Suppose you believe that the market is going to go down, what would you do? The normal answer is sell what you have and get out. However, what if you have nothing to sell? Until a couple of years ago, the answer would have been “Stay on the sidelines” for simple investors. The sophisticated investors always had plenty of avenues - shorting the stock, buying puts, selling naked calls, etc.

However, the gap was narrowed with the arrival of Inverse ETFs that allow even novice investors to short the market in a less risky way (you cannot lose more than what you put in the ETF, while in shorts your loss is theoretically unlimited and this can be psychologically unsettling for some). However, the power and pitfalls of these instruments are poorly understood by many, particularly by the long term investors. The power is obvious - you can go 1/X or 2/X of the market pretty easily, leaving all the pesky details of achieving them to the ETF managers. Here are the pitfalls.

1. Inverse and Leveraged ETFs lose money over the long term

Here is the chart from Yahoo Finance of DUG (Double inverse of petroleum companies) and DIG (Goes 2X in the direction of petroleum companies). Basically they are the yin and yang of Oil industry. Regardless of what happens in the market surely one of them must win, right? But, look deeply at the cart - both of these funds lost 45% in the last 20 months.

So, even if you had predicted the correct direction, you would have lost half your money in just 1.5 years.

2. Inverse ETFs can track the underlying for only one time period

Mathematically, leveraged and inverse ETFs can track their underlying index exactly for one time period only. If they track their index accurately for hourly, then it can’t track for daily, weekly, monthly and so on. This is due to the way compounding works. Let us say your underlying went 1% down everyday for 1 month. The underlying will go down 26% [(1-0.01)^30], while your inverse would have gone up 35% [(1+0.01)^30]. Most inverse funds plan to track daily, so for other time periods you will see an error.

3. Tracking error increases with time

Here is the comparison chart between XLF (Financial Sector Index) and its double Inverse SKF. SKF is supposed to go 2X in the opposite direction of XLF, and though it was good in maintaining the direction, it was not very good in exact tracking. XLF fell 62% in the period from February 2007, while SKF has gone up only 90%, instead of 124% as would have been expected.

4. Degenerative decay and relationship to volatility

Leveraged ETFs’ efficiency goes down with volatility. The problem is even more so with inverse ETFs. Let us say the Dow went from 10K to 8K and back to 10K. An inverse ETF tracking accurately will go up from 100 to 120 (20% gain to equal 20% loss in Dow) and then from 120 to 90 (25% loss because Dow gained 25%). So, from period t1 to t2, the Dow stayed the same, while its inverse ETF fell by 10% from 100 to 90. Repeat the same process x number of times, and you will find the inverse ETFs totally wiped out of the value, while underlying has not moved much. If the Dow goes up to 10000 from 9900 and back to 10000, the inverse would be reasonably accurate. However, we are at a historically high volatility - the highest in the last 20 years. Here is the movement of volatility Index [VIX] over the last 18 years.

5. Constant Leverage Trap

Constant Leverage Trap is a well know problem in financial modeling and affects the performance of inverse ETFs. Here is a simple scenario explained by Tyates in a financial forum:

Proshares has $1m of investor money and borrows $1m of additional money to invest $2m in the S&P 500 index. After six months, the index appreciates 10%, and then the fund has $2.2m in assets and $1.2m of equity. (Let’s ignore interest on debt for now).

The problem is that the fund now has a lower debt to equity ratio than advertised. It is supposed to be a 2x fund, but now only has $1m of debt paired with its $1.2m of equity, making it a 1.67x fund. In order to get back to its target leverage it has to borrow $200,000 and invest in the index. Now the fund has $2.4m in assets and $1.2m in debt. Six more months go by, and the index falls 10%. The fund now has $2.16m in assets and $1.2m in debt, leaving the investors with $960k in equity. This 4% loss surprises investors who thought that the index was down 1% for the year (+10% and -10% = -1%).

But what happens next is even worse. Because the leverage ratio is out of balance again - total assets are 2.25x the equity, not 2x - the fund has to sell its shares in order to reduce its leverage back down to 2x. It sells $240k worth of shares, and applies all of this cash to reducing the debt to $960k. The fund is now smaller than when it started. Yes, you read that correctly, to maintain constant leverage, this index fund is constantly buying and selling, incurring short-term gains, and doing the worst possible market timing - buying more on margin when prices are high and selling when they’re lower.

6. Regulatory Actions:

When the SEC comes up with a short ban as it did in September, it can substantially screw up the market. For a couple of weeks SKF was affected due to its inability to find appropriate counterparties for its trade. Typically, governments tend to go more after bears than bulls in a mistaken fear that bears are causing the problems instead of being the messenger of problem information. Thus regulatory actions can be more unfavorable to bearish strategies than bullish strategies.

http://biz.yahoo.com/ms/080919/253823.html

7. Counterparty risk

Inverse ETFs achieve their strategies through swaps and futures contracts with various counterparties. There are troubles when the counterparties don’t honor their contract.  When these parties fail, then the ETF could lose money.

