Archive for July, 2012

Francois Trahan Transcript 7/27/12 #905

WEALTHTRACK Transcript #905- 7/27/12

CONSUELO MACK:  This week on WEALTHTRACK, a Financial Thought Leader who is not afraid to go against the crowd. Investment strategist Francois Trahan makes the case for an economic and market rebound in the face of evidence to the contrary next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this edition of WEALTHTRACK. I’m Consuelo Mack. It’s nice to be able to focus on some positive news for a change and as you will discover in a moment, this week’s guest is one of the most upbeat Financial Thought Leaders out there right now, at least for the next several months. Here are some developments he’s following that might lift your spirits as well.

The devastation in the housing market, the largest asset held by many Americans, appears to be healing and improving. Although still at depressed levels, new home construction- called housing starts in the trade- recently rose to the highest level in nearly four years. And confidence among home builders climbed by the most since 2002. Even Federal Reserve chief Ben Bernanke noted the “modest signs of improvement in housing” in his otherwise somber remarks recently. And for those of you contemplating buying a home, they have never been more affordable. The U.S. Housing Affordability Index is at a record high due largely to record low mortgage rates. Of course qualifying for a mortgage is another matter! It is still difficult for many Americans.

Another positive trend: inflation. It is decelerating. We can thank falling oil prices over the last few months for putting more money in our pockets. The Fed now predicts that its favorite measure of inflation, the Price Index for Personal Consumption Expenditures, or PCE, will be under the Fed’s targeted 2% level and below last year’s 2.5% rate-  not only a boost to the economy, but giving the Fed some flexibility to provide more monetary stimulus if it sees the need. By one count, there have been well over two hundred stimulative policy initiatives around the world in the past eleven months. That’s a lot of economic juice.

Meanwhile, as this week’s guest has been telling clients recently, investor sentiment is as low as it’s been since the financial crisis. Investors are still net sellers of stock mutual funds and buyers of bonds, even though a record high number of stocks, about 60% of S&P 500 companies, now pay dividend yields greater than the yield on the ten year U.S. Treasury note.

Our guest this week is Francois Trahan, Vice Chairman, Chief Investment Strategist and Head of Quantitative Research at investment research boutique Wolfe Trahan. Institutional investors have ranked him either the number one or number two portfolio strategist on Wall Street for the past eight years. He is also co-author of the recently published book, The Era of Uncertainty: Global Strategies for Inflation, Deflation and the Middle Ground, which I highly recommend. I began the interview by asking him why, after several years of bearishness, he turned bullish last October.

FRANCOIS TRAHAN: Because leading indicators of the economy were beginning to turn the corner. So for the last two years almost, I’ve been using the mantra, “inflation is the new Fed funds rate.” And what I mean by that is in a world where the Fed funds rate is at zero, what you find is that inflation becomes a more important barometer of the economy. When inflation goes up, consumers feel as if there’s attacks being imposed on them. The economy tends to slow in the wake of that. That’s what you saw in the wake of QE2, but it works in reverse. When inflation goes down, consumers feel like they have more money in their pockets. When the price of gasoline goes down, clothing, food, et cetera, and what you tend to see in the wake of that is a better economy. So leading up to last October, what we’d seen is a big decline in inflation, which finally was starting to have an impact on leading indicators of the economy, and by the same token, on the equity market.

CONSUELO MACK:  So you, Francois Trahan, at Wolfe Trahan, now, that instead of watching the Fed funds rate religiously, like many other people have done over their careers.

FRANCOIS TRAHAN: So I used to be a huge Fed watcher.

CONSUELO MACK:  Right.

FRANCOIS TRAHAN: It used to be the only thing that mattered for the economy, but the Fed took away my ability to do that in December of 2008, when they took the Fed funds right down to zero. And it’s from that point on that you start to see that inflation began to play a bigger role in the business cycle. And so I now call myself an inflation watcher. That’s the bigger driver of the business cycle today.

CONSUELO MACK:  So let me ask you about now, because we are seeing what seems to be an economic slowdown. We’ve got unemployment rising, we’ve got corporate earnings are weakening. So the question is, this soft patch that we’re going through, why do you think it’s a soft patch, i.e., that we’re going to get out of it, and not something more, you know, lengthy?

