April 28, 2006
THE NEW TRANSPARENCY
Fresh clues about how Fed Chairman Ben Bernanke will run the world's most important central bank came rolling out of his testimony yesterday to Joint Economic Committee in Congress. The excerpt that's received the most attention from Ben's talk is this tidbit:
"…at some point in the future the [Federal Open Market] Committee may decide to take no action at one or more meetings in the interest of allowing more time to receive information relevant to the outlook. Of course, a decision to take no action at a particular meeting does not preclude actions at subsequent meetings…."
Ok, so the Fed may stop, then again it might not. No promises. But if does, it might start tightening again later on. Is this the new definition of clarity in central banking? If so, maybe we were better off with the tortured rhetorical acrobatics of Greenspan.
Then again, Bernanke's performance yesterday was judged a success if you were long stocks. The equity market certainly cheered the idea that rate hikes may take a breather at some point, even if it's only temporary and less than assured. The S&P 500 yesterday reversed some of the selling from earlier in the week with a healthy bounce. Meanwhile, the yield on the 10-year Treasury slipped a bit yesterday, pulling back under 5.1%.
Bernanke's comments were still being dissected this morning when the Commerce Department released the advance GDP report for the first quarter, which confirms the healthy economic rebound of recent months that's been otherwise obvious for some time. The economy expanded by an inflation-adjusted rate of 4.8% in the first months of this year, a sharp rise from the fourth-quarter's sluggish 1.7% gain. The first-quarter jump was the fastest since 2003's third explosion of 7.2%.
Helping repair the slippage from the fourth quarter was the sharp rebound in Joe Sixpack's appetite for durable goods. Joe rushed back into a buying mode and bought $53.5 billion more in cars, refrigerators, etc. in the first three months of 2006 compared with the preceding quarter. That reverses the $52 billion drop in the fourth quarter, and then some.
Overall, personal consumption expenditures--which represent about 70% of GDP--climbed by 5.5% in the first quarter. That's the biggest quarterly rise since 2003's third quarter, and a world above the 0.9% blip in the fourth quarter.
The consumer, in case you didn't notice, is back. Yes, GDP reports are backward-looking documents. But momentum driven by an $8 trillion train (which is roughly what Joe and his counterparts collectively spend each quarter) isn't easily or quickly derailed.
In fact, we're inclined to assume that Joe's reaction to the prospect of stopping interest-rate hikes would be the same as yesterday's Pavlovian response from the stock and bond markets: buy. Joe doesn't necessarily need more incentive to do that, but that didn't stop Bernanke.
© 2006 by James Picerno. All rights reserved.
April 27, 2006
A BULL MARKET IN MIXED REAL ESTATE SIGNALS
Real estate may appear to be a singular industry to the masses, but it has multiple personalities if you dig a bit deeper.
True, Mr. Market hasn't been much for distinguishing among the various corners of real estate in recent years. A bull market in virtually anything associated with property has diminished the incentive to emphasize differences. But now there are pressing questions about where real estate goes from here, and what it means for Fed policy and the economy. Those questions are resurrecting a focus on the divisions that were always relevant in real estate, but otherwise ignored when profits came easily.
In one corner is the ever-popular REIT industry, a long-running favorite of optimists, thanks in no small part to a bull market that's run longer than many thought possible. On the opposite side of the sentiment scale these days is the homebuilding industry, populated by the likes of such companies as DR Horton and Toll Brothers.
While REITs and homebuilders are both in the business of real estate, no one will confuse their investment performance of late. The Morningstar homebuilder industry index is down so far this year by 6.3% through yesterday, April 26. REITs, on the other hand, remain firmly in the black, and strikingly so. So far this year, the Morningstar REIT index has climbed 8.6%--well above average for stocks generally, to judge by the S&P 500's year-to-date climb of 5.1%.
Is this divergence something more than just a curiosity? Real estate, after all, is front and center as a key industry to which the Federal Reserve looks in deciding if additional interest-rate hikes are necessary, or so we've been told by several investment strategists and economists. True, there are many factors that weigh on the central bank's monetary policy, but arguably the property market carries a bigger-than-usual weight these days.
In fact, the Fed may be more than a little sensitive in 2006 to charges that it's been asleep at the switch in letting asset bubbles run out of control on the fuel of easy money over the years. The grand example is the stock market boom of the late-1990s. Just about the time that speculative juices were gearing up for an unprecedented run in the decade's final years, Fed Chairman Alan Greenspan made his famous comment about "irrational exuberance" in a 1996 speech.
But talking about the threat and doing something to cool it before it bursts are two different things. Under Greenspan's tenure, the Fed choose to mop up the damage afterwards, much to the consternation of critics--including The Economist--who argue that pre-emptive efforts were required, and should be going forward. The counterargument is that central banks can't effectively prick bubbles, as argued by Adam Posen of the Institute for International Economics in a recent paper.
Still, there's something less than a consensus on this point, and it's not exactly clear if Bernanke may be willing to lean a bit more on the pre-emptive side of policy.
And so the debate goes on. Which brings us to the current bubble. Or is it just a healthy bull market? Whatever you call it, real estate has had a good run in the 21st century, perhaps too good. In the minds of some, the Fed must act to slow the property market or risk a correction that could trigger a recession in the general economy. Not everyone agrees that the Fed is targeting real estate when it comes to monetary policy, but it's tough not to suspect that property is having some effect on the central bank's thinking.
But that then raises the question of which real estate market? There are countless ways to measure this slice of the economy. Two of the more obvious ones that investors watch are homebuilding stocks and REITs. Until recently, both were flying. For the five years through April 26, homebuilding and REIT stocks have been among the best performing industries, with homebuilders posting an annualized 30.3% return while REITs advanced with a 20.1% gain through yesterday, according to Morningstar industry data.
But the bloom has come off the rose for homebuilders this year. Year-to-date, the group has shed more than 6%. REITs, by contrast, keep rising, adding 8.6% so far in 2006 as of yesterday, based on Morningstar's calculations.
Ted Aronson, founder of Philadelphia money manager Aronson+Johnson+Ortiz, tells CS that homebuilders in 2005 represented "the biggest industry bet we ever took." At one point, the group was weighted at five percent over the benchmark. No more. These days, it's down to around two percent over the benchmark on average in portfolios run by AJO, which is a quantitative shop with a value orientation. "That's a significant shift," he says of the downshift in weight. A key reason for the change: homebuilding stock prices have been falling. That's been picked up in AJO's model, which is driven by a mix of valuation and momentum factors.
"It's mostly a simple function of our quantitative, multi-factor approach to investing, which has about a third of its weight on momentum," Aronson explains. As homebuilding stocks' valuations were getting richer and richer, we still owned them because their momentum was good. When their momentum stopped being a positive, we blew them out in no time."
REITs have stumbled recently as well, but are still in the black so far this year. In fact, there's reason to separate REITs from homebuilders beyond just recent performance differences. REITs and homebuilders are in different corners of a vast industry. For the most part, REITs reflect businesses focused on commercial properties, such as office buildings, warehouses, and so on. Although some REITs manage apartment portfolios, the largest slice is dedicated to the non-residential side of the street.
"Homebuilders and REITs are totally different," says Barry Vinocur, editor of Realty Stock Review and REIT Wrap in an email to CS. "You might even make the case that what's good for one isn't for the other. For instance, as rates tick up and home affordability presumably decreases that's perceived as not good for homebuilders; however, it's good news for the apartment guys. By extension, anything that increases apartment renters might also be good for the self-storage business," which is one of the various segments that REITs focus on.
So, are homebuilders a better gauge of the prevailing real estate winds? Or are REITs better served with that task?
Bull markets are easy. Unfortunately, the future looks set to become a bit more difficult.
© 2006 by James Picerno. All rights reserved.
April 26, 2006
The 10-year Treasury yield surged yesterday while the stock market sagged. The threat of higher long rates (the 10-year's nearly 5.1% yield is the highest in four years) is becoming reality, weighing on equity and bond traders alike. But in keeping with the times, the long-anticipated rise in long rates arrives just as a cloud of debate descends over what the Federal Reserve is planning for monetary policy in the coming months.
The central bank may not be the most transparent institution on the planet, but few have been surprised by the continual string of 25-basis-point rate hikes that have prevailed since June of 2004. The absurdly low 1.0% Fed funds rate was last seen on June 29, 2004, a day before the FOMC declared it defunct by way of a quarter-point rise to 1.25%. The Fed has been making similar declarations ever since, and so Fed funds now stands materially higher at 4.75%.
The next opportunity for a declarative statement on monetary policy from Bernanke et. al. comes on May 10. Expectations for another 25-basis-point hike are baked into May Fed funds futures, but there's also a rising tide of prediction that the tightening may be the central bank's last for some time.
We emphasize "prediction" because this particular moment is proving to be tricky when it comes to deciding when the Fed will cease and desist with its rate hikes. Arguably, the main catalyst for expecting an end to the tightening will be a material slowdown in the real estate market. But by what definition will "slowdown" be decided? And when?
Whatever the answer, real estate is a sector that's received a laser beam of focus recently over whether the bull market in home prices is a bubble threatening to burst until and if the central bank intervenes with sentiment-shifting incentives, i.e., higher rates. In fact, there's been some recent evidence that the housing market has been cooling, if only marginally. But turning points in real estate, Fed policy, or any other economic/financial trend are rarely crystal clear, and the transition in housing from boom to something less is proving to be no less wily, and so the cloud of unknowing may be spilling over into the outlook for Fed policy.