Here is some good information on this, written by Paul Amery.

8. Other factors to consider

Can you stomach the volatility? Double Inverse and Leverage ETFs tend to move enormously by definition, particularly in troubled times like these - you could see your portfolio going up or down 50 or 75% - even if it too heavily weighted in such ETFs. Will you have trouble sleeping well in such roller coaster activity? If so, you should not play.
High Management Expense - given that these ETFs are not plain vanilla - buy a bunch of stock types, management expenses of maintaining leverage is pretty high. Sometimes the expense ratios can be up to 5X more than popular index ETFs.
Summary:

Inverse and leveraged ETFs are great tools that democratized bear strategies. However it should not be used for anything other than short term trading purposes. And when you use it, understand its risks and don’t be surprised when you find the results are not as promised.

Deposits at FDIC-insured institutions are now insured up to at least $250,000 per depositor through December 31, 2013. On January 1, 2014, the standard insurance amount will return to $100,000 per depositor for all account categories except for IRAs and other certain retirement accounts which will remain at $250,000 per depositor. (This supersedes the October 3, 2008 changes.)

May 20, 2009

President Obama’s budget proposes to hike the marginal tax rates of the wealthy to 36% and 39.6% beginning in fiscal 2011, and to increase by 5% the capital gains and dividends tax rate for the wealthy - tax changes that market participants say could lead to higher demand for tax-exempt bonds.

“The Obama tax hike [on the marginal rates] would mean that muni investors could buy bonds about 40 basis points richer in yield to achieve the same after-tax yield,” said Matt Fabian, a managing director at Municipal Market Advisors.

Wealthy would be defined as married couples earning over $250,000 and individuals earning $200,000 or more.

However, the administration has abandoned a proposal aired in a budget outline released in February that would have capped the amount of deductions taxpayers could take at 28%, another move that may have pushed wealthier investors into the muni market.

The most recent budget document also shows an even smaller estimate for how much the federal government will pay for the new Build America Bonds program than a document released Thursday.

However, market participants said the discrepancy does not really matter since the higher numbers were already underestimating the amount of payments that will be made under the program.

In an appendix to the budget released last week, the administration estimated that the Treasury Department would spend $91 million in fiscal 2009 and $340 million in fiscal 2010 on BABs, which it said included Recovery Zone Economic Development Bonds

But the Analytical Perspectives document released yesterday estimated just $50 million and $192 million for BABs during those years. Neither administration officials nor market participants could explain the differences in the estimates.

Treasury officials say roughly $9 billion of BABs have been issued during the past two months since the program started. Clifford Gannett, the director of the Internal Revenue Service’s tax-exempt bond office, which is charged with processing the direct payments for those bonds, said Friday that doing “very conservative” math on those numbers indicates $90 million of payments on just those issuances.

It is possible that the budget numbers stem from revenue estimates put together when the BAB legislation was being drafted, well before anyone knew how popular they would become, sources said.

The BAB program, created by the stimulus law, allows governmental issuers to sell an unlimited amount of taxable debt and either receive a cash payment from the federal government or provide investors with a tax credit equal to 35% of the interest rate.

The Recovery Zone Bonds, $10 billion of which were authorized under the stimulus law, also would provide issuers with a cash subsidy, but that payment is equal to 45% of the interest rate, and there is no option to provide a tax credit to investors. The bonds are to be allocated to areas hit hard by unemployment in 2008.

The budget documents also provide some fresh details for the administration’s estimated savings of phasing out the Federal Family Education Loan student loan program and moving to a system in which all federally guaranteed student loans are originated directly by the Department of Education. Many state-level FFEL lenders, who are opposed to the switch, issue municipal bonds backed by their student loans.

By ending “subsidies” paid to FFEL lenders, the budget documents estimate savings of $24 billion over five years and $48 billion over 10 years.

But an appendix to the budget proposal shows that the federal government has historically overestimated the costs of subsidies for FFEL while underestimating the costs of the direct loan program.

For the roughly $811.7 billion of FFEL loans originated since 1992, the cost of each loan averaged about 8.2 cents per dollar, compared to original estimates of about 10 cents. Issuance costs for the roughly $249.8 billion of direct loans were about 4.5 cents for each dollar loaned, compared to estimates of about 0.6 cents.

Almost three quarters of the budget’s proposed $100.5 billion of grants to state and local governments would be used for transportation infrastructure, mostly highways.

The budget proposed some modest changes to transportation and infrastructure funding, including a new user fee that would fund the air traffic control system beginning in 2011.

The administration argued that the current excise tax that is levied on users based mostly on airline ticket prices should be replaced by a tax related to the cost of services provided by the Federal Aviation Administration. If such a measure is taken, it will generate $9.6 billion in 2011 and existing aviation excise taxes could be reduced, according to the budget.