FRANCOIS TRAHAN: Well, there’s no doubt that what’s happening is about the economy. If you think of when the stock market ran into difficulties, which was late March, early April, it’s when leading indicators of the economy started faltering. So you see initial jobless claims that began to rise. All the regional PMIs, those regional leading indicators, started to come down.

CONSUELO MACK:  Purchasing Managers Index, right. People buying stuff.

FRANCOIS TRAHAN: Purchasing Managers Indices. Exactly. And so it’s clear that it’s about the economy, but as long as you have low inflation, what you’re going to have is data points that will eventually recover. And we’re beginning to see that now in the month of July. So, so far we have, three leading indicators have been released for the month of July, all three are up. National Association of Home Builders Index rose to a five-year high. If the economy is about to fall off a cliff, going into recession, why is that going up to a five-year high? And to me, that’s a great barometer of how consumers feel. It can’t be that bad if homebuilders are doing okay. We have the Empire Fed Index, which came out for July. It went up. The Philly Fed Index for July went up. So I think we’re slowly exiting this soft patch, and when we write the history of this cycle, we’re not going to remember these last three months. We’re going to remember that in October the stock market bottomed. Then it continued to power through 2012.

CONSUELO MACK:  So there has been a pattern over the last three years of the economy doing, you know, really well, kind of in the fall and into the winter, and then in the spring, like we have now, that the economy starts to falter, and then there is a market route. So, you know, a year ago August, in three days, the S&P 500 went down 12%, which really has spooked investors. So why don’t you think that could happen again?

FRANCOIS TRAHAN: Right. Well, a year ago what you were facing were the lagged effects of inflation. Inflation was very high. Central banks around the world had raised rates. What you have today is the exact opposite. Inflation has come down remarkably, sitting at a cycle low in the U.S. and in many countries around the world, and you’ve seen Central Banks cut rates around the world. So a year ago, you have tightening in the pipeline. Today you have easing in the pipeline. What follows in the wake of easing is better economic data points. So I think this is a completely different animal. I think you’re about to see a recovery in stocks, and probably a melt up in stocks. If you look at where sentiment is right now, people are very skeptical of this recovery.

CONSUELO MACK:  Right. Everyone wants out of stocks.

FRANCOIS TRAHAN: Right. And yet, the S&P is up over 100 points from where it was in early June. So think about this. The S&P is up 100 points on bad data, and beta in the market that hasn’t really contributed- so cyclical sectors that haven’t really worked. I think both of those things are about to change. So imagine what happens when the data starts to improve, we’re seeing glimmers of that now, and beta starts to kick in, where all of a sudden the cyclical industries begin to work. You know, that’s a very powerful combination for equities, at least in the short run.

CONSUELO MACK:  The naysayers are looking at the headlines and they’re saying Euro zone crisis has not gone away. We’ve got an election coming up. We have no idea what’s going to happen there. And we’ve got this fiscal cliff.  So all of the same things that were in play, except for the election, a year ago, when the market went through that route. So where do those figure in in your calculus?

FRANCOIS TRAHAN: Well, those are all legitimate concerns. You know, the fiscal issues in the U.S., I think, are a structural concern. The state of the Euro is a structural concern. But the reality is there’s lots of ways to kick the can. You can kick the can with policy, or sometimes the business cycle can do it for you. So if you think back to last fall, when the leading indicators of the economy started to rise- even in Europe they started to rise- all of a sudden CDS spreads, right, what we call country risk, the CDS spreads started to narrow. It means the country risks started to go away.

CONSUELO MACK:  Right. The credit default swaps, which were like insurance policies, so if the premiums go up, that means there’s more risk. If they go down, there’s less.

FRANCOIS TRAHAN: That’s exactly right. And so leading indicators started to go up. That means the economic outlook improved just a little bit. But all of a sudden the CDS spreads began to narrow. And so it felt like the Euro crisis was resolving itself. Of course, you’re not going to resolve it, but you’re going to get the impression that you’re resolving it for a while. To me, it’s kicking the can, but, you know, those can be very powerful moves. And I think we’re staring at one now.