The latest reason to pause before proclaiming that housing is suffering comes in yesterday's update on existing home sales for March, via the National Association of Realtors. There was enough of a sales rebound last month, following a much larger upward surge in February, to keep investors guessing as to whether the Fed really will end its hikes in May.
“It’s a good sign to see home sales holding close to the level of a strong rebound in the month before,” says David Lereah, NAR’s chief economist, in a press release accompanying yesterday's update. “This is additional evidence that we’re experiencing a soft landing. We may see some minor slowing in home sales as interest rates rise, but the market clearly is stabilizing.” Just to be clear, Lereah expects 2006 to be the third-strongest year on record for home sales.
Does that sound like the conditions that will convince the Fed end the rate hikes? And while we're considering reasons to rethink when the tightening will stop, consider this: this morning's new home sales for March also posted a tidy rebound last month v. February, according to the Commerce Department.
In addition, today's durable goods report for March brings news of an exceptionally strong rise in this series by 6.1% for March. That's above the consensus forecast of 1.8%, according to TheStreet.com.
Yes, much of the rise in durable goods comes from overseas aircraft orders, and so it's questionable just how relevant last month's pop is in the grand scheme of macroeconomic trends. Fair point, although it's harder to dismiss the fact that March's rise in orders follows February's strong 3.4% ascent. In fact, durable goods orders have risen in five of the last six months. If this is an anomaly, it's a persistently bullish one.
In any case, if divining the future path of Fed policy has been relatively easy in recent quarters, it threatens to become less so for the foreseeable future. A quantitative assessment of that perceived leap in opacity can be found in the estimated probability of various rate hike scenarios, courtesy of number crunching by the estimable Macroblog, which is run by an economics professor who also happens to work at the Cleveland Fed. On Monday, Macroblog noted that the implied probability of holding Fed funds steady at the June meeting have been falling recently while the odds for another hike in June had been rising.
In other words, confidence about comes next may be fading. Every new economic report now holds the potential to move the market, change perceptions, and alter outcomes. It's getting interesting all over again.
April 25, 2006
IS THE CLOCK TICKING FOR EMERGING MARKETS STOCKS?
Emerging Markets stocks are comfortably in first place in the performance race among asset classes so far this year through April 24. No, let's rephrase that: Emerging markets are flying. The MSCI Emerging Markets Index, based in dollars, has climbed a stellar 19% year to date. Even small-cap stocks, another hot performer with a 14% rise so far, are having a hard time keeping up this year through last night's close.
Meanwhile, bonds of various types dominate the opposite end of the return spectrum. Among the dozen investment types we track here, inflation-protected Treasuries (measured by the Vanguard Inflation-Protected Securities Fund) have lost 2.3% year to date. A broader measure of U.S. bonds, via the Lehman Aggregate Bond Index, is off fractionally. This year is proving to be relatively tough sailing even for U.S. high yield bonds, which have climbed 3.3%, according to the Merrill Lynch High Yield Master II Index.
Indices/Funds: MSCI EM ($), Russell 2000, MSCI EAFE ($), MSCI REIT, S&P 500, DJ-AIG Commodity, ML HY Master II, 3-mo T-bill, Pimco EM Bond Fund ($), Lehman Bros. Aggregate, Pimco Foreign Bond ($), Vanguard Infl Prot Sec
Stocks, in other words, are enjoying a bull market this year. The riskier, the bigger the payoff in the land of equities. Expecting the party to end has been a losing proposition so far in 2006. Contrarians might expect that the good times will soon end, but looking for warning signs amid valuation ratios offers a mixed bag.
According to S&P/Citigroup Global Indices, emerging markets overall look only slightly pricey to world equities based on dividend yields and the price-to-sales ratio for data as of March 31. In contrast, emerging markets are a modest bargain if you compare them to the world stocks by way of the price-to-book, price-to-cashflow, or trailing 12-month price-to-earnings ratios.
There are other threats that could derail the party in emerging markets, but the obvious ones that can be sliced and diced in spreadsheets are for the moment fairly benign. That may be false comfort, but in the meantime upward momentum is still the path of least resistance. But the hour is late. Caveat emptor!
© 2006 by James Picerno. All rights reserved.
April 24, 2006
LOOKING TO FRIDAY'S CLUE
On Friday, the Commerce Department unveils the government's first estimate of economic growth for this year's first quarter. The consensus outlook calls for a hefty rise of 5.0%, according to Briefing.com. If that proves accurate, the optimists will no doubt celebrate the rebound from the dismal 1.7% rise logged for the fourth quarter. Indeed, 5.0% would be the fastest quarter growth since the 7.3% advance in 2003's third quarter.
Meanwhile, the shadow from the previous number still looms. The fourth-quarter GDP report, you may recall, sent shivers throughout Wall Street and Main Street. The sky was finally falling, and recession loomed, or so it appeared from the sharp slowdown posted in the last three months of 2005 vs. the previous quarter.
Statistically, who could argue? The thin 1.7% advance in real GDP for the fourth quarter was a world below the 4.1% climb that prevailed during July through September. But as we wrote back in January, when the fourth-quarter number was initially released, there were more than a few skeptics claiming disbelief that the economy could be as weak as the Commerce Department said it was. A modicum of justification for the doubts came with each of the two subsequent 4Q GDP revisions. Once the numerical dust cleared, the 1.1% rise in GDP first reported migrated upward to the final 1.7%.
Still, 1.7% doesn't suffice to keep the pessimists at bay. The task of regaining optimism's commanding heights necessarily falls to the shoulders of this Friday's 1Q GDP number. If the consensus holds, the coming weekend promises to be one when cries of "I told you so" echo throughout the land.
In fact, the optimism would jibe with the bond market's bias so far in 2006. When 2005's advance 4Q GDP report was released on January 27, the benchmark 10-year Treasury Note closed the day's trading session at just a hair over 4.5%. As of Friday's close, the "riskless" government bond changed hands at a considerably higher yield of just over 5.0%. Conviction that the economy will continue humming along could hardly look clearer through the eyes of the fixed-income set.
Ah, but there's a complicating glitch that was dispensed last Thursday in the form of the Conference Board's Leading Economic Indicator. As we noted on Friday, the LEI suggests that the economy's due to slow.
The bond market apparently doesn't agree, but Paul Kasriel thinks it may be time to rethink conventional wisdom when it comes to deciding where the path of least resistance lies on the economy's immediate future. The "steady downtrend in the year-over-year growth in the LEI has been a warning of an imminent recession," writes the director of economic research at Northern Trust in a research report published on Friday. Although the metric gets little respect, he notes that a "steady downtrend" in LEI has proven to be a reliable, if not quite perfect predictor of the onset of recession. There have been two notable exceptions, the last one coming in 1995. The reason that recession was averted 11 years ago, Kasriel opines, is that the Fed rushed to the rescue with interest-rate cuts.
Is that prescription warranted in the here and now? It's a tricky question, in part because there have been a number of economic reports over the last few months that refute the idea that a stumble is imminent. All the more reason that all eyes will watch Friday's 1Q GDP report for clues as to what comes next. To be sure, GDP reports are backward-looking snapshots, but influential nonetheless.
In any case, the futures market is anticipating another 25-basis-point hike in Fed funds, based on the May contract. That may be the final increase in the round of tightening that began in June 2004, or so the June 2006 Fed fund futures contract implies. But for those who read the future by way of LEI's prism, there's the question of whether even one more hike is too much.
Maybe Friday's GDP report can offer some clarity.
© 2006 by James Picerno. All rights reserved.
April 21, 2006
BERNANKE'S CONUNDRUM IS MR. MARKET'S CONUNDRUM
Is the economy slowing or isn't it? As always, there are competing views and conflicting data. That doesn't stop some from making predictions, including Lakshman Achuthan, managing director of the Economic Cycle Research Institute, who advised in an interview with CS last week that the first-quarter bounce would give way to something less impressive in the second half of this year.
Adding support for Achuthan's outlook is yesterday's update on the Conference Board's leading index, which posted a slight decline last month. That comes after a larger drop in February. But even this downward bias of late, which implies slower growth in the months ahead, isn't quite the negative it appears to be.
"Despite the weakness in the leading index in February and March," the Conference Board said in a press release yesterday, "its six month growth rate picked up to an average of 3.2% annual rate in the first quarter, up from an average growth rate of 2.7% in the fourth quarter, which was higher than its average growth of 1.8% in 2005." In addition, five of the ten indicators that make up the leading index increased in March.
Ok, so is the economic glass half full or half empty? One could make a case for either, although today's release of survey results from the National Association of Business Economists leans toward the glass-is-half-full view. “Results of the April NABE industry survey suggests continued economic growth but with somewhat greater price pressures,” says Ken Simonson, chief economist, Associated General Contractors of America, in a press release accompanying the survey, which reflects the views of 116 economists who are NABE members.
Among the highlights from the full NABE report obtained by CS:
* 55% of NABE economists said the demand for goods and services is rising in the April survey. Although that's down from 62% in the January poll, it's up from 51% from 12 months previous.
* 34% of NABE economists reported that employment is rising, up from 30% in the January survey and from 29% in the April 2005 poll.
