Economists: Your New BFFs (part 1)

1. Economists: Your New BFFs (part 1) Applied Investment Management Spring 2014

2. Held article: “Why It Is (Still) All About Sectors” “Sectors are truly unique economic entities.” - Each responds differently to : 1) the ebb and flow of the business cycle 2) changes in government policy (example: Affordable Care Act -- healthcare) 3) improvements in technology (example: fracking – energy) - Average annual difference in return between best and worst sectors is 50%! Held’s recommendation: Carefully manage sector exposure.

3. What are our 2 biggest sector exposures in the Regents’ portfolio? • Information technology (IT): is the most over-weighted relative to the S&P 500 benchmark’s sector weights • Our active return is hurt if IT does WORSE than other sectors - Financials: is the most under-weighted relative to the S&P 500 benchmark’s sector weights - Our active return is hurt if Financials does BETTER than other sectors

4. Fidelity article: “How to Invest in Sectors Using the Business Cycle” “At any given time, asset price fluctuations are drive by a confluence of various short-, intermediate-, and long-term factors.” “For this reason, adopting a comprehensive asset allocation framework that analyzes underlying factors and trends among the following 3 temporal segments can be an effective approach: - Tactical (one month to 12 months) - Business Cycle (6 months to 5 years) - Secular (5 to 30 years) (per Wikipedia: “A secular market trend is a long-term trend that lasts 5 to 25 years and consists of a series of primary trends”. We’ll look at Long-Term or Secular Trends in a few weeks.) Fidelity’s recommendation: Know what sectors to avoid!

5. Fidelity article (continued)

6. Fidelity article (continued)

7. Fidelity article (continued) Implications for us: • Watch for signs of business cycle moving from MID phase to LATE phase. • Watch economists forecasts and leading economic indicators • Watch money flow indicators (i.e., are professional money managers taking money out of IT investments and putting it to work in Financials?)

8. Economists There are lots of them out there and they are easy to find! • Examples of some that we’ll watch in here: • Wall Street Journal’s monthly survey of 46 economists– here’s the link to the latest (Jan. 16) • http://online.wsj.com/news/articles/SB10001424052702303932504579256200568843432 • Wells Fargo’s economists’ web site • https://www.wellsfargo.com/com/insights/economics/ • Other individuals of your choice (e.g., here’s a link to Charles Schwab’s Liz Ann Sonders’ blog today: • http://www.fa-mag.com/news/schwab-s-sonders--secular-bull-market-has-years-left-16756.html • The Fed. (Why worry about what the Fed does?)

9. From “Global Woes Fail to Send Cash Into U.S. Stocks: Further Selloff Could Put Stocks on Track for Correction,” Wall Street Journal, Jan. 26, 2014, by Tomi Kilgore and E.S. Browning

10. The Federal Reserve (“The Fed”) and Quantitative Easing (“QE”) • Many believe that the Fed’s QE is responsible for the dramatic outperformance of the U.S. equity (stock) asset relative to the dramatic underperformance of the U.S. bond asset in the past few years • A Quick Review: 1) What’s the difference between “sectors” and “assets”? 2) What’s the difference between asset allocation decisions and sector allocation decisions? 3) Which assets are we allowed to invest for the Regents?

11. The U.S. Federal Reserve System • “On December 23, 1913, the Federal Reserve System, which serves as the nation's central bank, was created by an act of Congress. The System consists of a seven member Board of Governors with headquarters in Washington, D.C., and twelve district Reserve Banks located in major cities throughout the United States.” • Which district is New Mexico part of? Kansas City http://www.kansascityfed.org/ • Cite and more information at: http://www.federalreserve.gov/pubs/frseries/frseri.htm

12. Federal Reserve Chairman Ben Bernanke • “Ben S. Bernanke began a second term as Chairman of the Board of Governors of the Federal Reserve System on February 1, 2010. Dr. Bernanke also serves as Chairman of the Federal Open Market Committee, the System's principal monetary policymaking body. He originally took office as Chairman on February 1, 2006, when he also began a 14-year term as a member of the Board. His second term as Chairman ends January 31, 2014, and his term as a Board member ends January 31, 2020. • Before his appointment as Chairman, Dr. Bernanke was Chairman of the President's Council of Economic Advisers, from June 2005 to January 2006.” • There are 7 members of the Fed Board (“governors”). http://www.federalreserve.gov/aboutthefed/bios/board/bernanke.htm

13. http://www.federalreserveeducation.org/about-the-fed/structure-and-functions/districts/http://www.federalreserveeducation.org/about-the-fed/structure-and-functions/districts/

14. Federal Reserve Chairman Ben Bernanke

15. Federal Reserve Chairman Ben Bernanke

16. Federal Reserve Chairman Ben Bernanke

17. Federal Reserve Chairman Ben Bernanke

18. “Helicopter” Ben Bernanke

19. “Helicopter” Ben Bernanke

20. “Helicopter Ben” Speech Remarks by Governor Ben S. Bernanke Before the National Economists Club, Washington, D.C.November 21, 2002 http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm Deflation: Making Sure ‘It’ Doesn't Happen Here “With inflation rates now quite low in the United States… some have expressed concern that we may soon face a new problem--the danger of deflation, or falling prices. That this concern is not purely hypothetical is brought home to us whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation--a decline in consumer prices of about 1 percent per year--has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors.”

