July 31, 2006
BULL MARKETS EVERYWHERE. BUT FOR HOW LONG?
Turmoil from geopolitical tension and economic confusion may be weighing on the global economy, but you wouldn't know it by looking at returns of late. Indeed, risk became popular again in July, as the chart below illustrates.
Asset class proxies: Vanguard REIT ETF, iShares Russell 2000, iShares MSCI Emerging Markets, MSCI EAFE, S&P 500 SPDR, Vanguard High-Yield Corporate, PIMCO EM Bond, Morningstar Short Gov't Category, PIMCO Foreign Bond, iShares Lehman Aggregate Bond, Vanguard Inflation Protected Securities Fund, Credit Suisse Commodity Return Strategy Fund.
The top-performing asset class over the past month through last Friday was emerging market equities, based on Morningstar data for iShares MSCI Emerging Markets Index ETF. Not even the perennially strong REITs sector could match emerging markets' recent comeback after losses in May and June. Of course, REIT investors probably aren't complaining, having scored the second-best rise for the past month with a 7.4% total return, based on the Vanguard REIT Index ETF. In fact, REITs are still the leader in 2006, with a year-to-date total return of nearly 18%--far and away the best performance this year.
Perhaps more striking is the fact that there's nary a sign of red ink on our performance tables, save for the tiny loss posted by inflation-indexed Treasuries so far this year, as per Vanguard Inflation-Protected Securities fund. Otherwise, it's been onward and upward across the board, at least by our somewhat narrow view of performance time frames.
This is a bit odd, however, since the point of diversification is to weather storms by exposing assets to corners of finance that zig when others zag. But if everything's zigging (albeit in varying degrees) what's the point of emphasizing zag? Good question, and based only on one-month and YTD numbers, the answer's not all that compelling.
One intrepid reader recently chastised us for daring to suggest that maintaining a widely diversified portfolio was less than optimal when it comes to deploying capital (his actual words weren't quite as technical and a tad more colorful). REITs and foreign stocks, our enthused reader advised, were the only place to be. The implication being that an enlightened investor should dispense with the nonsense of owning other asset classes until and if they showed signs of delivering stellar returns.
Our reaction was a bit boring, but at least it was consistent: we attempted to explain that over longer-term periods, the benefits of diversification tend to shine, as we observed in our own unscientific study in a post back on March 7. We're hardly the first to observe the value of owning multiple asset classes, but we're second to none in praising the associated merits. And in a world where tapping various asset classes is easier and more affordable, it only seems rational to avail oneself of strategies formerly available only to wealthy and individual investors.
Of course, there are no guarantees with investment strategies, even with broad asset allocation strategies. That said, we continue to harbor more than a little faith that such thinking will do quite nicely over time. Yes, you could get richer quicker with a more aggressive approach, although you could get poorer in no time as well.
Owning ten asset classes is first and foremost about wealth preservation, immersed with a health dose of capital growth. Or so we believe, based on a number of years of pondering the alternatives and studying the numbers. In a world where the future seems to become more uncertain by the week, we cling to our ten, over three or four, like a man does to a life preserver who finds himself somewhere in the Atlantic.
Ah, but what if you have a taste for something racier? Not to worry. For those inclined to emphasize capital growth over wealth preservation, owning a mix of the ten asset classes still holds potential. It's all a matter of how one goes about weighting the individual pieces and the frequency of rebalancing. God and the devil, one might say, are in the details of mixing the ten asset classes. In sum, you can dial up a wide, wide variety of expected risk/return levels by sticking ten asset classes. For our money, this is an investment chassis that can be attached to a broad variety of investment engines.
Speaking of risk, we think it will rear its ugly head in more tangible terms in the capital markets in the weeks and months ahead. In other words, don't let the easy gains across the board this year lull you into a false sense of bullish security.
Yes, Virginia, there's always a bull market somewhere, but there's rarely a bull market everywhere for more than a brief, fleeting moment in time. As such, we'll continue to sleep with one eye open and an overweight allocation in cash, to be deployed later when (we predict) bargain prices prevail elsewhere in more robust terms.
Meanwhile, we now return you to the bull markets in progress....
July 28, 2006
ANY WAY THE WIND BLOWS
It's anyone's guess what Fed Chairman Ben Bernanke's legacy will be, but the possibilities are still wide open.
For those who think monetary policy falls short of perfection these days, there's reason to read the recent weekly updates on money supply and wonder what comes next. Seasonally adjusted M2 money supply shows a rise of 5.0% from a year earlier (using a 52-week formula), according to the latest numbers from the Federal Reserve. In fact, M2 money supply has been rising by 5.0%-plus now for the past three weeks relative to levels of 52 weeks previous. As the chart below illustrates, that pace represents something of a minor milestone in money supply trends. The last time money supply was rising at 5% or higher on a consistent basis was early 2005.
For confirmation that the rolling 52-week trend is no statistical anomaly, we also ran the numbers on seasonally adjusted M2 on a 10-week rolling basis. The trend, however, confirms what the 52-week analysis shows: the supply of money is rising at higher rate than in the recent past.
The question is whether the new bull market in money is temporary or the start of something big. That's hardly an innocent question with fears of inflation threatening. Only the Fed knows what comes next in matters of money supply, but for those of us on the outside there's reason to keep an eye on the Thursday dispatches from the central bank regarding the quantity of dollars in circulation.
The Fed is trying to win over the bond market's respect and admiration, but we wonder how that project will ultimately turn out if the path of least resistance in money supply is upward. A few weeks a trend does not make, of course, when it comes to overseeing the near $7 trillion of currency swirling around in the system. But a billion here and a billion there eventually add up to something more than a footnote if the momentum isn't checked.
To be blunt, something looks amiss if the Fed is raising interest rates on the one hand while pumping more money into the system with the other. In fact, the two trends can't coexist for very long, short of suspending the laws of supply and demand. (Yep, they apply to the quantity of money too.)
Of course, the devil's in the details, and we're the first to recognize that money supply can rise even as interest rates do. It's all a matter of degree and timing, and on that score there's enough moving parts in the American economy and monetary levers to keep observers like us guessing for quite some time. Big trends, in other words, are confirmed or denied only over relatively lengthy time periods. But the proverbial thousand-mile journey starts with the first step.
