt;">
<td class="xl67" height="20" style="height: 15.0pt; width: 51pt;" width="68"></td>
<td style="width: 61pt;" width="81"></td>
<td class="xl75" colspan="5" style="width: 240pt;" width="320">Annualized Default
Rates</td>
</tr>
<tr height="21" style="height: 15.75pt;">
<td class="xl74" height="161" rowspan="8" style="height: 120.75pt;">Recovery Rate</td>
<td align="right" class="xl70"><br /></td>
<td align="right" class="xl68"><b>0.11%</b></td>
<td align="right" class="xl68"><b>0.38%</b></td>
<td align="right" class="xl69"><b><span style="color: blue;">0.50%</span></b></td>
<td align="right" class="xl68"><b>0.61%</b></td>
<td align="right" class="xl68"><b>1.10%</b></td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>20.0%</b></td>
<td align="right" class="xl71">3.76%</td>
<td align="right" class="xl72">3.57%</td>
<td align="right" class="xl72">3.48%</td>
<td align="right" class="xl72">3.40%</td>
<td align="right" class="xl72">3.06%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>25.0%</b></td>
<td align="right" class="xl73">3.77%</td>
<td align="right" class="xl67">3.58%</td>
<td align="right" class="xl67">3.50%</td>
<td align="right" class="xl67">3.43%</td>
<td align="right" class="xl67">3.10%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>30.0%</b></td>
<td align="right" class="xl73">3.77%</td>
<td align="right" class="xl67">3.60%</td>
<td align="right" class="xl67">3.52%</td>
<td align="right" class="xl67">3.45%</td>
<td align="right" class="xl67">3.14%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl66" height="20" style="height: 15.0pt;"><b><span style="color: blue;">35.0%</span></b></td>
<td align="right" class="xl73">3.77%</td>
<td align="right" class="xl67">3.61%</td>
<td align="right" class="xl69"><b><span style="color: blue;">3.54%</span></b></td>
<td align="right" class="xl67">3.47%</td>
<td align="right" class="xl67">3.18%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>40.0%</b></td>
<td align="right" class="xl73">3.78%</td>
<td align="right" class="xl67">3.62%</td>
<td align="right" class="xl67">3.56%</td>
<td align="right" class="xl67">3.50%</td>
<td align="right" class="xl67">3.23%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>45.0%</b></td>
<td align="right" class="xl73">3.78%</td>
<td align="right" class="xl67">3.64%</td>
<td align="right" class="xl67">3.58%</td>
<td align="right" class="xl67">3.52%</td>
<td align="right" class="xl67">3.27%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>50.0%</b></td>
<td align="right" class="xl73">3.79%</td>
<td align="right" class="xl67">3.65%</td>
<td align="right" class="xl67">3.60%</td>
<td align="right" class="xl67">3.54%</td>
<td align="right" class="xl67">3.31%</td>
</tr>
</tbody></table>
</div>
<div class="MsoNormal">
<br /></div>
<div class="MsoNormal">
<b><br /></b>
<b>EM Sovereign (USD
Pay) – Current Yield 7.66%, Median 33.1% 10-year Cumulative Default<o:p></o:p></b></div>
<div class="MsoNormal">
<br />
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 469px;">
<colgroup><col style="mso-width-alt: 2486; mso-width-source: userset; width: 51pt;" width="68"></col>
<col style="mso-width-alt: 2962; mso-width-source: userset; width: 61pt;" width="81"></col>
<col span="5" style="width: 48pt;" width="64"></col>
</colgroup><tbody>
<tr height="20" style="height: 15.0pt;">
<td class="xl67" height="20" style="height: 15.0pt; width: 51pt;" width="68"></td>
<td style="width: 61pt;" width="81"></td>
<td class="xl75" colspan="5" style="width: 240pt;" width="320">Annualized Default
Rates</td>
</tr>
<tr height="21" style="height: 15.75pt;">
<td class="xl74" height="161" rowspan="8" style="height: 120.75pt;">Recovery Rate</td>
<td align="right" class="xl70"><br /></td>
<td align="right" class="xl68"><b>0.85%</b></td>
<td align="right" class="xl68"><b>2.20%</b></td>
<td align="right" class="xl69"><b><span style="color: blue;">4.00%</span></b></td>
<td align="right" class="xl68"><b>4.80%</b></td>
<td align="right" class="xl68"><b>5.65%</b></td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>20.0%</b></td>
<td align="right" class="xl71">6.85%</td>
<td align="right" class="xl72">6.00%</td>
<td align="right" class="xl72">4.92%</td>
<td align="right" class="xl72">4.46%</td>
<td align="right" class="xl72">3.98%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>25.0%</b></td>
<td align="right" class="xl73">6.88%</td>
<td align="right" class="xl67">6.07%</td>
<td align="right" class="xl67">5.05%</td>
<td align="right" class="xl67">4.62%</td>
<td align="right" class="xl67">4.18%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>30.0%</b></td>
<td align="right" class="xl73">6.91%</td>
<td align="right" class="xl67">6.14%</td>
<td align="right" class="xl67">5.19%</td>
<td align="right" class="xl67">4.78%</td>