The administration also confirmed in its budget that it hopes Congress will create a national infrastructure bank and fund it at $5 billion in fiscal 2010. However, only a portion of that would be spent in 2010, the budget said.

The budget estimated that the federal government will provide $73.4 billion of transportation in grants to state and local governments in fiscal 2010, up about $11 billion from this fiscal year. Federal transportation grants would reach $102.3 billion in fiscal 2019 under current policy, according to budget documents.

The administration also proposes a five-year, $5 billion high-speed rail state grant program that would add on to the stimulus funding provided for high-speed rail development.

In addition, the budget includes $3.9 billion for the clean and drinking water state revolving funds.

By Peter Schroeder, Audrey Dutton and Andrew Ackerman, Bond Buyer
May 12, 2009

WASHINGTON — The U.S. recession appears to be losing steam, with growth likely to resume later this year on the back of firmer household spending, a bottoming housing market and an end to inventory liquidation, U.S. Federal Reserve Chairman Ben Bernanke said Tuesday.

But Bernanke said that the recovery will probably be slower than usual, and warned that the unemployment rate may stay high “for a time” as businesses remain cautious about new hiring.

“We continue to expect economic activity to bottom out, then to turn up later this year,” Bernanke said in prepared testimony to the Congressional Joint Economic Committee.

The “key elements” to that forecast, he explained, “are our assessments that the housing market is beginning to stabilize and that the sharp inventory liquidation that has been in progress will slow over the next few quarters.”

Fiscal and monetary stimulus should support demand, he said.

Last week, in a cautiously upbeat statement accompanying their decision to hold the target federal funds rate for interbank lending near zero, Fed officials said that the economic outlook has “improved modestly” but activity “is likely to remain weak for a time.”

U.S. gross domestic product has contracted in excess of 6%, at an annual rate, in each of the last two quarters, the worst six-month performance in a half century. But Wall Street economists generally expect stabilization around the middle of the year with a gradual recovery thereafter.

That scenario has found support from recent consumer- and business-sentiment surveys as well as housing and construction figures that have helped push equity markets up sharply. However, grim automobile sales for April suggest consumers remain cautious amid rising unemployment.

Still, Bernanke said there are “tentative signs” that household demand is stabilizing, citing a rise in consumer spending during the first quarter.

“The housing market, which has been in decline for three years, has also shown some signs of bottoming,” he added, citing “fairly stable” existing home sales, firmer sales of new homes and a reduced backlog of unsold new homes. Still, sales levels remain “depressed,” he said.

Meanwhile, “some progress” has been made on inventory adjustment, Bernanke said, and as inventories move into better balance with sales, “a reduction in the pace of inventory liquidation should provide some support to production later this year.”

Even foreign economies appear to be stabilizing, he added, and their financial markets appear to have improved somewhat as well.

Still, Bernanke warned that even when the U.S. recovers, growth is likely to remain below its long-run potential for a while. Many economists assume the economy’s noninflationary potential to be between 2.5% and 3%.

“We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly,” Bernanke said. With firms still cautious, the unemployment rate “could remain high for a time, even after economic growth resumes,” Bernanke said, adding that expects “sizable” job losses “in coming months.”

The unemployment rate is currently at a 25-year high of 8.5%. Wall Street economists expect the April jobless rate, due for release Friday, to hit 8.9%.

There are other headwinds, too, Bernanke warned.

“In contrast to the somewhat better news in the household sector, the available indicators of business investment remain extremely weak,” he said, while conditions in commercial real estate “are poor.”

And while financial conditions appear to have improved, markets and institutions “remain under considerable stress,” he said.

“A relapse in financial conditions would be a significant drag on economic activity and could cause the incipient recovery to stall,” Bernanke said.

With a good deal of slack still in the economy, inflation should remain low and come in below its 2008 pace this year, Bernanke said.

“However, inflation expectations, as measured by various household and business surveys, appear to have remained relatively stable, which should limit further declines in inflation,” he said.

Bernanke told lawmakers that the Fed will soon provide additional information on its lending programs, including breakouts of the types of collateral the Fed is accepting.

Fed Vice Chairman Donald Kohn has been leading a review of the Fed’s disclosure policies.

By Brian Blackstone
Of DOW JONES NEWSWIRES

NEW YORK — Stock exchange-traded funds have been lambasted for slicing the market too narrowly. But with bonds, more precision is what financial advisers need.

Investors turned to fixed-income holdings last year to offset plunging stock values. But while Treasurys held up, municipal and corporate bonds cratered alongside stocks.

This exposed a problem with many basic fixed-income mutual funds: These are often designed as catch-alls, holding all kinds of bonds and making it difficult for investors to gauge risk.

