Does the Small-Cap Premium Exist? It is unreliable at best.

Does the Small-Cap Premium Exist?

It is unreliable at best.

By Alex Bryan | 01-22-14 | 06:00 AM | Email Article

It is intuitive to presume that small-cap stocks should outperform their large-cap counterparts over the long run. After all, small caps do tend to have more limited financial resources, weaker competitive advantages (if any), and lower profitability than large caps. They also tend to be more volatile and have less analyst coverage–which may increase the risk of mispricing. An efficient market should compensate investors for accepting greater non-diversifiable risk with higher expected returns. Consistent with this view, United States small-cap stocks historically have outpaced their large-cap counterparts over the long term. Rolf Banz from the University of Chicago first published this finding in 1981, and it served as the foundation for Dimensional Fund Advisors’ first equity fund when the firm was founded later that year. However, since the early 1980s, the small-cap premium has diminished despite outperformance during the past decade. Even if the premium still exists, it is unreliable at best. Investors should not count on a small-cap tilt as a way to boost long-term performance.

From 1927 through 1981, U.S. small-cap stocks outperformed large caps by 3.1% annualized, according to the Fama-French “Small Minus Big” factor. But this performance was uneven. In fact, much of this premium was concentrated in the month of January (Keim, Horowitz, and Easterday). This uneven performance suggests that the market is not offering a consistent risk premium for small-cap stocks. It’s also hard to argue that small caps are riskier at the beginning of the year. As an alternative explanation, some researchers have suggested that small caps may experience greater tax-loss selling in December because they include a disproportionate number of stocks that have declined in value (Crain). In January, when this selling pressure subsides, small caps are poised for greater gains, or so the argument goes. However, arbitrage should eliminate this effect, at least in the more liquid stocks. Small caps’ inconsistent performance edge over time further undermines the view that they offer a reliable risk premium. As the chart below illustrates, they have underperformed their large-cap counterparts for decade-long spans, such as during the 1950s and 1980s. That’s a long time to wait.

Source: French Data Library.

In the periods when small caps did outperform large caps, the illiquid micro-cap stocks included in the group drove a significant portion of the performance gap (Horowitz, Fama, and French). This suggests that the small-cap premium may actually be compensation for liquidity risk. A few studies have presented direct evidence that liquidity risk helped explain the small-cap premium (Amihud and Liu). But small-cap stocks are more liquid than they used to be, partially because the proliferation of small-cap funds has made these securities more accessible. That may explain why the U.S. small-cap premium declined to 1.02% annualized from 1982 through November 2013. During that time period, this premium was not statistically significant, meaning that it may not really exist. Investors may have a tough time capturing what’s left of the small-cap premium because most small-cap stock funds invest in fairly liquid securities. For instance, from its inception in December 1978 through 2013, the Russell 2000 Index generated a nearly identical annualized return (12.1%) as the Russell 1000 and S&P 500 Indexes (12%).

There is also no evidence of a small-cap premium in many foreign markets during the past two decades. Small-cap stocks actually underperformed their large-cap counterparts in Europe, Japan, and Asia ex-Japan, from July 1990 through November 2013, based on the Fama-French “Small Minus Big” factor. This illustrates that small market capitalization is not a reliable source of higher expected returns, even over long horizons.

Valuation Matters
Valuations ultimately determine the long-term performance of small caps relative to larger stocks. In January 2004, the stocks in the Russell 2000 Index were trading at a lower price/forward earnings multiple (16.9) than those in the Russell 1000 Index (18.6). They subsequently generated higher returns over the next decade. However, these stocks are now trading at a premium (19.7 times forward earnings) to those in the Russell 1000 Index (16.2). Consequently, they are less likely to outperform going forward. Differences in expected growth rates can influence the valuation gap between large- and small-cap stocks.

In some cases, lofty growth expectations can work against small-cap stocks. Small-cap growth stocks have actually underperformed their large-cap counterparts over the long term, as illustrated in the table below. These stocks resemble lottery tickets. Some will offer big payoffs, but most won’t. On average, investors overpay for these stocks, leading to mediocre returns. However, small-value stocks have a better record relative to their large-cap counterparts. The value premium historically has been greatest among small-cap stocks. Consequently, a small-cap value fund may offer investors a better chance of boosting returns over the long run than a broad small-cap fund. Within this category, Gold-rated  DFA US Small Cap Value(DFSVX) (0.52% expense ratio) and  Vanguard Small-Cap Value ETF (VBR) (0.10% expense ratio) might be worth considering.

But All Is Not Lost
Even if a broad portfolio of small-cap stocks won’t reliably outperform large-cap stocks, it still can offer good diversification benefits, particularly in the international arena. Small-cap stocks tend to be more highly leveraged to the domestic economy than large-cap stocks. As a result, foreign small-cap stocks tend to have lower correlations with U.S. stocks than their large-cap counterparts. For example, during the past decade, the MSCI ACWI ex USA Index was 0.89 correlated with the Russell 1000 Index, while the corresponding figure for the MSCI ACWI ex USA Small Cap Index was slightly lower at 0.85.  Vanguard FTSE All-World ex-US Small-Cap ETF(VSS) (0.25% expense ratio) offers low-cost exposure to foreign small-cap stocks from 46 developed and emerging markets.

Investors still may be able to capture an illiquidity premium from micro-cap stocks. However, index funds are poor vehicles to get exposure to these stocks because they usually screen out the most illiquid securities, which may offer higher expected returns than more-liquid stocks. Index funds may also incur high market-impact costs of trading when they rebalance, because they often have to pay a premium to obtain the necessary liquidity to quickly execute trades. (Samuel Lee’s article “Micro-Cap ETFs: Still Bad” in the March 2013 Morningstar ETFInvestor newsletter explains these challenges in more depth.)

 DFA US Micro Cap (DFSCX) (0.52% expense ratio) offers a better model. It provides broad exposure to U.S. micro-cap stocks, which DFA defines as the smallest 5% of the market by market capitalization. Yet, because it does not track an index, the fund is not forced to trade when doing so would not be cost-effective. The fund’s traders often act as liquidity providers in thinly traded stocks–buying when the herd is selling or selling to satisfy demand–which allows them to obtain better transaction prices. Consequently, this fund offers investors a cost-efficient way to harness an illiquidity premium.

1) Amihud, Yakov. 2002. “Illiquidity and Stock Returns: Cross-Section and Time-Series Effects.” Journal of Financial Markets, vol. 5, no.1 (January): 31-56.

2) Banz, Rolf W. 1981. “The Relationship Between Return and Market Value of Common Stocks.” Journal of Financial Economics, vol. 9, no. 1 (March): 3-18.

3) Crain, Michael A. 2011. “A Literature Review of the Size Effect.” SSRN Working Papers. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1710076

4) Easterday, Kathryn E., Sen, Pradyot K. and Stephan, Jens A. 2009. “The Persistence of the small Firm/January Effect: Is It Consistent With Investors’ Learning and Arbitrage Efforts?” The Quarterly Review of Economics and Finance, vol. 49, no. 3 (August): 1172-1193.

5) Fama, Eugene F. and French, Kenneth R. 2008. “Dissecting Anomalies.” The Journal of Finance, vol. 63, no. 4: 1653-1678.

6) Horowitz, Joel L., Loughran, Tim and Savin, N. E. 2000. “The Disappearing Size Effect.” Research in Economics, vol. 54, no. 1: 83-100.

7) Keim, Donald B. 1983. “Size-Related Anomalies and Stock Return Seasonality: Further Empirical Evidence.” Journal of Financial Economics, vol. 12, no. 1 (June): 13-32.

8) Liu, Weimin. 2006. “A Liquidity-Augmented Capital Asset Pricing Model.” Journal of Financial Economics, vol. 82, no. 3 (December): 631-671.

The Elders of Organic Farming; two dozen pioneers of sustainable agriculture from the United States and Canada shared decades’ worth of stories, secrets and anxieties

The Elders of Organic Farming

By CAROL POGASHJAN. 24, 2014

BIG SUR, Calif. — Among the sleek guests who meditate and do Downward Facing Dog here at the Esalen Institute, the farmers appeared to be out of place. They wore baggy jeans, suspenders and work boots and had long ago let their hair go gray.

For nearly a week, two dozen organic farmers from the United States and Canada shared decades’ worth of stories, secrets and anxieties, and during breaks they shared the clothing-optional baths.

The agrarian elders, as they were called, were invited to Esalen because the organizers of the event wanted to document what these rock stars of the sustainable food movement knew and to discuss an overriding concern: How will they be able to retire and how will they pass their knowledge to the next generation?

Michael Ableman, a farmer and one of the event’s organizers, said the concerns were part of a much larger issue, a “national emergency,” in his words. Farmers are aging. The average age of the American farmer is 57, and the fastest-growing age group for farmers is 65 and over, according to the Census Bureau.

During their meetings, some of the farmers worried that their children would not want to continue their businesses and that they might have to sell their homes and land to retire.

Esalen is the birthplace of the human potential movement and a stunningly beautiful spiritual retreat overlooking the Pacific Ocean. When they were not in conference, the farmers wandered among floating monarch butterflies through Esalen’s farm and garden, rich with Calypso cilantro, tatsoi and flamboyant orange marigolds.

But the institute also holds conferences on major world and national issues. Mr. Ableman and Eliot Coleman, a Maine farmer, organized the intimate conference. Mr. Ableman, the author of “Fields of Plenty,” is writing a book about the gathering. Deborah Garcia, the widow of Jerry Garcia of the Grateful Dead and a filmmaker whose previous films include “The Future of Food” and “The Symphony of the Soil,” is making a documentary.

While the farmers here were proud of their anti-establishment beginnings, their movement has since gone mainstream, and organic farming has grown tremendously. Sales of organic food in the United States reached $31.5 billion in 2012, compared with $1 billion in 1990, according to the Organic Trade Association.

So the grandfathers and grandmothers of organic farming should be joyous, but they are not. Their principles of local, seasonal fruits and vegetables have been replaced in many cases by year-round clamshelled tomatoes for Walmart, Target and other stores. Some of today’s organic farmers have thousands of acres of single crops, which are flown to supermarket shelves, where they are sold at lower prices than many small organic farmers can afford to sell their produce.

Generally, the farmers at Esalen have less acreage and sell dozens or hundreds of varieties of fruits and vegetables at local farmers’ markets, to upscale restaurants and through so-called community-supported agriculture. C.S.A.’s, as these arrangements are known, consist of consumers who pay before the harvest for weekly deliveries of seasonal fruits and vegetables.

The sustainable agriculture these farmers practice goes beyond farming without synthetic fertilizer and pesticides. They adhere to a broader political and ecological ethos that includes attention to wildlife, soil, education and community. For most of them, the bottom line has never been their bottom line.

Many have done well, though not all organic farms succeed in the same way.

Some farmers operate a “debit card” C.S.A.; members make annual payments and buy at a discount only what they want. Jake Guest, who farms 70 acres in Norwich, Vt., said customers told him, “It’s like we’re getting free food.”

Stephen and Gloria Decater of Live Power Community Farm in Mendocino County, Calif., whose six Belgian draft horses help till the soil, operate “a participatory C.S.A.” with 200 households whose members split operating costs for the season and share the harvest with weekly baskets of organic food.

The proliferation of farmers’ markets has been a boon. Betsy Hitt sells her cut flowers, fruits and vegetables at one of 12 Saturday markets within 70 miles of her farm in Graham, N.C. Nash Huber, who farms in Washington State, sells his produce at seven farmers’ markets.

Some farmers have farm stands, some of which bring in $1 million or more annually. Another has a farmer’s cafe.

Farming an acre and a half of land in Harborside, Me., Mr. Coleman grosses $150,000, netting $30,000 annually. Tom Willey, with his wife, Denesse, grosses $2.8 million in direct food sales in the San Joaquin Valley. A few have had rough patches. But even they wax romantic about their love affair with the land.

“We went out of our way to give everything to the earth, and the earth gives back to us,” said Jack Lazor, who started his organic dairy farm in the 1970s. The earth doesn’t always give cash, though. He dropped his health insurance in 2008, because, he said, “We couldn’t afford it.”

All of the farmers were rebels. “We were told it was impossible to grow food without chemicals and pesticides,” said Mr. Coleman, who farms year-round, aided by his invention, a greenhouse on wheels.

They had few mentors or books to guide them. They went to schools like Tufts, Dartmouth, Cornell and the University of California. Some dropped out, protested the Vietnam War, occupied buildings or went to jail. They smoked marijuana and started communes.

“Every one of us broke the law,” said Frank Morton, 57, an Oregon seed farmer, with perverse pride.