Nonetheless, we can't help but notice that today's report on second-quarter GDP shows the economy advancing at an annual pace of 2.5%, or about half as fast as money supply growth these days. Clearly, the economy's slowed considerably from the blistering 5.6% advance in the first quarter. As such, reasonable minds in central banking can argue that a little stimulus is in order to keep the economy from slipping further; thus, the uptick in money supply growth of late.
That would be the end of it except for the fact that core rate of inflation is showing signs of building a head of steam. On a year-over-year basis, core CPI has now climbed by 2.6%, based on June numbers. As Anthony Chan, chief economist of J.P. Morgan Private Client Services, told CNBC's "Squawk Box" last week, "With 2.6% year over year, it is a number that's way too hot for the Federal Reserve. It's certainly out of the comfort zone."
Life isn't getting easier for Bernanke and the Fed. The central bank's twin mandate of minimizing inflation and maximizing employment has always been a difficult task. It's also been relatively easier in years past because of disinflationary winds blowing. Those winds may in fact still be blowing on global basis, but for the moment the monetary breeze is pushing prices upward in the United States.
To be fair, Bernanke's a banker and a professor of monetary economics. That's a powerful position, but he's not omnipotent. He can only do so much, and in fact may have to choose to do less than he would like, starting with the thankless task of emphasizing inflation fighting or economy stimulation. Doing both effectively, at the same time, is probably impossible. Everyone knows that and recognizes the limits of central banking's influence. Nonetheless, Bernanke has compounded the challenge with missteps as it relates to honing perceptions of the Fed in the trading pits. To right this ship he needs to a) convince the bond market that he means what he says; and b) communicate the Fed's intentions in no uncertain terms.
Meanwhile, we're all data dependent, subject to flying any which way the wind blows.
July 27, 2006
FEAR V. FUNDAMENTALS IN THE OIL MARKET
Crude is king when it comes to bull markets in the 21st century. The price of a barrel of oil in New York futures trading has climbed some 280%, as of last night's close from January 1, 2002. As bull markets go, this one's been extraordinarily profitable for those who've ridden the wave. This year alone, crude's ascended by more than 30%, based on the near-$80-a-barrel mark set earlier this month. But every wave crashes, eventually, even one that's driven by a potent supply/demand profile that drives the oil market.
Timing, of course, is everything when it comes to making predictions, and on that score we have no more insight than anyone else. But we do have eyes in our head, which informs our ever-cautious temperament when it comes to money.
Any analysis of where oil prices are headed necessarily starts with a survey of the geopolitical tension, which is also in a bull market. Front and center is the reality that Israel's locked in a war with the Lebanon-based Hezbollah militia. A month ago it was hard to imagine how the Middle East could become more volatile, but the Israeli invasion of Lebanon has resolved that mystery. Not that there wasn't already plenty of anxiety harassing the region and raising questions about the ramifications for oil. From Iran's nuclear ambitions to the chaos that is Iraq, the Middle East had more than its share of worries. Unfortunately, the region's recently descended down another notch into what is in the running to be its worst case of disorder and confusion in the modern era.
Suffice to say, the madness is deemed sufficient to warrant a fair amount of risk premium on a barrel of oil, perhaps as much as $40 by some estimates.
Human nature being what it is, it's not impossible to imagine that that the situation in the Middle East could yet go from bad to worse in the coming weeks and months. We certainly don't minimize that possibility. The United States, as we write, isn't keen on imposing a ceasefire in the Israeli-Hezbollah fighting, and so it's a safe bet that a ceasefire isn't coming in the next few days. Forty-eight hours, we might add, can be an eternity these days in matters of Middle East politics.
The longer the war rolls on, the greater the potential that it could spin out of control and become a regional conflict involving Syria, Iran and other nations. In that case, the ceiling on oil's price could shoot up dramatically in just one trading session. A hundred bucks a barrel, in other words, could be lurking just around the corner.
But oil prices could fall sharply too. Indeed, a review of the underlying fundamentals suggests as much. Inventories of crude oil in the OECD nations are the highest in 14 years, advises a research report issued yesterday by Bernstein Research (see graph below).
The report, penned by Ben Dell, also predicts a robust rise in global spare oil production capacity for 2006 through 2008, reversing last year's dramatic drop, as the graph below from the report shows. Historically, the correlation of spare capacity to oil prices has been negative; that is, as spare capacity rises, oil prices tend to fall.
Obviously, that negative correlation has been suspended of late, although one might wonder if it's due for a return engagement. Based on Bernstein's analysis, oil prices are now more than $20 higher than the price/spare capacity correlation history implies. If spare capacity increases in the months and years ahead, as Bernstein forecasts, the current price of oil would look even more excessive.
"The unstoppable rise of the crude price has begun, in our opinion, to defy fundamentals," the Bernstein report observes.
Adding to the uncertainty of what comes next in oil prices is the rise of passive investors in the commodity. A growing number of strategic investors have come around to recognizing that a long-term allocation to commodities enhances the risk-reward profile of a traditional stock/bond portfolio. That, combined with the rise in the number of mutual funds, and more recently ETFs, catering to this new source of demand has funneled money into commodity indices, for which oil is usually the dominant component.
This relatively new demand source for oil, the Bernstein report correctly notes, has been overlooked, with the media focusing primarily on the rise of short-term speculation in oil trading. To be sure, the increase in passive investing in oil and other commodities isn't, by itself, the reason for the bull market in oil, but it's a significant driver, and an increasingly potent one. Last year, more than $80 billion was earmarked for net passive investment in the two main commodity indices, the Goldman Sachs Commodity Index and the Dow Jones-AIG Commodity Index. That's up from less than $20 billion in 2003, according to Bernstein.
Perspective is important here for understanding how big passive commodity investing is on the margins of the oil market. "By the end 2006 this net investment [from passive investing] is estimated to account for over $110 billion, of which the majority is in the GSCI, which is over 74% weighted to energy and 50% weighted to crude," Bernstein advises. In fact, the report continues,
the incremental growth or funds flow in during 2006 will account for almost $21.3 billion of which $7.7 billion will flow into crude. To place this in perspective, if matched by physical barrels this would account for almost 120 million barrels annually or 320,000 barrels of daily demand. This is bigger than China’s [oil demand] growth and would be the largest source of incremental worldwide demand. The impact of this on the physical market is clear when one sees the correlation of contango to storage builds. As the futures price is increased storage operators are incentivized to fill storage and sell forward.