* 43% of NABE economists said that capital spending is rising, up from both the 40% reading in January and 36% from April 2005.
* While the overwhelming majority of NABE panelists anticipate a slowing of the housing sector in the next six months, most expect that this will have minimal impact on their firms.
* The NABE industry panel of economists was more upbeat in their real GDP outlook for 2006 as a whole compared with three months earlier. Overall, 34% of respondents said they were more optimistic on the year with their current forecast for economic growth-- twice the percentage who say they're becoming “somewhat” more pessimistic.
If the strategic choice is one of economic growth or economic slowing, the bond market seems inclined to choose the former. The yield on the benchmark 10-year Treasury Note continues to climb, rising back above the 5.0% mark for the second day running as of yesterday's close. The sentiment that anticipates growth finds support in the stock market recently: the S&P 500 in intraday trading yesterday reached its highest level since 2001.
But then there's the bit of news from earlier this week that the Fed may be close to ending the rate hikes that have prevailed for nearly two years, or so suggests some of the commentary published in the Fed minutes for the FOMC meeting on March 27 and 28 released on April 18. The stock market obviously likes the news, but as a policy matter there's more to consider and potentially fear.
Yes, the Fed will hike again by 25 basis points at the May 27/28 meeting, bringing Fed funds to 5.0%. Or so the futures market predicts. But the outlook becomes cloudy beyond that. June Fed fund futures, for instance, are somewhat ambivalent about forecasting the outcome of that month's FOMC meeting on the 28th and 29th.
Ambivalence and caution in fact may be the prudent path for the moment. There are risks looming over rate hikes just as there are risks threatening if there's a decision to cease additional monetary tightening.
Oak Associates' chief investment strategist Ed Yardeni nails the dilemma head on by calling it "Bernanke's Conundrum" in a note sent to clients today. "If he stops raising rates to avert a housing-led recession, commodity prices, in general, and oil prices, in particular, might rise to levels that either cause a supply-shock recession or else boost inflation, forcing the Fed to resume tightening at the August 8 meeting," he writes.
On the other hand, there's a case to be made that globalization has "moderated and shortened" recessions, Yardeni observes. If that's the case, the Fed may still have more leeway to keep raising rates. But there's no free lunch. "If Globalization means that economic expansions can last longer, does it follow that the less frequent recessionary shocks will be much greater than in the past, and the economic downturns might be much deeper and longer, though less frequent? I'm not sure, but it is a possibility."
In any case, the former Fed chairman, Alan Greenspan, has noted that economic growth has become less volatile over the past 20 years, Yardeni notes. Others have made similar observations. A working paper from three New York University professors--The Declining Equity Premium: What Role Does Macroeconomic Risk Play? finds that there's been "a fall in macroeconomic risk, or the volatility of the aggregate economy" in recent decades.
For investors, deciding what Bernanke's Conundrum will produce in the weeks and months ahead is at once a burning issue and one with no easy answers. So, what else is new? At least there's a consistent theme to the 21st century.
© 2006 by James Picerno. All rights reserved.
April 20, 2006
THE GREAT GAME, CURRENTLY ON TOUR AT THE WHITE HOUSE
China President Hu Jintao is in Washington today to chat with President Bush about matters large and small. Firmly entrenched in the former category is oil, the mother of all strategic topics for the countries at the top of the world's energy feeding chain.
China, as everyone on the planet surely knows, has a large and growing thirst for crude. That thirst arguably will be quenched only by way of a dramatic shakeup in the market for the world's most valuable commodity and more than a little turmoil on the world's geopolitical and military stages. The Bush White House expects no less. Reflecting that sentiment is the observation (warning?) to China that it can't stay on a "peaceful path while holding on to old ways of thinking and acting that exacerbate concerns throughout the region and the world," according to the National Security Report issued last month by the Bush administration. The "old ways" are defined in the report as follows:
* Continuing China’s military expansion in a non-transparent way;
* Expanding trade, but acting as if they can somehow “lock up” energy supplies around the world or seek to direct markets rather than opening them up – as if they can follow a mercantilism borrowed from a discredited era; and
* Supporting resource-rich countries without regard to the misrule at home or misbehavior abroad of those regimes.
Repricing oil upward to reflect such tensions, in other words, is the order of the day. The 21st century's version of the Great Game, and it's being played out around the world. One recent skirmish unfolds as we speak in Central Asia, the site of the original Great Game.
Given this backdrop, it's not exactly shocking to learn that the price of crude was trading above $72 a barrel this morning in New York futures trading--yet another all-time high. That's a fitting greeting for President Hu's arrival in Washington. The increase in oil consumption in the Middle Kingdom far exceeds the pace of domestic production, as the chart below shows. That's a big deal for the world's fastest-growing major economy, which is second only to the United States in petroleum consumption.
As China's wealth grows, so too will its oil demand. Among the key factors powering that upward demand will be an explosion in the number cars on the road. From Beijing to Shanghai, the appetite for personal mobility has taken wing, in line with the elevation of wealth. Those who can are buying cars, and there are more who can with each passing year in China.
As a new report on China and oil from the Congressional Budget Office relates, the country's economy has been growing at sizzling 9.2% pace (based on real GDP) since 1990, but the per capita incomes of urban households has been advancing even faster, rising by 13.3%. No wonder that the number of licensed drivers in China exploded by 90 million during 1990-2003. That's something on the order of another California population coming on line with new drivers every five years.
The Chinese government is responding by spending some $29 billion a year on new highways. The population is responding by buying cars for the first time and doing what any self-respecting car owner does: drive.
Annual sales of new cars in China were 4.3 million in 2003. That's extraordinary, considering that the country's entire stock of cars was roughly four million in 1995. More recently, that amount of autos is being added every year--and those stats are three years old!
It's a safe bet that China's top priority is keeping its increasingly wealthy and arguably restive population happy. Oil is an integral part of the political calculus. As a result, a major focus of China's strategy on the world stage for the foreseeable future will revolve around the acquisition of oil, which is to say: importing ever larger quantities of the stuff to slake domestic demand.
The United States fears the trend, in part because America has intimate knowledge of the trend. China is roughly at a similar moment in its energy history as the U.S. was in the 1950s. China today, like American then, was on the cusp of a dramatic rise in the use of automobiles, a surge fueled by robust economic growth and expanding wealth. One of the differences between then and now is that in the 1950s the U.S. didn't have a large and increasingly thirsty competitor for oil.
Another difference: from the vantage of the 1950s, many of the world's biggest oil fields had yet to be discovered or were still being developed to materially increase output. Today, there are two large economies on the world stage vying to secure oil supplies. But there's a growing consensus that the low-hanging fruit of super big oil-field discoveries are behind us.
What does it all mean? The future is always debatable, of course, although the present is sprinkled with clues. The front line for guesses starts with the futures market for oil.
April 19, 2006
IN RISK WE TRUST
In the land of textbook economics, a central bank takes away the proverbial punchbowl when the party threatens to spin out of control. The removal convinces the partiers to cool their jets. In time, the central bank rewards everyone by returning the punchbowl, thereby planting the seeds to launch a cycle anew.
Nothing's quite so simple in 2006. In fact, much of what professors like to teach in economics 101 is up for debate. Take the punchbowl, everybody's favorite central-banking metaphor for easy money. This basin of liquidity injection was delivered in earnest a few years back. Predictably, the presence of cash sloshing around the system ignited bull markets far and wide. Evidence can be found everywhere, with the repercussions continuing to the present. It's hard not to find an asset class that's not running skyward these days. As a sampling, here's a slice of what's unfolded so far in 2006, through yesterday:
Large-Cap Stocks: +5.24% (S&P 500)
Small-Cap Stocks: + 14.68% (Russell 2000)
REITs: 10.03% (Morgan Stanley REIT)
Commodities: +8.17% (Oppenheimer Real Asset Fund)
10-year Treasury: +1.12% (10 Year Constant Maturity Treasury)
Junk bonds: +2.98% (ML US High Yield Master II Index)
The Federal Reserve is of course currently engaged in a gentle effort to remove the punchbowl with minimal fuss. In fact, one might argue that the Fed has been attempting to elevate interest rates but without affecting investor perceptions, which is a bit like trying to trying to discipline Rover and hope that he still retains his old habits. But even the central bank's subtle effort may be nearing an end, if yesterday's release of minutes from the Fed's March 27-28 FOMC meeting are an indication. "Most members thought that the end of the tightening process was likely to be near..." the minutes advised.
San Francisco Federal Reserve president Janet Yellen brought the thinking of the March minutes into the here and now in a speech yesterday by voicing concerns of "the policy tightening going too far," via TheStreet.com.
Cycles, it seems, aren't quite what they used to be with respect to timing. Consider that with optimism finding fertile ground in a broad array of assets, the stewards of monetary strategy seem to be thinking that it's time to bring the punchbowl back. As you might expect, the mere hint of that party favor brought cheers to the stock market: the S&P 500 soared yesterday, jumping 1.74% on Tuesday.
Meanwhile, the bond market registered its own brand of approval, cutting the yield on the 10-year Treasury Note down below 5.0%, and for the moment putting the hawks back on the defensive just a few days after it seemed the fixed-income set had reordered its thinking.