When he was younger, Bob Cannard, 61, sprayed DDT and malathion, he said, and he passed out “many times” while working for his nurseryman father. Now Mr. Cannard lets weeds grow in harmony with his crops and is the main herb and vegetable grower for Chez Panisse in Berkeley, a temple of organic cuisine.

Mr. Ableman climbed out the window of his parents’ house when he was 16 and ran away. He was soon managing a 100-acre orchard, and then a 12-acre farm in Southern California, which grossed close to a million dollars. He now farms on Salt Spring Island, British Columbia, and travels to Vancouver to oversee urban farms he developed for people coping with addiction and mental illness. They are paid to work the land, and they sell their food to 30 restaurants and at six farmers’ markets.

Amigo Bob Cantisano’s dreadlocks dangle below his knees; he is tie-dyed down to his socks. Mr. Cantisano, 63, is the only one of the group at Esalen who has regular contact with industrial organic farmers. Some of them are Republicans in cowboy hats, he said, but they overlook his nonconformist appearance. He consults with companies like Sun-Maid, Sunkist and Earthbound Farm on how to improve yields and practice better sustainable agriculture.

Mr. Morton, who sells seeds through his Wild Garden Seed catalog, discovered at age 6 that food could be free but digging was hard. As a teenager, he said he “came to the realization that seed was the key to wealth and independence.”

Some related their marketing tips. Mr. Coleman, who sells his produce to 10 restaurants, said the endive variety called Bianca Riccia da Taglio would not sell until he renamed it. “Within two weeks, every lobster salad was sitting on a bed of golden frisée,” he said.

When farmers changed the name of Mandarin Cross tomatoes to tangerine tomatoes, sales soared. A farmer who had trouble selling her misshapen potatoes labeled them “Ugly Potatoes” and cut the price. They sold.

And many came looking for answers to the conundrum of retirement. Some have put their farms in land trusts; others said they tried to negotiate similar deals but failed. Like other family farmers around the country, some are finding that their children do not want to carry on their work.

Dru Rivers of Full Belly Farms in the Capay Valley in California was one of the few farmers whose children had returned to the farm, with their own ideas. A son is doing farm weddings and dinners. A daughter is operating a summer camp and running farm tours. In true hippie style, Ms. Rivers said: “I don’t want to die with one thing to my name. I want to give it all away. We have to do that to regenerate.” So she will give the farm to her children.

Norbert Kungl, 58, who farms in Nova Scotia, is concerned about the future of his land, which he says produces enough income for only one family. “I can’t find a cushion,” he said. “What options do I have other than selling to the highest bidder, which I do not want to do? These are questions that I have no answer for.”

Mr. Willey, 65, said he called a family meeting with his three children. “We made clear to them we have a very profitable business,” he said, but none were interested in carrying it on.

He understands why. “Farmers often work seven days a week and as many hours a day as the sun is up,” he said. “Young people looking into agriculture are not willing to make that drastic a sacrifice.”

Mr. Huber, who owns 25 acres and farms more than 600 acres on the north Olympic Peninsula in Washington State, said, “I think we’re looking at models that don’t work anymore.”

“I’m 72. I love what I do,” he said. “Obviously, I can’t keep doing it.” But young people “don’t have the financial resources to make it happen,” he said, with land in his area going for $26,000 an acre. “And they don’t have the knowledge, yet.”

Buy-in barons: Buy-out firms like selling to each other, much to their investors’ annoyance

Buy-in barons: Buy-out firms like selling to each other, much to their investors’ annoyance

Jan 18th 2014 | From the print edition

IN THE popular imagination, private-equity moguls unearth their targets by scouring obscure corners of the business world for corporate diamonds-in-the-rough. They buff such firms up and sell them for a fortune a few years later. The truth is rather more prosaic: often the buy-out barons merely take over companies owned by their private-equity rivals. Once a rarity, these “pass-the-parcel” deals have become common. In 2013 they represented nearly half the deals in Europe by value, according to Preqin, a data provider. Investors are grumbling that this defeats the point of private equity.

Reasons abound for the rise of “secondaries”, as the industry prefers to call such deals. For one thing, finding fresh corporate meat is hard. Taking listed companies private is tricky, since shareholders have enjoyed bumper returns of late and valuations are high. Conglomerates, which used to hive off unloved divisions to private equity, are flush with cash, which they started to stockpile as soon as the economy soured in 2008. At least in Europe, they remain wary of big mergers and acquisitions, which typically involve selling off expendable appendages to the likes of Blackstone or Carlyle. At the same time, private-equity groups have plenty of companies to sell, notably the firms they bought in the run-up to 2008, the industry’s apogee. Five years on, investors are clamouring for a payout, leaving private-equity funds eager to offload their stock.

Private-equity firms are not just forced sellers, they are also forced buyers. Funds globally have nearly $400 billion of cash on hand, about a third of it in Europe. Not spending the full amount is tantamount to failure: better to do a so-so second-hand deal than none at all. Some buy-out firms were left with slimmed-down teams in the aftermath of the crisis, meaning they are hesitant to commit scarce staff to take on a complex corporate spin-off. Secondary deals are easier: many of the due-diligence papers can be dusted off from the previous sale. The bankers who supplied the financing for the deal the first time round are often on hand for a repeat. Whereas a primary deal can take months or years of preparatory work, a secondary one can be set up in weeks if needed. Tertiaries are easier still.

Investors who back private-equity firms—typically pension funds, endowments and the like—are less than happy with the rise of secondaries. They offer much less scope for operational improvements, the main way in which private-equity firms purport to create value. Worse, the same institutions have sometimes invested in both the fund doing the buying and the one doing the selling. Strip away the financial montages, and they are in essence buying firms from themselves, with hefty transaction costs, including a 20% cut of the profit (if any) to the managers of the divesting fund.

Buy-out executives point to a host of profitable secondaries, as well as to studies that show that such deals are no less lucrative than other takeovers. Pets at Home, a purveyor of dog toys which three private-equity funds have chewed over in a decade, will deliver a handsome return for KKR if a proposed flotation goes ahead this year, for instance.

Many private-equiteers worry, however, about earning a reputation as repeat buyers, particularly in Europe. Joe Baratta, head of private equity at Blackstone, a buy-out titan, recently said it was “not a sign of health” that three-quarters of big deals in the region were secondaries. Things might change as the economy recovers, says Dwight Poler of Bain Capital, a rival buy-out firm: multinationals might regain an appetite for divestments, selling out of mature markets to focus on growth in emerging economies, say. Until then, more investors will discover the dubious pleasures of back-to-back buy-outs.

Which country gets the most out of international commerce?

Which country gets the most out of international commerce?

Jan 18th 2014 | WASHINGTON, DC | From the print edition

“CHINA is now No 1 in trade”, proclaimed the front-page headline of China Daily USA, the American edition of an official Chinese newspaper, which is showcased in vending machines across America’s capital. The paper, published around the world, is one of the $2.21 trillion-worth of Chinese exports that helped make the headline true—or mostly true.

China’s international trade in goods did indeed lead the world in 2013. Its combined imports and exports amounted to almost $4.2 trillion, exceeding America’s for the first time (the exact size of its lead will not be known until America reports its full-year figures next month).

But goods are not the only things that countries trade. Alongside China Daily’s triumphant front-page story was an article about “PANDA!”, a Las Vegas show performed by the China National Acrobatic Troupe, which chronicles the quest of a heroic panda to liberate a peacock princess from a demon vulture. Such cultural exports are part of the international trade in services, which is of growing significance to global commerce. If trade in services is added to trade in physical goods, China remains number two (see chart).

China’s exports and imports are voluminous partly because its economy is so big. Relative to the size of its GDP, China’s trade is below the world average. Its exports and imports were equivalent to almost 53% of GDP in 2012, whereas the ratio of global trade to world GDP was over 63%.

Relative to the size of its population, China’s trade is also modest. It amounted to just $3,200 per inhabitant in 2012, ranking only 99th in the world. But China has over 1.34 billion people. Any economic magnitude, when divided by a number that size, looks rather less impressive. Populous, spacious economies are often quite closed: America’s ratio of trade to GDP is, for example, only a little above 30%. Brazil’s is about 26%. Indeed, Arvind Subramanian of the Peterson Institute reckons that China’s trade is almost 70% greater than one would expect given the modesty of its income and the vastness of its territory and population.

By the same token, measures of trade per person flatter small countries, like Luxembourg or Singapore. Some of the countries that rank highest by this measure are tiny emirates blessed with oil or gas. Their exports are lucrative, but not terribly sophisticated.

Ricardo Hausmann of Harvard University and his colleagues have devised an alternative measure of the sophistication of a country’s exports. To score highly, a country’s exports have to be both varied and esoteric (meaning sold by only a few countries). Using Mr Hausmann’s method, Saurabh Mishra and Nikola Spatafora of the World Bank have ranked countries according to the sophistication of their exports in 2012. Out of 181 countries, China ranks 39th. But that is a higher ranking than one would expect given its modest level of development. Controlling for its income per person, China ranks 10th.

Some sceptics of China’s trade point out that many of its seemingly sophisticated exports include valuable imported components. According to the World Trade Organisation and the OECD, China itself adds only 67% of the value of its exports; America adds 89%. Indeed, if you count only the value that a country adds to its exports, then America’s export figures are about the same as China’s.

But such a calculation would miss the point. Measures of international trade are not trying to capture the value a country adds to its economy through its international dealings. They are instead trying to capture a country’s integration with the rest of the world. The benefits of this integration mostly lie not with exports, but with imports. Countries export what they must to import what they want.

Which economy gets the most out of its imports? The biggest importer is America; the biggest per person, Hong Kong. But the country that gets the most bang for its import buck is possibly Norway. According to the IMF’s calculations, its currency, the krone, is now 83% overvalued—more than any other currency. As a consequence Norway’s money has far more purchasing power when spent on internationally traded goods, selling at world prices, than it does when spent on its own goods at home. Contrary to what China Daily declared this week, it is arguable that Norway is “now No 1 in trade”.

Archimedes would blush: Regulators go easy on Europe’s overstretched banks

Regulators go easy on Europe’s overstretched banks

Jan 18th 2014 | From the print edition

“IT WAS always the French and the Germans,” grumbles a senior financial regulator, blaming counterparts from those two countries for undermining international efforts to increase capital ratios for banks. Every time the Basel committee, a grouping of the world’s bank supervisors, neared agreement on a higher standard, he says, a phone call from the Chancellery in Berlin or the Trésor in Paris would send everyone back to the table.

Similar phone calls almost certainly inspired the committee’s decision on January 12th to water down a proposed new “leverage ratio” for banks. It had originally suggested obliging banks to hold equity (the loss-absorbing capital put up by investors) of at least 3% of assets. In theory, that standard will still apply. But the committee came up with various revisions to how the ratio is to be calculated, in effect making it less exacting.

The new rule will allow banks to offset some derivatives against one another and to exclude some assets from the calculation altogether, thus making their exposure seem smaller. Analysts at Barclays characterised it as a “substantial loosening”. Citibank called it “significant regulatory forbearance”. Shares in big European banks such as Barclays and Deutsche Bank surged to their highest level in nearly three years on the news.

Leverage ratios have their critics—even outside overleveraged banks. They contend that leverage is a crude and antiquated measure of risk compared with the practice of weighting assets by the likelihood of making losses on them, and calculating the required cushion of equity accordingly. The chances of losing money on a German government bond, the argument runs, are much smaller than they are on a car loan; but a simple leverage ratio makes no distinction between the two. As a result, leverage ratios might actually encourage banks to buy riskier assets, in the hope of increasing returns to shareholders. Officials at Germany’s central bank, for instance, have argued that a binding leverage ratio “punishes low-risk business models, and it favours high-risk businesses.”

Bankers also claim that tough leverage requirements risk stemming the flow of credit to the economy, as banks shrink their balance-sheets to comply. BNP Paribas, a French bank, says this would particularly disadvantage European banks because they do not tend to sell on as many of their home loans as American ones.

The full extent of the new change is difficult to gauge, partly because there is still some uncertainty surrounding the rules. Yet a rough calculation suggests that they have been loosened just enough to allow most big European banks to pass the 3% test. Without the committee’s help as many as three-quarters of Europe’s big banks might have failed the test (see chart).

A detailed analysis by Kian Abouhossein of J.P. Morgan Cazenove, an investment bank, suggests that under the old rules big European banks may have had to raise as much as €70 billion ($95 billion) to get their leverage ratios to 3.5%, which is far enough above the minimum for comfort. Yet the new rules alone may improve big European banks’ leverage ratios by 0.2-0.5 percentage points compared with the previous ones, he reckons—enough for most to avoid raising new capital.

That does not mean banks will be able to shrug off the new leverage ratio entirely. Simon Samuels, an analyst at Barclays, expects it will prompt some European investment banks to reconsider their strategies. Some may have to cut lines of business and reduce their assets. That hints at the potency the measure could have had, if the regulators had allowed it.