The bottom line is that there are at once powerful bullish and bearish forces at work in the oil market. No one knows which one will prevail, or when, although the easy assumption is that higher prices will prevail. Nonetheless, investors should recognize that this is a different oil market than the one in 2003-2005.
Yes, oil's probably in a multi-decade bull market. We've written extensively on the subject over the years, and know the details well enough not to dismiss the idea that a barrel of crude will probably go for much more in 2015 compared to today. But getting there from here promises to be volatile, perhaps much more so than the lazy bulls realize.
Bernstein, for its part, recommends taking some profits in the energy stocks. "Given the potential for a sharp correction in crude prices, we remain cautious on the group recommending a net underweight position, despite the secular bull story, believing that the commodity has overrun itself."
July 26, 2006
THE FED'S BIG ADVENTURE
The debate's over: it's slowing. No doubt about it. Now begins the next phase of the discussion: How long will it slow, how far will it dip, and will it bring recession?
Existing home sales declined 1.3% in June, the slowest since January and nearly 9% below the pace from a year ago, the National Real Estate Association reported yesterday. And while prices for existing homes kept rising last month, it was the weakest jump in more than a decade. But there are signs that something less is coming. Indeed, condo prices are already slipping on a year-over-year basis.
David Lereah, chief economist at the NREA, downplays the negative implications regarding yesterday's news. “Over the last three months home sales have held in a narrow range, easing to a level that is near our annual projection, which tells us the market is stabilizing,” he said in a press release that accompanied NREA's data update.
Is the transition to stability from red-hot bull market merely a step to a bear market in housing? No matter how you spin it, there's no getting around the fact the housing market is cooling. By any number of metrics, the trend is clear. What's more, there's no mystery behind the falling volume of sales. Higher mortgages rates aren't helping, which in turn is helping elevate the supply--a textbook case for predicting lower prices ahead.
Again quoting NREA's Lereah, who explains that "a year ago we had a lean supply of homes and a sellers’ market, with monthly home sales at an all-time record high." The lean supply has since blossomed into something meatier. Existing homes available for sale in June were at a 6.8-month supply at the current sales pace, up from a 4.4-month supply a year ago, according to NREA.
Paul Kasriel, who heads up Northern Trust's economic research division, yesterday predicted that prices will fall for existing homes in the months to come so as to reduce the excess supply that currently prevails. "The knock-on effects of all this will be subdued consumer discretionary spending as those 'home ATMs' are not refilling as rapidly as before," he wrote in a research note yesterday. "Another factor that will curtail consumer discretionary spending is slower income growth in housing-related industries as employment and sales commissions moderate further."
The bottom line: the residential real estate market is now in a recession, Kasriel opines.
If so, that raises the stakes in the Fed's ongoing struggle to balance inflation fighting with keeping economic growth intact. The United States now leads the industrialized world in inflation rates, based on the top-line year-over-year increase in June. The core rate of inflation is creeping higher as well. The Federal Reserve can't ignore this, should it prove to be a trend with legs in the months ahead. The Fed's data dependent, Bernanke recently remarked; in fact, depending on what the data reveals going forward, the Fed may be held hostage by the numbers.
For the moment, Fed Chairman Bernanke seems to be counting on a slowing economy to do the heavy lifting of nipping inflationary momentum in the bud. But as we wrote last week, a slowing economy doesn't necessarily insure that inflation will follow, at least not initially.
Ben, quite simply, is in a bind, observes economist Robert Dieli, who runs MrModelonline.com, an independent consultancy. In an interview with CS today, he says that the central bank is effectively behind the inflation curve because it opted to raise rates slowly. As a result, Fed funds probably aren't yet high enough to squelch inflation.
Dieli doesn't think a softening housing market by itself will tip the economy into recession. But there are other factors conspiring. "Three-dollar-and-fifty-cent gasoline will probably have a bigger impact on consumer discretionary spending than housing," he says.
No matter the details, a slowing economy at this moment presents a thorny challenge for the Fed, Dieli continues. Normally, at this stage of the business cycle, the Fed could/should be talking about cutting rates, or at least holding off on further hikes. But that's a luxury the Fed can't afford, courtesy of the slow and modest rate hikes over the past two years. What's more, the bond market knows the Fed's in a bind. "The bond market won't blink," Dieli says. Thus, the yield curve remains more or less flat, and may soon invert, handing the fixed-income set a victory of sorts, and no doubt emboldening the bond boys to engage in more of the same Fed bashing.
Dieli predicts that the Fed will raise rates again at the next FOMC meeting on August 8. The meeting after that, in late September, may provide a pause in hikes, depending on the data. But a Fed that's publicly committed to running monetary policy based on the latest numbers, as per Bernanke, also opens itself up to surprises. Indeed, Dieli notes that if future inflation numbers are ugly, the pressure to tighten the price of money further will prove immense.
In fact, the great unknown can be boiled down to when (and if) Bernanke earns the bond market's respect. The fact that long rates are still low relative to Fed funds suggests that day has yet to come.
Meanwhile, welcome to the world of uncharted waters, with Captain Ben as your guide. On-the-job training never looked so dangerous.
July 25, 2006
CONFESSIONS OF AN ANXIOUS INVESTOR
Asset classes don't go bankrupt, but neither do they consistently radiate value relative to the competition. Indeed, the value of any asset class waxes and wanes, providing an endless stream of opportunity and risk.
Deciding if one or the other dominates in one or more asset classes is the perennial challenge, a task that itself goes through its own peculiar cycles. Sometimes there are screaming buys, and sometimes valuations are at pinnacles of excess. Unfortunately, such extremes are rare. Most of the time, valuations are a gray area, making analysis uncomfortable and prone to error due to the whims of the moment. That, one could argue, describes the current climate for the major asset classes, where neither bargain nor excesses dominate.
The immediate source of this middling scenario is the fact that ours is a time of transition in the price of money. Interest rates, in other words, are climbing. The latest evidence comes from the world's second-most populous country. The Reserve Bank of India (RBI) today raised its key short-term rate by 25 basis points to 6.0%--the highest in four years. The hike was billed as a pre-emptive attack on inflation's gathering momentum on the subcontinent, subtle though it may still be at the moment. The source for the monetary anxiety remains the bull market in energy, explained RBI Governor Y.V. Reddy. "Fuel prices, which account for 35% of the increase in wholesale price index, constitute a major risk to headline inflation," he said, as reported by India eNews.