The reaction in the forex market was no surprise either, although it unfolded with a broad based selling of the dollar, which has fallen to its lowest level since January, based on the U.S. Dollar Index. The fear is that with rates hikes behind us, the yield premium that the dollar's enjoyed recently will continue to fade. Indeed, while the Fed toys with the idea of ceasing to tighten, Europe and Japan are increasingly inclined to raise rates, making the euro and yen incrementally more attractive.
The primary question on American soil is whether it's time to stimulate the economy or continue laying the groundwork for fighting any future inflation. The ongoing debate about whether core or topline inflation measures are the true gauges of pricing pressures is back in the driver's seat. The debate is very much present in the FOMC meetings, as the latest release documents. Consider the range of commentary in the March minutes on the topic of inflation:
* ...meeting participants generally remained concerned about the risk that possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, could add to inflation pressures.
* Preliminary survey measures of short-term inflation expectations in March edged up, but longer-term measures remained steady.
* Core inflation had stayed relatively low in recent months, and longer-term inflation expectations had remained contained. Nevertheless, the Committee noted that possible increases in resource utilization as well as elevated energy prices had the potential to add to inflation pressures.
* Core PCE inflation was expected to move slightly higher in 2006 because of cost pressures induced by high energy and import prices and to step back down in 2007 as these cost pressures were anticipated to abate.
* ...productivity growth, moderate increases in compensation, contained inflation expectations, and international competition were helping to restrain unit labor costs and price pressures. Nonetheless, meeting participants generally remained concerned about the risk that possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, could add to inflation pressures.
The Fed, in case you didn't notice, is struggling to find context in 2006. But if the signals are ambiguous, the stakes remain high, and climbing. Indeed, commodity prices are high because the global economy is growing at a healthy clip. That's feeding into investors' appetite for risk, an appetite that seems to have gone up a notch after yesterday's release of Fed minutes.
But the strategically minded investor knows that asset allocation is a discipline for a reason, namely: asset classes exhibit varying degrees of correlation, which is to say they deliver a range of results in any given snapshot. You wouldn't know it by looking at returns so far in 2006, a year when risk across the board continues to be satisfied with positive performance. That can't last, but for the moment there are many who are acting as though it will.
April 18, 2006
TWO BULL MARKETS, BUT THE JURY'S STILL OUT
Gold and oil don't have much in common. The former, which is almost never consumed, is generally admired in one form or another for eternity; the latter is destined for a relatively short life after extraction from its natural environs. There is one exception, though. Gold and oil share an infamous link: inflation.
Gold is the medium that historically has offered a hedge against inflation. Oil, if its price rises high enough and stays elevated long enough, is said to be a primary driver of inflation at a rate above and beyond what central banks consider acceptable.
The value of the link as a window on the future, like most relationships where money's concerned, is open to debate. Empirically, this makes perfect sense. The instances of twin bull markets in gold and oil that's also accompanies by rising inflation are relatively rare. The last clear example came in the late-1970s and early 1980s.
So, where's the relevance? In the eye of the beholder.
For those who believe, the current dance of gold and oil looks potent. Gold and oil, in case you didn't notice, are running higher. The metal that many equate with money soared yesterday by more than $10 an ounce to $613 and change, the highest in a generation. Oil, meanwhile, closed up a buck in New York futures trading to close on Monday at over $70 a barrel, a new all-time high. The fact that both commodities are ascending together, with conviction, raises questions about what it means.
The easy conclusion is that the inflationary warning signals are running full out. Yes, geopolitics is arguably the main driver in the bull market in energy. But if energy's inflationary signal casts a long shadow, the reasons for the price hike are all but irrelevant. Or so says the gold market.
And then there's the bond market. Yes, the yield on the 10-year Treasury Note slipped slightly yesterday, although it still held above 5.0% for the second trading session. The five-percent mark is the highest since June 2002.
More than a few eyes are focused on the bond market as a means of tipping the scale one way or the other--lending confirmation or denial to gold and oil's warning. If the 10-year yield keeps rising, the trio of omens will be that much tougher to ignore.
That's why attention on the housing market is destined to increase for the foreseeable future. The housing market is the Fed's favorite benchmark these days for deciding if the central bank's having any effect on investor perceptions. There's just one problem: defining the real estate trend du jour is more art than science.
Any number of statistics define housing on any given day: new housing starts, existing home sales, mortgage activity, to name just three of the usual suspects. Unfortunately, housing numbers can and do give conflicting signals at times. Consider that the latest installment of the National Association of Home Builders sentiment index registered a decline, giving the bond market reason to buy and thereby lower yields a bit on Monday. Score one for the Fed and its campaign to slow the real estate bull.
But the message hasn't yet found its way into every nook and cranny of the property market. In fact, by some accounts the market isn't slowing so much as it is returning to something approaching a calmer state of supply and demand. "We're returning to normal," Ellen Daly, founder of Daly's Properties Shoppe in Gardner, Mass., tells the Sentinel & Enterprise. "We've had a very, very brisk market for several years and it just sort of plateaued a little, and now it's coming back at a nice, normal comfortable pace."
Is that perspective widespread? Will it convince the Fed to call off its rate-hike assault? Or, is the property market cooling at a pace that Daly and others don't yet recognize? Such questions aren't easily answered when it comes to the real estate market. As a result, it's not yet clear if the gold and oil markets are harbingers of trouble or just isolated bull markets?
The case for arguing the two are isolated rests heavily on the fact that the government's official measure of inflation has been calm and well behaved of late. In fact, an update of consumer prices for March comes tomorrow, giving another opportunity to embrace or dismiss the gold/oil show.
Even so, there's a mismatch of timing when it comes to searching for clues about inflation with commodities that are priced in real time. Traders must buy and sell now, this second. The forces that send inflation higher, or lower, are slow moving, and at times virtually imperceptible to the garden variety analyst. That won't stop the markets from making a bet, although the accuracy will remain in doubt until hindsight renders its always perfect analysis.
In the meantime, it's anyone's guess. At this moment in history, any number of macroeconomic and geopolitical catalysts are waiting in the wings, fomenting the variables that hold the potential to surprise and shock on a scale that's grander than usual.
Volatility, it seems, may be the only sure bet when it comes to bull markets for the foreseeable future.
April 17, 2006
THE TAX MAN COMETH, AND COMETH, AND COMETH
Today is tax day in the U.S. Show your postmark, or file an extension. Meanwhile, be thankful that the IRS has extended the filing deadline to April 17, or two days beyond the traditional April 15, courtesy of the 15th falling on a Saturday this year.
The tax man may be willing to wait an extra 48 hours for his money this year, but rest assured he'll settle for nothing less than the usual take in the end. Unfortunately for taxpayers, the usual take is on the rise again, based on the Tax Foundation's newest calculation of "Tax Freedom Day." This is the day that the average American taxpayer has earned enough to pay for his taxes, based on a measure of national, state and local taxes. For example, if tax freedom day is April 1, wages for the first three months of the year go to pay the various levies imposed by governments for the year.
In 2006, Fax Freedom Day comes on April 26, according to this year's Tax Foundation study. "Tax freedom will come three days later in 2006 than it did in 2005," Tax Foundation President Scott Hodge advises in a press release, "and fully 10 days later than in 2003 and 2004 when a combination of slow income growth and tax cuts caused Tax Freedom Day to arrive comparatively early, on April 16."
Source: Tax Foundation
Yes, that's better than 2000's May 3--a year when the Federal government enjoyed a budget surplus.
Tax Freedom Day's bias of late should come as no surprise to anyone who watches the government's rising tide of social programs, war, and other assorted activities that apparently only the enlightened representatives in Washington and assorted state and local capitals can intelligently manage.
The government needs money, and more of it. Deficits are in vogue again too. The strategy of choice to deal with the problem: printing more money while dipping ever deeper into workers' pockets. This is arguably the only perennial winner when it comes to big ideas in Washington.
Indeed, if Tax Freedom Day is rising so soon after one of the biggest tax cuts in recent American history, what does that say about the future, when the burdens of budget deficits and other financial pressures threaten to weigh on politicians like never before?
With that in mind, here are a few additional highlights, such as they are, to ponder, courtesy of the latest Tax Foundation study. No, you can't avoid taxes, but at least you can marvel at the creeping power of government to separate you from your money.
* Connecticut holds the dubious honor of having the latest Tax Freedom Day (May 12) among the 50 states. The earliest (April 11) is found in Alabama.
* Tax Freedom Day for the U.S. in 2006 is later now than it was during each year of World War Two in the 1940s, when Washington imposed a variety of a then-unprecedented wave of new taxes to pay for fighting (and ultimately winning) history's greatest battle to date.
* Tax Freedom Day tends to move further along in the year over time, but it's still relatively early compared with some countries. A few examples: TFD in Great Britain this year falls on June 3; for Canada, June 25.
April 14, 2006
A MINOR MILESTONE
Cole Porter confessed that he received no kick from champagne. Even alcohol delivered no thrill. The stock market is equally unmoved by a different and decidedly negative tonic known as interest rates. Bulls of earlier generations felt differently. The question is whether today's optimists can maintain their cheery outlook even in the face of a more determined assault from a bond market that's newly inspired to reprice and revalue?
In particular, the benchmark 10-year Treasury Note closed above 5% yesterday for the first time since June 2002. If that was a warning shot across the stock market's bow, it was a minor milestone received with a flurry of buy orders among equity traders. Although the S&P 500 has slumped this week, it managed to eke out a small gain yesterday even as the 10-year yield crossed north of 5%.
