The Capital Spectator: March 2006 Archives

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March 31, 2006

EQUITY RISK CONTINUES TO PAY OFF IN 2006

Short rates keep rising, long rates may be inclined to follow, but the stock market doesn't seem to mind. In fact, the big stumble so far this year through March 30 among the major asset classes seems to be commodities, as the chart below shows.

Indices/Funds: S&P 500, Lehman Bros. Agg Bond, ML US High Yield Master II, MSCI EAFE, MSCI EM, Russell 2000, Pimco Commodity Real Return Fund A, Pimco EM Bond Fund, Vanguard Inflation Protected Securities Fund, Vanguard Prime MM Fund, Pimco Foreign Bond (Unhedged) A

Equity risk, in short, continues to pay off in 2006. Small-cap stocks are firmly in the lead so far this year, with emerging markets stocks close behind.

It doesn't hurt the bullish case for stocks overall with news that U.S. corporate profits jumped 21.3% in the past year. In fact, the Department of Commerce yesterday reported that corporate profits now represent the biggest slice of national income in 40 years.

Momentum, as a result, looks set to dominate in the land of equities. Is that affecting the perpetual race between value and growth stocks? Yes, and no, depending on how you slice it.

In the large-cap arena, value stocks are well ahead of their growth counterparts so far this year, based on the Russell 1000 style indices. By these gauges, growth is up 3.44% in 2006 through March 30, well below value's 6.26%.

But it's a close year-to-date race over in small caps, with growth leading only by a nose relative to value in the Russell 2000 style indices: 13.96% v. 13.15%.

If Fed Chairman Ben Bernanke wants investors to err on the side of caution, he's still got his work cut out for him. Another 25-basis-point rate hike for May?

Posted by jp at 10:21 AM | Comments (0)

March 30, 2006

WHAT'S NEXT FOR THE DOLLAR?

The price of money affects everything financial. When the price changes, so does everything else, including perceptions. Relationships adjust, risk-reward dynamics move, and investors rethink, recalculate and review.

Evolution on this plane usually moves at a snail's pace over a day or two, only to reveal itself more fully in longer stretches, with the repercussions rippling across asset classes, markets, and borders. So, when the Federal Reserve raises interest rates for the 15th time in a row, as it did on Tuesday, and the dollar reacts by slipping, you may wonder what Mr. Market is thinking.

The U.S. Dollar Index is lower this morning, despite this week's 25-basis-point bump in Fed funds to 4.75%. In fact, the Dollar Index is considerably lower than compared to mid-November, a moment in time when Fed funds were a relatively slight 4.0%.

Higher interest rates and a falling dollar. What gives?

In theory, higher interest rates imply a stronger currency. In a make-believe competitive world, with only those two variables defining capitalism, capital consistently flows to the higher-yielding currency for the simple reason that higher beings prefer profits that are bigger rather than lesser. Of course, the global economy has more than two variables determining outcomes, and the dollar is subject to any and all of them. The trick is figuring out which variables dominate at the moment, and for the foreseeable future.

We can begin searching for an answer by observing that interest rates seem to carry less potency as a buck-boosting stimulant these days. That could change in six minutes, but for now this is our story and we're sticking to it. This despite the fact that Fed Chairman Ben Bernanke has all but assured us that yet-another rate hike is coming in May, when the FOMC meets again.

In truth, there are no absolutes in forex trading, the world's biggest marketplace and the one that's subject to more macroeconomic factors than any other. As a result, it's easy to see what you want to see when it comes to predicting the future path of the dollar.

The pessimists see a dollar ultimately succumbing to the twin deficits that hound the American economy--i.e., the red ink on the trade and federal-budget ledgers.

In contrast, the optimists say that America's relatively robust economy, driven by heavy doses of free-market incentives, will carry the day, keeping the buck stronger than it would otherwise be in a more state-controlled environment.

Within those two extremes lie a rainbow of variety, some of it as nuanced a Congressional budget. Consider, for instance, one outlook for the dollar that calls for a strengthening buck and a weakening U.S. economy. A weaker economy suggests lower interest rates, and so a lower dollar. But the burning desire, particularly in Asia, to export goods to the U.S. will prop up the buck regardless, and keep long rates lower than they otherwise would be. Or so some analysts figure.

If that argument fails to impress you, there are other choices to consider, some with bearish implications for the buck. That includes the fear that the explosion of petrodollars, primarily in the Mideast, will find paper alternatives to the dollar more alluring in the years ahead. A smoking gun leaning in that direction comes to us by way of the United Arab Emirates central bank, whose governor reminds this week that he's intent on upping its euro-based reserves to 10% from 2%, coming at the expense of the dollar. Translated: sell the greenback. "Although the potential shift in reserves by the UAE does not represent a huge amount on its own, if this becomes a trend throughout the region it will have a significant impact on currency markets," advise currency analysts from BNP Paribas, via Marketwatch.com.

In fact, an unprecedented rise in foreign reserves among central banks generally, especially among emerging market economies, is creating a massive pool of liquidity that carries new-found power to move currencies and interest rates. Unfortunately, the implications are less than clear, in part because the central banks behind the trend don't respond to the same set of risk/reward factors that inform profit-seeking individuals. The motivations of the central banks may be fuzzy, but their influence is large and growing, suggests a February research paper from the European Central Bank. "A significant share of the U.S. current account deficits is financed by foreign official institutions pursuing objectives that are, to some extent, insensitive to risk-return considerations," concludes The Accumulation of Foreign Reserves, No. 43.

Suffice to say, the dollar's reaction to any future interest-rate hikes may very well be driven by trends outside the usual suspects found in textbooks. That leaves open a wide variety of possible outcomes in the land of forex, including the possibility that the dollar slumps, even in the face of additional interest-rate hikes.

If the Fed can't support the dollar by tightening the monetary strings, what options are left for the central bank in a world where precedent's under constant threat of extinction?

Posted by jp at 10:20 AM | Comments (3)

March 29, 2006

BEN V. BEN

Fed Chairman Ben Bernanke's at war with the bond market, and himself.

Yesterday's 25-basis-point hike in the Fed funds rate was the 15th in a row for the central bank, and the first for Bernanke, who took over from his predecessor, Alan Greenspan, on January 31. Judging by the FOMC statement that accompanied Tuesday's rate hike, more rate hikes may be coming: "The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance."

Traders in the Fed funds futures market responded immediately, repricing the May contract a bit in anticipation of another 25-basis-point hike, which would bring Fed funds to 5.0% when the FOMC meets next on May 10.

Traders in the bond market followed suit, selling the 10-year Treasury with a vengeance, and thereby boosting the yield yesterday to around 4.78%, or up by nearly 8 basis points over Monday's close. In fact, as we write, the selling continues, pushing the 10-year yield to 4.80%, which is approaching the highest levels in almost two years.

But for all the selling going in fixed-income lately, the yield curve remains flat, which means it could invert quickly and without warning. And as the last few years show, the bond market has embraced selling only to return to form and argue in favor of lower rates.

In our view, Bernanke wants the market to blink for more than a week or two this time, if only to announce his intent to dominate monetary policy. Filling Greenspan's shoes is tough, and nowhere more so than when it comes to convincing Mr. Market to follow the Fed's script. Greenspan himself had some trouble in that regard, with bond yields staying lower than he thought prudent. Such is life in the 21st century.

Or, to use Bernanke's observation, there's a global savings glut in the world, and that's keeping long rates artificially low. Perhaps, but if you accept his line of thinking then it follows that artificially long rates, if left untouched, will eventually redirect capital in ways that financial prudence might otherwise reject and thereby boost inflation to higher levels than is tolerable. All of which leads the Fed to focus on the real estate market, and take actions that slow the passion for property, which may be convincing Joe Sixpack to borrow and spend above and beyond levels the Fed deems appropriate at this juncture.

In fact, there are signs that the housing market may be cooling--last week's sharp drop in new home sales being the latest smoking gun. Then again, Bernanke still has his work cut out for him, if one measures the still-buoyant state of housing sentiment by the much larger sample drawn from existing home sales. What's more, consumers are growing more optimistic, or so the Conference Board tells us. Modifying such momentum may take another rate hike or two.

Indeed, Bernanke desperately needs to show Wall Street and Main Street that he's in charge, and that the markets respond when he acts. The jury's still out, but whatever the final outcome the front line on gauging results will be the 10-year Treasury yield, which carries no small influence over mortgage rates, which in turn casts a long shadow over the real estate market.

For the moment, the yield curve remains more or less flat. In relative terms, that means that borrowing money is still attractive, perhaps too attractive for Bernanke. The bond market in the last 24 hours has shown a willingness to revise its long-standing position that central banks can't push traders around like they used to. Indeed, Bernanke has admitted as much in the past, a la his global savings glut argument.

But now Bernanke must effectively dismiss his own argument over worldwide liquidity, or at least convince bond traders to dismiss it. The central bank still matters, Ben is saying. Eventually, the bond market will listen. But when, and at what price? Will a 5.0% Fed funds do the trick? 5.25%, or even higher? Must Ben bring the economy the precipice of recession to make his point? Will he? Or will the Fed chief blink first?

Posted by jp at 10:36 AM | Comments (0)

March 28, 2006

CRUDE FOR THE MASSES. WILL THEY BITE? SHOULD THEY?

The first oil ETF is almost here.

The Wall Street Journal (subscription required) today reports that the American Stock Exchange will launch a crude oil fund next Monday, with the symbol USO. (For a copy of the SEC filing, click here.) Another milestone in the world ETFs, which trade on exchanges like stocks.

Once the ETF is trading, investors will be able to buy direct exposure to crude oil futures contracts via a listed security for the first time. The question, of course, is whether there's a compelling case for buying oil futures at this juncture.

Leave it to Wall Street to come out with a product after the price of oil has been climbing for the better part of nine years. That, of course, is the way the financial system works. When oil was languishing at just over $10 a barrel in late 1998, the idea of oil-related investment products was the financial equivalent of leprosy. Today, in the wake of a near five-fold climb in the price of crude from late-1998, the Street can't talk enough about of the opportunities in energy. Indeed, there are any number of hedge funds dedicated to energy plying the markets that were mere ideas a few years back.

To be fair, the SEC probably wouldn't have approved a publicly registered oil ETF in 1998. Then again, it probably wouldn't have mattered if the regulators ok'd the idea. New-product launches tend to reflect the investment du jour, or hadn't you noticed? Remember internet-equity mutual funds?

No, oil's not tech. That is, oil's no fly-by-night investment gimmick. Even so, you can lose lots of money in crude, or turn a tidy profit. But after watching a barrel's price climb almost steadily in recent years, one has to wonder when the show will take a breather.

Yes, we're second to none in recognizing the case for a long-term bull market in oil. Indeed, we've penned more than a few articles on the subject over the years, as regular readers of CS know. But at this juncture, in the here and now, the question is whether jumping on the bandwagon is enlightened or something less? Ergo, is the emotion that's likely to dominant for the foreseeable future in oil pricing A) Greed, or B) Fear?

