Justice for Nortel's Disabled?

Diane Urquhart wrote an article in Benefits Canada, Nortel employees seek legal clarity around health and welfare trust:

The dissenting disabled employees of Nortel have filed a leave to appeal to the Court of Appeal of Ontario to gain a last minute reprieve from the life of poverty and medical crisis they feel they will face now that their health and welfare trust (HWT) has been terminated, a move that went into affect on Jan.1, 2011.

A decision on whether the appeal will be heard is expected to come soon.

Many Canadians with disabilities live in poverty due to grossly inadequate Canada Pension Plan (CPP) disability income. A single person with a disability receives a maximum of $13,521 per year. A disabled parent with two children receives only a maximum of only $18,408 per year. Nortel disabled employees have average medical costs of $7,200, with one at $50,000 per year.

These benefits are under par when compared to benefits in the U.S. and U.K. In the U.S, a disabled person with two children gets $48,780 per year from Social Security and the U.K. Pension Protection Fund provides for $47,509 a year.

This appeal will define whether vested pensioner life insurance benefits are the legal obligation of the employer or of the legally distinct HWT. If the court precedent is for vested pensioner life insurance benefits to be legal obligations of an HWT, 1.1 million Canadians in self-insured disability income plans had better opt out of their employer plans and seek personal disability insurance coverage.

The actuarial liabilities for disability income are always a small proportion of the total actuarial liabilities for pensioners vested life insurance benefits and disability income due to only 0.9% of the workforce is disabled. HWT’s are generally not fully funded. When deficient HWT assets are used to pay both pensioners life insurance and disability income on an HWT termination, the disabled get deeply compromised.

In his Nov. 9, 2010 decision, the Nortel Companies’ Creditors Arrangement Act judge, Justice Geoffrey Morawetz, added the following words to interpret the meaning of future benefits in the 1980 Nortel HWT Trustee Agreement termination clause: “claims that would certainly have been made in the future.” The termination clause says: “The trustee shall also determine on a sound actuarial basis the amount of money necessary to pay and satisfy all future benefits and claims to be made under the plan in respect of benefits and claims up to the date of notice of termination.”

The added words allow a lump-sum payment of $3,500 each to the 10,000 living pensioners from the HWT. The 400 disabled are left with a lump-sum settlement from the HWT that funds just 27% of their disability income until age 65, death or recovery.

The leave to appeal asks that legal interpretation of “future benefits and claims” be made in the context of “incurred claims.” Under accepted insurance and actuarial principles and practices, future benefits relate only to incurred claims for insured events that have already occurred prior to the termination of the contract. Deaths benefits for living pensioners are not incurred claims, because the insured event of death has not occurred prior to the termination of the HWT.

Justice Geoffrey Morawetz’s Nov. 9, 2010 Nortel HWT decision conflicts with Canada Revenue Agency (CRA) rules for HWTs. The income tax act has had a clause since 1979, of no tax deduction for employer contributions paying for life insurance beyond the current year. The Nortel HWT has always had pensioners’ group one-year term life insurance policies that are automatically terminated upon Nortel’s receivership or bankruptcy. CRA ruling documents clearly say that HWT’s have no liability for future life insurance premiums and must not have a permanent surplus.

On the other hand, future disability income is part of the incurred claim from the onset of disability before the HWT’s termination. According to a 1979 CRA interpretation bulletin, a self-insured disability wage loss replacement plan is to operate on insurance principles and like “an insurance plan.” So, the HWT does have a legal obligation to pay the future income of the disabled beneficiaries.

The 1998 Canadian Pacific Railway law case reinforces that HWT assets funding future disability income are not a contingent reserve, but a legal obligation.

It is surprising that income tax act rules for HWTs, which are a CRA defined vehicle, have been ignored by Justice Geoffrey Morawetz and the counsel representing the employer, court monitor, pensioners, and the disabled and continuing employees.

The appeal will clarify whether income tax rules for HWTs and insurance and actuarial principles and practices may be ignored in the interpretation of HWT trustee agreements.

The legal implications of this case are important and I thank Diane for sharing her analysis with me. I do hope that this case gets resolved soon and that the judgment from the appeal will favor Nortel's disabled employees who have been through a long, tough struggle. They deserve to have peace of mind as they battle their illness and provide for their families.

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The Great Inflation Debate?

Linda Stern of Reuters reports, The great inflation debate:

Worried about inflation? Neither Federal Reserve Chairman Ben Bernanke nor all those traders currently dumping gold seem to be, but that may be the best time to make sure you're covered if prices go haywire.

Some people think the combination of an expansive Fed policy and an expansive fiscal policy make that inevitable. Oh, and as I'm writing this, the United Nations is announcing that world food prices are at an all-time high.