CONSUELO MACK:  So let’s talk about how powerful, because you’re saying that, in fact, the S&P 500 could reach an all-time high in the next several months. Why?

FRANCOIS TRAHAN: So we’re up over 100 points from the low. The S&P is off three to four percent from its peak, which we reached in late March. But what’s strange is people are behaving as if it’s off 30%. It’s off three to four. You know, things aren’t that bad. So sentiment’s very skeptical. You look at the surveys of bullish consensus. Right now, sitting at the same levels, you mentioned August of last year, we’re sitting at those levels. That’s how skeptical people are. At a point in time where I think the data is about to surprise on the upside. That’s a very powerful combination. And that’s how you get a melt up in equities.

And so I think it is possible that the S&P goes to a new all-time high. That’s about 1550. It’s a little ambitious. I think if it goes to 1450, it’s a huge surprise for people, to be quite honest. But, you know, when moves start initially, it’s just returning to the mean. People acknowledge that they’ve been wrong, you know, and eventually what they do is they extrapolate. You know, they will believe that this cycle will be sustainable. I’ve seen this movie before. And that’s how, you know, equities end up overshooting. So, you know, nothing has changed in my structural view of the world, but I think in the next few months what you’re going to see is a very powerful stock market.

CONSUELO MACK:  And let’s be quite clear about this, you’re talking about the next few months. This is not a long-term bull call anticipation. This is within, you know, a business cycle, and so you’re basically advising…

FRANCOIS TRAHAN: Couple quarters, maybe. Something till the end of the year. Maybe early next year.

CONSUELO MACK:  Right. So you’re telling your clients, who are institutional clients, essentially, not individuals- you’re telling them what’s the strategy to follow.

FRANCOIS TRAHAN: Well, it’s to be… to be aggressive, and to believe in cyclical sectors, what we call the risk-on trade. Everything that is a risk-on asset. That’s equities. That’s the cyclical industries. When you’re picking stocks, it’s emphasizing those high beta names.

CONSUELO MACK:  So it’s financials, for instance, right?

FRANCOIS TRAHAN: Absolutely.

CONSUELO MACK:  It’s what? Material stocks. I mean things that, you know, go up when the economy does well.

FRANCOIS TRAHAN: Yeah.  And it’s European equities.

CONSUELO MACK:  European equities?

FRANCOIS TRAHAN: Of course. Everything that has worked in the last couple months has been has been risk off.

CONSUELO MACK:  Right. Defensive issues.

FRANCOIS TRAHAN: Defensive.

CONSUELO MACK:  Healthcare, REITs

FRANCOIS TRAHAN: It’s not just healthcare. It’s also …

CONSUELO MACK:  Utilities.

FRANCOIS TRAHAN: … the U.S. dollar. It’s U.S. Treasuries. You know, think about it, the ten-year Treasury bond yield is around one-and-a-half percent. You know, people are so fearful of the world right now that they’ve piled in to treasuries. And so at some point, when they start to believe that the data is, indeed, going to improve, money’s going to come out of that defensive trade, and it’s going to go right into the other trade, which is the risk-on trade, or the cyclical trade, and I think you’re going to get a very powerful move in equities.

CONSUELO MACK:  So the point is, this really could turn on a dime. I mean it’s something… so are you advising clients to kind of get set now and to start moving out of defensive issues and into, you know, the risk trade, the more cyclical issues, starting now, I mean in a major way, or…

FRANCOIS TRAHAN: Yeah.

CONSUELO MACK:  …incrementally, or what?

FRANCOIS TRAHAN: Well, so what we did in June, is we said if you believe this is a soft patch- if you believe the market has suffered, because of a soft patch in the economy, then we’re going to be out of this. You’re going to have a big green light for equities when the soft patch is over. So we made a checklist. You know, what are the data points that you want to look at? So we want to look at initial jobless claims. We want to look at…

CONSUELO MACK:  We want them to come down.

FRANCOIS TRAHAN: You want them to come own. You want to look at the NHB Index. That’s one that already gets a checkmark, because it’s risen a lot. You want to look at the PMIs. They’re starting to rise.

CONSUELO MACK:  Yes.  Purchasing Managers… right.