To gauge an answer, we looked at the latest data from the Energy Information Administration, on the perhaps naive assumption that supply and demand trends can shed light on prices going forward. On that note, there are several reasons to be cautious. Exhibit A is the stocks of crude oil. As the graph below shows (courtesy of EIA), supplies of oil in the U.S. refinery system have been running above average recently, which casts a short-term bearish pall over prices.

Meanwhile, EIA's short-term projection for oil predicts an average price of $61 next year, down from the expected $64 average price per barrel for 2006. In fact, $64 a barrel just happens to be the current price of oil, based on last night's close in New York futures trading.

Then again, Mr. Market has his own ideas about what comes next. The October 2006 crude oil contract traded on NYMEX is priced for a $67 a barrel.

There are as many guesses about where oil's headed as there are rigs in the Middle East. The past, at least, is clear. With that in mind, it's a safe bet that the robust state of the U.S. economy has been front and center in keeping oil prices buoyant in recent years. U.S. GDP climbed by an annualized range of 3% to 4% last year, based on quarterly numbers. But expectations for something slower are percolating through the punditry system. If so, a material slowdown in the economic expansion in 2006 and 2007, as EIA and others expect, is likely to put downward pressure on oil prices.

With that in mind, the best guess for where oil prices are headed may come from reading the tea leaves on the economy. As it happens, that's a timely bit of advice, given this afternoon's announcement from the Fed on interest rates. The central bank may not have much influence on the price of oil, but it has the capacity to squeeze the economy, which may be the next best thing. Thus the question: Is the central bank still intent on slowing the economy? If so, what does that imply for oil prices in the land where the thirst for petroleum is second to none?

Of course, all the enlightened analysis in the world isn't worth a nickel in the wake of an "event." Oil, afterall, is more than just another commodity, and so its price reflects geopolitical as well as economic risk. Modeling oil prices, in other words, doesn't work all that well, at least compared to corn or lead.

Posted by jp at 9:50 AM | Comments (1)

March 27, 2006

NUMBER CRUNCHING TO PASS THE TIME

Until tomorrow afternoon, debate over whether the Fed will or won't raise interest rates again, and whether the decision is warranted, promises to dominate conversations on Wall Street. We don't have any special insight into what's coming, but it's clear that Mr. Market is anticipating another 25-basis-point rise to 4.75% in Fed funds tomorrow. That, at least, is the message coming from the April contract on Fed funds.

Some pundits nonetheless think the central bank will hold steady for the time being. That's a minority view, but anything's possible in the 21st century.

Deciding whether the economy needs another 25-basis-point jolt is a judgment call, although even that conclusion is debatable. With that in mind, here's a recap of some of recent numbers that will be weighing on Fed officials as the vote yea or nay. For convenience, we've divided our somewhat-randomly-chosen 13 economic and financial measures into two groups. The first nine, in our humble opinion, suggest another hike is in the offing, based on the 12-month trend, which isn't always confirmed by more recent data.

In any case, the second group of four lean in the opposite direction.

Does this mean a rate hike is all but certain? The Fed will have the answer around 2:10 pm tomorrow, Washington time.

GROUP 1
S&P 500: -0.3% (week through Mar 24)
+11.2% (12 months)

Gold: +1.1% (week through Mar 24)
+31.9% (12 months)

Crude oil: 0.1% (week through Mar 24)
+17.2% (12 months)

Producer Price Index: -1.4% (Feb)
+3.8% (12 months)

Core Consumer Price Index: +0.2% (Feb)
+3.0% (12 months)

Retail Sales: -1.3% (Feb)
+6.7% (12 months)

Industrial Production: +0.7% (Feb)
+3.3% (12 months)

New Orders for Durable Goods: +2.6% (Feb)
+7.5% (12 months)

Initial Claims for Jobless Benefits: -3.5% (Week through Mar 18)
-8.5% (12 months)

GROUP 2
Existing Home Sales: +5.2% (Feb)
-0.3% (12 months)

New Home Sales: -10.5% (Feb)
-13.4% (12 months)

US$ (trade weighted): +0.6% (week through Mar 24)
+2.1% (12 months)

10-year Treasury Note, change in yield: +0.1% (week through Mar 24)
+5.0% (12 months)

Posted by jp at 10:02 AM | Comments (0)

March 24, 2006

M3, R.I.P.

Now it's official. The M3 money-supply series is dead and buried. The official word from the Fed and its minions: it's no big deal, really. (For some background on M3 and its scheduled demise, see our previous post here.)

In yesterday's weekly release of money supply data, the central bank said of the newly defunct series: "M3 does not appear to convey any additional information about economic activity that is not already embodied in M2 and has not played a role in the monetary policy process for many years. Consequently, the Board judged that the costs of collecting the underlying data and publishing M3 outweigh the benefits."

Maybe this is the Fed's contribution for reducing the government budget deficit. In any case, Edward Nelson of the St. Louis Fed agrees with the powers that be back in Washington, explaining that a wider definition of money supply, which is M3's raison d'etre relative to M2, isn't always better. Writing in the April issue of the St. Louis bank's Monetary Trends, Nelson asserts that a "broader definition of money is not necessarily always preferable....Monetary analysis needs to draw the line between money and nonmoney assets, and some financial instruments lack sufficient similarities with traditional money to merit inclusion in a monetary aggregate."

Not everyone agrees, although it seems that the majority of dismal scientists don't seem to have a problem with sending M3 to the guillotine. That's a conclusion we draw from the fact that so few economists are calling on the Fed to reverse its decision. In any case, Congressman Ron Paul is one of the few who'd like to see the publication of M3 data roll on. (Our recent interview with Paul on the topic of M3 and his legislation can be found here.)

But for the moment, M3 is gone, and the odds of it being resurrected don't look good. Does that mean that the true nature of money supply and, by extension, insight on inflationary trends will remain shrouded in mystery? Let's hope the answer is no, if only because M3's final message was noticeably different from that of M2. To cite the Fed's numbers, M3's seasonally adjusted annual rate of growth has been materially faster than M2's. For the 12 months through February 2006, for instance, M3 advanced by 8.0%, well above the 4.7% climb posted by M2. Is that something to worry about? No, the Fed tells us. The answer will suffice if inflation doesn't rise from current levels. But if pricing pressures mount in the months and years ahead, the subject of M3 may reach out from the grave and pose some awkward questions for the central bank.

* * *

Those who buy to let mortgages take care of the rest do not always remain where they are. They usually get stuck into the traps of mortgage lenders, since they have so many mortgage loans on their credit. Whether this is commercial mortgage or a free home mortgage, certain base line rules are to be followed at all times. Even if you are looking for housing finance, prefer bank loans to this category.

Posted by jp at 9:27 AM | Comments (2)

March 23, 2006

CAN THE INVERTED YIELD CURVE SURVIVE ANOTHER RATE HIKE?

Will the Federal Reserve raise interest rates again next week, when the FOMC convenes on March 27 and 28? Another way of asking the question: is the central bank willing to add momentum to the forces that have generated an inverted yield curve? If so, what message will the Fed be sending to the markets?

As we write, the two-year Treasury carries a yield that's four basis points above the 10-year Treasury. Elevating Fed funds up by 25-basis points to 4.75% threatens to increase the inversion by raising the price of short-term money. Indeed, the six-month T-bill is currently 4.80%. Tacking on another 25 basis points would push it over 5.0%.

If there's any doubt that another 25-basis-point hike is coming next week you won't find many skeptics in the market for Fed funds futures. The April contract has for some time been priced in anticipation of 4.75%.

Once again, the great question in the halls of bond trading are: what signals, if any, does an inverted yield curve present? More than a few observers have noted that an inverted yield curve can be seen as a harbinger of recession. A New York Fed study published last October, for instance, found that inverted yield curves have a history of presaging economic slowdowns of varying degrees. It's not a perfect record, but neither is it infrequent.

No matter, as Bernanke devalued such studies in a speech on Monday. Opining at the Economic Club of New York, the Fed chief cast aspersions on the notion that short rates above long ones have any great meaning in the here and now. He offered three reasons. One, interest rates are relatively low compared to previous cases of inverted yield curves, and so any warning signal at present is a shadow of its former self. "This time, both short- and long-term interest rates--in nominal and real terms--are relatively low by historical standards," he explained.

Two, demand for debt securities is relatively high these days, and so the premium on longer dated bonds is lower, which is bullish for the economic outlook. As he put it, "to the extent that the flattening or inversion of the yield curve is the result of a smaller term premium, the implications for future economic activity are positive rather than negative."

Third, yield curves are but one variable, and the message dispatched by this measure isn't entirely consistent with other gauges of economic activity. For example, "the fact that actual and implied volatilities of most financial prices remain subdued suggests that market participants do not harbor significant reservations about the economic outlook," he argued.

One might wonder what Bernanke is trying to say about the future by diminishing the predictive powers of the inverted yield curve. Yes, it may simply be that the Fed chairman is doing his best to rally the troops and send a message of hope and optimism on matters economic. If so, does it also follow that the path of least resistance for interest rates is upward?

Important questions, to be sure. But they pale in comparison to wondering if the yield curve will stay inverted even after a rate hike next week. If so, what will Bernanke say then? And while we're at it, how will bond investors react?

Posted by jp at 10:12 AM | Comments (1)

March 22, 2006

WILL THE COMMODITIES' DIVERSIFICATION BENEFIT SURVIVE?

Commodities have been discovered by the masses in recent years. Rediscovered is probably the more accurate description, since raw materials were formerly all the rage in investing circles in the 1970s and through the first half of the 1980s. The fact that Wall Street and Main Street are finding reason anew to embrace a broad mix of commodities is arguably a more-strategic move this time around, courtesy of the widely publicized data that show the diversification power of adding commodities to a portfolio of stocks and bonds.

But some worry that the diversification value of commodities may fade over time as more and more investors climb on the bandwagon. One way to monitor that diversification value is by watching the correlations of returns between commodities and other asset classes, primarily stocks and bonds. On that front, there's reason to wonder if the price of popularity is starting to take a toll.

Consider that the rolling 36-month correlations between stocks and commodities have been rising sharply for more than a year, as the chart below illustrates. The correlations between commodities and bonds have been rising recently too, albeit with less drama.

Granted, even after the jump in correlations between stocks and commodities there's still a hefty diversification advantage left. Indeed, the trailing 36-month correlation of total returns as of last month between the Russell 3000 and Dow Jones-AIG Commodity Index was a mere 0.20. (1.0 is perfect correlation, 0.0 is no correlation, and -1.0 is perfect negative correlation.)

By comparison, there's a lot correlation these days between U.S. stocks and foreign stocks, as measured by the Russell 3000 vs. MSCI EAFE. The two equity indices post a 0.82 correlation for the past 36 months as of February 2006. The two indices, in other words, are generally moving in line with one another.

Simply put, commodities still offer a strong diversification counterweight to stocks and bonds. But if the stocks/commodities and bonds/commodities combos still yield diversification benefits, one might reasonable ask: how long will the strategic value last? Not much longer if the rise in correlations between the two asset classes maintains its current pace.

Then again, correlations aren't set in stone. They evolve, ebbing and flowing over time. Bull markets in one, a bear market in another, keep the relationship dynamic and fluid. It may well be that the recent rise in correlations between stocks and commodities is just part of the natural process of ups and downs in correlations.