India's hardly alone in raising the price of money or worrying about the future for inflation. Central banks the world over are generally tightening the monetary strings, albeit after a lengthy period of easy money. Because rates around the world have been so low in real (inflation-adjusted) and absolute terms in recent years, the reaction by the capital markets has been sluggish compared with previous rounds of tightening. Indeed, the frog doesn't jump out of the pot if the transition from cool to boiling water is slow. But at some point the frog realizes that he's being cooked alive, at which point it may be too late to snatch victory from the jaws of defeat.
Something similar may be unfolding in the world's capital markets, where optimism fueled by cheap money has helped investors see bull markets as the continued path of least resistance. The Federal Reserve has been more than a little complicit in this lethargic attitude adjustment, courtesy of its consistent delivery of "baby step" rate hikes over the past two years. But baby steps add up to something bigger eventually.
The fate of the major asset classes now rests with the central banks to a higher degree than we've seen in recent years. If the world's most important central bank continues to squeeze the price of money, the asset class that we've favored on these pages for some time now will look even better. Only time will tell if that means that competing asset classes will look that much worse.
Meantime, there are the numbers. That includes the current yield of the Vanguard Prime Money Market Fund, which sits at an alluring 5.03% as we write. That is virtually identical to the current yield on the benchmark 10-year Treasury Note, as of last night's close. But while the 10-year yield is fixed upon purchasing said bond, the appeal of money market funds in the current climate is their wondrous capacity for adjusting yields based on the prevailing monetary winds. For the moment, this strikes us as the greatest invention since the wheel, or at least the self-cleaning oven.
But even wondrous investment strategies have their limits, and we are ever attentive to the risks of expecting interest-rate hikes to roll on forever. As a strategic matter, we believe that interest rates will be higher five to ten years from now, but we're not so sure looking out six to 12 months. At some point, the logic of locking in some of the prevailing long rates will avail itself, but not yet. For the time being, we're still inclined to sit in an overweight cash allocation comprised primarily of money market funds and collect the rising income stream that the Fed has so generously engineered on our behalf. Eventually, we'll reallocate that elsewhere, boosting our underweight holdings of stocks, bonds and commodities. Till then, we're reading the tea leaves.
On that note, we recognize that it is late in the day, or so the Fed funds futures markets tells us. The August contract is priced precariously on the fence when it comes to projecting what the next FOMC meeting on August 8 will produce. Fed funds are 5.25%. Deciding if they'll go to 5.50% on August 8 is the burning question that, we predict, will grow ever hotter in the days ahead.
But waiting still has its rewards. Just don't confuse waiting with sleeping. The lazy, hazy days of August are nearly here, but this is no time for dozing.
July 24, 2006
WHAT AILS STOCKS?
When the last company dispatches its numbers for the quarter just passed, S&P 500 earnings will have risen by 13.6%, or so predicts First Call/Thomson Financial, via RTTNews. That would mark the 17th straight quarter of double-digit gains. As fundamentally driven tailwinds go, it doesn't get much better than this for the stock market. So why is the S&P 500 slumping these days?
The highs for the year were set back in early May, when the S&P 500 closed above 1320 for four straight days. As of Friday's close, the index has fallen about 6%. Technically, the market doesn't look inclined to turn around any time soon: each rally since May has brought a lower peak than before.
Whatever ails the stock market, no one can say that weak earnings are to blame. But as the bears are quick to point out, there is any number of other reasons to sell these days, ranging from geopolitical tension to fears that an economic slowdown is coming.
But the bulls shouldn't despair, writes Milton Ezrati, senior economic and market strategist at Lord Abbett. If equities moved sideways for the rest of this decade, as some predict, that would make this decade's stock market performance since the 1930s, he observes in a research note published Friday. "If the popular forecast is correct and the S&P 500 were to show no further gain thorough the end of the decade," he asserts,
the market would have no better performance than the Great Depression—an unlikely event, to be sure, especially in light of today’s positive fundamentals. If the index, aside from dividends, falls short of a 14 percent annual rise during the next 3½ years, this first decade of the 21st century would fall well short of any 10-year stretch of the past 30-plus years. We believe the implication of these statistics clearly is that matters are very likely to improve going forward. History is indeed on the side of the bulls.
Perhaps, although history is a guide to the future, not a guarantee. That said, it seems likely that when the Fed is truly done with its current round of rate hikes, there will be a relief rally that lasts more than a day or two. No less was suggested last Wednesday, when stocks rose sharply after Fed Chairman Bernanke made what some thought were dovish comments about monetary policy in testimony to Congress.
But expecting stocks to surge on a long-term basis simply because the Fed refrains from further rate hikes, however, is a fool's game. If the central bank decides it's time to conclude monetary tightening, it's like to be driven by the clear and persistent evidence that the economy is slowing. In turn, a weakening economy, if only on the margins, threatens the one saving grace that has kept the bulls optimistic: earnings growth.
To be sure, earnings growth isn't about to dry up any time soon. Corporate America has become leaner and savvier over the past few years. The ability to extract profit in a world that is increasingly volatile is a skill that companies in the S&P 500 have mastered. But corporate earnings rising by, say, 6% pales next to growth of 13.6%, which is the current outlook for the second quarter. How might Mr. Market react with a material slowdown in earnings growth? If he's not willing to buy when earnings are soaring at a double-digit pace, is he likely to be enthused if the rate of advance slows?
Meanwhile, bonds are drawing attention away from stocks by way of the yield on the 10-year Treasury that's 5%-plus. The average annual return on stocks during 1926-2005 was 10.3%, Ezrati writes. That's virtually the same as the 10.5% pace for 1990-2005. But some investors are deciding that a guaranteed 5% on the 10-year looks more attractive at a time of transition.
In fact, hedging one's bets looks better still. Stocks may face a headwind in the coming months and years, but Ezrati's number-crunching isn't easily dismissed.
Diversification by any other name still smells as sweet.
July 21, 2006
Is the economy slowing or isn't it? As usual, the answer depends on the numbers one chooses to emphasize (or ignore).
For those who still see the glass half full, this week's industrial production and leading indices offer reasons for hope. But any optimism from these dispatches were minimized by signs of cooling elsewhere, notably in the real estate sector. Indeed, housing starts fell by more than 5% last month.