The last time consumer prices went crazy, it happened pretty fast: They rose roughly 3 percent in 1971, 6 percent in 1972, and 12 percent in 1973, according to the Labor Department's Consumer Price Index data. Back then, it took almost a decade and a deep recession to get that genie back in the bottle.

"The rapidity with which that ... changes is actually pretty astonishing," says Hans Olsen, chief investment officer for J.P. Morgan Private Wealth Management.

Olsen's clients already have roughly 25 percent of their portfolios in inflation hedging assets. "You want to skate to where the puck will be, not to where it is," he said in a recent interview.

But not everyone thinks inflation is looming, or that typical inflation-fighters, such as gold, are a good place to keep money right now.

"I'm concerned with investors making big bets on gold" and other traditional inflation hedges, says Dave Loeper of Wealthcare Capital Management in Richmond, Virginia.

Loeper, a former adviser to the Virginia Retirement System, recently studied the behavior of anti-inflation assets during inflationary periods. He concluded that the payoffs for hedging inflation might not be worth the extra trading and holding costs.

"Adding gold and real estate to a 60/40 (60 percent stocks, 40 percent bonds) portfolio looks pretty similar to a 50/50 balanced portfolio," he wrote. "Those extra positions... are certain to add cost... and do not appear to be worth much unless we do have that perfect storm" of an unusual and severe double-spike in inflation.

Loeper looked at the most recent three major periods of inflation and observed that there was not one asset class that produced positive real returns in all three periods. Because gold, in particular, has been bid up as a safety plan during recent low-inflation years, he's concerned that it may not perform its typical anti-inflation role when prices rise.

The yes-it's-coming/no-it-isn't debate about inflation can be seen in market prices and consumer expectations, too. Both bond market swaps and inflation-protected securities seem priced with an expectation that prices will rise a modest 1.5 percent or so, says Olsen.

But consumers responding to the Conference Board's last survey had a different view: They expect prices to rise about 5.3 percent in the next 12 months.

So, what's an investor to do? Here are some tips for preparing for a run-up in prices, which may or may not materialize.

* Let some investments do double duty. Loeper and Olsen agree on this: Some investments already in your portfolio might protect against inflation without being strictly anti-inflation plays. For example, if you own a large-cap stock fund, you probably already own shares of Exxon Mobil Corp. or Weyerhaeuser, two traditional inflation-fighters.

Similarly, Olsen's clients own foreign stocks; they'll be some protection if runaway prices hurt the U.S. dollar more than other currencies.

* Go long on items you'll use. Not all investments happen in your brokerage account. If you're a year or two away from buying a new car, lawnmower or retirement house, think about buying now while prices and interest rates are comparatively low. You can stockpile canned goods and paper towels, too, but not to the extent that you end up on A&E TV's reality show, "Hoarders."

* Keep carrying-costs low. There are now many inexpensive exchange-traded funds which focus on commodities and other anti-inflation strategies. Many are available for an annual expense charge well below 0.8 percent.

* Stay safe. You may lose purchasing power, but you won't lose money by buying individual Treasury inflation-protected bonds and holding them to maturity. Yields are low, but guaranteed to rise as the CPI does. The big risk there? If interest rates rise faster than prices, you could find yourself losing ground to better-yielding short-term securities.

Is inflation the real threat going forward? The answer is nobody really knows for sure. Inflation is already present in China and emerging markets, but it has not picked up significantly in the US and Europe. We are likely to see higher energy prices, but even this is not enough to kick start a severe inflationary episode. Only wage inflation can do this, and to compare what is going on now with the 1970s is simply wrong. Despite December job gains, unemployment remains stubbornly high, unions are not as strong as they used to be, and the structure of the global economy has changed significantly in the last three decades.

Demographics, global competition, the internet, deleveraging, are all factors weighing down inflation. It is possible that we start importing inflation, but even this is debatable. Bottom line: the great inflation debate will continue for quite some time, and while you should hedge against all scenarios, be careful not to jump on any inflation bandwagon. Deflation hasn't died; it might just be hibernating.

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Pension Fund Losses Hit States Hard

Michael Cooper of the NYT reports, Pension Fund Losses Hit States Hard:

When total state government revenues across the nation plummeted by a record-breaking 30.8 percent in 2009, the steep investment losses of pension funds proved to be an even bigger drain on state coffers than recession-battered tax collections, according to census data released Wednesday.

States reported $1.1 trillion in total revenues in 2009, down from $1.6 trillion a year earlier — the steepest drop the United States Census Bureau has reported since it began collecting data on state government finances in 1951.