The weather report: Economists are getting to grips with the impact of climate change

The weather report: Economists are getting to grips with the impact of climate change

Jan 18th 2014 | From the print edition

THE “polar vortex” that brought freezing weather to North America chipped roughly $3 billion off American output in a week. It was a reminder that extreme weather has economic consequences even in the richest countries and that climate change—which may usher in even wilder fluctuations—is likely to have a big economic impact. A recent burst of studies look at how large it may be, adding useful detail to the initial efforts, such as the Stern review of 2010. The results suggest that climate change may be having an effect already; that the weather influences economies through a surprisingly wide range of channels; but that calculating the long-run effects of climate change is harder than estimating the short-run impact of weather.

The link between more heat and more poverty is robust. Tropical countries are poorer. In a review of the literature, Melissa Dell of Harvard University, Benjamin Jones of Northwestern University and Benjamin Olken of the Massachusetts Institute of Technology find that, for each 1°C rise in the average temperature of a country, its GDP per head is 8.5% lower. Another study of poor countries alone showed that being 1°C warmer in any given year reduces income per head by 1.4%. These findings would not have surprised Montesquieu, who in 1748 argued that hot climates were inimical to the material conditions of the good life.

But it does not follow that if global temperatures were to rise by 1°C because of climate change, then world output would be 8.5% lower than it would otherwise have been. Perhaps the correlation between heat and poverty might exist because of some third factor (for example, the presence of malaria). If it were possible to change that factor (ie, eradicate the disease), temperature might cease to matter. Recently, tropical regions from southern China to Rwanda have been among the world’s most economically successful.

However, a correlation also exists between heat and growth, suggesting a longer-run effect. Despite some successes, tropical countries grew by 0.9 percentage points a year more slowly than the global average in 1965-90. In a sample of 28 Caribbean countries national output fell by 2.5% for each 1°C of warming. Again, this does not prove that high temperatures were to blame. But the correlation is strong enough to make it worth investigating whether the weather itself might be dragging down countries’ growth rates directly. The new literature suggests several ways in which it might do that.

First, natural disasters still wreak a lot of damage. One study reckons cyclones pushed down the world’s annual GDP growth by 1.3 points in 1970-2008. (Poor countries suffer disproportionately because they are more vulnerable to such disasters.) So if global warming were associated with more extreme weather, it would lower growth.

Next, higher temperatures and worse droughts tend to reduce farm yields. This hurts poor and middle-income countries most because agriculture has a bigger share in their GDP. To take one case, a decline in rainfall of one standard deviation cuts Brazilian farm incomes by 4%. But the agricultural effect of changing weather varies a lot. There seems to be a threshold of 29°-32°C below which rising temperatures can be beneficial; above it they are sharply harmful. With some crops, rising night-time temperatures do more damage than rising noontime ones. Farmers also adapt to higher temperatures by planting new crops or by emigrating to cities. So the impact of rising temperatures on farming is heterogeneous and hard to measure.

It is often assumed that the economic effects of climate change will be confined mainly to poor countries. That may be wrong. A study of time-use surveys and temperatures in the United States found that when temperatures reach 100°F (38°C), the labour supply in farming, forestry, construction and utilities falls by an hour a day, compared with what happens at 76-80°F. These are outdoor activities, which may explain why workers fail to show up. But a study of call centres also showed that each 1°C rise between 22°C and 29°C cut labour productivity by 1.8%. And in car factories in America, a week of outside temperatures above 90°F reduced output by 8%. Perhaps the heat disrupts the supply chain—or perhaps air conditioners fail to work properly.

Lastly, the weather influences basic conditions of life and hence factors of production. In America each additional day above 32°C raises the annual age-adjusted mortality rate by 0.1% relative to a temperate day (10-15°C). In India the rate increases by almost 0.8%. Heatwaves cause early deaths (especially of mothers and infants) and, by affecting the harvest, damage nutrition. This in turn has long-lasting effects on the economy.

Uncertain, with a chance of sub-optimal equilibrium

Almost all these correlations derive from weather data from the past five or ten years. But drawing conclusions about climate change—which takes place over hundreds of years—is perilous. Even more than with farming, the impact of climate change will be “non-linear”: changes may be modest up to a point, then turn dramatic. Meanwhile, people can adapt in important ways to changing conditions. This makes simple extrapolation nonsense.

But the new literature is a start. It shows how information in models of climate impact—recently described as “completely made up”—can be improved. It shows the multiple channels that economists of the climate must heed. It suggests that climate change is not something that will affect only poor countries, or hit rich ones only in the distant future. And—who knows—it may one day show how public policy, now so ineffective, might stem the emissions that are causing the mess in the first place.

Sources

^{“What do we learn from the weather?”, by Melissa Dell, Benjamin Jones and Benjamin Olken.} Journal of Economic Literature^{, forthcoming.}

^{“Informing climate adaptation”, by Carolyn Kousky.} Energy Economics   

^{“Quantifying the influence of climate on human conflict”, by Solomon Hsiang, Marshall Burke and Edward Miguel}

^{“Envirodevonomics” by Michael Greenstone and Kelsey Jack.} MIT Working Paper ^series   

Value of countries’ listed firms matched to companies with equivalent market cap

Investors love the promise of high returns from emerging-market equities, but there are not many of them to buy. Especially if you exclude stakes held by governments, the market capitalisation of bourses beyond the rich world is tiny. Just how tiny is apparent from the map below: in many emerging markets, the value of all the freely traded shares of firms that feature in the local MSCI share index (which typically tracks 85% of local listings) is equivalent to a single Western firm. Thus all the shares available in India are worth roughly the same as Nestlé; Egypt’s are equal to Burger King. This suggests that emerging economies need deeper, more liquid markets-and investors need more perspective.

The Sad Truth About Hedge Funds

The Sad Truth About Hedge Funds

By Larry Swedroe

January 22, 2014

No matter how you slice it, hedge funds seem like a rip-off, Swedroe says.

There are many well-documented problems with investing in hedge funds, and it’s hard to know where to start in pointing them out.

Among them are: lack of liquidity; lack of transparency; loss of control over the asset allocation and thus risk of the portfolio; non-normal distribution of returns (they exhibit excess kurtosis and negative skewness); and they have a high risk of dying (12.3 percent per year from 1994 through 2008).

Also, many invest in highly risky assets—creating problems when comparing with appropriate benchmarks—and returns have not been commensurate with the risks. They also tend to be highly tax inefficient, and their risks tend not to combine well with the risks of equities.

Not least, there’s no evidence of persistence in performance beyond the randomly expected, and their compensation structure creates agency risk, which is to say the incentives between the managers and investors are not aligned, which can lead to excessive risk taking.

And there are well-known biases in the data. Each of the following contributes significantly to a overstating of the actual returns earned by investors.

Self-reporting bias occurs because poorly performing funds are less likely to report.

Backfill bias occurs when funds with good performance during their incubation periods are added to databases.

Liquidation, or delisting, bias occurs when funds that become defunct fail to report their last returns.

Survivorship bias occurs when poorly performing funds disappear from the database of “live” funds.

Philippe Jorion and Christopher Schwarz, authors of the study “The Delisting Bias in Hedge Fund Databases,” which appears in the winter 2014 edition of the Journal of Alternative Investments, used information from three hedge fund databases with about 10,000 pairs of hedge funds to provide direct estimates of the amount of delisting bias.

The most famous example of a hedge fund that terminated its reporting because of serious negative performance is Long Term Capital Management. The managers of that fund managed to lose 92 percent of the invested capital from October 1997 through October 1998, and did not report that loss to public databases.

The authors note that while the delisting bias is impossible to assess from the information in one database only—they found funds delisted in one database often continue to report returns to another—they were able to build an estimate of the delisting bias. Following is a summary of their conclusions:

12.3 percent of funds delist per year, on average.

The delisting bias is greater for smaller funds solely due to their higher death rate, which goes from 20.2 percent for small funds to 5.5 percent for large funds.

The average omitted delisting loss is approximately 3.5 percent per fund, and 5 percent of omitted delisting losses are greater than 35 percent.

By tracking the typical performance of a fund that disappears in one database in others, they estimated a lower bound for the delisting bias of 0.35 percent per year across all funds, live and dead.

0.35 percent is only a lower bound because it ignores situations where the fund manager decides to stop reporting to all databases.

They inferred an upper bound for this delisting bias of approximately 1 percent a year.

The performance of hedge fund indices should be adjusted downward by about 0.5 percent a year to account for the delisting bias. This is still an estimate because it relies on self-reporting.Jorion and Schwarz note that the bias can help explain the systematic differences between the performance of the average hedge fund and that implied by funds of funds—once the extra fees of funds of funds are accounted for. Funds of funds cannot backfill the performance of their underlying funds, nor can they hide the performance of funds that perform poorly or fail. Avoiding the bias makes the funds-of-funds data more reliable.

With this information in mind, let’s take a look at the performance of hedge funds. In 2013, the HFRX Global Hedge Fund Index earned 6.7 percent. The table below shows the returns for various equity and fixed-income indices.

The HFRX Global Hedge Fund Indexunderperformed all but two (U.S. REITs and Emerging Markets) of the major equity asset classes. An all-equity portfolio with 50 percent international/50 percent domestic, equally weighted within those broad categories, would have returned 24.2 percent. Also, a 60 percent equity/40 percent bond portfolio with those weights for the equity allocation would have returned 14.6 percent using one-year Treasurys, 14.1 percent using five-year Treasurys and 10.0 percent using long-term Treasurys.

Given the freedom to move across asset classes that hedge funds tout as their big advantage, one would think “advantage” would show up.

Over the long term, the evidence is even worse. For the 10-year period from 2004-2013, the HFRX Index returned 1.0 percent per year, underperforming every single equity and bond asset class. The table below shows the returns of the various indexes:

Annualized Returns 2004-2013

Perhaps even more shocking is that over this period, the only year that the HFRX index outperformed the S&P 500 was 2008. Even worse, compared with a balanced portfolio of 60 percent S&P 500 Index/40 percent Barclay’s Government/Credit Bond Index, it underperformed every single year.

For the 10-year period, an all-equity portfolio with 50 percent international/50 percent domestic, equally weighted within those broad categories, would have returned 9.2 percent per year. And a 60 percent equity/40 percent bond portfolio with those weights for the equity allocation would have returned 7.1 percent per year using one-year Treasurys, 8.2 percent per year using five-year Treasurys, and 9.4 percent per year using long-term Treasurys.

The poor performance of the industry raises the question, Why is so much capital invested in hedge funds? One explanation is that it’s the triumph of hope, hype and marketing over wisdom and experience.

I also believe that the behavioral explanation of the desire to be a member of a special club explains the large amount of capital investment in hedge funds. Meir Statman, a leader in the field of behavioral finance, explains: “Investments are like jobs, and their benefits extend beyond money. Investments express parts of our identity, whether that of a trader, a gold accumulator, or a fan of hedge funds… We may not admit it, and we many not even know it, but our actions show that we are willing to pay money for the investment game. This is money we pay in trading commissions, mutual fund fees, and software that promises to tell us where the stock market is headed.”

Statman goes on to explain that some invest in hedge funds for the same reasons they buy a Rolex or carry a Gucci bag with an oversized logo—they are expressions of status, being available only to the wealthy.

He also explains that hedge funds offer what he called the expressive benefits of status and sophistication, and the emotional benefits of pride and respect. He cites the cases of investors who complain when hedge funds lower their minimums.

Those expressive benefits explain both why Bernard Madoff was so successful and why high net worth individuals continue to invest in hedge funds despite their lousy performance—they are ego-driven investments, with demand fueled by the desire to be a “member of the club.”

With that in mind, investors in hedge funds would be well served to consider the following from another leader in the field of human behavior, Groucho Marx: “I don’t care to belong to any club that will have me as a member.”

Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management.

CHART OF THE DAY: The Emerging Market Currency Bloodbath

CHART OF THE DAY: The Emerging Market Currency Bloodbath

SAM RO

JAN. 24, 2014, 8:14 AM 3,201

“Emerging Market weakness is widespread and after a long period of resilience is starting to impact credit markets,” said Morgan Stanley’s Rashique Rahman.

And there doesn’t appear to be one sudden event to blame.

“There is no single proximate cause, in our view, rather the cumulative impact of a number of events has led to a deterioration in risk sentiment,” added Rahman. “Growing concern over China’s macro trajectory and uncertainty over credit risk in China’s trust and wealth management products are probably the main drivers, but contributing factors to the spillover into other markets include Turkey’s ongoing currency volatility and political concerns, weakness of Ukrainian credit markets and the ARS devaluation.”