We'd be inclined to leave it at that, except for one thing: money's pouring into commodities at a robust clip. What's more, a lot of that new money is chasing commodities specifically to tap into the long history of low correlations.

The oldest mutual fund targeting commodities, Oppenheimer Real Asset, has an asset base of $1.9 billion since launching nine years ago. Several other commodities mutual funds have come on the scene since then. Notably, the mutual fund Pimco Real Return, has accumulated $15 billion--up by $3 billion last year alone, according to Morningstar. And the choices keep expanding: as of February, the first commodities ETF in the U.S. debuted, the DB Commodity Index Tracking Fund. Meanwhile, there are additional commodities ETFs are in registration with the Securities and Exchange Commission. In addition, there are many more billions rolling into private commodities funds, courtesy of institutional investors.

The recent inflow of money is no doubt driven, at least in part, by the strong returns in commodities. Hot asset classes always attract money, and commodities have clearly been hot. Consider the annualized five-year total returns through February 28, 2006 for commodities, stocks and bonds:

Commodities (Dow Jones-AIG Commodity Index) 10.31%
Bonds (Lehman Bros. Aggregate Bond) 5.16%
Stocks (Russell 3000) 3.28%

If commodities stumble, perhaps the correlations will fall. Or, maybe a selloff in stocks or bonds will bring correlations lower.

It doesn't help to consider that foreign stocks once posted much lower correlations with domestic stocks. Indeed, in the 1980s and early 1990s, there was a much greater bang for allocating money into foreign equities of developed markets. Today, after so many investors went overseas, the diversification value of foreign stocks has faded. Not completely, but it's faded relative to what it once was. Is the same process now attacking commodities?

The future, as always, is unclear. The past, by contrast, yields no secrets. Bridging the gap between the two is always the great chasm in investing. Correlations threaten no less of a challenge.

Posted by jp at 9:40 AM | Comments (2)

March 21, 2006

FLY-BY VIRUS

David Kotok, chief investment officer of Cumberland Advisors, a Vineland, N.J. shop with $800 million under management, is preparing for bird flu, which he thinks may come to the United States. Should you be doing the same? Or is the fear unjustified?

Kotok's view is one of erring on the side of caution. In an email to clients last Friday, he warned that bird flu "must be taken very seriously." He's doing no less, as our conversation with him yesterday reveals.

It's hard to know if Kotok's money-management counterparts across America share his concern, although anecdotal evidence suggests that worrying about bird flu is not yet in season. That may change, and perhaps quickly. But for the moment, Kotok appears to be in the minority within the financial community.

If you're interested in how the minority thinks on this matter, Kotok's your man. Although he's an investment professional, he's well-read on the subject of bird flu, and has talked to various officials about what may be coming. He also has definite thoughts about what bird flu means when it comes to an investment portfolio. In sum, he says that raising cash will become increasingly warranted if and when the danger signs start to rise. If the virus becomes serious enough, he thinks selling equities completely will become prudent.

For the moment, however, bird flu is still very much a foreign hazard, and so cash-only portfolios remain the stuff of disaster planning in paper form only. Time will tell if it stays that way, although the flu seems to have some momentum, as the chart below suggests. The death toll among humans, although still tiny, is growing, as is the number of countries with avian flu in animals.

Source: US Health & Human Services Dept.

Meanwhile, with the approaching migratory season of Asian birds flying to North America there's reason to worry anew, or so Kotok tells us in the following interview, which we conducted by phone yesterday, March 20. In fact, U.S. Interior Secretary Gale Norton said as much yesterday. "It is increasingly likely that we will detect a highly pathogenic H5N1 strain of avian flu in birds within the U.S. borders, possibly as early as this year," the Secretary warned, according to McClatchy News Service via Detroit Free Press.

(If you're interested in getting the government's current spin on bird flu, take a look at PandemicFlu.gov. For news reports, Google has the usual surfeit of updates. Meanwhile, sleep with one eye open, and cast a wary eye on strange ducks in your backyard.)

DAVID, WHAT ARE THE ODDS OF BIRD FLU BECOMING A MAJOR THREAT TO THE U.S. ECONOMY AND THE FINANCIAL MARKETS?
We break down the whole bird flu risk into four scenarios. There are a thousand permutations and combinations, but we boil it down to four.

Scenario one is the present level of sick birds, mainly poultry, and the spread worldwide with a very robust virus that kills them. The virus can obviously jump to a human, but to do that a person has to handle an infected bird, and come in contact with the excrement since this is an intestinal tract virus. The virus itself can survive in cold temperatures for a couple of days, so it has some robustness. There's maybe a hundred dead people around the world [from the virus], and all because they were in direct contact with the disease in a bird.

So you have a terrible threat to poultry, and the requirement to act quickly. We saw [a quick response] to the outbreak in Israel over the weekend.

Let's call the existing scenario a poultry threat with a very, very strong robust virus. We know there's evidence that migratory water fowl are carriers, so we know that ducks, geese carry without getting sick. There's lots of evidence of that. That's scenario one.

WHO GETS HURT IN SCENARIO ONE?
Obviously, the chicken industry, and some of the agriculture-related distribution-related areas.

Most people aren't changing their behavior because of scenario one, at least not yet. They view it more or less as another version of mad-cow disease, only this time it's on wings and spreading a lot faster than it is in beef.

WHAT'S SCENARIO TWO?
Scenario two hasn't occurred, but there are suspicions that it can occur. In this scenario, the virus moves from birds to other mammals--to pigs, for instance. There's evidence of sick pigs, but it's not yet clear why. But if we see it spreading in mammals, that ups the risk profile of the virus.

HOW SO?
In that case, you're into a much larger food-supply issue. You're infecting immune systems that get closer to human immune systems, which means that the virus is constantly at work in terms of changing. Pigs, by the way, have an immune system very close to humans. So infecting pigs would be an additional warning, meaning that the impacts are larger and the risks are higher.

AND SCENARIO THREE?
If the virus becomes human-to-human transmissible. There are two possibilities as I see it, although as practical matters there are many permutations. We've boiled it down to two for Scenario three:

One, the virus is still controllable with barriers, masks, quarantines, treatment--I'd call this the SARS case study, which was a case where there was a virus, it was transmitted from human to human, and was airborne. However, you could take lots of defense mechanisms. I remember traveling in Asia and Canada, where people wore masks. While SARS had some negative economic impact--the airport in San Francisco had many unused gates--it didn't shut down the system.

Scenario three with bird flu could reach epidemic proportions, meaning that it could spread in concentrated areas. You could have a region, or a city or a country [infected], but the defense mechanisms were still working. The virulence of the disease is controllable by barrier and separation. Yes, it would be bad for air travel, bad for tourism. However, lots of the system is still functioning.

AND SCENARIO FOUR?
This is the worst-case scenario--a pandemic. Now you've got human-to-human transmission, and you've got a robust virus that's a killer. This is a horror story.

In the first world, this taxes the healthcare system and readiness systems to their limits. We've got lots of scenarios that have been constructed--the financial impact is huge, lots of dead people, healthcare systems without enough hospital beds or respirators, etc., because the handling and the servicing of the sick has to be done with masks and hazardous material suits and things like this. This is a science fiction movie that becomes real.

It doesn't take much mutation for this thing to become human to human. There are a lot of issues here, such as, you don't know what the final vaccines are until you know what the virus is, and the virus can change. Defense mechanisms take time.

Obviously, there's a lot of activity for the pharmaceutical and healthcare industries. In terms of financial markets, we're overweight the healthcare sector now. It's cheap by historical standards. We think it's a growth sector for a while, and all the bad news about certain drugs and litigation is known, and so we'd overweight the sector anyhow. But you overweight it even more as a defense mechanism against bird flu spreading human to human.

THE HEALTHCARE SECTOR IS CURRENTLY ABOUT 13% OF THE S&P 500 IN TERMS OF MARKET CAP
Yeah, I'd add five or six percentage points to that, which is pretty substantial. We're an ETF-only manager and we benchmark against the S&P 500.

On the negative side, if you add quarantine, separation, change people's behavior, you hurt tourism and the financials sector, and you introduce lots of levels of business risk. So, people become unemployed. There are lots of financial-related areas that are vulnerable--I don't think life insurers have adequate for mass deaths, for instance. How do you handle disabilities? What happens in businesses that haven't prepared, in terms of workman's compensation claims? There are a lot of issues here.

ARE YOU PREPARED AT CUMBERLAND ADVISORS?
In our office, we're inventorying masks, non-perishable foods. We're inventorying for the worse and hoping for the best.

YOU'RE PRETTY ACTIVE ON THIS FRONT. THERE'S PROBABLY NOT A LOT OF PEOPLE AT THIS POINT THINKING LIKE YOU.
I think that's changing very rapidly. For example, the Federal Reserve issued guidelines to financial institutions about bird flu on Friday. There is a very quick ratcheting up of readiness because the implications are broader than just chickens on chicken farms. I don't think anyone wants to have another bird-flu version of a Category Five storm opening a levee and finding that people aren't ready.

SO THERE'S GROWING POLITICAL PRESSURE ON PREPARDNESS?
That's right.

If we have scenarios three or four, we'll have a recession. In my Scenario four, gross domestic product goes from plus-five-percent to negative-five percent at once. In the 1917/1918 pandemic, the GDP estimate shift then--based on ancient data, of course--was based on a fall of around ten or 11 percentage points.

Today, our much more intensely service-oriented economy requires socialization, which can suffer. Who would go to supermarket?

On the other side, there would be a boom in truck-based deliveries. You can go online, place an order, and it arrives outside your front door.

IN FACT, A LOT OF JOBS THESE DAYS CAN BE DONE ON THE PHONE, OVER THE INTERNET
Yes, we can work virtually.

In my office, all key people are going to be high-speed and virtually wired. We're halfway there now. We've been doing this anyway, only now we've accelerated it. Every officer in Cumberland carries a Blackberry. Everyone's got a home-to-office hook-up. We've got an off-site duplication for all records. All of that was in the works anyway. What the bird-flu threat has done has accelerated it.

Now, some people might say, "You're an alarmist, just like you were with Y2K." Okay, what happened with Y2K? I upgraded my systems. The good news: nothing happened. Meanwhile, we have much more efficient, upgraded, tested systems. Maybe that will be the case with bird flu preparation. I think [the bird flu threat] makes a bull case for tech, telecommunications, wireless--all the things that deal with virtuality rather than face-to-face.

YOU MENTIONED IN YOUR EMAIL LAST WEEK THAT BIRD FLU IS "LIKELY" TO APPEAR IN THE U.S. IN FOUR TO EIGHT WEEKS BECAUSE THE FLYWAYS OF MIGRATORY BIRDS WILL BECOME ACTIVE AS THEY MOVE FROM ASIA TO NORTH AMERICA. THE FRONT LINE, SO TO SPEAK, IS WHERE THE U.S. BORDER COMES CLOSEST TO ASIA, I.E., ALASKA.
We're tracking this quite extensively. The best information we have today is that the Asian-to-Northern American flight path, which crosses the Bering Sea, becomes active in a matter of weeks. The intense period is four to eight weeks from now.