Tax collections fell by $66 billion, blowing a hole in the operating budgets of many states. But the biggest losses will be felt only in the future: states reported a $477 billion decline in what the census calls “insurance trust revenue,” mostly from pension funds but also from funds for unemployment insurance and workers’ compensation.

It is hardly a secret that the bursting of the housing bubble and the Great Recession pummeled state finances. But the new census data, for the fiscal year that ended for most states at the end of June 2009, provides the most comprehensive view yet of the decisions states made in the year they saw their revenues fall by record amounts.

The data told a tale of states struggling to adapt to the new fiscal reality. Thanks to an infusion of federal aid, largely from the stimulus, states saw their general revenues decrease by only 1.4 percent — but general expenditures by state governments rose by 3 percent.

The downturn gave states new priorities and needs. As more people lost their jobs, states found themselves paying $66 billion in unemployment benefits in 2009, up from the $35 billion that they had paid a year earlier.

Donald J. Boyd, a senior fellow at the Nelson A. Rockefeller Institute of Government in Albany, said the new census data showed how state governments as a whole began to respond to the recession in what he called “the year of shock and awe for state government taxes.”

Public welfare spending rose 6.1 percent in 2009, as needs rose during the prolonged recession and the federal stimulus bill provided more money to states for programs like Medicaid and the Temporary Assistance to Needy Families. But at the same time, Mr. Boyd pointed out, “spending on some of the bread-and-butter operations of government came to a virtual standstill” as corrections spending grew by only 1 percent, spending on government administration grew by less than half a percent, and spending on parks and recreation fell by 4.6 percent.

Even though President Obama only signed the stimulus bill into law in February 2009, midway through the fiscal year for most states, the injection of federal money helped offset some of the loss of tax revenue: total federal grants to the states rose by nearly 13 percent that year to $477.7 billion. The stimulus money is set to run out this summer — leaving states facing big deficits next year, since their tax collections, which have begun to rise again, are still far below their pre-recession levels.

The biggest loss recorded — the $477 billion decline in revenues earned by the pension funds and other social insurance trust funds — had little immediate impact on state budgets. But its effects are likely to be felt for years.

“It is truly astounding,” Mr. Boyd said of the losses. “They don’t translate immediately into budgetary stress for states. But what does happen is through the wizardry of actuarial valuations, they will drive pension contributions by states and localities up considerably in the coming years, and that’s true despite the good stock market of 2009, and the relatively good stock market of 2010.”

In his article, Michael Fletcher of the Washington Post reports, Recession-bruised states' revenue sank 30 percent in 2009:

The recession blew a huge hole in the already shaky finances of state governments, causing them to lose nearly one-third of their revenue in 2009, according to a Census Bureau report released Wednesday.

The severe drop in state revenues resulted largely from the big investment losses experienced by state pension funds during the worst period of the downturn. Also, the report said, tax revenues slipped while surging demand from newly needy citizens drained the funds that back unemployment benefits, publicly funded health care and workers' compensation.

Overall, total state government revenue dropped 30.8 percent to $1.1 trillion between fiscal 2008 and 2009, according to the report.

The economy has improved since the depths of the recession as the stock market has rebounded and state tax revenues have begun to tick upward. Still, the recession's lingering effects - particularly a national unemployment rate that is hovering at close to 10 percent - have left the vast majority of states with large budget deficits and increasing service demands.

Governors and state legislators across the country are now confronted with a series of painful choices about future service cuts and tax hikes.

Next year "will actually be the most difficult budget year for states ever," said Nicholas Johnson, director of the state fiscal project at the Center on Budget and Policy Priorities. "If you look at the gap between the cost of providing public services and the revenue available to provide them, it remains very large," he added.

States' continued fiscal problems are projected to be a drag on the broader economic recovery as state payrolls are likely to shrink and state contracts to private companies are likely to be pared back.

Despite billions in emergency aid from the federal government through various stimulus programs, 46 states had to raise taxes and make cuts to close a combined gap of $130 billion in their current budgets, according to the Center for Budget and Policy Priorities. Moreover, 40 states already have projected budget gaps totaling $113 billion for next year, according to the center.

At the same time, states are grappling with swollen social service caseloads, underfunded pension funds and flat revenues - a situation that will worsen as federal stimulus aid comes to a halt in the coming months.

Future federal help is considered highly unlikely, as Congress and President Obama have put a greater emphasis on reducing spending and trimming the huge federal budget deficit.

The new census report adds to the bleak portrait that has emerged from other studies documenting the damage caused by the economic downturn, while making plain that states are likely to continue struggling fiscally for years.