In fund researcher Morningstar Inc.’s “intermediate term” bond fund category, for instance, the 10 best performers had, on average, almost 40% of their holdings in Treasurys and returned about 8.6% in 2008. The 10 worst performers in same category, with only about 6% in Treasury holdings, were down about 30% on average.

ETF firms are aiming to capitalize on that kind of discrepancy, hoping financial advisers are ready to replace all-purpose bond funds they previously bought for clients with a mix of several narrow-focus bond ETFs, an approach that may allow them to calibrate risks more carefully.

“With iShares ETFs, there are no investment-style surprises,” says Christine Hudacko, a spokeswoman for Barclays PLC’s (BCS) recently sold iShares unit. “No one needs more surprises now.”

Investors seem to be responding to the ETF companies’ pitch, having poured about $23 billion into bond ETFs in 2008 and another $10.9 billion in the first quarter of 2009, according to a recent report by Morgan Stanley.

Of course, some financial advisers buy individual bonds, skipping funds altogether. Others say this route can be costlier and makes it harder to diversify.

Some large brokerage firms are encouraging advisers to take the ETF approach. Morgan Stanley’s research department publishes “model portfolios’ that can serve as templates.

The moderate version suggests investors putting 40% in iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD), 35% in iShares Barclays MBS Bond Fund (MBB), 15% in iShares Barclays Agency Bond Fund (AGZ) and 5% to both iShares S&P US Preferred Stock Index Fund (PFF) and SPDR Barclays Capital International Treasury Bond ETF (BWX).

Moreover, while there are now more than 60 bond ETFs on the market, they’re one of the few places where ETF fund firms are still rolling out new funds. Eight new bond ETFs have debuted in 2009, while fund companies launched only one stock ETF, according to Morgan Stanley. Barclays’ iShares unit offers the greatest number of bond ETFs, with more than 20, and hopes to launch more funds this year. Rival State Street Corp. (STT) also has more than a dozen.

Vanguard Group, by contrast, offers just five, a “total bond market” ETF and four broad funds that target different durations.

Of course, companies’ hope that investors use a handful of narrow funds to replace broader, more cumbersome holdings won’t silence critics who say many funds are used to make big bets on volatile corners of the market.

Last week State Street Corp. (STT) launched the first ETF dedicated to convertible bonds, complex assets that involve aspects of both corporate bonds and stock options and that have traditionally had a much bigger following among hedge funds than financial advisers.

By Ian Salisbury
A DOW JONES NEWSWIRES COLUMN

 Evolution or Revolution?

The title of this Outlook, “The Future of Investing,” is a theme that will take the evolving years to resolve, let alone the next few days. Still, PIMCO is an organization that loves a challenge. All of us here today would agree that the answer to both questions will be highly dependent on the evolution of the global economy, and when it comes to those questions PIMCO has excelled because of its long-term secular outlook. It has paid dividends for our clients for over 30 years and it should do so now as well. The fact is, that the future of investing will depend on the long-term future of the global economy – its nominal growth rate and the distribution of that growth between public and private interests. And so we should start at the beginning, or perhaps at the top, of our top-down process – the future of the global economy.

 I. Future of the Global Economy

The future of the global economy will likely be dominated by delevering, deglobalization, and reregulating, yet if so, it is important to state at the outset that we do not envision a mean reversion, cyclically oriented future, but instead a new world where players assume different roles, and models relying on bell-shaped/thin-tailed outcomes based on historical data are less relevant. Historical models look backward while modern-day finance is being fast forwarded and reconstituted almost as we speak.

 1) Delevering – The prior half-century of leveraging and the development of the amorphous shadow banking system was growth positive. Major G-10 economies became dominated by asset prices and asset-backed lending most clearly evidenced in housing markets. Excess consumption was promoted, and investment based on that consumption followed in turn. Savings rates in many countries including Japan, the U.K., and the U.S. fell towards zero as the reliance on rainy day thrift faded. Deleveraging of business and household balance sheets now means those trends must reverse, and as they do, growth itself will slow, bolstered primarily by government spending as opposed to the animal spirits of the private sector.

 This topic is one which literally could take hours to discuss, and at PIMCO forums and Investment Committee meetings, it does. There are those of us here as well as highly respected economists outside of PIMCO who would suggest destruction as opposed to slow growth, and they may have a minority, but not insignificant, case. Much depends on the effectiveness of policy responses and the simplistic answer to a simplistic question. Can global financial markets and the global economy heal by pouring lighter fluid on an already raging fire? Can too much debt be cured by the issuance of even more debt? Must the debt supercycle come to an end by crashing and burning or does the world keep breathing with a whimper instead of a bang? We shall see, but there is a near certain probability that the financially based global economy of the past half-century will not return, nor will we experience the steroid driven growth excesses that it facilitated.