The nearest known dead-flu bird is 30 miles from the border of the United States in the Bering Sea off the coast of Alaska. There are teams in Alaska, because Alaska would be the first line of defense. I've had conversations with Federal agents, who may not want to speak on the record--they believe that we'll see cases in Alaska within eight weeks.

THAT'S THE SPOT FOR THE PROVERBIAL CANARY IN THE COAL MINE?
Well, that would be the canary in this hemisphere's coal mine.

How the virus spreads is an issue. However, we know that migratory birds carry the virus, and some waterfowl carry but don't get the disease. As soon as you see migratory birds coming from the North, you'll begin to see transmissions in the Pacific flyway. That takes it all the way to South America and Central America and down the coast. The Federal agencies believe the return to the East Coast of the U.S. comes in the fall. Flyways tend to run North-South, not East-West.

MR. MARKET DOESN'T SEEM TO SHARE YOUR CONCERN, OR SO ONE COULD ARGUE
The market reaction is another matter. I don't think the market's pricing in anything other than Scenario one. That is, the thinking is: It's over there, not over here.

But the first dead chicken in Anchorage, Alaska is a headline in every newspaper in the United States. It's the lead story on Fox and CNN. There will then be the media stories on readiness and preparation. There are all the usual interviews. There's the Congressional circus. I'm being kind. Again, the country will listen to its political leaders, not trust them; listen to their political talk and despise them--you can quote me--and say these idiots are running our government and are making our policy and, boy, are we in trouble. I believe that will come. That will only ratchet up the fear.

What the psychological reaction will be is unknown, and how it will translate to markets is unknown.

You have a very interesting case study if you contrast Israel and France. Israel sees sick birds on Wednesday. They've got a quarantined space three kilometers wide on Thursday. Their action was triggered by seeing the sick birds....The government already had in place the process of compensation and arrangements and all of its agricultural community knew it. The farmers didn't have to worry about being bankrupted. Everyone cooperated as a team.

What's going to happen in the United States? What's going to happen when the first chicken farm in, say, Oregon, has a sick chicken? Who's going to deal with it? The local farmer? The local department of agriculture? The state of Oregon? The Federal government? Which agencies? How are they going to talk to each other? What are the arrangements in place?

WHAT HAPPENED IN FRANCE?
The biggest political issue we saw in France was the President of France sitting down to lunch, saying, don't worry, and eating chicken for lunch. The man's an idiot. A cooked chicken doesn't make you sick with bird flu. But if the people who are doing the work [with infected chickens] aren't wearing hazardous materials clothing, with the right ventilators and the right systems, they can get sick and die.

SO WHAT'S THE RISK HERE IN THE U.S. AS YOU SEE IT?
The risk in North and South America is number one a psychological one--when we start to see cases. Preparation systems in first world countries are ratcheting up, but they're not ratcheted up. And we haven't given any thought to speak of, or at least it doesn't appear that we have, to the rest of this hemisphere. You're talking to a person who's toured Third World villages in Ecuador and Guatemala, where households occupy small spaces and where children crawl on the floor, along with the chickens. This is a recipe for trouble. What's the United States going to do for itself, and what's it going to do now in its own hemisphere?

WOULD YOU OVERWIEGHT GOLD AND CASH IF THE RISKS RISE?
I wouldn't today. Today you're in scenario one. Scenario two, you begin to raise cash. You're still in animal-to-animal transmission, but more broadly so, and so the risks are rising. Scenario three, people-to-people transmission, and you raise more cash, you take become more defensive. You know you're going to have some economic slowing, and so you have only the highest-quality bonds. Credit spreads will widen, highest-quality bonds will rally. The Fed will certainly look to drop interest rates, not raise them or hold the line. The enemy is no longer inflation. And if we ever get to scenario four, which I hope we don't, you don't want to own any stocks anywhere in the world. And when I say raising cash, I would raise it mostly from emerging markets, but I would raise it globally as well, not just U.S.

NO GOLD?
No. I don't' think gold is the place you go to in deflationary, contractionary economic times. Especially when gold's $550 an ounce, not $250. So, I look for the very highest grade bonds and alter the composition of stocks. Meanwhile, I think such an experience [from bird flu] could cause the demand for energy to decline. So our overweighted energy position, which has served us well for several years, gets peeled back.

WHAT'S YOUR ENERGY WEIGHTING NOW?
We're at probably 14%-15%, and the market weight's about 10%. We've ridden this from a 6% weighting to 10%. I'd peel back.

HOW QUICKLY DO YOU THINK WE MIGHT MOVE FROM SCENARIO ONE TO FOUR, IF IT CAME?
In 1918, it appears that the pandemic was really bird flu, and it jumped in one day from the bird to the human at a farm in Kansas. That's the worst case. Remember, though, we're dealing with an unknown.

How do you assess risk with math, probabilities? You use chaos theory and shocks. You model shocks. This isn't a trendline, it's not linear.

WHAT DO YOU THINK THE ODDS ARE FOR GETTING PAST SCENARIO ONE?
I don't know. The odds are completely unknown. The odds of mutating viruses are certain, though. The effect of the mutation, and how it will operate is the unknown. The virus is already mutating. This virus in its basic form has been observed since 1997. Why is it more active now than in 1998? Birds flew in 1998. Flyways were active then. Clearly, things are happening in the virus....The virus is changing constantly. The more the virus is changing in humans, the higher the probability that a mutation will get to a human and stick. So, one of the fears here, as it's been spreading in Third World countries, is that there's more and more contact with humans.

Posted by jp at 6:28 AM | Comments (2)

March 20, 2006

ASSET CLASS CORRELATIONS

Diversifying across asset classes (otherwise known as asset allocation) is the foundation on which prudent, long-term successful investment strategies are built. One of the essential issues for allocating among the various asset classes is carefully choosing those pieces that will offer the most diversification bang for the buck, and then weighting the asset accordingly. Modern portfolio theory advises that there are three primary variables that feed into this decision: volatility of returns, expected returns for each asset, and the correlation of returns among the assets.

Focusing on the latter for the moment reveals several interesting trends for the strategically minded investor. (We'll be publishing more on correlations going forward, but for the moment here's a taste of what we're tracking.) Let's start with the classic stock/bond mix, for which we crunched the data based on rolling 36-month trailing correlations for monthly total returns between the Russell 3000 and the Lehman Aggregate Bond Index, plotted monthly, starting in January 2001 and running through last month.

As the chart below reveals, the sharply negative correlation that defined equities and fixed-income in recent years is giving way to something less. To be sure, stocks and bonds still post slightly negative correlation, and so the diversification factor remains potent for owning both asset classes. But if the trend in recent years keeps up, investors may want to re-examine diversification expectations for the classic stock/bond mix. (Note: 1.0 indicates perfect correlation, 0 is no correlation, and -1.0 is perfect negative correlation).

Meanwhile, the correlation trend in domestic/foreign stocks has been improving, although only marginally so. In fact, the diversification value of domestic/foreign equities has been of relatively limited value in recent years, as the chart below shows. Thanks to globalization and enhanced liquidity across borders, the Russell 3000 and the MSCI EAFE ($) returns correlation has been high in recent years. Ditto for U.S. stocks and emerging markets equities, as tracked by MSCI EM ($). Is that high correlation status in the process of changing? Perhaps, as the fall in correlation between the two indices of late suggests (see chart below). If the trend continues, allocating a greater portion of assets to foreign stocks may be warranted in the future. Stay tuned.

If there's hope for the domestic/foreign equity mix as a diversification tool, something less inhabits the realm of large- and small-cap domestic stock blends. Or so the trend of late indicates. As the chart below illustrates, the correlation of monthly returns between the Russell 1000 and Russell 2000 indices (large- and small-cap proxies, respectively) has been on the rise. In fact, the correlation between large- and small-caps has been fairly lofty in recent years, and that status doesn't show any sign of changing. As a result, the diversification benefit of owning large and small equities within the U.S. has been uninspiring.

The correlation between monthly returns for REITs and U.S. stocks is on the rise too. The low correlations of 2002 have been fading for some time. Although REITs still have roughly a 0.5 correlation (based on the Wilshire REIT and Russell 3000), the diversification effect has sharply diminished in recent years.

If nothing else, the above charts remind that while finding low and negatively correlated assets is essential for building a diversified portfolio, the definition of what constitutes low and negative is always evolving.

Posted by jp at 11:04 AM | Comments (9)

March 17, 2006

ANOTHER $781 BILLION, ANOTHER BUDGET

Yesterday we wrote that the trend is your friend. We misspoke. To clarify, sometimes it's your friend, sometimes not. It depends on the trend, the context, and the end result. When it comes to deficit spending in the government of these United States, we know the trend, we know the context; only the end result is in question. Even so, we have our suspicions of what financial fate may have in store for us, and so does everyone else. But they are only suspicions.

Before we pontificate on the matter of red ink (again), let's identify the $781 billion in question. Indeed, there are so many billions earmarked for this and that in the halls of Congress these days that one can't assume much when it comes to referencing large pots of money headed for a government spending program. It's easy to get confused. As such, we're talking of yesterday's vote in the Senate to elevate the ceiling on federal debt by a cool $781 billion.

In some circles, $781 billion is a lot of money. How much is a lot? Seven-hundred-eighty-one billion buys a bit more than 39 billion copies of the paperback edition of Ben Graham's Intelligent Investor, more than 24 million of this year's Lexus ES300s model, and nearly 2.68 million homes at the average U.S. price in January, according to Census Bureau data. But when it comes to budgetary issues in Washington, $781 billion is a drop in the bucket. To be exact, $781 billion is less than 9% of total government debt, which rounds out to $9 trillion--that's with a "t."

Yes, Virginia, the debt ceiling needed to be raised. No question about it. Now's not a good time to default. Then again, there's never a good time for bouncing checks with the imprimatur of the world's lone superpower. But being at the top of the geopolitical and economic heap doesn't suffice for some who are frightened by $781 billion. "Somebody needs to stand up and say, 'Stop me before I spend again,' " said Pat Toomey via The Globe & Mail. Toomey heads up the Club for Growth, which advocates small-government and even smaller doses of red ink.

U.S. Comptroller General David Walker seems to agree, going so far as to charge that even Wall Street is remaining a bit too cool for comfort these days. "The business community was very engaged in the deficit debate in the late `80s and early `90s, and now they're largely missing in action, and that's got to change," Walker tells Bloomberg News. "If we don't end up doing things differently, ultimately they're going to pay a price, too, either through higher interest rates or through slower revenues or higher taxes."

But warnings don't receive much attention is the world of finance. Indeed, there's scant fallout from deficits. The bond market, for one, doesn't seem overly concerned. The yield on the 10-year Treasury Note is lower today than in 2000, when the government coffers were securely in the black vs. the budget-deficit and deficit-spending aura that dominate government finances in the here and now.

For those who are skeptical, be forewarned that you could hurt yourself looking for an obvious connection between the stated rate of inflation and the price of money. Ditto in the pricing of the dollar relative to the major paper alternatives dispensed by central banks around the world. The U.S. Dollar Index has shown an inclination to rise in recent history, belying the warnings that some have eagerly thrown around. Pessimism these days just doesn't carry any weight in the empirical results as determined by Mr. Market.