"This report paints a fairly compelling picture of the impact of the recession on states," said Susan K. Urahn, managing director of the Pew Center on the States. "There are many states predicting that they're not going return to pre-recession levels of revenue until 2014."

In Virginia, revenue declined 28.4 percent to $25.9 billion between fiscal 2008 and 2009. In Maryland, the decline was 15.9 percent. The report did not break out data for the District of Columbia, but the city said it saw a 5.2 percent decline during that span.

Even as revenues plummeted during the downturn, the report said, state government expenditures grew 3 percent. Those increases were mainly in essential services, including safety-net programs and education.

Those forces, coupled with the past reluctance of many state leaders to drastically reduce services or raise taxes, have resulted in large budget deficits in many states. Illinois, for example, has a budget deficit that is equal to 45 percent of its overall budget, according to a recent report by the Pew Center on the States and the Public Policy Institute of California. In California, the gap is equal to 13 percent of the state's total budget. In Arizona, the gap is 15 percent.

Given the growing fiscal problems, many states are moving more aggressively to rein in their costs. Last year, for example, Virginia raised the earliest retirement ages for its workers and limited cost-of-living increases for the pensions of new employees. Maryland, meanwhile, is in the midst of a debate over how to lower its future pension costs.

Tax collections account for almost half of the general revenue of states, and they plummeted by 8.5 percent between the end of fiscal 2008 and 2009, the census report said. The decline was the first year-to-year drop in tax revenues since 2002, according to the Census Bureau.

The decline in tax revenue was partially offset by a 12.9 percent increase in federal aid, which amounted to $477.7 billion in 2009, the report said.

"The basic point is we need to remember how far we fell in 2007, 2008 and 2009," Johnson said. "We're still 12 percent below where we were in revenues at the beginning of the recession, yet all the needs have gone up."

Any way you slice it, state finances are in dire straights. States need to make cuts and take tough decisions on public pension plans. I expect more states to follow Virginia in raising their minimum earliest retirement age. But that won't be enough to undo the damage caused by the recession.

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License to Steal?

A senior pension fund manager sent me a link to a Washington Examiner blog entry, Europe starts confiscating private pension funds:

The U.S. isn't the only place that's facing a major pension fund crisis. The Christian Science Monitor has this alarming report:

People’s retirement savings are a convenient source of revenue for governments that don’t want to reduce spending or make privatizations. As most pension schemes in Europe are organised by the state, European ministers of finance have a facilitated access to the savings accumulated there, and it is only logical that they try to get a hold of this money for their own ends. In recent weeks I have noted five such attempts: Three situations concern private personal savings; two others refer to national funds.

The most striking example is Hungary, where last month the government made the citizens an offer they could not refuse. They could either remit their individual retirement savings to the state, or lose the right to the basic state pension (but still have an obligation to pay contributions for it). In this extortionate way, the government wants to gain control over $14bn of individual retirement savings.

The article goes on to detail other pension grabs in Bulgaria, Poland, France and Ireland. Obviously, this is a cautionary tale for America. If fiscal austerity becomes a real issue in the U.S. the way that it's been reaching critical mass in Europe -- don't think that U.S. lawmakers regard your either your personal wealth or money they might owe you as sacrosanct. Government has a habit of looking out for itself.

While some governments are "Hungary for pensions", I wouldn't worry too much about a big US pension grab -- at least not yet. I am more worried about legalized theft taking place in the markets every single day. Yahoo Finance posted a CNBC article, Investing Dying as Computer Trading, ETFs & Dark Pools Proliferate:

There's an old Wall Street adage meant to inspire investors that goes "it's not a stock market, but a market of stocks." Consider that dead.

Computer trading, dark pools and exchange-traded funds are dominating market action on a daily basis, statistics show, killing the buy and hold philosophy still attempted by many professional and retail investors alike. Everything moves up or down together at a speed faster than which a normal person can react, traders said.

High frequency trading accounts for 70 percent of market volume on a daily basis, according to several traders' estimates. The average holding period for U.S. stocks is now just 2.8 months, according to the Crosscurrents newsletter. In the 1980s, it was two years.

"The theory that buy-and-hold was the superior way to ensure gains over the long term, has been ditched completely in favor of technology," said Alan Newman, author of the monthly newsletter. "HFT promises gains are best provided by holding periods measuring as few as microseconds, possibly a few minutes, or at worst, a few hours."

The problem is only made worst by the proliferation of exchange-traded funds, traders said. The vehicles, which make trading a group of stocks as easy as buying and selling an individual security, passed the $1 trillion in assets mark at the end of last year, according to BlackRock. This is probably why all ten sectors of the S&P 500 finished in the black for two consecutive years, something that's only happened one other time since 1960, according to Bespoke Investment Group.