FRANCOIS TRAHAN: You look at the European PMIs, you know, as well. You’re starting to see some of those data points beginning to turn, and so, you know, to me, you’re pretty much there. We’re exiting the soft patch right as we speak.

CONSUELO MACK:  Now, another, you know, big piece of evidence for the bulls is that, I think 60%, around 60% of the S&P 500 companies, their dividend yields are higher than the yields on ten-year Treasury notes, something that, you know, never, if ever, happens. And so they’re saying that makes stocks that much more attractive. This is a very unusual opportunity.

But if you look at the yields on the ten-year treasury notes, for instance, they’re artificially suppressed by the Federal Reserve. Correct? And the fact is that most individuals, for instance, and institutions, except unless you’re Chinese or Japanese, don’t buy treasuries. What they’re buying is corporate credit. They’re buying corporate bonds. So why is that such a big deal, given the fact that very few people own treasuries, except other governments, and the carry trade, and also that it’s, the ten-year treasury notice, the yield is artificially depressed by the Fed.

FRANCOIS TRAHAN: I think that just goes to show you how fearful people are. They’re willing to buy the ten-year treasury at any yield, at any valuation, at any level, to not own equities. So 60% of stocks in the S&P right now yield more than the ten-year treasury. Why wouldn’t you buy dividend-paying stocks instead of the ten-year treasury? Just as a frame of reference, at the low point in the market in early 2009, 50% of stocks yielded more than ten-year treasuries. So this is a bigger opportunity, in that sense, than it was back then. So I think the tradeoff is very, very interesting. This is not where a bear market begins. This is usually where a rally begins.

CONSUELO MACK:  So as I said earlier, your clients are institutional clients, and they’re judging their performance every quarter. The rest of us mere mortals, the individuals, you know, we just want to make money and we don’t want to lose money. So the things that have worked really well for us have been more defensive issues. I mean treasuries have been a great investment for many, many years now. The more defensive plays, you know, the healthcare stocks and utilities have been really good places to be. So should we be changing what’s been a winning game so far as well?  Individuals?

FRANCOIS TRAHAN: Yes. I think if we go back to the tradeoff between stocks and bonds, and when we’re talking about 60% of the S&P yielding more than a ten-year, I think that’s a big message in itself. It’s telling you, you know, that you should emphasize equities, at least dividend-paying stocks, over treasuries. And so if you’re thinking longer term, you know, ignore what I just said about the market going up for the next couple quarters, but if you’re thinking longer term, which should be the right strategy, to me, it made sense to own treasuries when, you know, the yield was interesting. At these levels, I think dividend-paying stocks are almost a no brainer.

CONSUELO MACK:  And, again, looking at people being so risk averse, when you look at Japan, for instance, and a lot of people are talking about it, and I want to take you now to be thinking longer term, because even though you are short term, you’re cyclical bullish, the secular picture, the long-term picture, you think, is highly problematical. So what’s your longer term outlook, as far as, you know, what we’re going to face in this country in the economy and the markets?

FRANCOIS TRAHAN: A lot of pain, unfortunately. You know, longer term, we do have phenomenal headwinds. And that’s different from the eighties and nineties, when we had phenomenal tailwinds. You know, for 20 years we had declining interest rates, friendly fiscal policy, commodity prices that were declining, you know, for 20 years.

CONSUELO MACK:  Right.

FRANCOIS TRAHAN: So where consumers were feeling an ongoing tax cut, if you will, it’s hard to come up with any sort of tailwinds to the U.S. economy nowadays. If you search, you can find a couple, but you can’t argue that, you know, the ten-year treasury bond yield will come down 13 percentage points when it’s sitting at one-and-a-half percent. It just can’t happen. The Federal Government can’t give you friendly fiscal policy when the deficit is eight percent to GDP. And so longer term, this is a very, very difficult  backdrop.  It’s going to be subpar GDP, I think, as far as the eye can see. So I think for stocks, you know, this is an opportunity that you’re not going to get very often. But to me, the comparison to Japan is interesting, because in the 20 years, you know, where the Japanese stock market has basically done nothing, you have seen major opportunities. Four times, you saw the Nikkei rally in excess of 50%.