In fact, optimism has its sources. The Congressional Budget Office's latest baseline projection of the federal budget deficit predicts that the current $318 billion of red ink will fade in coming years, turning into a small surplus in 2012. In short, don't worry, be happy, buy bonds and keep the faith, otherwise known as every fiat currency's favorite emotion.

But the pessimists are digging in their collective heels just the same. We know because the goldbugs aren't selling their preferred monetary alternative. An ounce of gold changes hands at nearly $555, or near its highest levels in a generation.

Maybe the goldbugs are wrong. Then again, maybe the government's red ink isn't going away, and maybe the deficit spending will come at a price after all. We don't know, and neither does anyone else if one fast forwards five or ten years down the road.

You can choose to embrace the best of all possible outcomes as a strategic proposition, or you can wonder if unexpected things can happen. Every investor has a choice, and that includes spreading one's portfolio across multiple assets. The government has choices as well, and that includes spending and defending its fiat currency. Meanwhile, there's only one future. The question is: which one are you expecting, and when?

Posted by jp at 9:56 AM | Comments (0)

March 16, 2006

THE TREND IS STILL YOUR FRIEND

Today's encouraging report on consumer prices for February can only embolden those who say that inflation's under control. With the news from the Labor Department that prices for consumers rose only 0.1% last month--down from a soaring 0.7% in January, you could almost hear a collective sigh of relief on Wall Street. The core rate (less food and energy) also advanced by a quiet 0.1% in February.

Meanwhile, housing starts slowed in February, falling 3.2%, the Commerce Department reports.

The Federal Reserve, at least for the moment, is being congratulated on keeping a lid on inflation while slowing the housing market. Arguably, housing is in dire need of some cooling if only to compensate for the boom of recent years that some say the central bank mistakenly engineered by keeping interest rates artificially low.

In any case, the pessimists are again on the defensive in the capital markets. Even the bond market is regaining the urge to buy again, with the benchmark 10-year yield at 4.66% as we write, well down from the near 4.80% mark of a few days ago.

Contained inflation, slowing but not crashing housing, and any number of economic reports in recent weeks giving statistical aid and comfort to the general notion that the economy's humming along quite nicely. It's not nirvana, but it smells like it, albeit in a new mild and not necessarily permanent packaging.

No wonder that risk continues to be rewarded quite nicely in the stock market so far this year. Small-cap stocks have run ahead of large caps at twice the pace in 2006 through last night's close. Looking at the S&P 500 and S&P 600 on a sector basis reveals even bigger gains in some corners; meanwhile, there are no sign of losses this year, as the charts below reveal.

In the large cap space, telecom services has climbed nearly 14% through March 15. Over in small caps, materials are up almost 18% year to date. Momentum may not work as a long-term proposition, but if you're arguing with the trend these days it's been a costly quarrel so far.

Meanwhile, housing starts slowed in February, falling 3.2%, the Commerce Department reports.

Posted by jp at 11:28 AM | Comments (1)

March 15, 2006

FAILURE TO YIELD?

The U.S. current account trade deficit jumped to an all-time record high in the fourth quarter, rising to $225 billion--up 21% from the third quarter the Bureau of Economic Analysis reported yesterday. With the latest numbers, the tally for 2005 is in, and the red ink for last year has pushed higher to another unprecedented level. Indeed, last year's deficit was a record in both absolute-dollar and relative terms (as a % of the economy).

If you thought any of this would cast a pall over the mood of bond traders by suggesting higher interest rates, think again. In fact, the fixed-income set found reason for hope (such as it is from the view of a bond trader). As a result, buying was in evidence on Tuesday, and so the benchmark 10-year Treasury yield retreated sharply yesterday, falling to just under 4.70% from nearly 4.78% the day before.

One might argue that yesterday's decline in yield was merely a temporary pullback in an otherwise rising trend in the price of money for long-dated bonds of late. The 10-year yield was under 4.3% at one point in January, but as of Monday it was threatening to break above 4.80%.

Whatever new thinking dominates bond traders at the moment, at least one crucial aspect of the credit markets appears unchanging: the Federal Reserve is all but certain to raise the rate on Fed funds again at the FOMC meeting on March 27/28. The April Fed funds futures contract is priced in anticipation of another 25-basis-point hike to 4.75%, and more of the same is expected beyond. A 5.0% Fed funds, in short, looks like a reasonable bet by the summer, to judging by the futures.

Assuming no change in the 10-year yield, a 5.0% Fed funds represents an inverted yield curve (again) in no uncertain terms. Therein lies the great, familiar and so far unsatisfying debate that hangs over the fixed-income world, and a few other corners of finance as well.

One theory of what will come goes like this: rising rates will continue to pinch the world of real estate, which relies in no small degree on the affordability of mortgages, which of course are heavily influenced by the risk-free yields from long Treasuries. As the folks at Comstock Partners lament, the housing slowdown of late "is being exacerbated by high energy prices, continued Fed tightening, an inverted yield curve, rising long rates, and declining real weekly earnings. Moreover, for the first time since 1980 the U.S., the EU and Japan will all be tightening at the same time. In our view this combination is likely to result in a weakening economy and disappointing earnings at a time when the market doesn’t expect it."

The bond market hopes for no less, or so one might reason. Yes, rising rates for the time being will incur a capital-gains bite for bonds in coming weeks and months. But eventually, the higher rates will take an even larger bite out of the bull market in real estate. As a result, a wilting property market will convince consumers to tighten their belts, pull back on spending, and slow the economy, perhaps to the point of recession. This is stuff that dreams are made of for those buying bonds.

Of course, many have been anticipating that future for some time now, with nothing in the way of hard evidence to show for it in terms of consumer spending. Well, almost nothing. Yesterday's retail sales report for last month suffered a sharp 1.3% fall from January. A reversal of fortunes relative to January's 2.9% surge in retail sales over December. So much volatility, so little trend.

Much of the volatility in retail sales is due to the back and forth in auto sales. But there's no small danger in reading too much into consumer thinking by focusing on month-to-month sales of cars. Indeed, the U.S. economy is nothing if not overloaded with autos, and so volatility in sales in times of extreme and rising competition is hardly unusual. The days when General Motors was a relevant bellwether of U.S. fortunes has long since passed, as the carmakers shrinking presence in relative and absolute terms suggests.

Nonetheless, when and if Joe Sixpack cracks remains the big question, and the answer (whatever it is) will no doubt come by way of what happens in real estate. Joe and the trend in housing are hitched, for good or ill.

In theory, the bond market can and does anticipate the future, or at least try, by pricing a 10-year Treasury accordingly. We can argue about whether yesterday's ~4.70% offers sufficient compensation for what's coming, but the bigger question is whether the fixed-income set is up to the task of assessing future risk and reward. More than a little confidence has been lost that was once afforded the fixed-income set as an unwavering force of fiscal rectitude and ghoulish integrity. Even if traders are up to the challenge, there are any number of additional factors moving yields these days that potentially can cloud, obfuscate and otherwise complicate the price of money as it relates to basic economic fundamentals--foreign investors and derivatives, to name two of the more obvious variables.

It all boils down to one question that every investor must ask and answer in the here and now: Do you trust bond traders to prudently set the price of money?

Posted by jp at 10:08 AM | Comments (1)

March 14, 2006

RANKING, SORTING, SLICING & DICING EQUITIES, BUT ULTIMATELY GUESSING

For all the tension in the world, stock markets around the globe have shown no trouble climbing. Call it well-founded optimism or a blatant disregard for risk, but whatever the correct the label it's clear that 2006 is proving to be a good year for equities. Whether the trend continues remains to be seen, but it's hard to argue with the results so far. Indeed, it's only March and many investors are sitting on tidy gains already.

The 29 regional/world benchmarks in the S&P/Citigroup Global Equity Indices series, for example, all show increases this year through March 13. That's on top of robust advances last year. Although there's a fair amount variation in the total returns, depending on the market, it's been hard to lose money by spreading assets around the world.

The best performer this year in dollar-based terms through March 13 among the regional/world indices from S&P/Citigroup is European Emerging, soaring 17.32% on a total return basis so far. The bottom performer is Asia Pacific, although it's still in the black year-to-date by 1.64%.

There may be room to run further in global equity markets, to judge by some of the more optimistic commentators of late. Indeed, the fear of the moment in the bond market is that economic growth may be stronger than the fixed-income set expected--news that, in contrast, tends to inspire buying among equity investors.

Nonetheless, with everything bubbling in stocks in broad terms, now seems like an opportune moment to find out which corners of the globe look pricey, and which ones are in the running for offering a bit more value. As always, that's a tricky call, and subject to a wide variety of misleading conclusions. Indeed, there's no sure-fire method for deciding if stocks are priced to run, crash or tread water. What's more, the immediate future is vulnerable to so-called exogenous threats, which is to say that something out of left field that no one expected, and that has no relevance in financial analysis, could throw a wrench in the machine.

But the lack of definitive measures and clarity about the future doesn't mean we must remain completely ignorant of valuations. In the long run, valuation matters, or so the academics tell us. With that in mind, we sorted the 29 regional/world benchmarks from S&P/Citigroup listed in the chart above, ranking each on five metrics: dividend yield, price-to-book ratio, 12-month trailing price-to-earnings ratio, return on equity, and price-to-cash flow. Here's a summary of the results:

Dividend Yield--Asia Pacific excluding Japan looks most attractive by this gauge, carrying a yield of 3.34%, or more than 100 basis points above the average yield of 2.31% for the 28 regional/global indices. The lowest-yielding benchmark was emerging markets at 1.45%. The World index is 2.04%.

Price-to-Book Ratio--The lowest P/B is Asia Emerging + Hong Kong + Singapore at 2.02, well under the average of 2.53 for the 28 regional/global benchmarks. Mid-east and Africa had the highest P/B at 3.24. The World index P/B is 2.67.

12-month Trailing Price-to-Earnings Ratio--Latin America posted the lowest P/E of 12.99, while Asia Pacific had the highest at 21.15. The average for the 28 indices is 16.64. The World index P/E is 18.65.

Return on Equity--Latin America also looks most attractive on this measure, boasting the highest ROE, weighing in at 19, handily above the average of 15.07 among the 28 benchmarks. The lowest ROE designation goes to Asia Pacific at 10.07. The World index ROE is 14.66.

Price-to-Cash flow Ratio--EMU Countries and Eurozone are tied for the lowest PCF ratio, although at 7.06 the lowest is only slightly below the average of 8.68 for the 28 benchmarks. The highest PCF ratio goes to North America at 10.97. The World PCF ratio is 9.71.

Posted by jp at 9:12 AM | Comments (1)

March 13, 2006

THIS WEEK'S NUMBERS GAME

Data junkies will be going through withdrawal symptoms today. With no economic releases of relevance scheduled, there's a vacuum to be filled. As it happens, the Federal Reserve's quarterly Flow of Funds report was updated for the fourth quarter and released last Thursday. As always, there are enough numbers here to satisfy even the biggest data addicts. In an effort to help soothe the numerical DTs, we present sliver of the report via the following chart:

At a moment when anxiety seems to be on the rise in the bond market, we note that consumers' inclination to dig ever deeper into debt took a chill pill in the fourth quarter. Consumer credit contracted for the first time in many a moon in last year's fourth quarter, while the growth rate in home mortgage credit slowed a notch. Is Joe Sixpack rethinking his spending habits? If so, is there reason to think the recent strength in the economy will soon fade?