"The capital raising stock market of the past hundred years has morphed in just the last 10 years into a casino," said Sal Arnuk of Themis Trading and a market infrastructure expert who advised the SEC after last year's so-called Flash Crash. "Who is doing the fundamental work analyzing stocks? In the end, we've greatly increased systemic risk."

Another factor jumped into the fray in December: dark pools. Off-exchange trading accounted for more than a third of the trading volume in December, says Raymond James. While these trades are eventually reported to the public markets, they further damage price discovery, an essential element for a fair securities market, investors said.

"This was a record high market share for off-exchange trading and we believe the SEC will ultimately be forced to react to support the price discovery process by limiting off-exchange trading for all traces except for large block trades," wrote Raymond James analyst Patrick O'Shaughnessy in a note to clients yesterday.

"This destroys capital markets," said Jon Najarian, co-founder of TradeMonster and a 'Fast Money' trader. "Hidden trading venues, where some participants get to peek at the orders as they are entered so long as they agree to 'interact' with a minimum percentage, is not an exchange, it's a license to steal."

While many see these forces aligning to cause a sort of self-correcting powerful drop in the market down the road, others feel like it's creating an opportunity for the stock pickers to mount a comeback.

At the end of last year, something strange happened. After tracking the S&P 500 for most of 2010, the Russell 2000 Index, made up of many small companies with very different characteristics and merits, broke away in the final three months to double the gains of large cap benchmark for the year.

"Small cap outperformance in the last quarter is a very good sign this trend is ending," said Joshua Brown, money manager and author of The Reformed Broker blog. "Winners and losers are starting to separate themselves after a year of the whole risk-on (buy anything), risk off (sell everything) of the last year."

Of course, you could have just bought the iShares Russell 200 Index ETF (NYSEArca:IWM - News) in September.

I also feel that all these dark pools, ETF flows, and high frequency trading platforms are wreaking havoc on the market, but they do present opportunities for stock pickers. This is because if things get really out of whack, long-term investors (like pension funds) will move in, and in extreme cases, they may even take a company private.

Nonetheless, the reality is that investors are struggling to make sense of wild market gyrations caused by high frequency trading and dark pools. Over at Zero Hedge, they have been writing on this subject for a long time, but only now is mainstream media waking up to the fact that markets are routinely being manipulated by a few large and powerful players in this space. Some will dismiss this as "part of the liquidity game", but I think large pension funds should also be asking some tough questions on how these new "sophisticated" trading methods impact their holdings.

For me, this is all a license to steal. Sure, it's legal, but it's still theft using multimillion dollar computers that are able to trade faster than the speed of light. And I'm not so sure that the CNBC article got it right. I think Michael Hudson got it right, the average stock is held for 22 seconds and foreign currency investment for 30 seconds. As sad as this sounds, this is the reality of our "new and improved" markets. Computers have taken over, and while there are limits to these trading platforms, they are increasingly dominating the way markets react to fundamental news.

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Korea's National Pension Investing in Energy

Saeromi Shin and Shinhue Kang of Bloomberg report, Korea's National Pension Plans Private Equity Fund for Energy Investments:

National Pension Service, South Korea’s biggest investor, may set up a private equity fund with the nation’s business groups, including Samsung Group and Hyundai Motor Group, to invest in overseas resource development.

SK Group, GS Group and KT Corp. may also join the plan, Kim Seok Joo, a spokesman for the pension fund, said by phone today. The timing and size of the fund have yet to be decided, he said.

“We may sign a preliminary agreement with major companies to invest in energy resources,” said Kim, whose pension fund manages 317 trillion won ($282 billion) in assets.

South Korea, Asia’s fourth-largest crude importer, has said it aims to boost supplies of oil and gas from overseas resources owned by the nation’s companies to 30 percent of its annual requirements by 2019 from 9 percent in 2009.

National Pension said in October it bought a stake in Colonial Pipeline Co., operator of the largest pipeline linking U.S. Gulf Coast refiners and East Coast markets, to diversify its portfolio. In September, state-owned Korea National Oil Corp. also won control over Dana Petroleum Plc in a 1.87 billion-pound ($2.9 billion) hostile takeover.

Resource Bets

Funds are increasing their investments in resources as energy costs rise. Hedge funds raised bullish bets on crude oil to the highest level in more than four years on speculation that futures will climb as the U.S. recovers from the deepest recession since the 1930s.

The funds and other large speculators increased net-long positions, or wagers on rising prices, by 4.6 percent in the seven days ended Dec. 28, according to the Commodity Futures Trading Commission’s weekly Commitments of Traders report. It was the top total in records going back to June 2006.