Year-to-date, the S&P 500's price is higher by 3.3%. Meanwhile, the small-cap S&P 600 is up an impressive 10.5% so far in 2006. Perhaps the stock market dreams of bulls conjured by comments like those espoused by Fed Board Governor Donald Kohn. Yesterday, he suggested in a speech that the central bank's recent monetary tightening may suffer from irrational exuberance as it tries to restrain the effects of excess liquidity that the Fed unleashed a few years earlier. "Overshooting is one of the things we are very aware of as a risk in policy today," Kohn said on Thursday in a response to a question after a speech, reports Reuters.
Risky or not, the Fed is now enthused about cutting off any emerging inflationary pressures in the bud. Whatever the risk of going overboard with rate hikes, for the moment they seem to pale next to the hazards that some think could ensue by ending the monetary tightening. The futures market, for one, all but predicts that the 25-basis-point hikes will continue in coming months, in which case the current 4.75% Fed funds would elevate to 5.25% and perhaps beyond. If so, the bond market, now that it's found monetary religion, presumably would keep pushing the 10-year higher. Flat yield curves, it seems, are in danger of becoming déclassé among the fashionably minded fixed-income set this season.
As an added incentive to rethink assumptions that prevailed last week, last month and last year, there is the ongoing parade of statistical smoking guns that show the economy to be something more than dormant. Yes, there are some who expect that the strength will soon pass. Perhaps, but before we can move forward we first must digest the present, which includes yesterday's update on March retail sales, which are conspicuous in their capacity for ascent. Indeed, last month witnessed a strong 0.6% advance in retail sales, the Census Bureau reports. The surge was both a surprise of strength to economists generally, and a sharp upturn relative February's revised 0.8% decline.
David Gitlitz, chief economist at TrendMacrolytics, reads the various writings on the wall and advises clients in note dated yesterday to prepare themselves for more of the same when it comes to the Fed's tightening campaign of late:
Despite having raised rates by 375 basis points in this policy cycle to date, there is yet little evidence that the Fed is nearing the point of reaching policy equilibrium. Indeed, there is good reason to believe that the recent improvement in growth prospects has actually put the Fed further behind the curve, as a consequence of the funds rate target failing to keep up with available returns. While the market is now fully priced for a 5.25% funds rate by this summer, we see more than two additional rate hikes as likely being necessary to complete the Fed's mission, and believe the FOMC is coming around to that view as well.
Yes, Kohn has a compelling academic point in worrying that the central bank may tighten too much for too long at times. It wouldn't be the first time, and we're comfortable in forecasting that it'll continue for as long as there's a central bank. The sin has been known to work in reverse too, i.e., loosening when events called for something different.
The Federal Reserve is many things, but a precision-guided institution that excels in timely, dosage-appropriate deliveries isn't one of them. As a result, the challenge, as always, is pricing securities to reflect the risk of imprecision that infects the world of central banking, and on that score the game isn't getting any easier.
April 13, 2006
Commodities may be the new new thing, but life in the financial world isn't doing so badly either. In fact, financial stocks have enjoyed a strong run in recent years. The question is whether things can get any better for finance?
For the moment at least, it's easy to say that more of the same is coming, a perspective that finds support by looking in the rear-view mirror. For the year through last month, for example, the S&P 500 Financials Spider ETF (XTF) ranks second in performance among the nine sector Spider ETFs, posting a total return of 17.1%. Only the S&P 500 Energy Spider (XLE) boasts a better record over that 12-month stretch, rising by 28.3%.
Delivering above-average gains at a time when interest rates are rising is no mean feat for financial stocks. In theory, an industry that thrives on cheap money should be hurt when liquidity starts to fade. But evidence in support of that textbook notion is scarce. Indeed, XLF has recently been making new highs--hardly the sign of anxiety about the future.
What's more, Wall Street expects the robust earnings rise in financial stocks to continue for the foreseeable future. AltaVista Independent Research, an ETF-focused shop, points out in its latest report to clients that "financial earnings are the fastest growing of any [S&P 500] sector in 2006." The good times are predicted to continue in the second quarter, for instance, with XLF's year-over-year percentage change in earnings forecast to rise 10.5%, according to the consensus outlook. That represents a respectable third place in relative terms, coming after energy's expected 17.6% rise and utilities' 17.5%.
None of this comes as a surprise to the bulls. Wall Street, after all, has rewarded financials past record handsomely. Financials remain by far the biggest slice of the S&P 500 sectors in terms of market cap, representing more than one-fifth of the benchmark.
One of the various arguments for expecting financials to keep bubbling is the prediction that mergers and acquisitions will remain robust, both generally and within the financial services sector. If so, the trend promises to create more business for the largest firms in XLF, while at the same time driving up the stock prices of smaller players as the bigger fish gobble them up as strategy for growth.
Perhaps, but it's also true that there are strange things unfolding in the bull market for financials. Consider the world of merger arbitrage, a business where the shares of the acquiring company traditionally fall in price on the logic that shelling out money to buy other firms is a short-term strain on earnings. Meanwhile, the target stock tends to rise after the announcement of an approaching acquisition makes the headlines. It's this standard that's keeps many a merger arb fund in the black by allowing a modest profit to be had from "the spread," generated by shorting the acquirer and going long the target company.
But that long-standing relationship has been turned on its head lately, according to Frank Yeary, who heads up global M&A at Citigroup, the largest company in XLF. According to a story in The Economist (subscription required), Yeary explains that doing takeover deals has in fact been good for share prices. He reports that those S&P 500 stocks have engaged in takeover bids of $1 billion-plus have delivered above-average returns in the last three months. So much for earnings strain by way of spending money.
There are other odd trends afoot in finance, for anyone who cares to look. For instance, consider that while the Fed is trying to instill a bit more modesty when it comes to borrowing, the private sector has the luxury of thumbing its nose at the ancient institution. Indeed, credit growth in the U.S. has been growing at a much faster rate than broad money-supply growth, notes Lombard Street Research in a report from earlier this week. The force behind much of this private-sector credit growth is capital inflows from abroad. In time, the divergence between credit growth and money-supply growth must converge, LSR advises. Ah, but the timing depends on when and if foreigners decide to reallocate money elsewhere, an act that would then pinch credit growth. Maybe.
In the meantime, liquidity is king, and that's been a boon for the financial sector. The Fed may be intent on sobering up the likes of Citigroup, but to date that effort has been less than successful. The financials like their punchbowl, and there's no indication that Bernanke and friends are up to the task of taking it away. Well, almost no indication.
The 10-year Treasury yield crossed above the 5.0% mark this morning for the first time in nearly four years. That seems to have attracted the attention of stocks, which are slumping this morning. But the bellwether of financials, Citigroup, isn't blinking. Shares of the financial conglomerate are up this morning, bucking the trend in equities so far today. Momentum doesn't last forever, but it can roll on longer a lot longer than you might expect.
April 12, 2006
TIMING IS STILL EVERYTHING
The opportunity to lock in a real, or inflation-adjusted interest rate is one of the great innovations of modern finance. The question of timing one's decision on buying and selling, on the other hand, is subject to all the usual pitfalls regardless of the security in question.
Fortunately, historical context sometimes offers a touch of enlightenment, as illustrated by the recent track record of the 10-year yield on the 10-year inflation-indexed Treasury, or TIPS as they're commonly called. As the chart below illustrates, higher yields have come to those who wait. Or so the last few months suggest.
Buying a 10-year TIPS as of last night's close delivered a real 2.37% yield. That's near the highest in several years. In fact, last Friday's trading closed with a 2.43% TIPS yield, the highest since September 2003. That's a nice improvement over the TIPS yields of under 1.7% as recently as last September.
The question, of course, is whether locking in a real 2.37% yield now is sufficiently enticing for weathering the future. Or, might there be even higher real yields available in the weeks and months ahead?
Given the propensity of interest rates of all stripes to err on the side of rising in recent days and weeks, investors can be forgiven for choosing the waiting game. Indeed, the strategy, such as it is, has worked in the recent past, and there's a case to be made for thinking that upward momentum in the price of money may continue to roll on.
Money market funds are particularly well suited to this game, as yields adjust along with the prevailing monetary winds. And for the moment, such flexibility has its charms. The Fed funds futures market all but expects another 25-basis-point rate hike in Fed funds to 5.0% at the next FOMC meeting in May, based on the May contract. Futures traders are less sure about the June FOMC meeting, judging by that month's contract, although the notion of elevating Fed funds to 5.25% can't yet be dismissed.
In the here and now, the bond market is digesting the recent turmoil that sent nominal yields higher in recent weeks. But the rise in the benchmark 10-year nominal Treasury to just under 5.0% this week has run out of steam. The benchmark bond's yield has slipped for two days straight through yesterday's close. This may be more a reflection of fresh anxiety over various global tensions than a fundamental reassessment of economic prospects. The ongoing news over Iran's nuclear program, along with the latest runnup in oil prices to just under $70 a barrel, has inspired some to opt for a flight to safety in Treasuries. Economic analysis for the moment is out; geopolitical-based pricing is in for the fixed-income set.