Rahman offered this five-day bar chart of the major emerging market currencies agains the U.S. dollar and the euro.

To the far right is the Argentine peso (ARS), which fell over 13% against the dollar on Thursday.

Here’s What Emerging-Market Leaders Are Saying And Doing As Their Currencies Burn

Here’s What Emerging-Market Leaders Are Saying And Doing As Their Currencies Burn

BEN HIRSCHLER AND CAROLYN COHN, REUTERS
JAN. 25, 2014, 6:37 AM 314

Demonstrators burn an effigy of Mexico’s Finance Minister Luis Videgaray during a protest against the federal government’s economic and tax reforms in Ciudad Juarez October 22, 2013.

DAVOS/LONDON (Reuters) – Top emerging market policymakers moved to allay concerns about their economies on Friday after investors sold off their currencies, raising fears of a broad market rout.

The U.S. Federal Reserve’s plan to gradually withdraw its stimulus has long been expected to lead to a pullout from emerging markets. But the prospect of an economic slowdown in China added to concerns on Friday that emerging markets, particularly those with large current account deficits, may struggle to support their currencies this year.

Argentina said on Friday it would relax currency controls it had long defended as essential, in a policy reversal forced by high inflation and a tumble in the peso.

Turkey’s lira hit a record low despite an estimated $3 billion of intervention by its central bank the previous day. The rouble and the rand also languished at levels not seen since the 2008-2009 financial crisis.

Turkey’s deputy prime minister, Ali Babacan, played down the lira’s slide, however, describing it as a “re-pricing process” due partly to the Fed and partly to recent political turmoil in the country.

He said that the central bank was taking the necessary steps to deal with the situation, adding that Turkey was protected against market swings by its sound finances.

“The balance sheet of the government, the banks and households are quite well protected against market volatility,” he told a panel at the World Economic Forum in Davos.

Mexican Finance Minister Luis Videgaray told Reuters Television in an interview at Davos that the current volatility would not be a major disruption for his country.

“Mexico is an emerging market, so all volatility is going to have some effect. But Mexico is well-positioned to weather the currency storm,” Videgaray told Reuters TV on the sidelines of the gathering of business and political elites in the Swiss mountain resort.

Policymakers and analysts at Davos also said that all emerging markets are not equal and that the market turbulence will drive investors away from economies that are suffering, but not from the stronger ones.

“Differentiation will be important,” Videgaray said.

CURRENCIES SLIDE

In Turkey, the central bank has refused to raise interest rates even though the lira has fallen almost 9 percent this month, raising fears of mounting inflation and an investor exodus. It has relied instead on auctioning dollars, and on Thursday resorted to what analysts said were its first direct interventions since early 2012.

Despite these sales, estimated to total almost a tenth of its reserves, the lira dropped almost 2 percent, falling through the key 2.30 level.

The lira is only one of many currencies feeling the heat from investor worries over China and over the reduction in U.S. stimulus, expected from this month.

Central banks of several emerging markets were believed to have intervened to defend their currencies on Friday including India, Taiwan and Malaysia.

Russia again moved the rouble’s trading band after $350 million in hard currency sales.

There was little respite, however. The rupee, Brazilian real, rouble and rand all fell more than 1 percent to the dollar. The Russian currency also hit a record low to the euro.

“I think we may see some actions from central banks, they will try to curtail the sell-off … They are unlikely to be able to stabilize the currencies,” said Lars Christensen, chief emerging markets analyst at Danske Bank in Copenhagen.

Christensen said currency weakness would ultimately help lift growth, but in the meantime, pain would be intense.

“If you are an emerging markets investor, you are seeing a lot of pressure on your positions,” he said.

Investors have been fleeing – almost $4 billion has exited emerging equity funds so far this year. The week to January 22 saw them lose $2.4 billion, banks said, citing data EPFR Global released to clients late on Thursday.

Bond funds were more resilient, with just $0.4 billion of outflows, but they too have lost $1 billion so far in 2014.

There are also growing signs of contagion.

The losses in the more vulnerable emerging markets with big current account deficits have now spread to relatively robust assets such as the South Korean won and Polish zloty. The won suffered its worst weekly loss since mid-2013

They are also reverberating across stock markets in Europe. Spanish shares lost 1.7 percent because of their exposure to Latin American revenues.

Funds such as Aberdeen Asset Management and Ashmore, with large emerging-market investments, led losses in London, falling 4-5 percent on the day <ADN.L> <ASHM.L>.

The moves come after a day of losses across emerging markets, with Argentina’s peso seeing its worst one-day trading session since the country’s 2002 financial crisis.

“GET USED TO IT”

After stunning the world by clocking over 10 percent growth on average for three decades, China took the bold step last year to wean itself off credit and investments and instead try to boost domestic consumption. As a result, its growth rate has steadily dipped, and data this month showed its economy grew 7.7 percent in the last quarter of 2013.

But Lin Boqiang, director of the China Center for Energy Economics Research at Xiamen University, said at Davos that investors couldn’t expect China to keep growing at the rates it has until now.

“There is a substantial slowdown in China, and we just have to get used to it,” he said in an interview.

Several of Friday’s sessions at the Davos forum focused on the future of emerging markets and how long the turbulence they are experiencing would last.

Corporate executives said they still viewed these markets as big growth opportunities despite the currency volatility.

Renault-Nissan chief Carlos Ghosn said he was not alarmed by the latest forex market moves.

“You have to be ready when you invest in emerging markets for ups and downs,” he told one Davos panel on Friday evening.

Mexico’s Videgaray said emerging markets knew 2014 would be volatile as the Fed scales back its stimulus. But he added that Mexico’s currency, the peso, was currently quite liquid.

“I don’t see any problems of liquidity in the market for the Mexican peso,” he said.

Read more: http://www.businessinsider.com/emerging-market-leaders-on-currencies-2014-1#ixzz2rPvGico4

Starbucks CEO Howard Schultz Perfectly Sums Up Retail’s Biggest Problem

Starbucks CEO Howard Schultz Perfectly Sums Up Retail’s Biggest Problem

ASHLEY LUTZ

JAN. 24, 2014, 2:39 PM 9,911 13

Howard Schultz, Chiarman & CEO of Starbucks, established the company’s European headquarters in Amsterdam in 2002

Huge companies like Macy’s, JCPenney, Best Buy, and Wal-Mart all suffered sales that were short of expectations this holiday season.

They blamed a shortened holiday shopping season, cash-strapped consumers, and the U.S. government shutdown.

But these explanations “ignore a larger fundamental truth,” Starbucks CEO Howard Schultz said in a recent earnings conference call.

Elaborating, Schultz perfectly sums up what’s really going on in retail:

“That truth is that traditional brick and mortar retailing is an inflection point. No longer are many retailers only required to compete with stores on the other side of the street. They are now required to compete with stores on the other side of the country.”

As Schultz points out, e-commerce has completely changed the retail game, meaning that weak holiday sales can’t be explained by calendar changes or inflections in the economy.

Traditional retailers will have to learn to compete in this new environment in order to succeed, Schultz says.

Starbucks boasted a 4% increase in traffic during the holiday season.

The company has aggressively invested in a new mobile app, loyalty program, and drive-thru service.

Barron’s Roundtable experts Abby Joseph Cohen, Marc Faber, Meryl Witmer and Bill Gross see big opportunities and challenges in 2014.

SATURDAY, JANUARY 25, 2014

Shaking Things Up

By LAUREN R. RUBLIN | MORE ARTICLES BY AUTHOR

Our Roundtable experts Abby Joseph Cohen, Marc Faber, Meryl Witmer and Bill Gross see big opportunities and challenges in 2014.

Sometimes, you need to study the forest, and sometimes you need to examine the trees. This year, with the Federal Reserve turning over a new leaf and ending its bond-buying program, the most successful investors will give equal attention to both.

Barron’s 2014 Roundtable — Part 1

That’s the word — thousands, actually — from the members of the Barron’sRoundtable, who expect macroeconomic forces and policy moves to exert the primary influence on security selection and performance in 2014. Our 10 Wall Street savants made that abundantly clear when the Roundtable convened on Jan. 13 in Manhattan, and the markets, now plummeting amid worries about emerging-market growth and diminished monetary stimulus, are proving them nothing but prescient.

Big-picture issues, from the Fed’s squeeze on its quantitative easing to a jarring slowdown in China, got a full airing in last week’s first of three Roundtable installments. But they remain ever-present — and ever up for discussion and debate — in the current issue, which features the latest investment picks of Abby Joseph Cohen, Marc Faber, Meryl Witmer, and Bill Gross.

Table: 2013 Roundtable Report Card

Abby, a go-to interpreter of economics and markets with a perch at Goldman Sachs, is looking for companies recommended by Goldman’s research department that are likely to benefit from stronger growth in the U.S. Marc, a born investment skeptic who runs his own show out of Hong Kong, can’t find a scintilla of growth on these shores (see what we mean about debate?), but he sees opportunities aplenty to prosper from a coming boom in Asia.

Meryl, Eagle Capital’s resident money-managing math whiz, dissects the prospects for four promising companies that she thinks have fallen unfairly out of favor. And Bill, chief of everything at bond behemoth Pimco, not only shares his insights into the workings of the Fed, but also offers suggestions on how to make money in fixed income, despite the central bank’s fixation on near-zero yields.

Table: 2013 Midyear Roundtable Report Card

Barron’s: Abby, which stocks intrigue you this year?

Cohen: First, I’d like to revisit the bigger picture. We gather here every January as if something special happens on Dec. 31. But in the middle of 2013, there were inflection points that brought changes that could be here for a while. One of the most important was the shift away from liquidity-driven markets to markets driven much more by economic and corporate-revenue growth, and equity-market valuation. The best-performing stocks previously had been those of companies with strong balance sheets that could raise dividends and repurchase shares. Now performance is shifting, at least in the U.S., toward companies with good operating leverage and strong returns on equity that are exposed to economic growth. Viewed another way, value stocks outperformed in the U.S. until July 2013. Now the rally is more growth stock oriented.

Many have said today that the U.S. stock market is the most expensive in the world. Let’s put that into context. The price/earnings ratio of the Standard & Poor’s 500 was 15.9 at the end of 2013, based on estimated 2014 earnings. Europe’s P/E was 13.6, and Japan’s Topix index sold for 14.6. But the economic prospects for the U.S. look far better. Take return on equity, which was 14.2% for the S&P last year, 8.4% for Europe, and 5.3% for the Topix. When we discuss valuations, it is important to focus not only on P/Es. To recap my comments this morning, if you assume no expansion in the price/earnings multiple, the Goldman Sachs research forecast for the S&P 500 is 1900 in 2014. If, with inflation under control, the P/E expands to 18 times earnings, the S&P could rise to 2088.

Abby Joseph Cohen’s Picks

Source: Bloomberg

We’re here to make predictions, so which will it be?

Cohen: The surprises are likely to be to the upside in the U.S. No. 1, we can still make government policy errors, but we’ve already made such big ones. The next issue in Washington will be raising the federal debt ceiling. The market has been through this before, and investors might not react as dramatically as they did in the past. More important, the U.S. economy seems to have more and better traction than it did at the end of 2012. Labor markets are better. Labor productivity has risen by about 2.5% in the past four quarters, which usually is a precursor to job creation and income growth. Also, while there have been significant inflows into the U.S. equity market, a lot of cash is still sitting on the sidelines here and around the world.

When you expect economic improvement, you look for higher-beta securities within sectors [stocks that are more volatile and thus more likely to outperform]. For example, you look at consumer-discretionary, energy, and materials shares. This brings me to Mexico, which will benefit from the improvement in the U.S. Last year wasn’t a good one for Mexico, but there now are signs, particularly in manufacturing, that things are looking up. Government reforms could help the energy sector. Short-term interest rates are 4.5% to 5%, but close to zero in inflation-adjusted terms. Fiscal policy is becoming more expansionary. The Goldman Sachs forecast for Mexican GDP growth in 2014 is 3.3%. We don’t see much change in the dollar/peso exchange rate. One way to gain exposure is through the iShares MSCI Mexico Capped exchange-traded fund, or EWW.

Zulauf: Mexico is structurally sound, but everybody and his brother is invested. If I am right and we see rising risk aversion, the peso will come under pressure. That’s why I would bet against you on this.

Cohen: Turning back to the U.S., economic growth has been held back by fiscal drag [the negative effect of tax hikes], which was considerable in 2013, but will be less so this year. An improvement could add one percentage point to economic growth. In addition, housing has added 0.5 of a percentage point, when the effects of renovation and furnishing are included.

Zulauf: Regarding fiscal drag and the deficit, where did the U.S. government book all the fines it took in from Wall Street? Maybe fiscal drag looked worse last year than it really was.