The question is laden with all the usual risks, and then some in light of the fact that the fixed-income set appears to be responding to the query with a resounding "no." Indeed, the yield on the benchmark 10-year Treasury is just under 4.80% as we write this morning, the highest in 20 months.

The Flow of Funds report, of course, is a rear-view mirror. It's the future that captures Mr. Market's attention. On that front, there's reason to think that the pullback in consumer credit was an aberration, or so the consensus seems to be saying. Judging by the futures market, the Fed is expected to raise Fed funds by 50 basis points to 5.0% by June. If so, the current yield of nearly 4.80% on the ten year looks a bit light.

Therein lies the dilemma for the bond market: Should the recent yield-curve inversion be maintained, or is that very much yesterday's news? Before you answer, consider too that rates around the globe are on the rise of late. Nothing dramatic, but the change of direction for the moment speaks louder than the magnitude of the adjustment. Notably, the European Central Bank now looks set for a course of tightening, albeit in small doses. Ditto for the Bank of Japan, which has been the focus of much chatter over the past week with speculation that deflation is finally dead and buried in the Land of the Rising Sun.

Rising yields around the world and in the U.S. too. Meanwhile, the week ahead offers a hefty dose of new numbers to confirm or deny what lurks in the hearts and minds of traders. That includes tomorrow's release of retail sales for February; followed on Wednesday with last month's change in import prices; the latest on consumer prices dispensed on Thursday; and industrial production on Friday. If nothing else, this week will not suffer for lack of drama.

Posted by jp at 9:44 AM | Comments (0)

March 10, 2006

ONE CONGRESSMAN'S FIGHT TO SAVE M3

There's less than two weeks of life left for the Fed's M3 series, the broadest measure of money supply. On March 23, the central bank plans to end publishing the data. But if one Congressman has his way, M3 will live on. It's an uphill battle, to be sure, but Ron Paul, a Republican who represents the 14th Congressional district of Texas, has sponsored legislation (H.R. 4892) to keep the data coming. (For the latest version of the legislation, visit Thomas at the Library of Congress and browse under Rep. Paul's bills.)

CAN THIS MAN SAVE M3?

M3 is arguably all the more relevant these days since its rate of growth has been roughly twice as high as M2, a narrower gauge of money supply. The Fed claims that there's not a lot of difference between the two, although the numbers as reported suggest otherwise. (For previous CS posts on M3, see our February 28 article, with additional links for background information.)

Paul's attempt to keep M3 alive and kicking may be quixotic, but he's not giving up the fight, as becomes clear in an interview we conducted with the Congressman yesterday by phone. Here are some excerpts:

What's the goal of your M3 bill?
My legislation would require that the Fed continue to report M3. It's no more complicated than that.

So you think M3 is valuable as a measure of money supply?
I realize the shortcomings of some of these numbers, and M3 isn't an answer to all the information that we would like. But it's better than not having it. I think it does represent a reflection of Federal Reserve policy. For them to quit reporting it you have to ask, why?

Ok--we'll bite. Why?
I don't know exactly why, but the Fed gives answers. They claim that it costs too much money and they don't use M3 any more. My argument to [Fed Chairman] Bernanke the other day was: some of us like M3, and Congress has a right to this type of information. There are still a few people in the country that think money supply's important, and M3 is a reflection of money supply. I mentioned that there are a few economic schools of thought that are still concerned about M3, although some deny it has any value.

The most interesting thing was when he said it cost too much to collect [the data for compiling M3]. I kid the Fed about that, and say, I don't why you should be concerned about it. If you need to spend money you just print it.

Somehow we can't imagine the folks at the central bank laughing.
Well, the Fed makes a lot of money on interest, and of course it creates a lot of credit in order to buy Treasuries. So, I think the notion that it's costly is preposterous. In fact, the Fed probably has most of the numbers right there anyway.

What's the bigger picture here? What's your thinking on what the impending demise of M3 suggests, if anything, in a broader context when it comes to the Fed?
I think back to what Mises talked about in Human Action: he writes that there's always a deliberate attempt to deflect concern about the money supply so that the common person thinks that inflation is caused by other things.

Arguably, the buck stops at the Fed, literally and figuratively, when it comes to inflation, right?
I see that the real culprit is the increase in the money supply and the distortion of interest rates causing malinvestment, overinvestment, overcapacities and excessive debt. If you don't have the information to indicate that there's something going wrong with the money supply, then we're less likely to blame the Fed for the problem.

A lot of people would agree. How does the Fed see it?
As long as I've been here in Washington, the Fed officials have always blamed Congress because of the deficits. And I agree: the deficits are bad and they create problems. But I think the Fed and Congress work together. When we run up the deficits, there's not enough money in the market without raising interest rates, and so the Fed accommodates. So I see the Fed in collusion with the Congress.

In other words, the Fed is only too happy to print up dollars to clean up the mess of red ink.
I don't know about happy, but the Fed always claims it wishes it didn't have any deficits to deal with. But the Fed never argues [about printing more money]. The Fed says that what it's doing is keeping the economy going by keeping interest rates low. But there's no other way it can do that, other than buying Treasury bills to keep the overnight rates low. It creates its own credit, and that's where I see the problem. I think this denial of the M3 information is just another effort to direct attention to the Congress, or the Arabs charging too much for oil, or the price of education going up too much, or the cost of medical care rising too fast. The Fed wants to direct your attention away from the real culprit: the creation of money and credit.

So, in other words, inflation is only possible if the Fed allows it?
That's what I believe.

What's your take on the fact that M3 is growing at roughly twice the pace of M2 recently? The Fed says that M3's redundant in that M3 and M2 are comparable. But the trend in each series suggests otherwise. We've asked the central bank about this.
I'll be they didn't give you a good answer. I asked the same question to Bernanke, and he totally ignored it. I said, M3's growing twice as fast as M2. And the change in the growth is important too. A couple of years ago M3 wasn't growing quite as fast, and in the last eight or nine months it's accelerated.

Given M3's relatively high rate of growth, and the Fed's intent on killing the series, does it suggest something fishy is going on here, in terms of suppressing monetary information that could be embarrassing for the Fed?
That's the question, and of course the Fed would deny it.

What about your colleagues in Congress? Is anyone else asking questions about M3?
Other members of Congress have no interest in it; there's very little interest in monetary policy. I couldn't get anyone to pay much attention to it. In fact, there are a lot of misconceptions. For example, one day I was talking to Greenspan, and one of the members in Congress came up and asked, "Isn't the dollar backed by gold?" This was a member of Congress! That's when I realized we have a lot of work to do. I argue that Congress, either deliberately or inadvertently, doesn’t think about [monetary policy] because the Fed irons out some of our problems when it comes to deficit spending.

What are the prospects that your M3 legislation will be enacted? Is the bill getting any attention?
It's not going to get attention unless the financial people help. Only if people like you, and all the way to Barron's and the Wall Street Journal and everybody else decided that this is an outrage. So, I make the point, and explain what the correction is, and talk about it when I get the chance. Hopefully, someone will pay attention. But I figure that no one will pay attention until they really ruin the dollar, which I think is on the verge of happening.

But isn't the stated rate of inflation quite low?
That's deceptive. The rate of inflation is actually horrendous, especially for low-to-middle-income people, who spend their money on food and fuel, and clothing and medical care. Even if inflation was as low as stated, it's the same type of deception that occurred in the 1920s. They kept saying there's no inflation. Inflation is measured by the increase in the money and credit. The distortions sometimes lead to higher prices, but many times you can't predict where those higher prices will emerge. Sometimes it's in a stock market bubble, sometimes it's in commodities, sometimes it goes into the consumer price index. So inflation emerges in different ways. Meanwhile, the biggest problem is the deception that interest rates are low, which causes people who save, people who invest, people who spend to do things they otherwise wouldn't do. For example, if interest rates are 2%, you're more likely to overbuild houses than you would if the market rate was 4% or 5%.

To me, it's a moral issue to. What if you're old-fashioned and frugal and you've saved your money, and you don't like stocks, because you know about stock market crashes? And so you put your money in CDs, and they get 2% instead of 5%. The market might have given them 5%. And it just makes it harder for them to live. I brought that up once to Greenspan, and he said, Well, sometimes you just can't take care of everybody at one time. He said, some people do suffer from it; he didn't deny it.

Some people argue that the Fed is forced to make compromises because of the twin mandates imposed on it of minimizing inflation and maximizing employment.
Yes, but that endorses the false concept of central planning, and we all seem to defer to the Fed to be very much involved in central economic planning, whether it's prices or interest rates or full employment, or whatever. Any time you give that much authority you can be sure there's going to be some deception, even in the collection of the numbers. Figures come out, and CPI's up at a rate of, say, 7%. Oh, but the core rate is lower, some respond, and so it's okay, and everyone's reassured. Anything to fool the people for as long as possible.

What do you think the Fed should be doing these days?
Ultimately, I wouldn't even have a Federal Reserve system, because you don't need one. Even Friedman, with his monetarism, thinks we shouldn't have a Federal Reserve manipulating interest rates.

Call us crazy, but we assume the Fed will endure. If so, in this less-than-perfect realm, what advice do you have for the central bank?
In a way, you can't argue with the techniques of Alan Greenspan. He was able to take one problem, and create another bubble and keep things going. Some of us believe that just builds a bigger problem into the system, and the correction will be that much worse. I have to say, if I couldn't get out of the system, I'd have some sort of Friedman-type of approach where we wouldn't manipulate interest rates. Instead we'd increase the money supply at a 2% or 3% rate. That would be entirely unsatisfactory for me, but if that's the only choice....

What should eventually happen is that the Fed shouldn't be able to buy Treasury bills. The Fed should never be able to finance government spending by buying Treasury bills with credit they create out of thin air. That's the high powered money, but when that gets into the banking system you then have the fractional-reserve-banking principle that allows that to expand that credit by six or seven fold. You expand money supply that way, and that's how M3 expands.

So, you think that particular aspect of how the Fed operates should end?
Like I say, it's far from my ideal solution, but, if you had to do something right now, yes. It's the type of thing that Volcker did. He said, we're cutting back, and interest rates went to 21% and he saved the dollar. If we get into a crisis again, that's what they're going to be forced to do. There are some that believe the crisis is going to be much worse than it was in 1979 and 1980.

We already know your answer, but we'll ask the question anyway: Are you worried about inflation?
To me, inflation is printing money. That's going to continue, and it's going to get worse. The conventional definition of inflation is rising prices for consumers. I think we're going to see a lot more of it.

* * *

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Posted by jp at 9:40 AM | Comments (10)

March 9, 2006

WHAT'S NEXT FOR ENERGY SECTOR EARNINGS?

Energy's supply/demand outlook makes it a no-brainer for maintaining exposure to oil and oil-related assets over the long haul. But what about the short term? At the moment, there's reason to wonder, in part because oil and oil stocks have had such an extraordinary run in recent years.