In theory, a slowing economy makes it easier for the Federal Reserve to cease and desist with its current round of interest rate hikes. In practice, life's more difficult, thanks to the worrisome rise in core CPI in June, delivering the third monthly advance of 0.3%, a pace that some economists say is above the comfort zone for keeping future inflation contained.
July 20, 2006
THE NEW NEW AGE OF DEBATING THE ROOT CAUSE OF INFLATION
Federal Reserve Chairman Bernanke has been hailed as one of the country's foremost authorities on monetary economics, but that doesn't necessarily mean Ben is a monetarist. In fact, in Bernanke's Congressional testimony yesterday, he snubbed the idea the idea that the quantity of money is the ultimate arbiter of inflation's level.
"FOMC participants project that the growth in economic activity should moderate to a pace close to that of the growth of potential both this year and next year," Mr. Bernanke said, as reported by the GlobeandMail.com. "Should that moderation occur as anticipated, it should help to limit inflation pressures over time."
History doesn't necessarily agree, as any card-carrying monetarist will point out. One the clearest examples can be found during a two-year stretch through the first-quarter of 1975. During that period, the economy contracted by 1.6%, with real (inflation-adjusted) GDP falling to $4.24 trillion by March 1975 from $4.31 trillion (in chained 2000 dollars) as of March 1973--a decline otherwise known as a recession. But while the economy stumbled, there was no reprieve from core inflation (less food and energy), which climbed sharply over those 24 months, jumping to a seasonally adjusted annual pace of more than 11% in March 1975 from 3.2% two years previous, as the chart below illustrates.
Since this measure of consumer prices excludes energy prices, we must consider other catalysts for the unleashing of the inflationary dogs at that moment in history. In fact, we find a suspect in money supply, which suspiciously indulged in a sharp burst skyward in the months and years preceding the rapid rise in core inflation during 1974-75. As the chart below shows, seasonally adjusted M2 money supply, based on a rolling 12-month change, exploded upward starting in 1971 through much of 1973. In June of 1970, M2's 12-month rise was under 3%; by March 1971, it was advancing at a double-digit pace, a trend that was maintained through July 1973.
Monetarists have reason to think that inflation is more than a byproduct of economic growth. Mr. Bernanke thinks otherwise, or so one could reason after sifting through his latest comments. Welcome to the new new age of debating the causes of inflation.
July 19, 2006
DOWN WITH LAGGING INDICATORS
How much lag resides in the lagging indicator known as core CPI? It's a potent question on a day when the Labor Department reported that the core rate of inflation (less food and energy) in June rose by 0.3%--the fourth straight month at that pace, which is above the Fed's comfort zone. On a year-over-year basis, core CPI has now climbed by 2.6%, the first time the rate of increase has topped 2.4% since 2002, MSN Money reported.
"With 2.6% year over year, it is a number that's way too hot for the Federal Reserve," Anthony Chan, chief economist of J.P. Morgan Private Client Services, told CNBC's "Squawk Box." via MSN Money. "It's certainly out of the comfort zone."
Against the backdrop of that worrying trend were comments from Fed Chairman Bernanke, who today told Congress that the economy was slowing and inflationary pressures would therefore moderate going forward. If there was any question about Bernanke's message that the past isn't necessarily prologue when it comes to inflation, he offered this clarification: "The lags between policy actions and their effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook for both inflation and economic growth,'' he said, as reported by Bloomberg News.
Core CPI is, of course, a lagging indicator. Indeed, all economic data is lagging in the sense that it reflects yesterday's trends. The question is how to project tomorrow from yesterday. It's a thankless job, and one that economists tackle routinely, albeit it with less than perfect results. That's the nature of forecasting, an art form that only slightly resembles science. The future, dear readers, is forever and always unknown.
Having proclaimed that revelatory observation, your editor is back to square one, namely, Now what? To be sure, we come neither to praise nor to bury core CPI, but to point out what should already be obvious: inflationary pressures have been bubbling in the recent past, raising the odds but not necessarily insuring that inflationary pressures will bubble in the near future.
If the Fed feels compelled to snuff out this bubbling, the message was somewhat garbled by Bernanke. "Bernanke's comments on inflation make it seem [that] the Fed is really getting close to the end of its rate-hike cycle," Jason Schenker, U.S. economist at Wachovia Corp., told Reuters today. "That is more than enough to give stocks a boost."
Yes, indeed, stocks soared today, with the S&P 500 climbing by nearly 2% (as we write in mid-afternoon), which amounts to the biggest jump in weeks. Meanwhile, futures traders repriced Fed funds futures upward, effectively betting that rate hikes were a thing of the past, or at least that the last hike would come at the next FOMC meeting on August 8.
To be sure, Bernanke isn't blind to the uptick of inflation of late. He said as much in Congressional testimony today. But Mr. Market is inclined to look for clues that bolster the case for an end to rate hikes. It's hard to know if Bernanke understands this bias, or even if he thinks it's relevant. In any case, Wall Street is falling over itself to find an excuse to buy stocks and bonds, and Ben (either by design or accidentally) satisfied that search.
Only time will tell if the new-found bullish aura now sweeping the Street will prove to be timely or something less. The answer awaits in the next CPI report, due for release on August 16. Till then, we can only debate just how much lag resides in the core CPI, and if that lag is about to sag or surge.
The argument for predicting that it will sag finds comfort in the fact that the lion's share of June's rise in core CPI comes from housing costs. "About 70% of the overall acceleration [of core CPI] was accounted for by the larger increase in the index for shelter," the Labor Department reported. "Shelter costs, which rose 2.6 percent
in all of 2005, have risen at a 4.3 percent annual rate in the first half of 2006."
It's been widely reported that the formerly red-hot real estate market is cooling. Making the natural leap of faith, one could surmise that the cooling process will moderate future increases in core CPI. Of course, that assumes that the other components of core behave themselves.
There are no easy answers when it comes to economic forecasting in 2006, in part because there's no shortage of moving parts that combine to deliver the macro trends. But for the moment, at least, there's a surfeit of optimism. Even Wall Street deserves a break every once in a while.
July 18, 2006
CLARITY DU JOUR
In June 2003, the 10-year Treasury did something extraordinary by yielding around 3.07% at one point in that month. That was a generational low, and it's proven to be the nadir for the 10-year ever since. Judging by this morning's report on producer prices, the odds improved again for 3.07% remaining the low for the foreseeable future.