Cohen: To repeat, the Goldman Sachs economics team thinks U.S. gross domestic product could grow by 3.3% this year. My first stock is in the energy area. Many commodity prices have fallen as a consequence of lower demand from China, changes in India, and the rise of fracking [hydraulic fracturing] in the U.S. The energy sector is now much cheaper than the S&P 500. It sells for 13.4 times estimated earnings and two times book value, compared with 2.7 times book for the S&P. The U.S. has done a phenomenal job in recent years of investing in energy, and it is good to have exposure to a sector that has benefited from research and development and long-term investment. The three countries with the greatest energy resources are the U.S., Russia, and Saudi Arabia. Annual capital expenditures on energy in the U.S. are 14 times greater than in Russia, and 28 times greater than in Saudi Arabia.

Gabelli: It isn’t only the money. It is the technology of horizontal drilling and fracking, which the U.S. developed and no one else in the world understood. Now, they want to embrace it.

Cohen: That isn’t possible in all countries. China, for example, has significant shale-oil resources, but it lacks water. One thing that encouraged me about the Third Plenum [a recent gathering of the Communist Party leadership] is that China acknowledged publicly some of the climate and environmental issues it is facing. It’s not just the dirty air; it’s the dirty water. In the northern provinces, most of the water isn’t suitable for agriculture or drinking, and 50% is too dirty for industrial use.

Zulauf: One of China’s major long-term weaknesses is the lack of good water, and enough water. The water table is much too low, because they didn’t care enough about water during the early stages of the industrial boom.

Cohen: My energy-sector pick isHollyFrontier [HFC], an oil refiner. It closed Friday [Jan. 10] at $49.79. Holly is a U.S. company that benefits from its geography. It has 100% of its refining capacity in the middle of the U.S., and has substantial exposure to light crude. Our energy team expects there will be good spreads [price differences in crude oil] around the world that will benefit U.S. producers. The spread between Brent and West Texas Intermediate crude is going to be lumpy, depending on the refinery, supply, and distribution infrastructure, but we expect it will average about $10 a barrel in the next few years. This means refiners can buy lower-priced crude, but sell gasoline at higher prices.

Holly, like many energy-industry stocks, underperformed the S&P 500 last year. Based on our 2014 earnings estimate, it has a P/E of 9.3. It yields 6.4%. Goldman analysts think the company could earn $5.35 a share this year. Wall Street’s consensus estimate is $4.40. The market capitalization is $9.9 billion.

What is Goldman’s oil forecast for 2014?

Cohen: We’re not big bulls. Our analysts forecast $90 a barrel for West Texas Intermediate at year end, and $100 for Brent.

My next stock is a materials company — International Paper [IP]. In many ways, it dominates the industry. It is No. 1 in container board, No. 1 in corrugated packaging, and so on. Typically, demand for its products goes up when GDP and industrial production rise. Industrial production could exceed 3% in 2014. A lot of people are nervous about paper stocks, given the move toward digitalization. Nevertheless, there seems to be good demand for packaging materials, particularly boxes.

Amazon.com [AMZN] boxes!

Cohen: You got it. A lot of prepared foods also come in boxes now. We know there will be increased supply in the industry, but demand will keep up. International Paper has a history of returning capital to shareholders. It yields 2.6% and could raise the dividend early in the year. The stock closed Friday at $48.93. We expect profit to grow quickly, to $4.40 this year from $3.20 in 2013. Our estimate is above the consensus. The P/E is 11 times our 2014 estimate.

Next, with an improving labor market and a modest increase in household income, we are seeing more spending. In 2013, much of it went to satisfy pent-up demand in housing and autos. This year, there will be more spending in other categories. One of our analysts likes to say that in 2014, people will spend on fun, not food. Wyndham Worldwide[WYN] could be a beneficiary. Wyndham operates several hotel chains, including the Wyndham hotels, Ramada, Days Inn, and Super 8. We are expecting earnings of $4.60 a share in 2014, up from an estimated $3.85 last year. We are notably above the consensus for 2014, which is $4.32. The stock is trading at a market P/E of 15.9 times earnings. [Goldman subsequently lowered its 2013 estimate to $3.82 a share, and raised its 2014 forecast to $4.62.]

Pimco’s Gross explains how much investors can lose if rates rise, plus the dangers of borrowing and what investors should buy now.

Does Wyndham pay a dividend?

Cohen: Yes. It yields 1.6%. The company will enjoy operating leverage, but there could be some risks. Wyndham has a time-share business, and some other companies’ time-share operations haven’t worked out well, depending in part on where the properties were located. Wyndham also could benefit from increased business travel in 2014.

When household incomes begin to rise, deferred spending occurs first. Along with autos and housing, that means spending on food. Supermarket stocks performed well until just a few months ago, when an inflection point occurred in economic growth. Now, a lot of the household dollar is going to things like department stores.

Are restaurants considered food or fun?

Cohen: Eating away from home is in the fun category. Our analysts are recommending some dining shares, but I want to talk about Nordstrom [JWN]. The stock closed Friday at $61.11. Nordstrom underperformed much of its category and the S&P 500 last year. It was up about 11% in the past 12 months. We estimate it will earn $3.68 a share for the fiscal year ending Feb. 2, and $4.20 for the following fiscal year, which is 2% above consensus estimates of $4.11. The stock yields 2%. The company could have good operating leverage. Same-store sales are estimated to have risen by more than 3% in the current fiscal year. They could jump to more than 5% in the year ahead.

Abby Joseph Cohen: “Mexico will benefit from the improvement in the U.S.”

Nordstrom generates return on equity, on a DuPont [DD] basis, of 30% and higher. [Under the DuPont performance model, developed by the company of the same name, ROE equals net margin multiplied by asset turnover multiplied by financial leverage.]

Black: What is the P/E?

Cohen: It is 16.6 times fiscal 2013 earnings, and 14.6 times the following year’s earnings.

Rogers: Was there a particular problem at Nordstrom? Many retailers did well last year, including higher-end companies.

Cohen: Earlier in the year, high-end retailers did well. Toward the end of the year, retailers appealing to middle- and lower-middle-income shoppers did well. Nordstrom’s shares missed out, as the company isn’t decisively in either category.

My last name is Extra Space Storage [EXR], the second-largest owner of do-it-yourself storage facilities in the U.S. It has also been an underperformer. The stock was up 15% in the past 12 months. Funds from operations could rise to $2.42 in 2014 from $1.97 in 2013. The stock yields 3.4%. The category hasn’t performed well in recent months, in large part because housing was doing better. The market reasoned that if people were moving into new homes and young people were moving out of their parents’ homes, they wouldn’t need storage. Yet demand is OK, and seems to have stabilized. Also, there has been a significant slowdown in new capacity coming onstream. Finally, Extra Space Storage has done a good job of consolidating smaller operators that had problems. It has made a number of accretive acquisitions.

Is this company a real-estate investment trust?

Cohen: Yes, it is a REIT. Some potential negatives could be a rise in the cost of capital and a slowdown in average rent charged to customers.

Thank you, Abby. Let’s hear from Marc.

Faber: This morning, I said most people don’t benefit from rising stock prices. This handsome young man on my left said I was incorrect. [Gabelli starts preening.] Yet, here are some statistics from Gallup’s annual economy and personal-finance survey on the percentage of U.S. adults invested in the market. The survey, whose results were published in May, asks whether respondents personally or jointly with a spouse have any money invested in the market, either in individual stock accounts, stock mutual funds, self-directed 401(k) retirement accounts, or individual retirement accounts. Only 52% responded positively.

Gabelli: They didn’t ask about company-sponsored 401(k)s, so it is a faulty question.

Faber: An analysis of Federal Reserve data suggests that half the U.S. population has seen a 40% decrease in wealth since 2007.

In Reminiscences of a Stock Operator [a fictionalized account of the trader Jesse Livermore that has become a Wall Street classic], Livermore said, “It never was my thinking that made the big money for me. It was always my sitting. Got that? My sitting tight.” Here’s another thought from John Hussmann of the Hussmann Funds: “The problem with bubbles is that they force one to decide whether to look like an idiot before the peak, or an idiot after the peak. There’s no calling the top, and most of the signals that have been most historically useful for that purpose have been blaring red since late 2011.”

I am negative about U.S. stocks, and the Russell 2000 in particular. Regarding Abby’s energy recommendation, this is one of the few sectors with insider buying. In other sectors, statistics show that company insiders are selling their shares like crazy, and companies are buying like crazy.

Zulauf: These are the same people.

Faber: Precisely. Looking at 10-year annualized returns for U.S. stocks, the Value Line arithmetic index has risen 11% a year. The Standard & Poor’s 600 and the Nasdaq 100 have each risen 9.4% a year. In other words, the market hasn’t done badly. Sentiment figures are extremely bullish, and valuations are on the high side.

But there are a lot of questions about earnings, both because of stock buybacks and unfunded pension liabilities. How can companies have rising earnings, yet not provision sufficiently for their pension funds?

Good question. Where are you leading us with your musings?

Faber: What I recommend to clients and what I do with my own portfolio aren’t always the same. That said, my first recommendation is to short the Russell 2000. You can use the iShares Russell 2000 exchange-traded fund [IWM]. Small stocks have outperformed large stocks significantly in the past few years.

Next, I would buy 10-year Treasury notes, because I don’t believe in this magnificent U.S. economic recovery. The U.S. is going to turn down, and bond yields are going to fall. Abby just gave me a good idea. She is long the iShares MSCI Mexico Capped ETF, so I will go short.

Cohen: Are you shorting Nordstrom, too?

What are you doing with your own money?

Faber: I have a lot of cash, and I bought Treasury bonds.

Gabelli: In what currency is your cash?

Faber: It is mostly in U.S. dollars. I also have Singapore dollars, and Malaysian ringgit.

Black: You have no faith in the Federal Reserve. Yet you keep the bulk of your wealth in U.S. dollars?

Faber: I have no faith in paper money, period. Next, insider buying is also high in gold shares. Gold has massively underperformed relative to the S&P 500 and the Russell 2000. Maybe the price will go down some from here, but individual investors and my fellow panelists and Barron’s editors ought to own some gold. About 20% of my net worth is in gold. I don’t even value it in my portfolio. What goes down, I don’t value.

[Laughter all around.]

I am a director of Sprott [SII.Canada]. Eric Sprott, the founder, is a smart guy who made a lot of money for himself, his funds, and charities. He sold a lot of his company’s shares because he sees better value in small mining companies. If the gold price goes up 30%, Sprott’s shares might double, but mining stocks could go up four times. We are already starting to see a move up in the stocks.

Which stocks are you recommending?

Faber: I recommend the Market Vectors Junior Gold Miners ETF [GDXJ], although I don’t own it. I own physical gold because the old system will implode. Those who own paper assets are doomed.

Zulauf: Can you put the time frame on the implosion?

Faber: Let’s enjoy dinner tonight. Maybe it will happen tomorrow.

We’ve been discussing China’s water problem. Pollution, too, has become so horrible that people are leaving China with their children. Sometimes, entire cities break down. You hardly have a clear day in Hong Kong any more, or in Shanghai. Agriculture is in disarray because the water table is falling, and agricultural commodities prices have corrected significantly, despite all the money-printing around the world.

Prices for commodities, such as soybeans, corn, and wheat, are now at reasonable levels. I am recommending Wilmar International [WIL.Singapore], an agribusiness company.

Tourism in Asia will grow, unless there is a war. I have seen Macau go from a sleepy village to a gambling center seven times the size of Las Vegas. This year, 30 million Chinese will travel to Macau. It also appeals to Thais, Indonesians, and others in the region. Chinese tourism in Thailand grew by 90% last year. How do you play this tourist boom?

Gabelli: Aircraft.

Faber: I am not keen to own Singapore Airlines [SIA.Singapore] or Cathay Pacific Airways [293.Hong Kong] because they have a lot of competition from budget airlines. But I like some airline-servicing companies based in Singapore, including SATS[SATS.Singapore], in the catering business, and SIA Engineering [SIE.Singapore], which overhauls aircraft. They have subsidiaries in many Asian countries. The stocks yield around 4%. They aren’t supercheap, and the Asian markets generally aren’t cheap enough for me. But longer term, if you want to park money in Asia, both companies will do well.

Returning to Wilmar, it specializes in palm-oil products and sugar. The founder, Robert Kuok, and his family are the controlling shareholders. It is a big family in the region.

The attitude has changed in Asia: Many family businesses used to be dishonest but now are more honest. They realized that by being relatively clean, they could earn a higher stock-market valuation. Also, the Singapore authorities are strict.

Cohen: Marc, how important to Wilmar is palm oil?

Faber: It accounts for 70% of revenue.