The wagers gained on signs that demand will advance as the U.S. economy improves. Analysts have forecast that prices may top $100 a barrel for the first time since the beginning of the financial crisis in September 2008. Global oil use will increase 1.7 percent to a record 87.8 million barrels a day this year, according to the U.S. Energy Department.

The Chosun Ilbo newspaper reported earlier the fund will be formed next month.

Last August, the National Pension boosted their equity stake. The fund was one of the top performers in 2008, down only 0.75% that year. These large strategic investments are a sign that things are heating up in the energy sector. One blog I highly recommend you track on a daily basis is oiprice.com. The choice of going the private route makes perfect sense as there are plenty of opportunities private energy deals. Other large pension funds and sovereign wealth funds are also investing in private energy deals, which bodes well for the sector.

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Overcomplacency in the Market?

Following up on my outlook 2011, Brendan Conway of the WSJ reports, Options Flash a Caution Sign for '11:

The options market has a handful of signals for investors looking to the new year. The most glaring: Rougher trading in the stock market may be right around the corner.

Investors can plumb prices in the options market for hints on stocks' outlook, specific sectors or even scenarios like bank-stock dividend increases. The broadest measure of investor sentiment, the Chicago Board Options Exchange's Volatility Index, suggests the market is more confident than at any time since the financial crisis. The "fear index" of Standard & Poor's 500 options prices recently sunk to levels last seen in July 2007, suggesting a green light for stocks.

But sophisticated investors also trade futures on the VIX, as the gauge is also known, to hedge or act on their views a few months out. Those futures show skepticism in the form of much higher volatility expectations. March contracts point about 38% higher than recent VIX levels, a view that would bring some gyrations to the stock market if it bears out.

"You definitely have some upcoming catalysts that could drive volatility, such as earnings results or renewed European sovereign concerns," Credit Suisse equity derivatives strategist Terry Wilson said. Mr. Wilson, who predicts that a rockier market could come as soon as January, calls the relatively low prices of options an opportunity to guard stock portfolios.

The low VIX level itself, viewed against its elevated futures, strikes some observers as cautionary. Dan Bystrom, head of U.S. equity derivatives trading, at MF Global Inc., views the contrast as one of several signs of overcomplacency in the market, at a time when a variety of macroeconomic head winds could blow stocks back.

Diving down to specific sectors shows the market's quite placid volatility outlook isn't fully echoed in a few key areas. For instance, for stocks to advance on full throttle, emerging markets and financial services are two areas where many investors would want to see a bullish outlook.

But over-the-counter "outperformance" options on emerging markets and financials show the market isn't pricing in much direction for either. The odds look to be roughly even for emerging markets and financial stocks to outperform or to underperform the S&P 500 index next year, according to a recent analysis of those contracts by UBS AG's derivatives strategists.

UBS also looked at the options market's view for the S&P 500 to fall to the 1000 level any time this year. The probability came in at a not-insignificant 38%.

The uncertainty persists even though at least some of the stock market's most hotly anticipated positives are showing up in the options market. For instance, the prospect for bank-stock dividend increases was one of the factors boosting investor confidence this past fall. Options have a say on that subject, since their prices reflect an "implied dividend" in order for the contracts to trade. The outlook is growing more positive.

J.P. Morgan Chase & Co.'s options show a widely anticipated dividend increase, as do contracts for Wells Fargo & Co. and PNC Financial Services Group Inc., according to an MKM Partners analysis. US Bancorp is also pricing in an increase, albeit smaller, the firm found.

Much of the anxiety leads back to the same subjects that roiled markets in 2010: Europe's sovereign-debt woes, the potential overheating of the Chinese economy or the uneven state of the U.S. recovery.

"Volatility is going to be a lot like 2010—low for much of the year, but we may see some spikes as these macro head winds emerge from time to time," UBS AG equity derivatives strategist Mitchell Revsine said.

One area that bears an especially close look is the health of the U.S. consumer. Retail is a sector that strategists mention repeatedly when recommending which stocks to hedge.

Credit Suisse recently recommended locking up some of the holiday froth in retail stocks by buying put options on the SPDR S&P Retail exchange-traded fund. In particular, the firm read Best Buy Co.'s tough quarter as a sign that analysts have overshot the good news that many retailers can deliver.

"There's an opportunity to acquire cheap protection right now, because volatility in the market has been so muted lately," Credit Suisse's Mr. Wilson said.