As of last night's close, the 10-year's yield was some 200 basis points higher from the low of three years ago. The great question coursing through the financial markets is whether the elevation that the price of money has accumulated over the past 36 months will suffice to stifle the mounting inflationary pressures that appear to be bubbling in the economy.
Producer prices advanced by 0.5% in June, the Bureau of Labor Statistics reported today. In addition to being well above the consensus forecast, 0.5% represents a sizable jump from May's 0.2% rise. On the other hand, the core PPI (which removes energy and food from the mix) slipped a bit last month, increasing by 0.2%, down from 0.3% the month before.
If any of this gives investors reason to wonder about the primary trend in wholesale prices, a rolling 12-month gauge of PPI offers a more-enlightening picture. On that score, there's reason to worry: PPI has climbed 4.8% over the past 12 months, the second-highest rate this year. Yes, the trend looks less ominous after subtracting energy prices. But in the real world, we all consume energy and pay market prices, ensuring that energy's threat on inflation is more than theoretical.
Granted, there's a sizable risk premium built into the price of oil these days. Neil McMahon, an oil analyst in Sanford C. Bernstein's London office, writes in a research note to clients today that a $27-a-barrel premium is embedded in crude's price. "In the absence of the perceived risks the market is factoring in, we believe prices would be below $50/bbl based on the supply demand balance, and current levels of spare capacity which has been steadily expanding for the last 12 months," he writes.
All of which highlights the same old challenge facing the Federal Reserve: to hike or not to hike. If oil was priced purely by supply and demand, inflation fears would be considerably tempered. Meanwhile, there are expectations that an economic downshift may be coming, in which case more inflationary momentum may be curtailed. But the Fed can't wait for such macroeconomic aid, nor is Opec about to start pricing oil based on what economic fundamentals imply.
Indeed, the immediate reaction to the PPI report this morning has been one of selling the 10-year Treasury, thereby pushing its yield up to 5.13%, the highest since last Tuesday's close. Erring on the side of caution, in short, is popular sport in bond trading today.
The Fed, however, may find it more difficult to be so single-minded. Finding the sweet spot between expectations of an economic slowdown and bubbling inflation in the here and now is Bernanke and company's primary challenge. Second guessing what comes next when the Fed meets next on August 8, futures traders have surmised that another 25-basis-point hike to 5.50% remains a distinct possibility.
But make no mistake: we are close to the end of the current rate tightening cycle. Minds differ over how close. No, we won't see 3.07% on the 10-year Treasury soon, if ever, but might see 4.5% again in 2007?
Economic growth isn't poised to accelerate. The jury's out on whether that's also true for inflation. Nonetheless, we suspect that over the next 12 months, there will be new opportunities to take advantage of the economy's downshift by readjusting asset allocations in fixed-income. But first we must survive the summer, which is proving to be hotter than predicted. Tactics are in, for the moment; grand ten-year strategies are out.
July 17, 2006
CALLING ALL STRATEGISTS...HELP!
Optimism is on the defensive at the moment because the world is a dangerous place. Dangerous, and getting more so with each passing day.
Danger is hardly new, nor is the capital markets' capacity for digesting and pricing peril a recent innovation. Crises come and go, and the markets reprice as events require. And still the disciplined long-term minded investor manages to make a buck. No less will be true in the future, but no one said it'll be any easier than it has been in the past. In fact, it may get tougher relative to the already challenging standard that has been investing in the 21st century. Indeed, as one looks out over the escalating warfare in the Middle East, it's hard to see an endgame in the near future that leaves investor sentiment on the mend.
We're talking, of course, about the war between Israel and Hezbollah, the guerrilla group in Lebanon. The accelerating conflict is wreaking havoc in the two countries, and raising tension in a region that's already tense from the ongoing state of chaos, otherwise known as Iraq. Adding to the bull market in instability is long shadow of Iran, which has become increasingly confrontational in promoting its anti-Western agenda. Iran, courtesy of its massive petrodollar-infused bank account, has the means to back up its inclination to run interference in the West's (read: America's) political agenda in the Middle East. That includes funding Hezbollah, which reportedly draws no trivial degree of financial help from Iran.
'Tis easier to tear down confidence than it is to build it up. To the extent that such disorder and bedlam serve wider political objectives, pursuing turmoil and confusion is path that's tragically easy to follow and difficult to repair. Investors the world over must understand this risk, even if it only informs only partly informs their decision-making process.
Yes, there may be a light at the end of the tunnel, but for the moment the aura from the Middle East is casting shadows of a particular hue on sentiment. A week is hardly a representative sample on which to base a long-term investing strategy, but given the events of the moment it comes as no shock to learn that commodities were last week's big winner among the major asset classes. Oil and gold were particularly popular, rising 4.0% and 5.3%, respectively, in a week when the S&P 500 dropped more than 2% and Treasuries were only fractionally higher. Diversification, in other words, still carries more than a little weight as the only true friend in portfolio management.
All the more so once you consider that war and the threat of instability are only part of the obstacles facing paper assets. Valuations are hardly a screaming buy, or so one might reason. At best, equities and fixed income are fairly priced, but even that's hardly the source for new round in the middle-aged bull market when bullets are flying in a part of the world that has a history of injecting havoc at times with America's peace and prosperity.
The intrepid investor will no doubt keep an eye out in the weeks and months ahead to exploit Rothschild's famous maxim to buy when blood runs in the streets. Alas, blood is running in the streets from the mortal victims of war, but paper assets have yet to suffer a wound of any magnitude. As such, grander bargains may await.
Rest assured, when and if stocks and bonds go on sale in dramatic fashion the pricing adjustment is apt to be accompanied by a dark sentiment coursing through the veins of the capital markets. The great risk, as always from a strategic vantage, would then be one of overlooking the bargains at a moment of maximum value. Human nature, being what it is, tends to minimize the allure of sale prices in the context of strategic investing. DVDs, shoes and cans of tuna fish fare better when it comes to opportunistic bargain shoppers. But thanks to the fear and greed syndrome, which burns brightest in the realm of investing, Joe Sixpack is disposed to overlook those exceptional junctures in history when valuations move to extremes.
True, the price-earnings ratio on the S&P 500 looks inexpensive by the standard of the past decade and the yield on the 10-year Treasury bond is the highest since 2002. As a result, minds may differ about what constitutes the most enlightened course in the here and now. But for our money, we're inspired only to err on the side of caution. In part because after deducting energy earnings from the S&P 500, the index's recent history looks less encouraging. And so, rar more comforting at the moment is a preference for assuming modest positions across the asset classes, waiting and hoping for more persuasive opportunities when and if they avail themselves.