The performance of the Energy Spider (Amex: XLE), which represents the energy stocks in the S&P 500, towers over the stock market for last three years through yesterday, according to Morningstar. XLE posts 33.7% annualized return as of March 8. That's nearly double the S&P 500's advance. Meanwhile, the relative market cap of energy keeps climbing in the S&P 500. The energy sector currently represents about 9.5% of S&P 500 market cap--a rise of about one-third from a year ago, which is by far the biggest increase among the ten sectors.

What's driving XLE? Surging oil prices, of course. A barrel of crude oil currently changes hands at about $60, or more than twice the price of three years ago.

The case for projecting higher oil prices for the years to come has merit, but expecting crude to keep up the pace of the last three years may be asking too much. Indeed, even the super oil bulls don't think crude will double in price every three years going forward. A few analysts think $100 a barrel is possible in the near future, but that would represent a 66% gain from current levels. And once we're at $100 a barrel, then what? Two hundred bucks? Don't hold your breath unless you're thinking in terms of five, ten and 20 years.

True, anything's possible when it comes to the world's most valuable commodity. One "event" could change everything. But waiting for the world to end is questionable as prudent investing strategy. Then again, even in the best of times crude oil is priced by its own strange rules, which are influenced by any number of variables that don't otherwise pervade commodity pricing.

In sum, oil prices may have reached a permanently higher plateau, but further increases from this point may be more measured, not to mention widely anticipated. In fact, there's reason to at least consider scaling back one's expectations for earnings performance in oil stocks. In fact, that seems to be happening, at least when it comes to analysts' estimates.

Analysts' projections for earnings in energy sector of the S&P 500 tell the story, as the chart below illustrates. After enjoying a long stretch of 40%, 50%, and even higher year-over-year comparisons in earnings increases, the energy sector's outlook is one of moderating optimism. And to the extent one wants to believe the projections, analysts predict that energy earnings in the fourth quarter of 2006 will post their first decline relative to the previous year's quarter for the first time in recent memory.

"Energy is expected to lose earnings share in 2007, as growth is forecast to be lower than that of the overall market," writes Dirk Van Dijk of Zacks.

One could argue that oil stocks will need a large bump in energy prices in the near term to maintain the stellar record of increases that oil stocks have posted of late. But what if $60 a barrel remains the norm for some time? "Absent further large increases, energy stocks have probably lost at least one powerful driver of performance," writes Michael Krause of AltaVista Independent Research, in a research report published yesterday.

Meanwhile, volatility in the Energy Spider has been on rise lately, with the standard deviation of the ETF's price more than doubling from 2003. The implication: XLE faces the prospect of slower earnings growth amid rising price volatility. "Because XLE now appears more reasonably valued based on current fundamentals, the machination of politics in oil exporting countries has taken on increased importance since the daily fluctuation in the price of oil now has more impact on value investors assign to energy profits," Krause writes.

Yes, the case for energy-related investments still looks good for the long term, but getting there first requires surviving the short term.

Posted by jp at 9:39 AM | Comments (0)

March 8, 2006

HARM & PAIN IN THE BOND MARKET

There goes the swagger. Sure, the bond market's attitude (or was it misplaced nonchalance?) of late has evaporated amid the roar of selling the benchmark 10-year Treasury Note in recent days. As such, the yield on the 10-year jumped to as high as 4.78% at one point yesterday, up from around 4.50% at the end of February.

Yesterday's closing yield was the highest in nearly two years for the 10-year Note. What's up? The economy, one could argue. A number of reports of late leave the impression that economic growth remains sufficiently potent to keep the Federal Reserve on track for raising short-term interest rates. To be sure, the Fed's been doing just that for almost two years, and the bond market has more or less yawned. Why is the fixed-income set taking note now?

Good question, and there's any number of theories about what constitutes an answer. That starts with some who argue that it's the renewed fear of higher inflation down the road that's caught the bond market's notice. Perhaps, although the hard evidence remains a gray area at the moment. Inflation may present an approaching challenge to fixed nominal yields, but the statistics don't yet confirm such fears. And as of this morning, at least, the 10-year yield has slipped a bit, offering some hope that the bull market that some in bond land expect even at this late date is intact.

So, how to square that with the realization that the string of economic reports over the past two weeks has shown a bias, though not exclusively, toward the forces of growth? Is the bond market reacting to the revised thinking that the formerly anticipated letup in the Fed's tightening will be postponed? More than a few pundits have noted that the prospect of a 5% Fed funds rate in the coming months doesn't sit well when then 10-year bond yield isn't much higher.

The debate over a flat and/or inverted yield curve has been topical of late, but until recently the bond market has only talked about it rather than acted. But that's changing, or so one could argue. How long it lasts is an open question, but for the moment the fixed-income market is inclined to demand higher yields.

A similar outlook prevails in the trading pits of Fed funds futures. The July contract is currently priced for 5.0%, or 50 basis points above current Fed funds.

But for all the talk of economics and statistics, the bond market is susceptible to emotion as well as numbers. Fear and greed, in other words, play a role, in degrees that vary with the news du jour. Fear and greed, of course, aren't easily modeled in spreadsheets. Nonetheless, fear may be in a bull market again, its current form coming by way of the "harm and pain" rhetoric, which Iran has reportedly announced as what awaits the United States in response to Washington's campaign of "hauling Tehran before the U.N. Security Council over its nuclear program," to quote today's Guardian.

The appropriate yield on a 10-year Treasury is the great question in finance of late. Traders have recently decided that higher is better. Figuring out what's driving that decision is never easy, but rarely has it been as tough as it is right now. Perhaps that's the key reason that the bond market prefers to err on the side of higher rates. Such thinking doesn't lend itself to quantitative modeling, but investors still understand the reasoning.

Posted by jp at 10:10 AM | Comments (0)

March 7, 2006

IN SEARCH OF STRATEGIC FRIENDSHIP

If there's any consensus in the business of managing money, diversification probably comes closest to the ideal of strategic agreement and accord. Diversification, after all, is your only friend in the long run. Timing the market and choosing securities is far more exciting, but who among us thinks such high arts can be sustained?

The alternative, of course, is the time-tested antidote of diversification, which is the only effective defense against the great unknown, otherwise known as tomorrow. Since no one really knows what's coming, prudence dictates the embrace of diversification, at least for us mere mortals who have no chance at becoming the next George Soros or Warren Buffett.

To be sure, not all diversification is enlightened. Owning three tech-stock funds, for example, doesn't come close to informed diversification.

Yes, it's true that there's no shortage of debate about what constitutes a prudent level of diversification. But there are some ground rules, starting with the fact that investors should have exposure to the various asset classes. We're defining asset classes as those groups that exhibit relatively unique characteristics that distinguish them from other groups. Price correlation is one way to measure such characteristics.

Bonds and stocks, to cite the obvious example, post a sufficiently low correlation with each other over time so as to warrant embracing them as separate and distinct asset classes. What that means is that there's a good chance that when one's losing money, the other will be holding its own, if not posting gains. In fact, history shows just that. Owning bonds in 2000-2002, for instance, offered valuable ballast when the stock market was suffering.

But how do you protect a portfolio when bonds are under attack? Traditionally, stocks can help, although the record shows that stocks and bonds have been known to tank together at times--this limited form of diversification fades just when you need it most. Meanwhile, cash is an asset class in its own right, and always holds its value, at least in nominal terms, which makes it an essential candidate for diversification. But holding too much cash opens one to the inflation threat over time.

The true solution is embracing a broader array of asset classes. That's not been easy for individual investors in the past, but as mutual funds and exchange traded funds bring formerly exotic asset classes to the masses, quite often in cost-efficient index-fund packages, the opportunity for greater diversification is here.

The question then becomes: is more diversification better? In search of an answer, or at least some perspective, we crunched the numbers on 10 asset classes (courtesy of Morningstar and Dow Jones) for the decade through the end of 2005 and compared three diversification strategies:

1) an equal mix of U.S. stocks, U.S. bonds and cash
2) an equal mix of 10 asset classes
3) a traditional pension-fund-inspired 60% U.S. stocks/40% U.S. bonds mix

The asset classes for the three strategies are based on returns from the following indices, most of which are available via index funds or an actively managed fund that serves as a proxy:

1. U.S. Stocks (Russell 3000)
2. U.S. bonds--Treasuries, corporates, mortgaged backed (Lehman Brothers Aggregate)
3. Cash (3 Month T-bill)
4. Emerging markets debt (Citigroup ESBI-Cap Brady, in dollars)
5. Foreign government bonds, developed countries (Citigroup Non-$ World Govt, in dollars)
6. U.S. high yield debt (CSFB High Yield)
7. Foreign developed markets stocks (MSCI EAFE, in dollars)
8. Foreign emerging markets stocks (MSCI EM, in dollars)
9. Real estate investment trusts (Wilshire REIT)
10. Commodities (DJ-AIG Index)

Starting on December 31, 1995, we rebalanced once a year, every December 31, back to the relevant weight as per each strategy, running the test for 10 years through December 31, 2005. The results were encouraging, and perhaps a bit surprising. Overall, an equal mix of the 10 asset classes delivered a 9.1% average annual total return over the 10 years, well above the stocks/bonds/cash return of 6.9%, and slightly higher than the 8.9% of 60% stocks/40% bonds.

Much of the superior performance in the 10-asset-class strategy's stellar returns in 2003-2005, as the chart below illustrates. To be sure, sometimes owning everything disappoints. But over time, our sample suggests that it pays to take an expanded approach to diversification, if the short-term results won't win you any applause at the next cocktail party.

What's more, the equal mix of 10 asset classes is mindless, the byproduct of automatic rebalancing at the end of each year. But owning 10 asset classes opens the door for enhancing results a bit, at least for those with the ambition and skills to customize a portfolio. Consider junk bonds. When the spread of high-yield debt is relatively small relative to Treasury yields, there's a strong case for pulling back on the junk bond weight, and vice versa.

Whether you're tweaking or mindlessly rebalancing, there's a case to be made that investors should own some of each of these asset classes. Why? For the simple reason that you don't know what's coming, and so diversification truly is your only friend.

Posted by jp at 8:55 AM | Comments (7)

March 6, 2006

A GLOBAL TOUR OF STOCKS

Foreign stocks remain hot in 2006. The S&P 500 is up 3.5% on a total return basis through March 3, and the small-cap Russell 2000 has climbed 8.7%. But those are no great feats in terms of finding comparable performance in equity markets elsewhere on the planet. The "catch" is that much of the stellar flights in returns this year continuing coming by way of emerging markets.

We say "catch" because emerging markets have been on a tear since 2003. This being the fourth consecutive year (so far) of potent performance, the question necessarily arises: How long can the good times last in emerging markets? There's no easy answer, if only because no one knows what the future holds. But at least we can study the past and digest whatever scraps of insight that task offers.

Nonetheless, there's a risk of drawing too many (and arguably any) conclusions from history. Indeed, more than a few bears have been waiting for REITs to correct after a multi-year run. A similar sense of dread hangs over some when it comes to surveying bonds. But each of those markets has continued to confound and confuse by refusing to do the decent thing for bear-minded investors and take a dive.