21. “Helicopter Ben” Speech (continued) Remarks by Governor Ben S. Bernanke Before the National Economists Club, Washington, D.C.November 21, 2002 http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm Deflation: Making Sure ‘It’ Doesn't Happen Here “… But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

22. “Helicopter Ben” Speech (continued) Why is this referred to as the “Helicopter Ben” speech? “Fiscal PolicyEach of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.”

23. “Helicopter Ben” Speech (continued) What is Bernanke referring to with respect to “Milton Friedman's famous "helicopter drop" of money”? “Friedman was the main proponent of the monetarist school of economics. He maintained that there is a close and stable association between inflation and the money supply, mainly that the phenomenon of inflation is to be regulated by controlling the amount of money put into the national economy by the Federal Reserve Bank. He famously quipped that deflation can be fought by "dropping money out of a helicopter". http://asderathoslchaimclassicalliberalism.blogspot.com/2010/03/milton-freidman.html

24. Bernanke’s Jackson Hole Speech Remarks by Governor Ben S. Bernanke at Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming.August 31, 2012 http://www.federalreserve.gov/newsevents/speech/bernanke20120831a.htm • In Bernanke’s August 31, 2012, Jackson Hole speech, he makes statements that made many economists conclude he still believed in fighting deflation by “printing money.” Following the speech, the Fed, under Bernanke’s leadership, expanded a policy of quantitative easing (“QE”). • What werethe stated objectives of Bernanke for asset prices? (Consider stocks, bonds, and cash.) STOCK and BOND PRICES INCREASE; interest rates for Treasury and Corporate bonds remain low. Little to be gained investing in T-bills and money markets – so investors put their cash into stocks, bonds, real estate, etc. • Since the speech, has QE have the effect Bernanke wanted? Answer: see slide #9. • If “printing money” drives up asset prices, why not “print money” all the time? Are there risks? If so, what are they?

25. Fed’s Press Release Today “The Federal Reserve’s policy committee on Wednesday wraps up its latest meeting, Ben Bernanke’s last as chairman. The Fed’s policy statement comes out at 2 p.m. EST. Mr. Bernanke won’t hold a news conference after the meeting and Fed officials won’t release new economic projections. “ Wall Street Journal 1/29 http://blogs.wsj.com/economics/2014/01/28/what-to-watch-for-from-fed-meeting/?mod=WSJ_hppMIDDLENexttoWhatsNewsSecond Per WSJ, watch for: “1) Full taper ahead. The central bank looks likely to again trim its monthly bond purchases by another $10 billion to $65 billion. 2) Watch how the Fed describes the economic outlook. The Fed has said it will only change its strategy on the winding down QE if its forecast for the economy shifts dramatically. Officials describe their view of the economic outlook in the first two paragraphs of the policy statement. Any changes there could provide signals that their forecast is shifting on the margins — and therefore clues about whether they may be wavering from the plan to reduce the bond purchases by $10-billion-per-meeting.

26. Fed’s Press Release Today (continued) Per WSJ, watch for: 3) What’s the guidance on forward guidance? Right now, the Fed has laid out seven different pieces of so-called forward guidance about its future intentions for short-term rates. Five of them are in the penultimate paragraph of the Fed’s last policy statement, where officials said: - easy money “will remain appropriate for a considerable time” after QE ends (which according to Mr. Bernanke’s timeline, won’t be until late this year) - they will keep short-term rates near zero at least until the jobless rate hits 6.5% - so long as inflation doesn’t rise above 2.5% - when unemployment reaches 6.5%, they’ll look at “other information” in deciding when to raise rates, including other labor market indicators, inflation gauges and financial developments -they expect to keep rates near zero “well past” the point when unemployment reaches 6.5% Fed officials will be discussing their forward guidance at this meeting. Odds are they won’t change or add to these statements yet, but all five bear watching. The jobless rate hit 6.7% in December, having fallen far faster than Fed officials expected, putting pressure on policy makers to figure out how to best communicate future policy plans to the public.”

27. Federal Reserve Chairman Janet Yellen

28. Don’t worry Ben, I got this!

29. Before Monday’s class begins, please read and prepare to discuss in class: • Find and read the Fed’s press release from this afternoon. Consider the WSJ article’s suggestions for what to look for (Full taper ahead? How has the Fed described the economic outlook? What’s the guidance for forward guidance?) • We said on slide #8 that every month, the WSJ conducts a survey of economists. Read the results of this month’s survey at http://online.wsj.com/news/articles/SB10001424052702303932504579256200568843432 How would you summarize their outlook on the economy? 3) On slide # 24, we talked about Ben Bernanke’s Jackson Hole speech from August 31, 2012. Read the speech in its entirety and answer the questions: - If “printing money” drives up asset prices, why not “print money” all the time? - Are there risks? If so, what are they?

30. Before Monday’s class begins, please read and prepare to discuss in class (continued): 4) Is it time to recommend moving some of the Regents’ money from the IT sector to the Financials sector? 5) Why did the stock market “hiccup” last Friday (Jan. 24)? (For example, on slide #8, the source of the graph is given at the top of the slide. If you Google that article, you can read what those authors thought. But don’t limit yourself to just what they had to say.)