Ours is a moment of great risks and middling valuations, an observation that informs our strategic outlook. There is a bull market lurking somewhere in the distance, but for the moment it's not clear to our jaded eyes, and so we sit in above-average allocations of cash and related securities until confidence returns. We may, of course, be wrong, and pay a heavy price. Such is the art of investing, and the danger of embracing portfolio counsel that costs exactly nothing. Risk, in short, is rising, assuring that predictions will be among the leading victims.
July 14, 2006
MEET THE NEW RISKS; SAME AS THE OLD RISKS
The price of money is going up, and so it seems is everything else, including security and stability.
The Bank of Japan, the last major holdout in the monetary universe for dispensing cheap money, threw in the towel today on its long-standing tolerance for zero-percent financing. The BOJ's policy board unanimously voted to raise the key overnight call money rate to 0.25% from zero.
While Japanese interest rates move off the floor, oil prices keep rising through the ceiling. The August crude oil futures contract briefly moved above $78 a barrel in New York yesterday, another all-time high. The immediate catalyst is the threat of a new regional war in the Middle East as Israel responded to cross-border raids by fighters of the Lebanon-based militant group Hezbollah. Oil supplies per se weren't threatened, but it doesn't take a Ph.D. in diplomacy to realize that new Israeli military campaign in Lebanon, which included attacking Beirut’s international airport and imposing a naval blockade on Lebanon, risks a wider conflict involving Syria and Iran.
Oil is nominally an economic commodity, but it also serves as an unofficial gauge of global tensions. No wonder, then, that the price of the world's most valuable commodity continues to soar.
Helping fuel the latest run in oil prices is Israel's reassertions that Syria and ultimately Iran are behind Hezbollah's attacks. As a result, there are fears anew that Israel may attack Syria. Among those who think this is a possibility is Iran's president, who reportedly felt compelled to respond to the perceived threat. “If the Zionist regime commits another stupid move and attacks Syria, this will be considered like attacking the whole Islamic world and this regime will receive a very fierce response,” Iran's President Ahmadinejad was quoted as saying in a telephone conversation with Syrian President Bashar Assad, according to YnetNews.com.
The threat of a new war near and about the heart of the world's largest oil reserves may still be a remote possibility, but traders are taking no chances. Given the history in the Persian Gulf region in the 21st century, no one should be surprised to learn that the pricing of oil is a business of erring on the side of caution.
The inclination to bid up oil on the first sign of trouble represents something of an evolution in the Mr. Market's thinking in recent years. After the terrorist attacks of 9/11, the price of crude fell sharply in the remaining months of 2001. There was also a drop in oil prices after the start of the Iraq war in 2003. Don't expect a repeat performance anytime soon. Oil supplies have since become pinched and global security appears more vulnerable.
Geopolitical threats are by themselves enough to promote discounting in the prices of paper assets, stocks in particular. Adding to the pressures on equities the world over is the rise in the price of money. The Federal Reserve continues to elevate interest rates in the United States, and the European Central Bank has started down the same path. China has been tightening as well. Now that Japan's joined the trend, all the major economic centers on the planet are elevating rates.
To say the twin demons of rising interest rates and oil prices complicate investment strategy is an understatement. In theory, the two trends, if they have legs, will slow the global economy. That, in turn, will likely boost bond prices and hurt equities. Buying opportunities, as a result, may be in the offing. Timing, of course, is the great unknown. Meanwhile, for those with overweight position in bonds and stocks, these are trying times.
There are no easy answers in the capital markets these days. But there's always cash, still the most attractive of the major asset classes in the eyes of some strategists.
July 13, 2006
GLOBAL NUMBER CRUNCHING
Are there any bargains left in the world's equity markets? Or has the bull market of the last few years dispensed with such alluring concepts as relative value?
Easy to ask, tough to answer. Beauty, as always, is in the eye of the beholder when it comes to putting a fair value on stocks. The challenge is even tougher when you consider that valuing securities isn't an end unto itself, but a means of divining the future path of stocks.
The assumption by many is that low valuations equals above average returns going forward. There is, in fact, quite a bit of truth to that notion, albeit one that can be risky when dissecting individual companies. Relative valuation offers a bit more comfort when comparing equity markets among the planet's various regions. Regional equity markets, after all, don't go out of business or get sideswiped by the ill-advised actions of a rogue CFO.
With that in mind, we dive into the performance statistics from the S&P/Citigroup Global Equity Indices, with the results listed in the table immediately below. With the usual caveats lurking, we nevertheless turn up a few intriguing profiles of what's going on in equity markets around the world. But first, let's go to the horse race, looking at total returns so far this year, through July 12, 2006 (see the table below).
Leading the pack year to date are European Emerging Markets, which have climbed more than 25% this year (all returns are total returns, calculated in dollars, as per the S&P/Citigroup index series). But even that impressive run pales in comparison to some of the individual markets in Eastern Europe. Slovenia's equity market, for example, has climbed by more than 40% this year through yesterday's close. Does that mean there's a Slovenia ETF in Wall Street's IPO future?
At the opposite end of the regional horse race is the Mid-east and Africa, which has shed nearly 3% so far in 2006. The United States, according to the S&P/Citigroup series, is also near the bottom compared with the major regions of the world, weighing with a relatively thin 1.94% advance.
Returns are fun to look at, but they don't tell you much about valuation. For enhanced insight in that corner we consider the major regions of the world on four fundamental metrics (see tables below), all of which are calculated as of June 30, 2006, as per the S&P/Citigroup indices. Among the trends that stand out:
* Latin America looks compelling next to its global counterparts. Based on price-to-earnings ratio and return on equity, the region tops our list for offering the best value.
* For dividend yield, Asia Pacific excluding Japan leads the way, weighing in at 3.26%. The U.S., by comparison, is at the bottom, courtesy of its paltry 1.79% yield.
* On a price-to-cashflow basis, emerging markets still rank as the best value among the major regions. Of course, the various risks that emerging markets harbor no doubt accounts for the relatively low pricing. Meanwhile, the U.S. is the most highly valued market place by way of P/CF ratio.