Does the low VIX indicate overcomplacency in the market? Maybe, but I wouldn't read too much into the low VIX level. The VIX might remain low for an extended period as markets edge higher. Vol make look cheap now but a year from now, it can look cheaper. In fact, I read this interesting comment on the OnlyVix blog written a couple of weeks ago:

As I'm writing this VIX is trading at ~15.60, very close to it annual low of 15.23 back in April. This level is obviously significantly below what I expect a month ago, but also lower than investor expectations. The front month futures expiring on Wed, Dec 22 that have only 2 full trading days until expiration are still relatively juicy at 17.30! Of course the big question on everyone's mind is what is next for the market and for the VIX.

While the future is uncertain, I think that VIX has entered a low-volatility regime (see my post here). I think economic uncertainty will not allow long-term VIX futures to fall much lower (back months are about 25) , which means that term structure premium is likely to remain high. If I'm correct in my hypothesis, we can see a steady decline in VXX due to increased rolling costs.

I also believe the VIX has entered a low-volatility regime. This means high frequency trading platforms will need to lever up to make the extra juice. Pensions should be taking a closer look at volatility arbitrage, either internally or through external managers that specialize in this strategy. Pensions should also be using some basic option strategies to protect their downside and/or enhance their returns. Some practitioners even feel that investors should treat volatility as a separate asset class. I agree, if done properly, investors can make money trading vol.

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Outlook 2011: Climbing the Wall of Worry?

Let me first wish all my readers a Happy New Year full of health & happiness. It's that time of year where I reflect on what lies ahead. Last year I wrote about Black Sloths and commented:

...the global pension crisis will not disappear overnight. It is a long-term structural issue that will plague governments for years. In fact, part of me thinks that the Fed and other central bankers will try to engineer inflation to partly offset future pension liabilities.

My worst fear is that they will fail miserably, creating another generation of paupers. I hope I am wrong, but this remains my worst fear for the next few years. I do hope monetary authorities and governments take the pension crisis more seriously.

Governments around the world are taking a closer look at pensions, especially public pensions, but I'm not convinced they're moving in the right direction. I worry that instead of bolstering retirement systems around the world, we are weakening them, leaving far too many people exposed to the vagaries of "sophisticated" wolf markets. This virtually guarantees more pension poverty down the road.

As for monetary policy, the Fed continued engaging in quantitative easing (QE) in order to reflate risk assets and is engineering inflation, including inflation in emerging markets.

I still maintain that the financial oligarchs and power elite have vested interests to keep the current financial system alive for as long as possible. Their worst fear is to be trapped in a prolonged period of debt deflation. That's why I still think the dips will be bought and that liquidity flows will continue driving risk assets higher in 2011.

But every year is different. The easy money was made in 2009 following post-deleveraging blues. Going forward, it will be much harder to make money off broad market moves, and deleveraging hasn't gone away, but I also think the world isn't half as bad as many bears scare us into believing.

Before you sell all your stocks or do anything extreme, take a step back and read some predictions for 2011. Let's begin with Larry MacDonald who reports in CTV, Reasons to be both bullish and bearish in 2011:

In 1931, The New York Times celebrated its 80th anniversary by asking Henry Ford and other luminaries to forecast what the world would be like in 2011, another 80 years ahead. As the archives on the newspaper’s website reveal, Mr. Ford envisioned more success “in passing around the real profit of life.”

He may prove to be right. Investment strategists, most economists and investor sentiment surveys see higher stock markets and economic growth in 2011. But there are voices of dissent, or at least caution. Here are three reasons to be bullish for 2011 – and three reasons to be cautious.

Bullish: improving economic signals

Recent U.S. economic indicators hint that the self-sustaining phase of the business cycle may be close at hand. Retail sales have trended up since July to a three-year high, while jobless claims have declined, leaving the four-week average at its lowest point in nearly two and a half years.

The widely watched Weekly Leading Index published by the Economic Cycle Research Institute (ECRI) has risen to its best readings since May 28. Money supply and credit aggregates are turning up as well, observes institutional advisory BCA Research, suggesting banks are beginning to lend and firms to borrow.

Bearish: housing sector missing in action

Historically, the housing market leads U.S. economic recoveries. But stimulus so far has been “inadequate to lift home construction and sales,” reports Asha Bangalore, senior economist at the Northern Trust Company in Chicago.

Adding to concerns, the S&P/Case-Shiller Home Price Index has started to go down in recent months and could fall further. “There is still roughly two years of unsold inventory overhanging the market once the ‘shadow’ foreclosure backlog is included,” Gluskin Sheff chief economist David Rosenberg declares.

Bullish: supportive policy

Sparked by earlier fears of a double-dip recession, U.S. policy makers recently announced new measures to boost the economy. Bush-era tax cuts were maintained, the payroll tax temporarily cut by 2 per cent, and unemployment benefits extended.