Cohen: The saturated-fat content in palm oil is considered highly dangerous. The food industry in the U.S. is moving away from hydrogenated fats, but especially palm oil. Aren’t you concerned about this?

Gabelli: He drinks and he smokes. What does he care?

Faber: From my studies of the food industry, everything you eat today is unhealthy.

Marc Faber’s Picks & Pans

Source: Bloomberg

There is a colossal bubble in assets. When central banks print money, all assets go up. When they pull back, we could see deflation in asset prices but a pickup in consumer prices and the cost of living. Still, you have to own some assets.Hutchison Port Holdings Trust[HPHT.Singapore] yields about 7%. It owns several ports in Hong Kong and China, which isn’t a good business right now. When the economy slows, the dividend might be cut to 5% or so. Many Singapore real-estate investment trusts have corrected meaningfully, and now yield 5% to 6%. They aren’t terrific investments because property prices could fall. But if you have a negative view of the world, and you think trade will contract, property prices will fall, and the yield on the 10-year Treasury will drop, a REIT like Hutchison is a relatively attractive investment.

Cohen: Under the new Chinese economic plan, there will be an increase in free-trade zones that could benefit ports other than Hong Kong.

Faber: For sure. I’m not bullish about Hong Kong port traffic. It is unlikely to grow. That is why the stock yields 7%. But the board is made up of smart people. The group, which is controlled by Li Ka-shing, the richest man in Asia, is keen on infrastructure investments around the world. They run their ports efficiently.

Felix, you are negative on Hong Kong. [Zulauf recommended in last week’s issue selling short the iShares MSCI Hong Kong ETF, or EWH.] Property companies are a big component of the Hong Kong stock market, and they are selling at 40% to 50% of asset value. Property values may fall further, but a lot of the bad news has been discounted. I would rather buy Hong Kong shares and short the Nasdaq.

Zulauf: I am short both, but you are right that Hong Kong real-estate companies sell at a discount, although it is unlikely the discount is as high as 50%.

Faber: The outlook for property in Asia isn’t bad because a lot of Europeans realize they will need to leave Europe for tax reasons. They can live in Singapore and be taxed at a much lower rate. Even if China grows by only 3% or 4%, it is better than Europe. People are moving up the economic ladder in Asia and into the middle class.

Are you bullish on India?

Faber: I am on the board of the oldest India fund [the India Capital fund]. The macroeconomic outlook for India isn’t good, but an election is coming, and the market always rallies into elections. The leading candidate, Narendra Modi…

Hickey: …is pro-business. He is speaking before huge crowds.

Faber: In dollar terms, the Indian market is still down about 40% from the peak, because the currency has weakened. In the 1970s, stock market indexes performed poorly and stock-picking came to the fore. Asia could be like that now. It is a huge region, and you have to invest by company. Some Indian companies will do well, and others poorly. Some people made 40% on their investments in China last year, but the benchmark index did poorly.

I like Vietnam. The economy has had its troubles, and the market has seen a big decline. I want you to visualize Vietnam. [Stands up, walks to a nearby wall, and begins to draw a map of Vietnam with his hands.] Here’s Saigon, or Ho Chi Minh City, the border with China, and the Mekong River. And here in the middle, on the coast, is Da Nang.

South of Da Nang is China Beach, and north [still drawing] are other beaches. This was the largest American base during the Vietnam War. Coming back to tourism, there is a new airport in Da Nang with international flights. The place will be like Benidorm, the Spanish resort area, in a few years. Benidorm used to be nice, and then it became overbuilt and cheap tourism arrived. Pockets of Asia, including Indochina and India and Bangladesh, are underdeveloped. Eventually there will be road and rail links, and the area will become a giant free-trade zone. There are many investment opportunities here.

Is the Market Vectors Vietnam ETF [VNM] the best way to invest?

Faber: No, because it includes other things besides Vietnamese shares. My favorite investment is Ha Noi-Hai Duong Beer [HAD.Vietnam], a local brewery. FPT [FPT.Vietnam], an information-technology company that sells mobile phones, Internet services, and software, is another pick. It is a technology conglomerate with more value than its share price reflects.

Zulauf: Can anyone buy Vietnamese shares, or are there restrictions on ownership?

Faber: There are restrictions. Non-Vietnamese investors can’t own 100% of the shares, but in time the rules will be liberalized. The price of real estate in Vietnam is bottoming. Prices will go up, especially on the coast around China Beach. In the interest of full disclosure, my partners and I own a hotel there, and have an indirect ownership stake in another.

Vietnam Dairy Products [VNM.Vietnam] is a Vietnamese blue chip. It has been growing around 30% a year, and can continue to grow by about 20% a year. The stock hasn’t been acting well lately, but the company has a big market in Vietnam and will do well long term. Asian consumer companies aren’t cheap anymore, but in time, multinational consumer companies will want to acquire them because they have distribution in the region. A basket of Vietnamese shares could be attractive.

Anything else, Marc?

Faber: I recommend shorting the Turkish lira. I had an experience in Turkey that led me to believe that some families are above the law. When I see that in an emerging economy, it makes me careful about investing.

Lastly, I recommend shorting a basket of momentum stocks, including Tesla Motors[TSLA], Netflix [NFLX], Facebook [FB], Twitter [TWTR], Veeva Systems [VEEV], and 3D Systems [DDD]. They might be good companies, but they are overpriced.

Thanks, Marc. Nice map-making. Meryl, where are you shopping this year?

Witmer: My first pick is Wyndham Worldwide. Abby and I are on the same page. The company operates in three segments: lodging, vacation exchange and rental, and vacation ownership. The first two are fantastic businesses. Given their return on tangible assets, at more than 20%, and their prospects, they are both worth high multiples. Wyndham would be trading much higher if not for the unfair, perhaps snobbish view of the third business, more commonly known as time-shares.

The company is the largest global franchisor of hotels. It makes money on the capital other people put up. It has 15 brands in 67 countries. It was built by acquisitions, starting with Howard Johnson and Ramada in 1990. In a display of great capital allocation, management bought Microtel Inns & Suites and Hawthorn Suites in 2008 for $132 million from Hyatt Hotels [H]. They consolidated the business, which was about break-even, and got it earning $40 million in short order. It is efficient to add brands to the Wyndham hotel franchise platform. It’s a bit like servicing elevators; the denser the service area, the more profitable the business. Like most franchisor businesses, lodging requires little capital to grow organically. Incremental margins typically are in the 40% range. Capital spending in this business is around $40 million a year, and Ebitda [earnings before interest, taxes, depreciation, and amortization] is $300 million.

Tell us about the other businesses.

Witmer: The vacation exchange and rental business includes RCI, the leading timeshare-exchange network, and a global network of vacation rentals under different brands. It is a fee-for service business that offers leisure travelers access to a range of fully furnished vacation properties. RCI has 3.7 million members and a 65% market share. It can grow with minimal capital investment. Being the biggest in the business is important, because it makes it possible to affordably spend on technology. Wyndham has pulled ahead in the field. About 70% of time-share owners are members of exchange companies.

Meryl Witmer’s Picks

Source: Bloomberg

When we met recently with Steve Holmes, Wyndham’s CEO, he said he was most excited about the global vacation-rental business. It, too, is fee-for-service, and offers vacation-property owners the chance to rent their properties to leisure travelers. Wyndham has developed software that enables it to have dynamic pricing, which could fuel better results for homeowners and the company in coming years.

How is the time-share business doing?

Witmer: That’s the third business segment — vacation ownership. Wyndham has a quality operation and a great reputation, along the lines of Hilton Worldwide Holdings [HLT] and Disney [DIS], the other class players in the field. Many of us in the “investment class” might look down on this type of product. But for many people, vacation ownership is aspirational, and there is a feeling of pride about owning a piece of a vacation property. Wyndham is the largest player in the industry, with more than 900,000 members. Vacation ownership is a relatively economical way to guarantee a nice vacation for your family in a property that has one or two bedrooms and, typically, a kitchen and living room.

The key is, how happy are the buyers of these properties with their purchases? About 80% of initial buyers acquire additional access. I was shocked by the resilience of the business; it didn’t seem to notice the recession in 2009. Return on tangible assets, at 13.5%, isn’t as robust as in the other businesses, but it still is healthy. The segment also has some excess property. Excluding that, we estimate a 16% return on assets.

What do Wyndham’s earnings look like?

Witmer: Holmes is a great capital allocator. He is personally exposed on more than a million shares, and has never sold any. He has shrunk the shares outstanding since 2006 from 199 million to under 132 million. We’re assuming he will continue to buy in shares with free cash flow.

Reported earnings could increase in the next two to three years by about $115 million to $625 million. To that we add noncash charges of $195 million for things such as excess depreciation and amortization, to get a free-cash target of $820 million. We see the share count falling to 112 million in two years, and 103 million in three years. This adds up to after-tax free cash flow of $7.30 to $8 a share. The stock is $72.97. Putting a multiple of 13 to 15 on estimated after-tax free cash flow gives us a target price of $95 to $119 in a year or two, if it all plays out.

Gabelli: Does the company have net-operating-loss carryforwards? [Previous losses that can be used to defray taxes.]

Witmer: Yes, but they are running out, so I exclude them from my numbers.

Next, I am reiterating a 2013 pick, Spectrum Brands Holdings [SPB]. It is trading at $69.80 a share. Spectrum is a diversified branded consumer-products company. Its brands include Spectracide and Black Flag in the home-and-garden aisle, Black & Decker and George Foreman in small appliances, Remington razors, Rayovac batteries, and Kwikset and Baldwin locks. Last year my low-end estimate of free cash flow for 2015 was $7 a share. Management recently forecast that free cash flow will be at least $350 million in 2014, so with 52 million shares outstanding, Spectrum is a year ahead of my schedule. The company is investing for organic growth and making smart acquisitions to take advantage of huge NOLs [net operating losses]. It bought Kwikset in 2012, and that is working out well. It recently announced the acquisition of Liquid Fence, which has a product that works to keep deer from eating flowers and vegetables. It should fold nicely into Spectrum’s home-and-garden distribution system. Spectrum should be trading 30% higher, with potential for share appreciation, as management continues to do the right thing.

Meryl Witmer: “Wyndham Worldwide is the largest global franchisor of hotels.”

Esterline Technologies [ESL], my next pick, is $101.67 a share, and there are 31.7 million shares outstanding. It has about $500 million of net debt.

What does Esterline do?

Witmer: It manufactures highly specialized engineered products for the aerospace and defense industry. The company is organized into three segments: avionics and controls, sensors and systems, and advanced materials. Total revenue is split 45% from commercial aviation, 35% from defense, and 20% from industrial customers. The company reported $2 billion in total revenue for fiscal 2013, ended Oct. 25, of which 15% came from higher-margin aftermarket business.

The avionics and controls business is 40% of revenue. It produces cockpit paneling and systems, as well as headsets and pilot-interface controls. The sensors and systems business is 36% of revenue, and manufactures power systems, connectors, and advance sensor systems. Esterline’s sensors measure the temperature, pressure, and speed of aircraft engines. The company will be a Tier 1 supplier to Rolls-Royce [RR.U.K.] for the new Airbus [AIR.France] A400 and A350. Finally, the advanced-materials segment is 24% of revenue, evenly split among defense and engineered materials. This segment is a real gem. It produces elastomer products such as clamps and seals that have high profit margins and a large, recurring aftermarket business. It also produces the stealth materials used on the new F-35 fighter jet and other systems that distract incoming missiles.

What attracts you to Esterline?

Witmer: The company has been built in the past 15 years through a series of acquisitions. While previous management bought some terrific businesses, they were never fully integrated. As a result, operating profit margins averaged about 10%, 5% to 7% below peers. Our interest was piqued when Esterline announced that Curtis Reusser would be joining the company as CEO in October 2013. He was previously president of the aircraft-systems unit at United Technologies [UTX], joining that company after it acquired Goodrich in 2012.

Our checks on Reusser came back positive. His experience in lean manufacturing and operations really stood out. We studied his track record at Goodrich, where he increased operating margins from 2006 through 2011 to 17% from 12% in the division he ran. When asked on his first conference call as CEO whether he thought Esterline could achieve 15% operating margins compared to about 12% reported in fiscal 2013, he responded, ‘There is a lot of opportunity. Internally, I’m sure going to drive higher than that.’

How high could margins go?

Witmer: Esterline could achieve 15% operating margins in 2015. We conservatively assume flat revenue of $2 billion next year, resulting in $6.62 of earnings per share. Add back $1.80 a share in noncash amortization resulting from previous acquisitions, and you get $8.42 a share of free cash flow. We value that at 14 to 15 times, and add the $7 a share of free cash we expect the company to generate this year, to get a base target price of $125 to $133 a share, up from the current $100. With revenue growth and higher margins, free cash flow could approach $10 a share in 2016 or 2017, yielding a target price closer to $160 a share.