 2) Deglobalization – Lost in the wondrous descriptions of finance-dominated, Bretton Woods-initiated, global growth has been the adrenaline push provided by global trade and indeed portfolio diversification into a multitude of markets – developed or developing. Yet historians point out that globalization is not an irreversible phenomenon – witness the aftermath of WWI and nearly three decades of implosion. Now the beginning signs of trade barriers – “Buy American” and “British jobs for British workers” among them – as well as government support of locally domiciled corporations (banks and autos) suggest an inward orientation that is less growth positive. Additionally, “financial mercantilism” is an added threat – a phenomenon that speaks to growing pressure on banks to retreat from international business and concentrate on domestic markets.

 3) Reregulation – Academics, politicians, investors, central bankers and everyday citizens are questioning the economic philosophy that idolized free markets and their ability to self-regulate. The belief in uncapped and unregulated incentives producing unlimited upside but nearly always cushioned downside losses is fading. While Sarbanes-Oxley was a well publicized but relatively toothless response to the dot-com bust of nearly a decade past, today’s politicians have gained the upper hand, driven by a citizenry that has recognized the unbalanced, disproportionate distribution of incomes. The efficient market thesis, so prevalent in academic theory and market modeling is now in retreat, and perhaps rightly so. In its place, we will experience less efficient but hopefully less volatile economies and markets – monitored and controlled by government regulation. Executive compensation, of course, is just the poster child. Government ownership and control of vital financial and manufacturing institutions will politely be described as “industrial based” policy and “burden sharing,” but we should have no doubt that we will move significantly away from the free market model that has dominated capitalistic countries for the past 25 years.

 With the top-down framework for future global economic growth in place, let’s take a look at PIMCO’s outlook for the future of investing – evolution or revolution.

 II. The Future of Investing

Whether evolution or revolution it is important to recognize that the aftermath of an economic and investment bubble transitioning from levering to delevering, globalization to deglobalization and lax regulation to reregulation leads to an across-the-board rise in risk premiums, higher volatility and therefore lower asset prices for a majority of asset classes. The journey to a new stasis is a destructive one insofar as it affects previously assumed wealth. Rough estimates suggest that as much as 40% of global wealth has been destroyed since the beginning of this delevering process. In essence, asset prices, which are really only the discounted future value of wealth creation, go down – not only because that wealth creation slows down but because it becomes more uncertain. In such an environment, equity interests in the form of stocks, real estate or even high yield bonds become re-rated. Those who believe that capitalism is and will remain a going concern and that risk taking – over the long run – will be rewarded, must recognize that those rewards spring from beginning prices and valuations that correctly anticipate the global economy’s future growth path and volatility. In terms of that old maxim “buy low – sell high,” this means at the minimum that an investor during this period of re-rating must “buy low.”

 In turn, investor preferences towards risk taking, even when correctly calculated and modeled must be considered. Peter Bernstein has for several years counseled that policy portfolios structured for the long run and based on historical return statistics should be reconsidered. The standard pension or foundation approaches to policy portfolios are being challenged, he asserts, and PIMCO agrees. Stocks for the long run? Home prices that cannot go down? The inevitable levering of asset structures to double or quadruple returns relative to risk-free assets? These historical axioms must now be questioned. In fact, as of March 2009, the superiority of risk-asset returns are not what many assume them to be. For the past 10, 25, and 40 years, for example, total returns from bonds have exceeded those for common stocks.1 Home prices have declined a staggering 30% since their peak in late 2006, and have barely kept up with inflation for the last century according to Case-Shiller statistics. Commercial real estate when ultimately mark-to-market over the next several years will likely show similar results. In short, our stereotyped conceptions of what makes money are being challenged. As Bernstein says, there is no predestined rate of return. And a PIMCO corollary would counsel that future rates of return will be dependent on the beginning price and future growth rates and risk preferences that cannot necessarily be derived from historical models. Government policies will also play an important role, especially insofar as they impact long-standing property rights and capital structures. What I have previously described as a CQ – a common sense quotient – may take precedence over IQ and quantitative analysis in future years. How much of a benefit, for instance, did the renowned risk modeling of some of our major competitors produce over the past several years in terms of their bond funds and derivative-related products as compared to PIMCO’s? We invite comparison, not only of our own risk models, but our collective common sense quotient.

 What then does common sense tell us about future asset returns? Let’s revisit our previous conclusions on the developing environment for some clues. They include: delevering, deglobalization, reregulation leading to slow global growth, a heightened risk aversion, a distrust of conventional investment model portfolios, and a greater emphasis on surviving as opposed to thriving. If valid, then an investor or an investment committee would likely stress the bird in the hand – as opposed to the one in the bush; stable and secure income – as opposed to uncertain capital gains; a government-regulated utility model – as opposed to innovative yet risky venture capital investments. At current price levels, to cite one example, the current income from corporate bonds is higher and certainly more secure than the dividend income from stocks.2 A return to an era reminiscent of the first half of the 20th century is not unimaginable where stocks were viewed as subordinated income producers with yields exceeding their senior bond companions on the liability ladder.