CONSUELO MACK:  Wow. Four times? Four times in the last 20 years.

FRANCOIS TRAHAN: That’s exactly right. And all four of those occurred in the wake of lower inflation, which is a form of stimulus. In any economy, where official rates are at zero, lower inflation is going to give you a little bit of oomph, if you will. It’s not the same thing as the Fed cutting rates, but it’s the next best thing in the absence of that.

CONSUELO MACK:  You know, it’s so interesting, because, again, so the fact is during even a lost decade or a lost two decades, then there are moneymaking opportunities. But it strikes me as… you know, one of the things that you told me when I’ve talked to you before, is that basically the buy-and-hold strategy is dead.

FRANCOIS TRAHAN: Correct.

CONSUELO MACK:  Do you feel that way for individuals as well, that you really… you, yourself, or your financial advisor has to be much more nimble? You’ve got to take advantage of these, you know, four times in twenty years, when the market’s going to go up 50%.

FRANCOIS TRAHAN: Yeah. Absolutely.

CONSUELO MACK:  And this is one of those times.

FRANCOIS TRAHAN: I think this is one of those times. Yeah. You know, I think we’re in the midst of it right now. The ideal entry point was last October, but we’re somewhere, you know, midway in that rally. I do think it’s one of those times. For 20 years, the S&P went up 18%  a year, on average. That’s the eighties and nineties for you. That’s a world where buy and hold works really well. You know, now, we’re in a much more volatile marketplace. And so I think it’s important to be more cycle aware, and to pick your entry points much more carefully. Absolutely.

CONSUELO MACK:  Looking at the situation of the consumer as well, we went through this, you know, historic credit bubble, and one of the things that you said that is really going to affect us for, really, for the next generation, is the consumer deleveraging. So all of that debt that we acquired, that deleveraging, is that basically the biggest overhang, the biggest headwind that we face?

FRANCOIS TRAHAN: Yeah. I think it is. I would tell you that most people I speak with believe that it’s the deficit at the federal level that is the big issue. I don’t think that’s a big issue.  I think…

CONSUELO MACK:  Why not?

FRANCOIS TRAHAN: Well, we can resolve it. You know, we have the Simpson-Bowles plan, which tells you how to balance the budget. You know, it’s doable. It’s not fun. It’s painful, you know. It’s going to lead to slower growth, but there is a way out of this. And if want, we can resolve it like this.

CONSUELO MACK:  And it might be resolved. At least the budget deficit might be resolved if the sequestration takes…

FRANCOIS TRAHAN: Well, at least part of it. Yeah.

CONSUELO MACK:  Right. Part of it.

FRANCOIS TRAHAN: It will put a big dent in it. But consumer debt, you can’t resolve, you know, by clicking your fingers. You know, unfortunately, it’s debt, and debt needs to be reimbursed, or it needs to be shrunk, as a percentage of the economy, but either way, it’s something that I think will take a generation or longer. To me, that’s the big overhang.  Deleveraging is the big overhang. You know, we had phenomenal GDP in the eighties and nineties, because we kept adding credit and debt, and now we’re in the process where we’re doing the exact opposite, and that means subpar GDP, as I see it. That’s the bigger issue.

CONSUELO MACK:  So let me ask you about some of the things that you’re very positive about, and one of them is natural gas, and basically extracting natural gas from shale. We’re seeing a big boom, energy boom, in the Dakotas… in North Dakota right now. So, you know, what’s your assessment of our energy situation, and why that could actually make a big difference in the economy?

FRANCOIS TRAHAN: That’s pretty much the only…

CONSUELO MACK:  Oh. It’s the only one.

FRANCOIS TRAHAN: Well, it’s the only structural tailwind I can think about, but I think what’s happening is potentially a game changer in many ways. You know, it’s not going to change necessarily the path of the stock market in the next few years, but to me, it’s something that can have an influence on our politics, our policies, our economy, you know, on a tremendous amount of things. If it’s the path to energy independence, it makes a huge difference. If you think about our trade balance, you know, a big portion of that is oil imports. And so …

CONSUELO MACK:  Much of it from Canada, actually.

FRANCOIS TRAHAN: Absolutely.

CONSUELO MACK:  Right.