The anxiety is spilling over into the stock market, which fell yesterday. In fact, there's more than geopolitical risk afoot. Investors are again struggling with the prospect that higher commodity prices, mainly oil, will elevate inflationary pressures, which in turn would inspire the Fed to keep hiking rates. Such fears may be weighing on equities, although the flight-to-safety has given the bond market a reprieve. Can it last? History suggests otherwise. Eventually, economic fundamentals dominate pricing in the capital markets. In the interim, of course, the capacity for alternative theories driving results is unlimited.
April 11, 2006
REIT RISK: HOW MUCH IS TOO MUCH?
Finance theory counsels that riskier asset classes carry greater volatility in their prices, a profile that necessarily spills over into returns as well. Stocks are more volatile than bonds, to cite the obvious example, and so the former tend to deliver higher returns compared with the latter over time. Unfortunately, finance theory doesn't tell us what to do, if anything, when and if those relationships are thrown out of whack. That's where common sense and the survival instinct fill in the gap.
Indeed, some of the volatility relationships these days may be deviating from terrain that some might recognize as typical. Nowhere does the atypical stand out more so than in the world of real estate investment trusts relative to the competing asset classes, as the following chart reveals.
In particular, the volatility for REITs leads the other major asset classes. (Volatility here is measured by the trailing 36-month standard deviation of monthly returns through March 2006.) Higher volatility implies higher risks. The question is whether REITs are deserving of their top-of-the-hill status as the most volatile asset class?
There are no absolutes for answering such matters, although one could make an argument that better candidates for the top volatility spot, using history as a guide, are commodities, emerging markets stocks and high-yield bonds. REITs, by contrast, are a fairly stable lot and not necessarily deserving of the current label. Some might even argue that REITs really aren't a high-risk asset class at all. Perhaps, although you wouldn't know it by look at REITs these days.
It's worth considering that the driver of the relatively high volatility in REITs is related to the fact that the asset class has been in a bull market for some time. To be precise, you have to go back to 1999 to find calendar-year red ink for the Dow Jones Wilshire REIT Index. In every year since, REITs have taken wing. And so far this year, the party rolls on, with the index up by 10% in 2006 as of yesterday's close.
In fact, the DJ Wilshire REIT Index boasts an impressive annualized total return of 23% for the five years through the end of last month, according to Morningstar. That's a universe or two above the annualized 4.0% gain for the S&P 500 over that stretch.
REITs compare quite favorably even next to small-cap stocks, which have been enjoying their own soaring bull market of late, a run that some analysts say is also living on borrowed time. Nonetheless, the Russell 2000's 12.6% annualized total return for the five years through last month still pales next to the 23% logged on behalf of DJ Wilshire REIT. What's more, not even the extraordinary 20.3% dollar-based annualized total return for the MSCI Emerging Markets Index for last five years has kept pace with REITs.
To say that REITs are due for a correction seems to understate the obvious. But the obvious isn't necessarily imminent. Still, as asset classes go, the trailing performance of REITs stands as one of the longer and stronger bull runs in recent memory. Quite simply, it's rare for an asset class to deliver such stellar returns, so consistently, for so long.
A correction may or may not be coming, but it's a subject that's become topical nonetheless. "This has been the most hotly debated topic in REITland for the past several years," observes Barry Vinocur, editor of Realty Stock Review and REIT Wrap. "And REITs are in the midst of their fifth major correction since spring 2004, partly as a result of valuation concerns, and partly because of the recent back-up in rates."
Of course, there's a risk in getting too cute in trying to call the top of the REIT market, or any other market for that matter, as history likes to remind. More than a few have tried, and so far all have failed. Predicting the end was at hand, only to learn differently, has come at a price over the years. Each and every time the correction was assumed to be the start of something bigger, REITs surprised by springing back to life. In January 2005, for instance, the end looked imminent, with the DJ Wilshire REIT shedding nearly 9% for the month. As it turned out, it was only a temporary setback in an otherwise rolling bull market.
REIT bulls have been eager to point out that the relatively high yields here have kept the asset class hot in an era when interest rates are otherwise low and less than satisfying. True enough. The 10-year Treasury yield has been inclined to stay flat in recent years, much to the chagrin of the Federal Reserve and to the relative benefit of the yield-rich REIT market.
But there's reason to wonder if that argument will now stumble, if not collapse entirely if the recent jump in long rates has legs. In relative terms, the pressure appears to be growing. As Michael Krause of AltaVista Independent Research reports in his firm's latest issue of ETF Advisor, the 4.5% dividend yield on the average REIT is the lowest in 35 years, courtesy of data from the National Association of Real Estate Investment Trusts.
Yes, the iShares Dow Jones U.S. Real Estate Index Fund (IYR) has a slightly higher yield, although REIT yields are even lower than it appears, Krause continues. He writes that "an increasing portion of IYR’s yield comes not from dividends but from a return of capital to shareholders."
Fortunately for investors, capital gains thrown off by property have been strong in recent years. But what if the stream of capital gains in the future isn't quite what it's been in the past? And while we're reviewing what may not happen, consider too that dividend income from REITs doesn't qualify for the lower tax rate on dividends enacted by Congress in 2003, Krause adds. "Because REITs themselves are tax exempt, if they pass most of their income through to shareholders, dividends received by shareholders are taxed at the shareholder’s tax rate on ordinary income—as high as 35% on Federal taxes alone."
But wait--there's more (or less, as he suggests). Krause also notes that IYR's fund expenses are deducted from dividends received prior to arrival in shareholders' accounts. "That’s true of all funds, but where yield is the primary focus of investors it’s particularly important."
When you add it all up (or subtract it all out), REIT yields may be lower than you think, Krause concludes. That by itself may not be enough to generate the tipping point, a la Gladwell. But REITs don't live in a vacuum, in case you didn't notice.
Yields found elsewhere may be heading higher, at least relative to what the fixed-income set was recently expecting. The yield on the benchmark 10-year Treasury Note continues to hold at just under 5.0%--the highest in nearly four years.
REITs may nonetheless prove resilient one more time. But circumventing fate surely will get tougher if bond yields continue rising. Competition, presumably, still counts for something in the 21st century. Exactly what remains to be seen.
© 2006 by James Picerno. All rights reserved.
April 10, 2006
A CONTRARIAN SPEAKS
The economy's on a roll, or so we're told. The latest smoking gun is Friday's employment report. Even the bond market appears convinced that there's more growth percolating than previously realized. In turn, the bubbling labor market inspires fears of higher inflation among traders of debt. Reflecting the sentiment, the yield on the 10-year Treasury jumped sharply on Friday, closing at 4.96%. The last time the 10-year explored such yield heights, in the summer of 2002, Greenspan's Fed was losing sleep over deflation anxiety.
The opposite risk now threatens. That, at least, is the new new message from the fixed-income set. But while some say it's about time the bond market woke up, a few lone voices in the financial wilderness warn of something else, namely, the possibility that a slowdown may be lurking just over the horizon, and so inflation may not be lurking in the shadows after all.
In the interest of exploring how the other half thinks, we called one of the leading analysts who's braving the headwinds of contrarianism at this juncture: Lakshman Achuthan, managing director of the Economic Cycle Research Institute, an independent research shop in New York. ECRI's forte is one of applying a disciplined, quantitative analysis to the economic data in search of identifying turning points in cycles. On that score, this respected shop points to two warning signs at this moment, Achuthan tells The Capital Spectator. Housing and the global industrial sector may surprise with weakness, relative to the crowd's current expectations, he advises. What's more, Achuthan says that ECRI's widely monitored FIG, or future inflation gauge, is counseling that inflationary pressures will soon wane.
Given the bullish economic news of late, some may be inclined to dismiss such forecasts. But ECRI is not just another forecasting shop. Indeed, it has an impressive record in calling turning points in the economy, thanks largely to a methodology that's one of the more intelligently designed systems for discerning the future. For details on the methodology, which leverages decades of cycle-oriented macroeconomic research, ECRI's book Beating the Business Cycle will satisfy. For a quicker fix on ECRI's current take on what may lie ahead, here's an excerpt from our Friday conversation with Achuthan.
Q: We keep reading that the economy's doing fine. The bond market certainly seems to be throwing in the towel after seeing the strength in the March employment report. And that follows other numbers in previous weeks suggesting that the economy has a head of steam.
A: That's an ok view near term. I wouldn't argue with anything you just said for the next month or two or three. But once we get into second half of 2006, that logic falls apart.
Q: What are we missing?
A: For starters, Friday's employment report is a coincident indicator, not a leading indicator. It's really a reflection of what was going on in the first quarter. But, yes, it's true: the economy is relatively healthy.
Mind you, a year ago, the majority of professional forecasters were predicting a sharp downturn. So they were wrong for 2005. Part of the lesson from the 2005 experience: this economy can live through anything. So, the safest bet is that it'll do well.
And that view's ok in the first half of 2006. But our indicators aren't based on what happened in the past; rather, ours are based on what the leading indicators saying today. And on that score, we have a mixed bag.
Our leading indicators were forecasting strength in the early part of this year. But when we look into the second half of 2006, there are two downturns that have shown up pretty clearly in the leading indicators. We think these two downturns are going to impact the overall economy. One is in housing, and the other is in the global industrial sector, which very few people are paying attention to.
Q: Let's talk about each one, starting with housing.
A: Our leading housing indicators turned down at the end of 2005. After four years of being bullish on housing, we finally said things are turning down. And we have seen both new and existing homes numbers coming in on the downside. That's going to pose some problems for consumer spending.