 But let me not go too far in suggesting that asset classes near the perimeter of risk have no future. They do if only because they eventually will be priced right. In fact, PIMCO intends to participate in the management of many of them, and as argued previously should be well and healthily positioned to do so. Our recent launch of a global multi-asset fund featuring tail-risk protection is just one example. The potential participation in TALF and other government-sponsored levered structures is another. Still, the tide seems to be going out and as Buffet suggests, all swimmers are being exposed, swimming suits or bare-bottomed naked.

 There are a host of investment implications that one can subjectively conclude from this outgoing tide, although they have not been officially endorsed by our upcoming secular forum. It seems to me, though, that one has only to ask what investments were positively affected by the previous long-term cycle of levering, deregulation, and globalization in order to imagine which ones will do poorly as the trends reverse. A short list might read as follows:

 (1) The Dollar – As the center of structured finance and the shadow banking system, the dollar was bolstered as it sold paper to the rest of the world. To date, its recent strength seems counterintuitive. Weakness may more accurately describe its future.

 (2) Credit – Lax regulation and increasing leverage squeezed risk premiums and spreads to historically overvalued levels. We are now moving in full reverse.

 (3) Equity – In addition to the previous conclusions, it is evident in retrospect that narrow risk premiums in credit markets facilitated narrow equity premiums in stocks if only because they seemed cheap by comparison and allowed corporations to borrow cheaply and buy back their own stock.

 (4) Emerging Market Globalization and lax lending standards re-rated emerging and developing country financial markets to unrealistic levels. Eastern Europe is likely the first to fall.

 Many of these trends, of course, have now reversed course, direction, and magnitude, and there will come a point where those low and lower prices, as well as the potential for successful policy healing, will favor what is now in disfavor. For now, however, let it be simplistically said that the trend is your friend and that the ad hoc, disjointed and anemic policy responses of government appear to be too little, too late. Investors should therefore favor stable income as opposed to speculative growth or the subordinate liability structures of most private market balance sheets. Shake hands with the government is and has been our motto although the contractual certainty of a government handshake may now be questioned in an increasingly number of marginal areas.

 Another way to summarize our caution would be to quote a recent comment by Barton Biggs. “I am a child of the bull market,” he said which upon further elaboration meant that he bought on cyclical dips with the expectation of riding mean reversion to an upward sloping trend line of prosperity and ultimately higher peaks. In a sense, we are all children of the bull market, although some of us are more mature than others – a bull market of free-enterprise productivity and innovation, yes, but one fostered by a bull market in leverage, deregulation and globalization that proved unsustainable in its excesses. We now must view ourselves as chastened adults, forced into acknowledging a new reality that is dependent upon bear-market delevering and debt liquidation to deliver us to our new and ultimate restructured destination – wherever it lies. Thus, while historians might describe these years as an evolution, for those of us living it day-by-day it most assuredly has the feel of a revolution. Much like Irving Fisher’s “permanently higher plateau” of prosperity that was quickly turned on its head in 1929, those who would forecast a “permanently lower valley” of despair might similarly be off the mark. Yet there should be no doubt that the bull markets as we’ve known them are over and that the revolution is on. Investing is no longer child’s play.

Bill Gross, CIO PIMCO
 

As the population ages, wealth advisers increasingly will be called upon to stretch retirement savings over more years — sometimes a lot more years.

Take the case of an adviser in Portland, Maine, who was retained by a 97-year-old man with a big problem. “His wife had just died,” says Tom Rogers, a certified financial planner and a principal in the Portland Financial Planning Group. “I guess because his wife was younger, his lawyer had put together an estate plan that assumed he would pre-decease her. It said that in the event of her death, their assets would go to her children from a first marriage.”

Surprise, surprise: She died first, leaving him with no money.

“The estate wasn’t huge,” says Rogers, who is on the board of the Maine Estate Planning Council. It was about $600,000 including real estate and investments, but it was all he had besides Social Security and a small pension.

In many states, a surviving spouse who is disinherited can petition the court for what’s called a forced share, typically 30% of the estate including beneficiary accounts. “His stepchildren weren’t thrilled, but he was able to do that, and he got $200,000,” Rogers says.

The question became how to invest that money for someone 97 years old.

“He was in good health, completely lucid, actually a bit of a curmudgeon,” says Rogers. “He didn’t know how long he was going to live, but he wasn’t willing to assume he was going to die in two years. Obviously the stock market would not be a good choice, but we wanted better returns than a money market or CD.”

During discussions with the client, says Rogers, “it turned out that he was very loyal to his prep school and college. So my solution was to set up charitable gift annuities with those schools.”