<td align="right" class="xl67">4.37%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl66" height="20" style="height: 15.0pt;"><b><span style="color: blue;">35.0%</span></b></td>
<td align="right" class="xl73">6.93%</td>
<td align="right" class="xl67">6.21%</td>
<td align="right" class="xl69"><b><span style="color: blue;">5.32%</span></b></td>
<td align="right" class="xl67">4.94%</td>
<td align="right" class="xl67">4.55%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>40.0%</b></td>
<td align="right" class="xl73">6.96%</td>
<td align="right" class="xl67">6.29%</td>
<td align="right" class="xl67">5.45%</td>
<td align="right" class="xl67">5.10%</td>
<td align="right" class="xl67">4.74%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>45.0%</b></td>
<td align="right" class="xl73">6.99%</td>
<td align="right" class="xl67">6.36%</td>
<td align="right" class="xl67">5.57%</td>
<td align="right" class="xl67">5.25%</td>
<td align="right" class="xl67">4.92%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td align="right" class="xl65" height="20" style="height: 15.0pt;"><b>50.0%</b></td>
<td align="right" class="xl73">7.02%</td>
<td align="right" class="xl67">6.43%</td>
<td align="right" class="xl67">5.70%</td>
<td align="right" class="xl67">5.40%</td>
<td align="right" class="xl67">5.10%</td>
</tr>
</tbody></table>
</div>
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In my next post, I turn to global equity markets.</div>
Bretthttp://www.blogger.com/profile/11094579354565486061noreply@blogger.com0tag:blogger.com,1999:blog-5803518473270155434.post-2162560192347812102013-06-15T12:52:00.002-07:002013-08-01T15:36:29.426-07:00The Profitability Illusion<div class="MsoNormal">
<i><span style="font-family: Calibri, sans-serif; line-height: 107%;">The current near-record level profit margins of
the S&P 500 are largely an illusion, created solely by the fact that
interest costs have fallen precipitously, even as overall debt levels have
increased. Operating profitability, is
actually below average. As the Fed’s
Quantitative Easing program is unwound, earnings are at significant risk</span></i></div>
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<span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;">Current profit margins for S&P 500 companies remain near
historic highs even as the broader economy struggles and real income growth
remains anemic. The stock market trades
near record levels supported, if not by fundamentals, by promises of the Fed to
hold interest rates near historic lows.
Today though, the certainty of those promises is being discussed with
potentially very negative consequences for US and Foreign Markets.<o:p></o:p></span></div>
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<span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;">Market bulls point to high profitability and supportive
market action as well as benign valuation as reason for their continued
positive stance. Indeed, market
participants are by many measures, as bullish as ever (hedge fund net longs,
investor sentiment measures).<o:p></o:p></span></div>
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<span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;"><br /></span></div>
<span style="font-family: 'Helvetica Neue', Arial, Helvetica, sans-serif;">However, analysts, like myself, who believe that margins
tend to be cyclical in nature, caution that today’s high margins are a reason
for restraint, not celebration. Traditional
valuation metrics like P/E ratios, tend to understate the valuation of markets
when margins are well above average, as they are today, leaving open to
question whether the factors supporting the market are capable of remaining in
place for an extended period.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjr-WLh9RwaYqAUdTKhdA8J49Hl-4zq5G4gwK_7r6zYaJglspYM4Rh3FVnCt5Oua-KCDzzBHqiI4uwk9GBeGrRRD5F89MKHEOTJdn02n1tGlzWedohltP0ZXno_AM23VwZKkOTsnkMvM20/s1600/Net+Margins.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="226" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjr-WLh9RwaYqAUdTKhdA8J49Hl-4zq5G4gwK_7r6zYaJglspYM4Rh3FVnCt5Oua-KCDzzBHqiI4uwk9GBeGrRRD5F89MKHEOTJdn02n1tGlzWedohltP0ZXno_AM23VwZKkOTsnkMvM20/s400/Net+Margins.jpg" width="400" /></a></div>
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<span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;"><br /></span>
<span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;"><br /></span>
<span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;"><br /></span>
<span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;"><br /></span>
<span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;"><br /></span>
<span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;">Bulls will counter that we have witnessed a permanent shift