To be sure, every market rises and falls. The timing is the great mystery. Still, we can't help but consider the past. Maybe it offers context, maybe not. While you ponder such imponderables, here's some graphics to pass the time.

First up is a look at developed markets, measured in broad terms. (All charts below are drawn from data published by MSCI for 2006 price returns through March 3.) The Nordic countries of Europe are clearly in the lead in the developed world, with Norwegian stocks jumping by more than 15% so far this year in dollar terms. The laggard is the developed markets in the Far East, with New Zealand taking a dive in 2006.

The real action in global equity markets is again in the emerging markets. MSCI Emerging Markets Index is up more than 11% in dollar terms, posting a rise so far in 2006 that's twice as high relative to developed markets overall, as tracked by MSCI EAFE. Even the relatively lagging regions of emerging markets are in the black. So far in 2006, it's been virtually impossible to lose money, a precedent that no doubt will prove easy to break at some point down the road and cause more than a few investors to draw the wrong conclusion in the here and now.

The top-performing emerging market this year is Venezuela, which has soared more than 39% in dollar terms, proving that President Chavez's anti-Bush rhetoric hasn't had much of a price when measured in local stock prices.

Posted by jp at 9:56 AM | Comments (1)

March 3, 2006

THE CONFIDENCE GAME

The confidence that has recently enveloped the Treasury market seems to be evaporating, or so one could reason in light of yesterday's jump in the yield on the benchmark 10-year Note.

As of Thursday's close, the 10-year yield was 4.64%, up sharply from Wednesday's 4.59%. At one point yesterday, the yield was nearly 4.67%. As a result, the 10-year yield is near its previous highs of late October, when 4.68% was briefly touched.

What's going on? There's no shortage of theories circulating, ranging from the usual suspects to some fresh catalysts for anxiety. To be sure, some pundits are still predicting an economic slowdown, if not worse, including the estimable Economic Cycle Research Institute. But those with the opposite view have the upper hand at the moment. Indeed, adding to the momentum among the latter is yesterday's 25-basis-point hike in the European Central Bank's key rate to 2.5%. Warning of inflation risks in 2007, ECB head Jean-Claude Trichet explained that he was intent on nipping the threat in the bud. Did the Europeans frighten traders in the Treasury market?

Another candidate for thinking that higher rates are still coming is the realization that the federal government's deficits may be deeper in red ink than previously thought. There's much debate about whether deficits and higher rates are truly linked, but expectations of bigger government debts can still move bond prices. On that note, Govexec.com, the website for Government Executive magazine, yesterday reported that the Treasury Department sent a "little-noticed" study to congressional leaders "that paints a bleaker picture of the nation's finances than is widely accepted and is beginning to attract attention as lawmakers prepare for election-year budget battles."

Meanwhile, Treasury Secretary John Snow told the San Francisco Chronicle that wages are at a "tipping point." He predicted that they'll start rising. "For the last three months or so, real wages are up something like 1.5, 1.6 percent," he said.

Cabinet members like to speak of such things, and are forever suggesting that sunnier days are just around the corner for the masses. But at this particular juncture, investors might think twice before dismissing Snow's outlook. The economy, after all, has been showing signs of strength recently, as we noted yesterday. Adding to the optimism is yesterday's update on weekly jobless claims: the advance figure for seasonally adjusted initial claims was 294,000 for the week through February 25, the Labor Department reported on Thursday. That's the seventh straight week of a below-300,000 reading, convincing many economists that the labor market is clearly growing.

One might then wonder if the inverted yield curve in Treasuries is about to reverse course and return to something approximating a more normal state, namely, higher yields in longer maturities. An inverted yield curve often signals an approaching recession, but for the moment it's harder to make that prediction, at least by considering the limited sample of data that's come across our desk. If in fact the economy is destined to keep chugging along for the foreseeable future, the inverted curve at the moment in Treasuries may be headed for change.

Traders of government securities seem to have no less on their minds. In fact, if you look at corporate bonds, the yield curve is upward sloping, which is to say there's no inversion, as per a newly minted chart from Cumberland Advisors.

Why is the corporate bond market priced in anticipation of economic growth while the Treasury market seems to expect the opposite? Add it to the ever-lengthening list of mysteries that inhabit the state of finances in the 21st century.

Definitive answers may be elusive, but there's no shortage of theories. One that caught our eye was dispensed yesterday by David Kotok, Cumberland's chief investment officer. In a letter to clients, he observed that not all yield curves are inverted, the Treasury's being the notable exception. One potential reason, Kotok opines, is that the government bond market is "distorted" by foreign investors, such as Asian central banks sitting on large trade surpluses looking for a home, courtesy of the United States penchant for imports.

But if Kotok is quick to come up with an explanation, he's less reluctant to rush to judgment when it comes to deploying capital. "All this means that the interest rate outlook is very unclear," he wrote yesterday. "There may be still higher interest rates in the future as the Fed raises the short term rate. We believe that is the most likely outcome. But how much higher is very unclear. Cumberland’s managed bond portfolios continue to have a defensive bias."

Posted by jp at 9:32 AM | Comments (1)

March 2, 2006

THERE'S NO STOPPING JOE

Joe Sixpack's demise as a consuming animal has been widely predicted for some time, but greatly exaggerated, to judge by yesterday's update on personal income and outlays for January.

The Bureau of Economic Analysis reported that personal income rose by a healthy 0.7% in January over December. But as is the inclination these days, Joe and his counterparts across the country spent more than they made in the first month of 2006 by elevating spending by 0.9%.

The trend of spending in excess of income is nothing new in the American economy. Deficit spending generally is very much the fashion these days, in both government and on the homestead. And if one defines the money supply by the M3 series, the central bank seems only to happy to make sure that everyone has enough paper to keep the spending train in motion.

One only has to look at the state of Joe's income and outlays to find the evidence of said rolling on the consumer front. Indeed, for the third month running, the percentage change in consumption expenditures has risen at a rate above that of personal income's advance. Going back over time, that's far from atypical. To be sure, elevating one's spending by a pace that exceeds income growth will eventually hit a brick wall, although one could die waiting for such economic constraint to kick in when it comes to our beloved Joe.

But for all the anxiety that persistent consumer spending causes among dismal scientists, the trend is clearly a boon to the economy, which relies overwhelmingly on Joe and his friends for expansion in gross domestic product. And in light of yesterday's update on personal income and outlays, it's a little harder to argue that this party's about to end.

Case in point: spending is heavily dependent on income growth, and the connection looks intact. For starters, employment growth keeps chugging along, which in turn is putting a potent tailwind behind wage and income growth. Indeed, January's 0.7% rise in income was the strongest since September 2004. Joe may be digging himself into a debt hole, but if his income keeps rising at this rate it could be a long time before the red-ink ditch spawns any blowback.

Adding to the belief that Joe and his cohorts will keep spending comes by way of yesterday's release of the February ISM Manufacturing Index. Challenging the notion that an economic slowdown is in the offing, this widely followed index continues to exhibit strength. Last month, ISM Manufacturing rose to 56.7, the highest since November 2005, and up from January's 54.8. Any reading above 50 implies an expanding manufacturing sector, and by extension, a robust economy overall, and so recent readings are clearly bullish.

The smoking guns of late may be changing the bond market's nonchalant mood, although this line of prediction too has been a less-than-fruitful exercise in recent years. Nonetheless, the benchmark 10-year Treasury yield is at 4.60% as we write this morning, the highest since mid-February.

Whether any of this persuades some rethinking among the pessimists on the outlook for the economy is an open debate, and an important one at that. The folks at the giant bond shop Pimco, for instance, expect a stumble triggered by a housing slowdown. And in fact, there's been some evidence this week that real estate may be cooling.

But Joe Sixpack doesn't give up his spending habits easily. As a result, the pressing question at the moment centers on whether any slippage in the property market will offset any gains in wages and income. The bond market overall seems unsure. Anyone else willing to take a crack at a prediction?

Posted by jp at 9:18 AM | Comments (1)

March 1, 2006

SHADOWS, CLOUDS, FORECASTS AND DOUBTS

"The boom is over." So says David Lereah, National Association of Realtors’ chief economist, regarding the extraordinary bull market that is, or at least has been the residential housing market. In comments published in today's Wall Street Journal, he observes, "Investors are pulling out in a lot of the nation's hot markets, and that's adding to the cooling."

Some fresh data updates lend support to Lereah's analysis. On Monday, the Census Bureau reported that sales of new houses slipped 5% in January from December's tally, and the fall was evident across the country.

Optimists were quick to counter that new home sales are but a small slice of the total of house transactions. A far larger sample of residential sales trends can be found in the monthly count of existing home sales. But that too showed weakness, when the January update was released yesterday by the National Association of Realtors. Total existing-home sales--including single-family, townhomes, condominiums and co-ops--backtracked by 2.8%. What's more, sales were 5.2% below the 6.92 million-unit level in January 2005, according to NAR.

Ok, sure. Sales were clearly weak in January. But, hey, it's winter, and demand will perk up once warmer weather arrives. Who wants to go home shopping in January? Relatively few, or so conventional wisdom says.

But if there's reason to think a housing slowdown, or something worse, isn't coming, the first choice for pointing to quantitative support isn't the latest revision to the profile of the fourth-quarter economy, as defined by annualized inflation-adjusted growth in gross domestic product. Yes, yesterday's release of the so-called preliminary estimate of GDP for 2005's fourth quarter was higher than the earlier guesstimate--1.6% v. 1.1%. But 1.6% is still a long way from the 4.1% logged in the third quarter. To the extent that a bubbling economy drives the housing market (or is it the other way around?), there's reason to wonder what comes next.

But getting from the proverbial here to there remains a challenge when it comes to perusing economic data in the 21st century. Nothing is quite what it seems, and so interpretations of what's happening, and what's lurking around the corner are perennially up for grabs.

Indeed, the economy and the housing market may be showing signs of fatigue, but it's hard to reconcile that profile with today's report on fourth-quarter home prices from Office of Federal Housing Enterprise Oversight. OFHEO advises that the average U.S. home price advanced by 2.9% in the fourth quarter of 2005. Although that's down a bit relative to recent history, but compared with recent years it's nonetheless impressive. Indeed, a 2.9% rise translates into an annualized appreciation of 11.4%. Even adjusting that for inflation, it's clear that the housing prices were running faster than the overall economy. Nice work if you can get it, but it can't last.

Higher home prices and a slowing economy? Sure. What's that? You think that's a mismatch? Really? Well, maybe you're not in tune with all the vicissitudes and secret hand signals of economic illumination in the new new new economy. But don't feel bad. We're unenlightened too. But we're hoping to improve ourselves, and so we're bursting with questions.

That starts with, what exactly what does the data imply for 2006? Also, is the housing market really slowing? If so, by how much? And then the $64,000 question: What might the impact of a slowing housing market be on the wider economy? Or, perhaps we should rephrase that, What effect will a slowing economy have on the real estate market? We could ask questions all day. If only we could find the confidence to accept one or two answers.

Posted by jp at 11:14 AM | Comments (0)

The Capital Spectator

Investing, Asset Allocation, Economics & the Search for the Bottom Line