Many charities offer these annuities where, basically, in return for handing over assets to the charity, the donor is guaranteed a lifetime income stream. And because of his advanced age, the client was eligible for a 12.5% annual return no matter how long he lived. No other conservative investment would have offered that kind of return, and he also received a major income tax deduction because it was part gift and part investment. “And it made him feel good that he was giving to his schools,” Rogers says.

As it turned out, the deal wasn’t so great for the schools. He died last year, at the age of 107.

“They probably were not expecting to pay out on that annuity for 10 years,” says Rogers. “But it goes to show you that you just never know.”

Clients don’t have to be centenarians to take advantage of charitable annuities. Rogers says an 80-year-old currently gets a return of around 7%. Rates have declined a bit recently due to increased longevity and lower expected returns on invested assets.

One catch for wealth advisers is that once the donation is made, the money is no longer under management, which means no ongoing fee income — though that wouldn’t stop an adviser like Rogers, who says the satisfaction of helping out his client far outweighed any lost fees.

By Max Alexander
A DOW JONES NEWSWIRES COLUMN

Improvement in the U.S. economy, whenever it comes, will be much weaker than recoveries from previous downturns, the founder of giant bond-fund manager Pacific Investment Management Co. said Friday.

Bill Gross, who is also Pimco’s co-chief investment officer, told CNBC that anyone expecting a robust uptick on the back of consumer spending ought to brace for a “new normal that in no way resembles past experience.”

“Those who would look for bottoms in the economy or the stock market, I think, are really focusing on the wrong thing, because that implies that we’re going to return to what is a normal stasis,” he said.

The “new normal” will likely see U.S. unemployment — now at a quarter-century high of 8.5% — reach 10% before it retreats to 8%, not 4%, Gross said. The economy, he added, will bottom before starting to grow at a modest 1% to 2%, not the 3%-4% of historical norms.

“We’re evolving into a post-levered financial economy which will witness intense regulation and a redistribution of profits and wealth, most importantly, to previously disadvantaged groups,” he said.

Gross said he believes the U.S. will show signs of recovery starting in the second half of this year, with the key driver being government stimulus spending.

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The Federal Reserve ramped up its efforts to resuscitate the sagging economy, saying it would purchase up to $300 billion of long-term U.S. Treasury securities in the next few months and hundreds of billions of dollars more in mortgage-backed securities.

By buying long-term government bonds and mortgage-backed securities, officials hope to push up their prices and bring down their yields, and thereby energize the economy. Interest rates on many corporate bonds and consumer loans are benchmarked to U.S. Treasury debt.

The move was a bold statement of force from the central bank, which during months of internal debate on the issue had been hesitant to begin buying long-term government bonds as the Bank of England recently began to do.

The Fed action underscores the central bank’s ability to move aggressively to combat the financial crisis without any action by Congress, an important attribute at a time when the political firestorm ignited by bonuses made to employees of American International Group Inc. (AIG). Other rescue efforts has made Congress hostile to approve any more taxpayer money.

Prices on U.S. Treasury bonds soared on the news and the yield fell sharply. Yields on 10-year treasury notes dropped, stock prices rose sharply and the dollar sank.

The Fed’s steps came against a gloomy economic backdrop. “Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending,” the Fed said in a statement after its two-day meeting. “Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession.”

The Federal Open Market Committee, the Fed’s policy-making arm, voted 10-0 to hold the target federal-funds rate for interbank lending in a range between zero and 0.25% and to continue using credit programs financed by an expansion of the Fed’s balance sheet to stabilize markets. Richmond Fed President Jeffrey Lacker, who dissented in January, went along this time. He had wanted the Fed to focus on Treasury purchases as opposed to targeting its lending on various corners of the credit markets. The discount rate that the Fed charges on direct loans to banks was unchanged at 0.5%.

With rates near zero, the Fed is now essentially printing money to increase the supply of credit in the economy.

The Fed said it will buy up to $300 billion in long-term Treasurys over next six months. The purchases of mortgage-backed securities guaranteed by Fannie Mae (FNM) and Freddie Mac (FRE) will push the maximum to $1.25 trillion, up from the previous $750 billion. The Fed also said it would increase the size of its potential purchases of the mortgage giants’ debt to $200 billion from $100 billion.

The Fed’s strategy appears to be to double down on the programs that it thinks work. In addition to commercial paper and money market mutual fund facilities, which appear to have stabilized those sectors, Bernanke has repeatedly highlighted the decline in mortgage rates in response to the agency and mortgage-backed securities facilities, calling it one of the “green shoots’ evident in some markets.

By expanding its securities purchase programs, the Fed also is effectively ramping up efforts they can control. The commercial paper program and a new consumer lending program that commences Thursday are driven by how much demand there is in the markets.

Demand has waned for the commercial paper program in recent weeks, a sign that the market is returning to health. Meantime, the new consumer lending program the Term Asset Backed Securities Loan Facility, or TALF, has gotten off to a slow start.