upward in margins given the now global nature of production and the ability of
corporations to manage costs better than ever by using offshore operations when
beneficial. This same argument is often
cited when explaining why US personal income growth remains anemic. While on the surface this is a believable narrative,
the data does not back it up.</span></div>
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<span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;"><o:p></o:p>When margins are decomposed into their component parts: <o:p></o:p></span></div>
<div class="MsoListParagraphCxSpFirst" style="mso-list: l0 level1 lfo1; text-indent: -.25in;">
</div>
<ul>
<li><span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;"><span style="text-indent: -0.25in;">·
</span><span style="text-indent: -0.25in;">operational factors (sales less the direct costs
of production)</span></span></li>
<li><span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;"><span style="text-indent: -0.25in;">·
</span><span style="text-indent: -0.25in;">tax factors (the percentage of sales one forfeits
in taxes)</span><span style="text-indent: -0.25in;"> </span></span></li>
<li><span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;"><span style="text-indent: -0.25in;">·
</span><span style="text-indent: -0.25in;">financing factors (amounts paid due to corporate
financing decisions), and</span></span></li>
<li><span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;"><span style="text-indent: -0.25in;">·
</span><span style="text-indent: -0.25in;">extra-ordinary items (one-off items, not likely
to be recurring in nature)</span></span></li>
</ul>
<span style="font-family: 'Helvetica Neue', Arial, Helvetica, sans-serif;">it becomes obvious that </span><b style="font-family: 'Helvetica Neue', Arial, Helvetica, sans-serif;"><i>the historic profitability of the S&P 500
today relies solely on the fact that interest costs have fallen precipitously</i></b><span style="font-family: 'Helvetica Neue', Arial, Helvetica, sans-serif;">
during the Fed’s period of QE </span><b style="font-family: 'Helvetica Neue', Arial, Helvetica, sans-serif;"><i>even as overall debt levels have increased.</i></b><br />
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<b><i><span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;"><br /></span></i></b></div>
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<span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;">Current net margins are quite high by historical standards
(8.04% versus the 15-year average 6.55%).
However, “operational margins” (the profitability of a company apart
from their taxes and financing decisions) are now actually below average – so
much for the benefits of global production.
The reason for the discrepancy between margins as generally discussed
and operational factors has to do with the very low level of interest expense
(1.78% of S&P 500 sales compared to an average of 3.88%), even though
overall leverage (debt as % assets) has risen to 14.2% from the long-term
average of 11.5% (Averages use year-end figures calculated from Dec 1998 through
Dec 2012).<o:p></o:p></span></div>
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<span style="line-height: 107%;"><span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;">The charts which follow demonstrate this dynamic
quite clearly. After a bump during the
period 2005 – 2007, interest expenses have fallen dramatically in spite of the
fact that debt levels climbed (most precipitously in 2009). To measure leverage, I have chosen to show both Total Debt to Asset as well
as Net Debt to Asset measures. It is my belief
that net debt better hints at corporate vulnerability to leverage as it takes
into account “tactical” debt issuance where retained cash can, theoretically,
be used to immediately reduce leverage should borrowing costs reverse).</span></span></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhpGbI7K_uGkDv5MZDLROTn4jwO_ANq2s68_1upa8cdeZNZG2mE-ZJ98_BbEIHblrdylGUN7Ngm1iKIEEh026Xccj5xapQv3qujCXx2SYf2Hhpai_8HNLiA5ohnF9FMPFLGpIJqZ61YMME/s1600/Interest+Expense.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="225" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhpGbI7K_uGkDv5MZDLROTn4jwO_ANq2s68_1upa8cdeZNZG2mE-ZJ98_BbEIHblrdylGUN7Ngm1iKIEEh026Xccj5xapQv3qujCXx2SYf2Hhpai_8HNLiA5ohnF9FMPFLGpIJqZ61YMME/s400/Interest+Expense.jpg" width="400" /></a></div>
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<i><span style="font-size: 8pt; line-height: 11px;"><span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;"><br /></span></span></i><i><span style="font-size: 8pt; line-height: 11px;"><span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;"><br /></span></span></i><br />