The Federal Reserve announced a second round of quantitative easing, committing to the purchase of $600-billion (U.S.) in U.S. government bonds by June. The Fed wants to keep five- and 10-year Treasury yields down and encourage U.S. banks to lend rather than park funds in Treasuries, economists say.

Bearish: bond risk

If stimulus leads to growth quickening too much, the bond market could sell off, causing yields to shoot up and undermine the economy. The flash point is currently 3.8 per cent for 10-year U.S. Treasury yields, according to models developed by Peter Gibson, the CIBC World Markets chief portfolio strategist who has earned top rankings in the Brendan Wood International survey of analysts since 1994.

If yields breach this ceiling, the Fed will try to hammer them down with quantitative easing. If that doesn’t work, the Fed could raise short-term rates to appease the bond market with the prospect of economic slowdown, Mr. Gibson says.

Bullish: healthy corporations

U.S. corporations are “in phenomenal shape” writes Tony Boeckh in the Dec. 17 issue of the Boeckh Investment Letter. Profit margins, at 8.7 per cent, are way above the long-term average. And cash balances are huge, led by the technology sector with a cash-to-equity ratio that exceeds 25 per cent.

If the recovery picked up, “those cash holdings could be used for M&A activity, capital investment, share buybacks and, of course, higher dividend payouts,” Mr. Gibson writes. Exceptions may be exporters who keep cash balances offshore.

Bearish: state and local cutbacks

“One shock is the sharp pending drag from widespread and accelerating spending cutbacks and tax hikes at the fiscally strapped state and local government level [in the U.S],” Mr. Rosenberg points out. “This promises to be a major macro theme for 2011.”

Funding pressures are going to be more intense when the “Build America Bond” program winds up. “The sector has laid off 250,000 people in the past year and more is to come as this crucial 13-per-cent chunk of the economy moves further into downside mode,” he adds.

We continue on a bullish note which seems to be the consensus. Bob Doll, Chief Equity Strategist of BlackRock makes his 10 predictions for 2011:

1. US growth accelerates as US real GDP reaches a new all-time high.

2. The US economy creates two to three million jobs in 2011 as the unemployment rate falls to 9%.

3. US stocks experience a third year of double-digit percentage returns for the first time in more than a decade as earnings reach a new all-time high.

4. Stocks outperform bonds and cash.

5. The US stock market outperforms the MSCI World Index.

6. The United States, Germany and Brazil outperform Japan, Spain and China.

7. Commodities and emerging market currencies outperform the US dollar, the euro and the Japanese yen.

8. Strong balance sheets and free cash flow lead to significant increases in dividends, share buybacks, mergers and acquisitions and business reinvestment.

9. Investor capital flows move from bond funds to equity funds.

10. The 2012 Presidential campaign sees a plethora of Republican candidates while President Obama continues to move to the political center.

I tend to agree with most of these predictions, especially the ones I put in bold. One of the key things to watch for is how capital flows out of bond funds into equity funds. While stocks are likely to outperform bonds, I'm not bearish on bonds. I don't see inflation in the US and backups in long bond yields present opportunities for investors to pounce.

Importantly, the Fed will do whatever it takes to make sure bond yields do not wreak havoc on the financial system. The problem is that some feel we didn't need QE2 and there is way too much stimulus in the pipeline. Maybe the bond market is worried that another round of QE will propel yields higher. One portfolio manager told me: "we don't need more QE; it's going to backfire big time!". The same portfolio manager sees the curve flattening in 2011 as short rates rise in anticipation of Fed rate hikes in 2012.

And what about Doll's prediction that the US market will outperform all other markets? It might very well be the case, but Bernard Lapointe wrote an interesting comment in the Sceptical Market Observer claiming that 2011 may be the year for Japanese stocks. Who knows? I see liquidity flows continuing to drive US stocks higher.

As far as commodities, the biggest risk I see going forward is the price of oil overshooting $100/barrel. Forget the "imminent collapse of the euro zone" (won't happen) and pay attention to oil because the biggest risk to the recovery is the price of energy. I remain bullish on energy and alternative energy where I see a long-term secular bull market developing (and potential bubble). Higher energy prices will be positive for the Canadian stock market.

Finally, listen to Barton Biggs, Traxis Partners and Jeffrey Gerson, Gerson Guarino & Meisel Group founding partner provide their predictions and outlook for 2011. Gerson says the housing double dip is likely to worsen in 2011 and will pressure the economy. Gerson is approaching the markets in a cautious and tactical manner because he believes the market is unlikely to regain the highs as soon as many might think.

Barton Biggs, however, is extremely bullish. Although he believes the market is overbought he says the market can continue to rally higher in the early portion of 2011. I agree with Biggs, especially on emerging markets, which is why I believe markets will climb the wall of worry.

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