Gabelli: With the middle class growing in India and China, anything tied to commercial aviation in any capacity will continue to do well, and the stock market likes it.

Witmer: Let’s hope so. My last pick is Constellium [CSTM], a producer of specialized aluminum products. The company went public in 2013 at $15 a share, and is not well known. It now trades at $22.98, and there are 105 million shares outstanding, for an equity capitalization of $2.4 billion. Net debt is $225 million. The company is headquartered in the Netherlands and reports financials in euros. Yet, the shares are listed in New York. I have converted my numbers to dollars, at 1.35 euros to the dollar.

Constellium converts aluminum into specialty products. It earns a conversion spread [the difference between aluminum and finished-product prices] and has minimal exposure to the underlying aluminum prices. It produces aluminum plate for aerospace customers, can stock for beverage manufacturers in Europe, and sheet and crash-management parts for automotive manufacturers.

Gabelli: It’s Alcoa [AA] without the upstream [aluminum-mining] business, right?

Witmer: Correct. Constellium has about a million tons of rolling capacity across six major rolling facilities. It is known for its research-and-development expertise and specialized technical capabilities, which have enabled it to develop long-term relationships with key customers including Airbus, Boeing [BA], Audi, and Mercedes. These companies require suppliers’ plants to be certified, which provides barriers to competitors. We see a structural change occurring in both the aerospace and automotive markets. The demand for lighter, stronger materials that are environmentally friendly will significantly increase aluminum usage in the years ahead. That will benefit Constellium as it moves production capacity to higher-value-added products.

In aerospace, Constellium is the global leader in plate and one of only two producers with certified production plants in both North America and Europe. Parts produced using aluminum include wing-skin panels, floor beams, and landing gear. Importantly, the company has developed Airware, a lightweight aluminum lithium alloy. It is 25% lighter than competing products, and has lower maintenance costs, better durability, and recyclability. Constellium signed a 10-year contract with Airbus to use Airware on the A350, and deliveries should start in 2015. Overall, this market is expected to grow by about 10% a year.

Cohen: How does this compound compare to the alloy used in Boeing planes, such as the Dreamliner?

Witmer: It is about as light, but has better properties. It is easier to work with, and cheaper, and you can recycle the waste economically.

Gabelli: Put some numbers on this.

Witmer: I will, after I tell you about the automotive division. Constellium is the largest producer of aluminum sheet for a vehicle’s core body structure, known as Body-in-White, for the premium European auto makers. Next year could mark a significant step-change in demand in North America, with the rollout of the new Ford [F] F-150. Aluminum will account for 20% of its weight, up from 5% today. Miles per gallon could increase to an estimated 30 from 23. Other auto makers are following in Europe’s and Ford’s footsteps. By the company’s estimate, demand in North America could grow to 450,000 tons by 2015 and a million tons by 2020 from less than 100,000 in 2012. Constellium currently doesn’t sell Body-in-White in North America, but is negotiating to do so. [Constellium announced on Jan. 23 that it had formed a joint venture with UACJ(5741.Japan), a Japanese aluminum producer, to supply Body-in-White to North America.] This is being driven by federal fuel-economy regulations mandating an average of 55 miles per gallon for corporate fleets by 2025.

Now, the numbers. Constellium is expected to earn about $2 in 2013, growing at a nice clip for many years thereafter, driven by aerospace and automotive trends. It has the potential to earn more than $2.50 a share in two or three years, all while generating free cash flow. It could start to pay a dividend this year. Our price target is $30 to $35 in the next two to three years. The company estimated that the replacement value of its assets is north of six billion euros [$8.2 billion], which compares to an enterprise value of $3 billion today. We see significant upside.

Gabelli: Alcoa has the same downstream dynamics. If it spun off this business, you’d have a great investment.

Bill Gross’ Picks

Source: Bloomberg

Thanks, Meryl. Bill, you’re next.

Gross: Almost all assets are artificially priced to the extent that interest rates and, specifically, the policy rate [the Federal Reserve’s targeted federal-funds rate] is artificially low. Some suggest that it should be even lower [the current fed funds target is 0.25%], and perhaps negative. The Fed is engaged in quantitative easing [buying bonds] to keep rates near zero, which is artificially low relative to history and a policy rate that more closely resembles inflation. Historically, this makes it harder to know what prices should be for stocks, alternative assets, and homes.

Let’s assume the Fed finishes tapering its asset purchases by the end of this year. It will be critical for the Fed and other central banks to guide our expectations for 2015 and 2016. Some Fed governors would like to guide us back to the less-artificial prices of yesteryear. I won’t take either side here, but want to emphasize only that guidance will be important in helping private investors understand the cost of financing and allowing them a hope of making money in five-, 10-, and even 30-year bonds. Guidance is meant to induce the private market to take the Fed’s place and buy what they have been buying. The market was disrupted in May, when the taper was hinted at, and there could be further disruptions, depending on whether investors believe central banks and can accept their forward guidance.

Will the private sector pick up the slack?

Gross: I expect so. In the movie Peter Pan, Tinker Bell throws pixie dust into the air and says, “Do you believe?” The audience is supposed to say “We believe.” If the Fed ends its bond-buying program when unemployment falls to 6.5% or lower and the real economy is self-sustaining, perhaps we can exit this fairy-tale world. Some have that confidence in the Fed, and some don’t. I continue to believe in a “new normal” slower-growth world for a long time to come.

Hickey: Money-printing has been tried for thousands of years. How many successful exits have there been? Any?

Gross: I am not a defender of central banks or fiat currency. But there have been successful monetary tightenings.

Hickey: How many times can you end money-printing and get away with it, without having some kind of dislocation in the economy?

Gross: There haven’t been many big money-printing episodes in the past few centuries. The conclusion of each wasn’t pretty, although the timing here is up for grabs. If institutional investors, hedge funds, banks, and investment banks have confidence in the availability of liquidity and the cost of funding, the system will keep going.

Bill Gross: “The sweetest spot, if the curve remains steep, is five- to six-year maturities.”

Black: The U.S. has $17 trillion of debt. Let’s say interest rates back up by 200 to 250 basis points [two to 2.5 percentage points]. Can our economy afford $340 billion to $425 billion a year in incremental interest expense?

Gross: The U.S. government can afford it. Whether households and corporations can afford it is the bigger question. The average interest cost for the government at the moment is about 2% of GDP. If you doubled that, which would take time, the deficit would increase by 2%. The government can handle it. But can a young family trying to buy a house afford a 6% mortgage?

Zulauf: If the Fed concludes its bond-buying by the end of the year, that would be a regime shift of major proportions. Wouldn’t it be an impediment to asset prices rising?

Gross: Stocks and bonds have risen in price because of the Fed’s check-writing, to the tune of a trillion dollars a year. Once that disappears, investors should wonder who is going to buy these assets. There are only two buyers: the private market and central banks. The private market dominated in 2013 with corporate stock buybacks.

If the yield curve remains steep, should investors expect price-appreciation on intermediate-term issues as they age and become shorter-term?

Gross: That’s our strategy — taking advantage of the so-called roll down. At the moment, yields are as low as 0.25% on the short end and as high as 3.75% on the long end. Investors are pricing in a significant rise in the federal-funds rate in coming years. If they are wrong and the curve remains steep, as we believe it will, a roll-down strategy will be successful.

What is the sweet spot in maturities?

Gross: The sweetest spot, if the curve remains steep, and the most dangerous spot if it doesn’t, is five- to six-year maturities. [The five-year Treasury note recently yielded 1.72%.] A barbell strategy [buying bonds at both ends of the yield curve] might be safer from the standpoint of curve risk, but it is lower-yielding. We like the fives.

I’ve chosen four picks this year that yield more than Treasuries, but are relatively “safe.” I put that in quotes. You guys have heard me quote Will Rogers, the famed Oklahoma journalist, before. He said during the Depression, ‘I’m not so much concerned about the return on my money as the return of my money.” Investors are at risk this year of not getting their money returned in all assets, not only bonds. Several of my ideas have “Pimco” in front of them, but other firms, including BlackRock [BLK], T. Rowe Price[TROW], and Invesco [IVZ], have similar vehicles offering excellent opportunities.

Rogers: Thanks for the advertisement, but let’s have the names.

Gross: My first recommendation is a new closed-end fund, Pimco Dynamic Income[PDI]. It was launched in May 2012 when interest rates were close to bottoming and prices were near their highs. Despite that, its price is nearly 20% higher than the original offering. PDI is slightly levered, which is one advantage. It borrows at repo [repurchase agreement] rates of about half a percentage point and invests at higher yields. The fund is managed by Daniel Ivascyn and others. By the time these comments are published, Ivascyn and Alfred Murata, co-managers of Pimco Income [PIMIX], will have been named Morningstar’s Fixed Income Managers of the Year.

Witmer: Is that a positive or negative indicator?

Gross: There are no guarantees, but Morningstar has given top honors to many Pimco managers. [Ivascyn got another honor last week; in the wake of CEO and Co-Chief Investment Officer Mohamed El-Erian’s surprise resignation, he was named Pimco’s deputy chief investment officer. Gross told Barron’s the firm’s new leadership team “has my full confidence. We had a good year in 2013, despite outflows from Pimco Total Return (PTTAX; the world’s largest bond fund, run by Gross), and I’m going to be here as long as they’ll have me.”]

Dynamic Income invests in nonagency securities and some corporate bonds. “Nonagency” is industry code for subprime [securities with low credit ratings]. The subprime market trades at a steep discount to par, and in the past two years has delivered an equity-like total return. The fund yields 7.85%, but it paid a special dividend that produced an annualized yield of 12%. The fund could have a lot of firepower if the housing market holds up. It trades at a 5% discount to net asset value. In a world of 4% to 5% yields on “junk” bonds, this is a high-yield alternative that has gone unappreciated by the market.

For those interested in tax-free income, Pimco Municipal Income Fund II [PML] is a national fund. It yields 7%.

Does it hold any Puerto Rico or Detroit debt?

Gross: No. It sells at a 1% discount to net asset value, and is a long-term bond investment — a negative, considering my earlier comments. In the muni market, however, you have to go beyond five years to find yield.

Third is something I’ve recommended in years past. It worked out well for those who like utility stocks, which yield around 4% to 4.5%. The fund is Reaves Utility Income[UTG], a closed-end. The fund is approximately 50% levered, so you get one-and-a-half times the kick in returns, although the kick can be in the pants if interest rates rise. The largest holdings are Verizon Communications [VZ] and AT&T [T].

Gabelli: Why do they still call those utilities?

Hickey: In the old days, you had your electric utilities, your communications utilities…

Gabelli: That was back in 1940s, when they used to call pants trousers. I have no problem with this fund, but these are not the utilities of old that earned a regulated return on capital.

Gross: The fee is high on this fund, at 1.2% of assets. But it gets flushed out with the dividend yield.

Witmer: It’s a good business for the fund-management company.

Gabelli: Bill, what do you do with your own money?

Gross: I own some Reaves Utility Income and Pimco Dynamic Income. I own lots of closed-end funds that sell at discounts to net asset value and borrow money in the current environment.

Faber: Do you think there’s a chance, as I do, that the Fed will increase its asset purchases in the next two years, to $200 billion a month?

Gross: Only in your world, although I don’t completely discount your outlook for gloom and doom.

My last recommendation is the Pimco 0-5 Year High-Yield Corporate Bond Index[HYS], a high-yield ETF. The market capitalization is $3.5 billion. Its maturities are five years or less, whereas many high-yield bonds are 10 years, plus or minus. If spreads widen, 10-year bonds are at greater risk. Companies in the high-yield space include Ally Financial [GOM] and primarily BB-rated securities

Do you have any recommendations in emerging markets?

Gross: Like many here, we are invested in Mexico. We like the economy. Mexico has roughly half the debt of the U.S. The government is initiating reforms. Interest rates on 10-year securities are in the 5% to 6% area, but the policy rate is 4.5%, so there is currency risk. We don’t like other markets at the moment. If global markets sell off, money will move back to safe havens, namely the U.S. Given the risks, we’re staying close to home.

Black: Bill, do you expect Janet Yellen [incoming Federal Reserve chair] and Stanley Fischer [incoming vice chair] to have a harmonious relationship?

Gross: Fischer [former governor of the Bank of Israel] is the central bankers’ central banker. He taught Bernanke and Mario Draghi [president of the European Central Bank]. There is always the possibility of friction when the second-in-command is so prominent, but I don’t expect any. Fischer and Yellen have similar policies and views on guidance. Fischer, though a leader, is a team player. But let’s ask Abby, who knows him.

Cohen: I agree wholeheartedly with Bill. I expect Fischer to be a gracious and supportive colleague at the Fed.