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<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjkXySiqMOD06hB8_TooPbp7qdd-a4-3Pb8IK8yemGl-QZrw1Wk0qlPa_BDolOFZYqEAqXJbmriL0pueIAJVkr28HpbrKwKFGY98qJu9kdB7v9c3NvT6-H4VzqaGlkgr-qmLQlL1usREjs/s1600/Debt+as+%25+Assets.jpg" imageanchor="1" style="clear: left; margin-bottom: 1em; margin-left: auto; margin-right: auto;"><img border="0" height="225" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjkXySiqMOD06hB8_TooPbp7qdd-a4-3Pb8IK8yemGl-QZrw1Wk0qlPa_BDolOFZYqEAqXJbmriL0pueIAJVkr28HpbrKwKFGY98qJu9kdB7v9c3NvT6-H4VzqaGlkgr-qmLQlL1usREjs/s400/Debt+as+%25+Assets.jpg" width="400" /></a></td></tr>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi_v_AFa5jt8un-tnoWO2dyH-sHBf4XeZbW_LO29-EYoUH2xzA4CyA4U3z5tVMNiExDtFrwOIO3t6RfqkhMtPWqvAOZ0jyObiyVjkTYiqRWb_h3XwJby1ABs0QcFu7OcjkGiq-RBz51awY/s1600/Net+Debt.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="225" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi_v_AFa5jt8un-tnoWO2dyH-sHBf4XeZbW_LO29-EYoUH2xzA4CyA4U3z5tVMNiExDtFrwOIO3t6RfqkhMtPWqvAOZ0jyObiyVjkTYiqRWb_h3XwJby1ABs0QcFu7OcjkGiq-RBz51awY/s400/Net+Debt.jpg" width="400" /></a></div>
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<span style="font-family: 'Helvetica Neue', Arial, Helvetica, sans-serif;"><br /></span>
<span style="font-family: 'Helvetica Neue', Arial, Helvetica, sans-serif;"><br /></span>
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<span style="font-family: 'Helvetica Neue', Arial, Helvetica, sans-serif;"><br /></span>
<span style="font-family: 'Helvetica Neue', Arial, Helvetica, sans-serif;">The chart below shows “operational margin” levels since
1998. Current readings are slightly
below average. Should interest costs
rise and encroach on overall business profitability, it is net margins that
will have to suffer disproportionately.</span></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjOmVRW_Y1iTUxSGeG57ye4f3COM8bCsNYfOlMGmPYY-CzQiNeusCOfgAjrVGqsr78XSujn2bwn23BiPbEealyHzxFEW0XjU_pY0hYDyr80ikiRvZzhQt5kup4sbRjyap_Hlj-K5Y5sTDk/s1600/Real+Business+Margins.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="225" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjOmVRW_Y1iTUxSGeG57ye4f3COM8bCsNYfOlMGmPYY-CzQiNeusCOfgAjrVGqsr78XSujn2bwn23BiPbEealyHzxFEW0XjU_pY0hYDyr80ikiRvZzhQt5kup4sbRjyap_Hlj-K5Y5sTDk/s400/Real+Business+Margins.png" width="400" /></a></div>
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<i><span style="font-size: 8pt; line-height: 11px;"><span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;">Sources for all exhibits: Brett Gallagher, Zack’s Investment Research</span></span></i></div>
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<span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;">Two conclusions can be drawn from the above. First, given the low level of interest rates,
further progress in margin enhancement via lowering interest expense without
paying down debt would seem limited and operational metrics must improve if
current margins are to be sustained.<o:p></o:p></span></div>
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<span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;">Secondly, should rates reverse their downward trend,
interest costs could have the opposite effect on profitability as financing
costs rise dramatically. If interest
expenses revert to their historic average, net margins would fall below 6% (all
else equal, this results in a 25% earnings decline from today’s levels).<o:p></o:p></span></div>
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<span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;">IN CONCLUSION, assuming continued sluggishness in economic
(and, hence sales) growth, high levels of leverage and a bottoming of interest
rates, maintaining margins above the norm is unlikely and reversion to mean
becomes a more likely outcome than a secularly higher level of profitability. In such an environment, earnings are
vulnerable as are P/E multiples, meaning equities themselves are at risk. <o:p></o:p></span></div>
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<span style="font-family: Helvetica Neue, Arial, Helvetica, sans-serif;">In the next two postings to this blog, I will provide long-term
return assumptions for US, UK, Continental European and Japanese equities
(under a range of margin and P/E assumptions) as well as a variety of government
and corporate bond markets using a proven valuation methodology. The results will have significant
implications for plan sponsors and other investors.</span><o:p></o:p></div>
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Bretthttp://www.blogger.com/profile/11094579354565486061noreply@blogger.com1