The U.S. economy is expected by economists to decline at an annual rate of 5% or more in the current quarter. It plunged at a 6.2% rate in the fourth quarter of 2008, the steepest in a quarter century. The economy is now shedding more than 650,000 jobs a month, pushing the unemployment rate to 25-year highs. One nugget of good news is that consumer-spending figures signaled some stabilization since the start of the year.

By Jon Hilsenrath andBrian Blackstone
Of THE WALL STREET JOURNAL

WASHINGTON — The U.S. economy continues to hemorrhage jobs at monthly rates not seen in six decades, a government report showed, signaling that there’s still no end in sight to the severe recession that has already cost the U.S. over four million jobs.

The report suggests that households, already seeing the value of their homes and investments plunge, face added headwinds from the labor market, which could put more pressure on consumer spending in coming months.

Nonfarm payrolls, which are calculated by a survey of companies, fell 651,000 in February, the U.S. Labor Department said Friday, in line with economist expectations. However, December and January were revised to show much steeper declines. In the case of December, the revision was to a drop of 681,000, the most since 1949 when a huge strike affected half a million workers. However, the labor force was smaller then than it is now.

The economy has shed 4.4 million jobs since the recession began in December 2007, with almost half of those losses occurring in the last three months alone. And unemployment is lasting much longer. As of last month, 2.9 million people were unemployed more than six months, up from just 1.3 million at the start of the recession.

“The sharp and widespread contraction in the labor market continued in February,” said Keith Hall, Commissioner of the Bureau of Labor Statistics. Layoffs announcements continued last month across industries including Macy’s Inc. (M), Time Warner Cable Inc. (TWC), Estee Lauder Cos. (EL), Goodyear Tire & Rubber Co. (GT) and General Motors Corp. (GM).

The unemployment rate, which is calculated using a survey of households, jumped 0.5 percentage point to 8.1%, the highest since December 1983 and slightly above expectations for an 8% rate. Some economists think it could hit 10% by the end of next year. For many industries including manufacturing, construction, business services and leisure, the jobless rate is already in double digits.

“It is hard to see where the bottom is,” said Sung Won Sohn, a professor at California State University.

By some broader measures, labor-market conditions are much worse than the overall jobless rate suggests. When marginally attached and involuntary part-time workers are included, the rate of unemployed or underemployed workers actually reached 14.8% last month, up almost six percentage points from a year earlier.

Average hourly earnings increased a modest $0.03, or 0.2%, to $18.47. That was up 3.6% from one year ago, as the recession has made it harder for workers to bid up wages. According to the Fed’s latest economic summary known as the Beige Book, “a number of reports pointed to outright reductions in hourly compensation costs.”

Friday’s numbers suggest that the economy hasn’t stabilized in the wake of the fourth quarter’s 6.2% slide in gross domestic product, which was the steepest since 1982. Economists expect a decline of similar or even greater magnitude this quarter.

One risk is that the stepped-up pace of layoffs may snuff out tentative signs of stabilization in consumer spending, which accounts for about 70% of GDP. Consumer spending rose in January, and retailers last month posted their first monthly rise in sales since September.

“Consumers and businesses are likely to become even more cautious after a bleak report such as this, and if they stop spending, the economy cannot get going again,” said Chris Rupkey, economist at Bank of Tokyo-Mitsubishi.

There’s little Fed policymakers can do on the monetary policy side to stem the slump, given that official rates are already near zero. But the Fed has created a number of credit programs — financed through an expansion of its balance sheet — aimed at spurring new lending. Officials this week unveiled a long-awaited initiative aimed at stimulating consumer lending.

Ironically, some of the pressure on labor markets appears to be a byproduct of robust productivity, which is actually a big plus for the economy over the long run. But in the current environment, it seems to be making things worse for workers as nimble businesses shed labor in anticipation of falling demand, which could become a self-fulfilling prophesy.

Hiring last month in goods-producing industries fell by 276,000. Within this group, manufacturing firms cut 168,000 jobs bringing the total since the recession began to 1.3 million.

Construction employment was down 104,000 last month. The unemployment rate in that sector is now 21.4%, almost double where it was this time last year.

Service-sector employment tumbled 375,000. Business and professional services companies shed 180,000 jobs, the fourth-straight six-figure loss, and financial-sector payrolls were down 44,000.

Retail trade cut almost 40,000 jobs, while leisure and hospitality businesses shed 33,000 as households curtail nonessential spending.

Temporary employment, a leading indicator of future job prospects, fell by almost 80,000.

The sole bright spot among private sector industries was health care, which tends to be more labor intensive and less productive than manufacturing and other services. Health care payrolls rose 26,900.

The government added 9,000 jobs.

The average workweek was unchanged at 33.3 hours. A separate index of aggregate weekly hours fell 0.7 point to 101.9.

By Brian Blackstone
Of DOW JONES NEWSWIRES