Gross: And that is probably what the Fed needs at this difficult time.

Well said. Thank you, Bill. 

China appoints Xi to head national security commission

China appoints Xi to head national security commission

Friday, January 24, 2014 – 19:00

Reuters

BEIJING – Chinese President Xi Jinping has been appointed head of the new national security commission by the ruling Communist Party’s decision-making Politburo, the latest sign of his rapid consolidation of power.

The move puts Xi in charge of a commission that deals with crises at home and abroad and comes nearly a month after the government said that Xi would head a leading group to steer the country’s overall reforms.

Premier Li Keqiang and Zhang Dejiang, number three in the party’s hierarchy and head of China’s largely rubber-stamp parliament, will be vice-chairmen of the commission, state news agency Xinhua said on its microblog.

It will also include several other members of the Standing Committee, the apex of power in China. Xinhua gave no further details.

Details of how the commission would operate were left unclear when it was announced in a government communique in November, but China had hinted it would have a domestic focus.

Experts say it is based on the National Security Council in the United States and would increase coordination among the various wings of China’s security bureaucracy, split now among the police, military, intelligence and diplomatic services.

Possible international flashpoints for China include Japan, North Korea and the South China Sea.

China says it also faces considerable threats at home, pointing to continued unrest in two regions heavily populated by ethnic minorities which chafe at Chinese rule – Tibet and Xinjiang.

At a key party plenum meeting in November, China unwrapped its boldest reforms since Deng Xiaoping set the country on a course of opening up to the world in the 1970s and 1980s.

Demand for protection against U.S. equity selloff soars to record

Demand for protection against U.S. equity selloff soars to record

Fri, Jan 24 2014

By Angela Moon

NEW YORK (Reuters) – Demand for protection against a U.S. stock-market selloff soared on Friday as traders scooped up call options in CBOE Volatility index VIX , Wall Street’s favorite index of anxiety.

January call options – contracts betting on the rise of the underlying security – on the VIX this week rose to a record 8.4 million contracts at the Chicago Board Options Exchange (CBOE.O: Quote, Profile, Research, Stock Buzz) while the index itself jumped nearly 30 percent on Friday and about 44 percent for the week.

Since the VIX usually moves inversely to the performance of the S&P 500 stock index .SPX, traders often use the index to hedge against a market decline.

Reflecting the surge in demand for short-term protection, the spread between the VIX and three-month VIX futures briefly turned negative on Friday. Generally, due to the mean-reverting nature of the VIX, when the VIX is low, VIX futures trade at a premium.

“We haven’t had a correction for a while now, and while I think the market is overreacting a bit, concerns about China and other emerging market equities and currencies are weighing,” said Randy Frederick, managing director of active trading and derivatives at Charles Schwab in Austin, Texas.

“Looking at the implied volatility of VIX calls versus VIX puts, it’s relatively cheaper to buy VIX calls now so it’s a good time to buy (VIX calls) if you think it’s headed higher.”

Wall Street was closing out its worst week since June 2012, weighed by concerns about growth in China that fed a broad selloff across the globe, but particularly in emerging markets. The S&P 500 is down 2.3 percent so far this week.

Reflecting the recent bearish sentiment in equities, fund managers cut their net long positions in S&P 500 futures contracts in the week ended January 21 by 1,024 to 224,255, U.S. Commodity Futures Trading Commission data showed on Friday.

While the VIX is at its highest since October, it is still way below its 20-year average of 20.50.

Along with the spike in VIX, VIX-related exchange-traded products also jumped including the iPath S&P 500 VIX short-term futures exchange-traded note VXX (VXX.P: Quote, Profile, Research, Stock Buzz) and ProShares UltraPro Short Russell2000 exchange-traded fund UVXY (UVXY.P: Quote, Profile, Research,Stock Buzz), up 9.8 percent and 19.9 percent, respectively.

The iPath VIX ETN tracks activity in near-term futures contracts and is a way to bet on volatility without actually buying options. With more than 47 million shares traded Friday, it was the third-most active exchange-traded product on U.S. exchanges.

STILL A LONG WAY TO GO

Earlier this week, a trader was reported to have paid 90 cents for 90,000 May expiration call options at the 23 strike on the VIX index. Considering that the index was below 13 at that time, the trader was betting the VIX to roughly double by May. On Friday, premiums on the May call options were centered around $1.10 per contract.

“While that’s a decent gain from its purchase price, we can’t help but feel as though traders are still assigning relatively low likelihood to a sustained rebound in volatility,” said Andrew Wilkinson, chief market analyst at Interactive Brokers in Greenwich, Connecticut.

“Maybe that is because in the last year the VIX index has only traded above a 20 reading on about five occasions. And so while the market may be running scared again today, option traders are not yet willing to throw in the towel on the bull market,” he said.

Other notable trade on the VIX for the day was a 33,000-lot of Feb 19 calls for 59 cents, according to WhatsTrading.comoptions strategist Frederic Ruffy. The most active options were the Feb 14 puts, Feb 22 calls, and Feb 16 calls.

As of the afternoon session on Friday, 460,000 calls traded, exceeding the recent average daily volume of 454,000 contracts, while 190,000 puts traded, compared to the daily average of 140,000 contracts.

U.S. pensions’ funding gap closes, driving corporate profits

U.S. pensions’ funding gap closes, driving corporate profits

Fri, Jan 24 2014

By David Randall

NEW YORK (Reuters) – Corporate America is rapidly healing one of the last wounds suffered in the 2008 financial crisis.

Large companies’ pension plans are reporting among their best returns on record in 2013, dramatically closing funding gaps that had opened up because of losses in the 2008-2009 stock market collapse, and as government bond yields sank.

All told, companies in the S&P 500 saw an aggregate improvement of more than $300 billion in their pension plans, a gain that brought assets to around 93 percent of expected obligations, according to International Strategy & Investment, a New York research firm. That is a robust recovery from 2008, when they hit an all-time low of only 70.5 percent.

For investors, the performance of corporate pension plans is a small but under-appreciated side effect of the bull market that has now lasted for nearly five years. It will free up corporate cash for dividends, stock buybacks, and new investments, while helping to drive earnings growth, which could give a further nudge up to stock prices, analysts say.

Some companies may also see upgrades to their bond ratings, lowering their future borrowing costs.

David Zion, an analyst at ISI who co-authored the report, estimates that the strong performance of pension plans will save companies in the S&P 500 a total of $26 billion in the current fiscal year, resulting in a 1.6 percent boost for the 2014 earnings per share of the index. Analysts tracked by Thomson Reuters currently expect earnings per share to rise 10.7 percent this year.

The benefits mostly accrue to older industrial companies, or those who were traditionally unionized, as some of their workers and many of their retirees tend to have the more generous defined-benefit plans that are directly funded by the companies. The newer technology and service companies, who tend to rely on 401K plans that are largely the responsibility of workers to fund, are mostly not affected.

Some companies reporting their fourth-quarter earnings in the past few days have already said their results are benefiting from reduced pension costs.

Business jet manufacturer Textron Inc, for instance, saw its shares jump to a five-year high Wednesday after its earnings beat analyst estimates. Along with a rebound in the business jet market, the company is riding the performance of its pension plan. In 2010, it contributed about $417 million to the plan as its funding ratio fell to 77 percent, while in 2014, it expects to contribute just $80 million – a decline of nearly 81 percent. And now its pension plan is funded at an estimated 101 percent level, according to ISI.

The same day, AT&T Inc said it expects to record a pre-tax gain of about $7.6 billion in the fourth quarter from its pensions and post-employment benefit plans. A day earlier, Verizon Communications Inc reported fourth-quarter 2013 earnings of $5.07 billion, $3.7 billion of which was due to increases in the value of its pension and other benefit plans.

“These kind of cost-savings over a three-to-four year span don’t happen often,” said Eugene Stone, chief investment strategist at PNC Asset Management, referring to the decline in pension costs at companies since the end of 2009. “This is going to provide a tailwind to earnings for 2014 that hasn’t been there lately,” he said.

The gains have largely come from the stock market. The S&P 500 soared 32.4 percent, including dividends, last year, and has

climbed nearly 170 percent since its low in 2009.

In addition, the so-called discount rate – which serves as a proxy for the interest rate a company could expect on a bond today to fund its future obligations – increased as the yield on the 10-year Treasury note rose off of historic lows in the second half of last year. A higher discount rate means that companies do not have to contribute as much to pension plans.

COST SAVINGS

Gains in defined benefit plans had an impact on many S&P 500 companies in 2013, ISI analyst Zion said. Only 58 companies in the S&P 500 now have pensions that are less than 80 percent funded, compared with 197 a year ago, and some recorded pension gains that totaled more than 10 percent of their market caps.

United States Steel Corp, for instance, saw its pension assets rise more than $1 billion (not including the company’s contributions), an improvement that brought its pension plan to a 92 percent funded level. The gain was the equivalent of almost 31 percent of its market value at the end of 2012 of $3.4 billion. The Goodyear Tire and Rubber Co, Northrop Grumman Corp and Owens-Illinois Corp saw gains of 15 percent or more of their end-2012 market caps.

Because most Wall Street analysts typically focus more on a company’s ongoing business than its pension obligations, those cost savings could result in earnings surprises, Zion said.

US Steel, for example, should see a benefit of 74 cents in earnings per share directly from the improvement in its pension funding, a level that amounts to 65 percent of consensus estimates of $1.15 per share for 2013, Zion said. Alcoa Inc, meanwhile, should get a pension benefit of 16 cents per share, a level that equates to 40 percent of consensus estimates of 41 cents per share. It is unclear how much of the benefit has already been factored into those earnings estimates by analysts.

HELP ON THE MARGINS

To be sure, few investors say they would invest in a company simply because its pension costs are falling.

For example, Matthew Kaufler, a co-manager of the $1 billion Federated Clover Value Fund, has held a position in Macy’s Inc for several years. He was pleased to see the department store chain announced on January 8 that it had decided to forgo a $150 million contribution to its pension plan in the fourth quarter because of better-than-expected returns.

The pension plan savings “was a positive but in the list of positives it was not at the top,” Kaufler said. “People fundamentally want Macy’s to sell lots of clothes and home goods. That’s what drives the business, not the pension plan performance.”

But higher funding levels do make these companies seem safer bets over the long run because it means their balance sheets look better, portfolio managers say.

“For so many of these companies, the magnitude of the downturn was so great that they were kicked in the shins,” said Scott Lawson, an analyst who works on the $178 million Westwood LargeCap Value Fund. “Now, with the plans back to their prior funding levels, it lowers the risk profile.”

TAKING RISK OFF THE TABLE

Several companies are heading into 2014 with pensions plans that are in dramatically better shape than a year ago. Harley Davidson Inc, for example, saw a 36 percentage point gain, to 118 percent of obligations, in its funding levels over the past twelve months, according to ISI estimates.

Yet despite the gains in pension assets, companies may still face some risk in the long-term, analysts say. Any sudden reversal in the stock market is one concern. Workers living longer is another.

A 60-year old worker who retires today is expected to live 26.7 years longer on average, a 1.8-year improvement over previous lifespan estimates released by the Society of Actuaries in 2000. That nearly two year increase will result in a 6 percent increase in pension obligations, said Karin Franceries, an executive director at J.P. Morgan Asset Management.

In the past, companies often cited overfunding as a reason to terminate their pension plans. More recently, companies such as General Motors Co and Ford Motor Co, cut their pension risks by offloading their plans onto insurance companies, which then offer annuities to plan participants.

Now, though, many companies may find it more attractive to keep their own plans, said Zorast Wadia, a principal at actuarial consulting firm Milliman, which produces an annual study of pension funding. Insurance companies typically want plans to have a funding rate of 115 percent or more before they will take on their risks, Wadia said.

“A lot of these companies are going to find it’s cheaper to keep (it),” Wadia said, referring to the pension plans.

Equities now typically make up about 40 percent of plan assets, though some companies, such as Warren Buffett’s Berkshire Hathaway Inc, had as much as 72 percent of pension plan assets in stocks as recently as 2012.

“These plan sponsors are coming off the best year in their careers, and I expect many of them are going to be happy to take some risk off the table,” Wadia said.

It may be the final paradox of a 2013 market rally that few saw coming: stocks have helped pension plans so much that they decide to sell them and buy bonds instead.

Billionaire Eurnekian Targets Greek Airports Following Crisis

Billionaire Eurnekian Targets Greek Airports Following Crisis

What’s Behind the Emerging-Market Meltdown

What’s Behind the Emerging-Market Meltdown

China to Cut Dependence on Coal for Energy as Smog Chokes Cities; China’s coal use accounted for 65.7 percent of its total energy consumption in 2013

China to Cut Dependence on Coal for Energy as Smog Chokes Cities