Q: How so?
A: Part of the reason why the economy was so strong in 2005 was because the wealth effect from housing offset, and then some, the lack of wage growth and the higher prices paid for energy. It's like the consumer's been saying, "Oh, damn, my salary increase doesn't cover the rise in energy prices, but since my house is now worth twenty grand more, I can dip into my savings and continue living large." That's basically been the equation.
Q: So, the consumer's going to sharply curtail his spending when he finds out his home's value is shooting up any more.
A: It's not that I'm saying that consumer spending drops. Rather, it's that the rate of spending growth eases.
Q: Even so, slower growth in spending could affect the economy, thanks to the fact that consumer spending represents the lion's share of GDP.
A: Correct. But if you distill all the investment bank letters and policy maker statements into one theme, then the current bet is that any housing-related consumer-spending slowdown will be mild, especially because we have reasonable jobs growth.
Q: Ah, it's that pesky American optimism again.
A: I'm as hopeful as the next guy. But our leading home price index, which is now down around an 11-year low, hasn't turned up yet. This index looks out three quarters. So, I don't think we're going to get a reprieve here. And perhaps things deteriorate further. Minimally, the positive is gone, and that weighs on the ability of consumers to grow their spending. Unless, they get great, great salary increases.
Q: Maybe a few corporate titans reading this will respond accordingly. Meanwhile, we could pray for a collapse in oil prices, which might convince consumers to keep going to the malls.
A: That hasn't happened yet. Energy prices are still up there. There are other types of inflation going on too. So, it's not clear that whatever wage growth there is--Friday's report put it at a 0.2% growth for March--it's not enough to offset the lack of growth in home prices.
That in and of itself isn't something we're suggesting is anywhere near recessionary. Nonetheless, an interesting factoid is that five of every six dollars spent in the economy are spent by a homeowner. That's a lot of dollars spent that can be impacted by the housing market.
Q: The other warning sign you mentioned is the industrial sector on a global scale.
A: Yes, and this downturn is completely off most radar screens. The industrial sector of the global economy has a cycle, and the reason it has a cycle is that a component built here goes into something built in Europe, which goes into something else built in Japan. We're all linked very closely. Any product can be sourced from all over the place. The factory floor is increasingly a global factory floor. And we see a cycle there. We have indicators on that--very long leading indicators. These are the ones that are looking out a year, and they've turned down quite clearly.
Q: How soon will the blowback from this downturn hit?
A: We don't have a great deal of precision on this, so I can't say the peak in the global industrial cycle will be, say, in June. But I think it's fair to say that we're going to have a peak in the global industrial cycle before the end of the year, probably in the second half.
What gets interesting here is the scenario is where a global industrial slowdown is lining up on some level with a pullback on consumer spending.
Q: What about the corporate sector coming to the rescue? Many analysts point out that corporations are flush with cash--cash that'll some predict will soon be spent on such things as investing in technology and hiring more workers. If so, won't an acceleration in corporate spending pick up any slack from a slower pace in consumer spending?
A: I'm not sure that corporations would do that. First, it's not rational for a business manager to spend if there's a downturn. Also, if there's a global industrial slowdown going on, some of the bigger ticket items, the capital-intensive items will probable be less urgently needed.
Q: Items such as?
A: Machinery, machine tools, durable-production equipment.
Q: What are some of the things you're looking at when you speak of the global industrial sector?
A: It's very esoteric. This is a slice from our long leading index, which has all kinds of components. The global industrial index is focused on many of the financially related components of our long leading index.
Q: What kind of financially related components?
A: Different kinds of liquidity, essentially. Profits, for example. Overall, it's all of the money-related stuff that drives the economy. This slice of the long leading index we take from each of our long leading indices for 18 major economies, including the G7 and India and China. We're taking that slice of the long leading indicators from all of those economies and that's a good leading indicator of the global industrial cycle. And that's turned down convincingly.
Q: Specifically, that downturn is saying….
A: It's saying that a cyclical downturn in the growth of global industrial activity is likely to appear in the second half of this year. If that's happening alongside a softening in consumer spending, the odds are that there could be a challenge to the layman's assumption about a strong economy.
Q: Yours is a contrarian view at the moment. The bond market, for instance, begs to differ, courtesy of the sharp rise in the 10-year yield to heights not seen since 2002.
A: Well, there's never been a time when the leading indicators have turned and everybody's says, "We totally agree." That just doesn't happen. It's the nature of turning points.
I'm not all bad news, by the way. But my good news is also contrarian.
Q: At least you're consistent. Lay it on us.
A: Our future inflation gauge fell again. Our leading indicator that's specific to the inflation cycle dropped again. Essentially, it's on the verge of signaling a peak in the inflation cycle two or three quarters ahead.
Q: Why's it predicting a softer, gentler inflation?
A: There are a handful of drivers of the economic cycle: money supply, housing, import prices, sensitive industrial materials, the dollar, the labor market, and so on. A lot of different things influence the direction of inflation. None of them on their own will tell you that much. But when they collectively start to shift it's important to pay attention.
Our future inflation gauge peaked in October 2005, and has fallen for four of the five months since then, including March. Granted, the labor market is bucking the trend by still holding the inflation index up a bit. In spite of that, our inflation gauge is close to tipping down. That would be good news if it begins to slip because it would start to give the Fed some options, if they needed them.
Q: In other words, the option of halting the current round of interest rate hikes, and perhaps even lowering rates.
A: I'm sure the Fed will be very eloquent in the way it explains it. They'll say it in a way that slowly allows the market to get the sense that they're not so worried. Of course, that would have a big impact.
Q: Sounds like you're questioning the logic of the latest rise in long bond yields.
A: No, no, no. I just think it's late in coming.
Q: A rose by any other name. But let's move on…sort of. What do you make of the fading of the inverted yield curve and the return of an upward sloping yield curve, just barely, courtesy of the latest jump in long rates?
A: We argued that it was not a great argument [that an inverted yield curve was reliable predictor of a recession] when it first started happening and everyone was worried. It's a faulty indicator. We've never used it. It failed in the 1990s, it failed a bunch of times in the 1950s. It gives false alarms and it misses turns.
By the way, I'm talking of the three three-month T-bill v. the 10-year Treasury. Everybody studies the three-month and 10-year curve. That's the one that Nobel Laureates have looked at. If you want to data fit it and make it fit into your current view, then you make it the 2-year and 10-year, and then it becomes easier. The two-year and 10-year curve is more convenient, if you want to be more bearish. But there's no good reason to do that.
It's not that the yield curve doesn't have interesting signals. It is somewhat useful in forecasting slowdowns and speedups, but it's not good at forecasting recessions.
© 2006 by James Picerno. All rights reserved.
April 7, 2006
STEADY AS SHE GOES
Another day, another set of data points that underscore the notion that the economy is doing fine. The Labor Department this morning released the March Employment Report and, once again, there were fresh numbers showing the labor market's death has been widely exaggerated. Does this mean that the forecasting ability of the inverted yield curve in weeks and months past has been proven to be something less than useful?
In any case, the unemployment rate last month dipped again, down to 4.7% in March, the lowest since July 2001. “Businesses are regaining confidence to the point where they are now actively hiring new workers,” Lynn Reaser, chief economist at Bank of America’s Investment Strategies Group, tells AP via MSNBC.com.
Meanwhile, the economy generated 211,000 new nonfarm payroll jobs last month, which translates into a roughly 1.5% increase in March over February. Although that's below the stellar days of the late 1990s, it's near the upper range that's prevailed in recent years, as the chart below reveals. More importantly, the rate of payroll increase has been holding steady. Below average is one thing; but below average growth that prevails over time adds up to something.
It's also worth noting that the bulk of the job gains in March came from the service sector, which is by far the largest chunk of the economy. In other words, the main cyclinders of the American jobs machine is firing away.
If the economy's headed for a slowdown, or worse, the broad labor numbers aren't betraying much in the way of an early warning sign. Perhaps that's why the yield on the 10-year Treasury is higher today. As we write this morning, the 10-year Treasury's current yield is 4.93--the highest since June 2002, according to Barchart.com data.
Perhaps the bigger question is whether the spread in the ten year over the two year is set to widen. Predicting that outcome is on firmer ground these days, if only because the formerly inverted curve of the 10-year/2-year Treasuries has gone flat lately, as the chart below illustrates.
If the economy keeps chugging along, reasonable minds will agree that further adjustment toward a normal yield curve (i.e., one where longer maturities offer materially higher yields relative to shorter ones) is warranted. Nonetheless, what looks reasonable in the 21st century doesn't always coincide with what Mr. Market ends up delivering.
Copyright 2006 by James Picerno. All rights reserved.
April 6, 2006
PESSIMISM TAKES ANOTHER LASHING
Yesterday's unexpected rise in the nonmanufacturing sectors of the U.S. economy delivered another blow to pessimists anticipating an imminent slowdown.
The Institute for Supply Management reports that its nonmanufacturing index rose to 60.5% last month from 60.1% in February. That's well above the 59% reading called for by the consensus estimate. March's reading also confirms the sharp rebound in February after January's drop to 56.8%, a dip that gave short sellers in the stock market a momentary burst of optimism.