FRANCOIS TRAHAN: So the initial step is Middle East independence, you know, possibly, but eventually, maybe this is the path to energy independence, you know, altogether. And so, you know, I think this can really change a lot of things in the economy.

CONSUELO MACK:  What is it about the technology and the energy industry that you think is so … could be so crucial?

FRANCOIS TRAHAN: Well, I think there’s a lot of people that still are in denial about this. People don’t necessarily believe that the new technology, you know, can make a huge difference. And so people are skeptical. I’m just trying to gain knowledge in that area. I think it’s absolutely possible. I forgot who was the first analyst that wrote, you know, this report that said that there is a path to energy independence in the U.S.  I remember running it through a couple clients that are energy specialists, and what they would say is, “Well, that’s impossible.” And, you know, my answer is, “Well, what if it is possible? What if it does happen?” You know, that really changes the way the U.S. operates.

CONSUELO MACK:  So is there an investment play in this opportunity that you see that you’re telling clients about?

FRANCOIS TRAHAN: Well, so far, you know, I would tell you the investment play has been in consumer stocks, you know, because the decline in natural gas prices has been very much like a tax cut for consumers. I think it’s been a big part of this decline in inflation that we’ve seen so far this year. And so I would say so far, it’s been the equity market overall, and more specifically, the consumer names that I think have been the biggest beneficiaries of it.

CONSUELO MACK:  So one of the things that’s also occurring on the inflation front is that we’ve had serious droughts in the Midwest and in other parts of the world as well, driving food prices up. How big a concern is that?

FRANCOIS TRAHAN: You know, ideally, I’d like to see all prices go down. I think that’s the way to benefit the consumer the most. Ultimately, I would say energy price is much more important than food prices. You can double the cost of grains, you know, the cost of your cereal box will go up. Not that much, because a big portion of it is cardboard and marketing, but it will still go up. You know, you can’t double the cost of gasoline without having a huge impact on the U.S. economy.

CONSUELO MACK:  So we always ask our guests what is the One Investment for long-term diversified portfolio that we should all own some of.  What is your recommendation for us?

FRANCOIS TRAHAN: Dividend. Dividend. Dividend. That’s the recommendation. You know, we were talking about how the strategy in the eighties and nineties was buy and hold. You know, in a world where the market is a lot more volatile, I think income is the way to go. Obviously, treasury’s not appealing at these levels. Dividend-paying stocks, in my opinion, are a phenomenal opportunity here.

CONSUELO MACK:  And I know your compliance officers do not allow you to make a specific recommendation, but we went to Morningstar to find out, you know, what their favorite kind of dividend ETF was- low fees in the ETFs- and the Morningstar favorite is the Vanguard Dividend Appreciation Fund. The symbol is VIG. So we just wanted to pass that on to our viewers. So Francois Trahan, it’s so great to have you on WEALTHTRACK. Thank you so much for joining us.

FRANCOIS TRAHAN: Thank you for having me.

CONSUELO MACK:  At the conclusion of every WEALTHTRACK, we usually leave you with an Action Point. This week we are deviating a bit, as we traditionally do around this time of year, to give you a reading suggestion for your summer vacation. This one is from our guest Francois Trahan. Trahan recommends The Quest: Energy, Security, and the Remaking of the Modern World by Daniel Yergin. The Quest is a follow up to the author’s Pulitzer Prize-winning history of the oil industry called The Prize.

Trahan told me energy is his number one topic of interest. He is trying to learn everything he can about it, because he believes it has the power to shape our economy, living standards, politics and place in the world. He is very optimistic about the possibly game-changing technology that extracts natural gas from shale and its potential to make the U.S. energy independent.

And on that hopeful note we will conclude this edition of WEALTHTRACK. Next week our guest will be bond manager Robert Kessler, who has consistently given WEALTHTRACK viewers the best investment advice of the last seven years: to own U.S. Treasury bonds. You’ll find out why he is sticking with this contrarian call. If you would like to watch this program again, please go to our website, wealthtrack.com. It will be available as streaming video or a podcast no later than Sunday night. And that concludes this edition of WEALTHTRACK. Thank you for watching. Have a great weekend and make the week ahead a profitable and a productive one.