But it's getting tougher to see the glass half empty rather than half full. Indeed, the service side of the economy (which dwarfs the manufacturing component) is expanding at a healthy clip. What's more, its broad based. "Thirteen of 17 non-manufacturing industry sectors report increased activity in March, compared to 10 that reported increased activity in February," ISM's press release advises.
Nomura Securities' chief economist in New York, David Resler, yesterday observed in a note to clients that the ISM nonmanufacturing index's rise last month "is well above its six-month average and signals a broadening expansion in the services sector."
More encouraging news on divining the future for growth comes this morning by way of the weekly update on jobless claims. Initial claims for unemployment insurance dipped below 300,000 again for the week ended April 1, the Labor Department reports. That's down by 5,000 for the week, and 47,000 below the year-earlier figure. If a broad economic stumble is coming, it's not evident in the jobless claims numbers.
Ditto for the so-called continuing claims for unemployment, a series that dropped to its lowest levels in the week through March 25 since January 2001, as the chart below illustrates.
It seems safe to assume that the labor market remains robust at the moment.
But if you thought the bond market would be growing increasingly anxious over such news, think again. Yes, the 10-year Treasury Note sold off last week, raising the current yield to nearly 4.9%, up from under 4.7% in late March. But bond traders once again are having second thoughts about selling. Buyers this week have overcome the sellers, keeping the 10-year Treasury yield from breaking above 4.9%.
There are, of course, a number of competing theories about where interest rates are headed. There are those who say that the economic growth implied by the labor market, the service sector, and elsewhere suggests higher rates. But that's only one school of thought. Indeed, if you buy into the global savings glut argument (which Fed Chairman Ben Bernanke is fond of promoting) you can make a case for expecting steady if not falling yields in the weeks and months ahead.
The stock market has no problem with all the back and forth in the land of fixed income. The S&P 500 is trading near its highest since 2001. Small cap stocks are doing even better--much better. The Russell 2000 index has continued making new all-time highs, having soared beyond its old highs of 2000 for more than two years.
The momentum is likely to roll on till it stops. Unfortunately, no one will issue a press release when that moment comes. Nonetheless, Wall Street and other enlightened souls love to play the game of predicting turning points. For the rest of us, there's asset allocation.
Copyright 2006 by James Picerno. All rights reserved.
April 5, 2006
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GRAPHING THE 2006 BULL MARKET IN STOCKS
As the first week of the second quarter unfolds, telecom stocks remain the clear leader among the big-cap equity sectors. For the year through April 4, the S&P 500 telecom sector is up more than 14%, or three times above the S&P 500's rise in 2006. Even energy, which remains hot but in second place, hasn't been able to keep up, posting a 10.6% rise so far this year.
The lone sector that's lost ground thus far in 2006 is utilities, which backtracked ever so slightly. That's hardly surprising, given that this is an interest-rate sensitive sector and the price of money continues to rise.
Among mid-cap equity sectors, industrials are on the leading edge of performance, rising 17% so far this year, or more than twice the gain for the S&P 400 mid cap index. But the bullish aura of telecom shines brightly in mid caps too, with the sector in close second place among mid caps by way of a 12.2% rise through April 4. The bottom sector performer in mid caps is health care, ascending by just 1.5%.
The real action this year is in small caps, which is leaving its larger brethren in the performance dust. The S&P 600 is up 12.5% year to date, with the leading small sector--materials--posting a sizzling 27% rise. The small-cap effect is so potent that even utilities in this arena are showing gains in both the mid- and small-cap indices.
If interest rates keep rising through the spring, one might wonder if small-caps are due for a correction. But for the moment, Mr. Market's not interested in considering things that could go wrong.
Copyright 2006 by James Picerno. All rights reserved.
April 4, 2006
A BULL MARKET IN SKEPTICISM AMONG GOLDBUGS
The bond market is finally paying attention to the 21 months (and counting) of ongoing rate hikes engineered by the world's most powerful central bank. It took a while, but the Fed seems to have grabbed the attention of the fixed-income set to a degree that's more than transitory. Maybe. But if the aura of higher short rates is beginning to take a toll on the long end, the gold market looks inclined to stay skeptical on what it all means.
The 10-year Treasury yield closed Monday's session at 4.87%, the highest in about two years. It remains to be seen whether the old highs from 2004 will hold. But for the moment, the bond market's inclined to sell, which translates into higher yields. The Fed, in sum, can claim a modicum of success in modifying expectations. Whether the trend lasts beyond the week is the operative question.
In theory, when and if the bond market throws in the towel and dumps debt securities in earnest, the war over inflation perceptions may be won. Higher long rates, after all, will do what ratcheting up rates on the short end can't, namely, convince Joe Sixpack that borrowing is going to become more costly and saving offers more exciting financial rewards. Fed Chairman Ben Bernanke wouldn't mind more of that brand of revised thinking these days, albeit in modest doses so as to sidestep a full-blown recession. A fine line as always, but that doesn't stop the Fed from trying.
But if all works according to the central bank's plan, it all adds up to lessening upward momentum on prices, real estate prices in particular. If consumers perceive that mortgage rates are indeed headed materially higher, courtesy of rising long rates, they may be inspired to look elsewhere for financial nirvana.
Arguably, that change of sentiment may encourage those who otherwise lose sleep when pondering the future course of inflation. But the gold market--which has a long history of representing the leading edge of thinking among inflation hawks--looks anything but encouraged these days. In fact, the goldbugs are becoming increasingly anxious even as long yields rise to highs not seen in several years.
The price of gold at one point yesterday traded above $590 an ounce before closing Monday at around $588 in New York. That's up nearly $40 in just seven trading sessions. What's more, $600 for an ounce may be just a few sessions away. You have to go back a generation to find the precious metal trading at such heights.
What's going on? David Gitlitz, chief economist at TrendMacrolytics, argues in a letter to clients yesterday, that gold's rally at the moment is less a referendum on the Fed's monetary policy than a reflection of a broad-based rally in commodities. "If that's the case," he opines, "it could be setting up a substantial downside correction [for gold] when the Fed finally reaches equilibrium [regarding interest rates] and dollar demand is enhanced along with confidence in the currency."
In any case, Hedge funds are reportedly jumping on the bandwagon, adding muscle to the already hefty momentum in gold. Meanwhile, there's the long-running argument that the U.S. twin deficits on the budget and trade ledgers continue to raise fears that the U.S. dollar's headed lower, which would be a boon to gold. Gold and the dollar share a long history of negative correlation--when one rises, the other falls.
In fact, the dollar's showing some signs of weakness over the past weak, even as the 10-year Treasury yield rises. One might expect that higher long yields in dollar-denominated instruments would boost the greenback. But for the moment, Mr. Market sees fit to sell the buck. The U.S. Dollar Index fell to 89.45 yesterday, near its lowest levels in about two weeks.
The determining factor that forces one side or the other to blink will ultimately be one decided on the matter of inflation perceptions. As such, the operative remains: Has the Fed convinced the marketplace that inflation's under control? The case for answering in the affirmative grows a bit stronger if long yields keep rising. Goldbugs, however, aren't convinced yet. Then again, the bond market has a history in recent years of reversing course just when it looks like yields are ready to spike higher.
Fear and greed, greed and fear.
April 3, 2006
With the dawn of the second quarter, we look back on the first and wonder if the Federal Reserve will deliver a similar performance on the matter of interest rates.
In the first quarter, there were two FOMC meetings and two 25-basis-point rate hikes. There are two scheduled FOMC meetings in the second quarter. In the first quarter, employment continued to hum along, arguably in stronger doses than the Fed expected. The trend was but one among many, although it played no trivial role in convincing the newly minted Fed chairman to lead the central bank into two more rounds of tightening, or so one could argue.
Indeed, weekly initial claims for jobless benefits posted a sharp drop in the first quarter, falling by 45% through the week ended March 25 from the close of 2005, according to numbers from the Labor Department, as the graph below illustrates. Currently, initial jobless claims are running near the lows of the last two years.
The strength is supported by the uptick in nonfarm employment growth. In the first two months of 2006, the nonfarm labor force grew by an average of 207,000 a month, or well above the monthly average of 173,000 that's prevailed since the start of 2004.
And while average hourly earnings of production workers slipped a bit in January and February from the torrid monthly pace set last October at 0.9%, this metric remains in the upper range of the last several years, posting a 0.5% gain in February.
No wonder that the national unemployment rate has been running under 5.0% for three straight months through February--the longest consecutive monthly run below-5% since 2001.
Is the Fed paying attention to the momentum on the labor front? Absolutely. And the market knows it. Fed funds futures for May are priced in anticipation of another 25-basis-point hike to 5.0%. But nothing lasts forever, and so there's a bit more doubt as to whether the June FOMC will also deliver another rate rise, as the June Fed funds futures contract suggest.
But a lot can happen between now and June, and for the moment there's the question of whether the employment picture will continuing strengthening for the next batch of numbers. On that score, it's not hard to find dismal scientists forecasting growth. "The labor market data continue to indicate strong job growth,'' Dean Maki, chief U.S. economist at Barclays Capital in New York, tells Bloomberg News. "We expect the economy to grow more strongly in the near term.''
In fact, the consensus forecast for this Thursday's release of the March employment report calls for a holding pattern on the 4.8% jobless rate, according to the Street.com.
In short, expect more of the same, short of some statistical shock elsewhere in the economy, such as a large negative surprise for the latest weekly jobless claims data scheduled for release on Wednesday.