July 12, 2006
"STRUCTURAL REASONS" TO THE RESCUE
The trade deficit has been larger than May's pot of red ink, but not by much.
The Commerce Department
announced today that total May imports exceeded exports by $63.8 billion. That amounts to $500 million deeper in the red from April's trade tally. On the other hand, May's deficit is below the all-time monthly low of $66.6 billion of last October.
Most of the trade deficit can be traced to the state of business in goods, such as industrial supplies, consumer goods, agricultural products and automobiles, as the chart below illustrates. The dollar-value of exports of these and other items in the aggregate have in fact been growing over time. For the 12 months through May, for instance, U.S. exports of goods rose by 12.9%. Impressive as that is, it falls short of the 13.4% increase in goods imports into America over those 12 months.
It's a different story with services, a catch-all label that includes an array of items that the government labels business, professional and technical services, for instance. Whatever you call it, exports of services expanded by 9.8% for the 12 months through May, comfortably above the 8.8% rise in services imports.
But while the U.S. does a booming business in selling services overseas, it's a relatively small part of the trade ledger, or so the Commerce Department tells us. The business of importing and exporting goods is several times larger, measured by dollar value, and so the U.S. posts a trade deficit.
These trends have prevailed for years, and so America continues to report a deficit in trade that, over time, continues to descend. Today's trade report isn't likely to change this secular trend. If anything, questions about what the ongoing trade deficit means for the U.S. economy will only loom larger after perusing today's numbers.
Chief among the queries: What lies ahead for the dollar if the trade deficit continues to deepen? Billions of dollars hang in the balance, not to mention the U.S. economy and its financial system, depending on the answer.
For the moment, however, stability reigns supreme. Although the greenback took a beating in the spring, it's been treading water for the last month, measured by the U.S. Dollar Index. But what's true in the short term doesn't necessarily hold fast in the long haul.
A widening trade deficit implies a falling dollar. Economics 101 suggests no less. Yes, the U.S. has become accustomed to living by a set of rules that don't apply to nations elsewhere on the planet when it comes to international finance. But living beyond one's means is invariably a temporary boon, or so history warns.
Ultimately, the fate of the dollar, and thus the American economy, turns on the sentiment in far-off capitals, starting with Beijing. Indeed, China reportedly held $925 billion in foreign exchange reserves in May--easily the world's largest stash of foreign currencies in one country, and born of the Middle Kingdom's extraordinary success at exporting goods, primarily to America.
The flip side of China's reserves is America's debt and deficit. The two are in fact intimately connected. The fear among some economists is that the imbalance will eventually unwind, casting turmoil across the U.S. economy in the process. In the meantime, the Chinese and other foreign countries, notably Japan, continue to hold large and growing hordes of dollars and equivalents. Why?
The latest of many attempts at finding an answer comes by way of a new IMF paper, appropriately titled: U.S. Dollar Risk Premiums and Capital Flows. The authors ponder the strange case of foreigners holding dollars in the face of mounting fiscal and trade deficits within America's shores. Have overseas investors taken leave of their senses? Far from it, argue the authors, who assert that demand for greenbacks remains robust despite the risks because America offers something that's otherwise missing in the global economy. As the IMF study explains,
The paper finds that the presence of negative dollar risk premiums (i.e. expectations of a dollar depreciation net of interest rate effects) amid record capital inflows could suggest that investors may favor U.S. assets for structural reasons. One possible explanation could be that the Asian crisis created a large pool of savings searching for relatively riskless investment opportunities, which were provided by deep, liquid, and innovative U.S. financial markets with robust investor protection. Moreover, the continued attractiveness of U.S. financial markets to European investors suggests that they offer a large array of assets, with different risk/return characteristics, that facilitate the structuring of diversified investment portfolios. Looking forward, this suggests that the allocative efficiency of U.S. financial markets could mitigate risks of a disorderly unwinding of global current account imbalances.
Perhaps, then, it's time for every American citizen to give thanks to "structural reasons" the next time they visit Wal-Mart or Target and pay $15 for a new shirt or $89 for a DVD player. Yes, globalization is a magnificent thing for Joe Sixpack. Enjoy it, Joe… while it lasts.
July 11, 2006
The age of self-managed retirement funds can be imagined as a wonderful world, one in which enlightened citizens invest their assets wisely over time so as to live out their golden years in comfort and style. Or so one could theorize. In practice, it may turn out to be something less. How much less depends on any number of factors, starting with the particular skills of the individual.
Alas, those skills, such as they are, may fall short of the minimum required to produce even modest results. Indeed, a new academic study throws more than a little skepticism on the notion that the masses are up to the challenge of managing their 401(k)s as a long-term proposition. The evidence for holding this pessimistic outlook comes from a testing of the most-basic of investing skills: picking the best S&P 500 index fund from a list of four choices, i.e., the fund with the lowest cost.
As tasks in financial decisions go, this one is arguably the easiest. There is, after all, just one factor for selecting the best portfolio: expense ratios. Since S&P 500 index funds are commodities in the true sense of the word, the only differentiating factor is one of price. A simpler methodology for picking mutual funds could hardly be imagined. As such, one could reason that if there's any hope of advancing one's investment station in life, success would reveal itself by investors mastering this important, but ridiculously easy investment hurdle.
Unfortunately, the participants in the study inspire anything but confidence as individuals continue to take control of their retirement assets. Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds, a paper authored by professors from Yale, Harvard and the Wharton School, asks Wharton MBA and Harvard College students to allocate an imaginary pot of $10,000 across four S&P 500 index funds with varying expense ratios and commissions of more than a little significance. In the first experiment, the only related literature the students are given to make an informed decision is the prospectus for each fund. The result? To quote the study authors, "Over 95% of control group subjects fail to minimize fees." In other words, only 5% made the correct decision of choosing the lowest-cost index fund.
In a second test, the students are asked to choose from the same index mutual funds but this time they're given the associated prospectus and a one-page summary that highlights the expense ratios of the four index funds. The results are slightly better, but barely. A still-high 80% of the students still failed to pick the lowest-cost index fund.
But wait--it gets worse. This time, students are handed a prospectus for each fund and a summary sheet that shows each index fund's annualized performance since inception. The professors throw a small curve ball to the students here, if only to test the complexity of life in the real world. That is, the performance summaries represent different time periods. No apples-to-apples comparisons here. But in fact, it's all a trick question. "Because each fund’s inception date differs," the professors write, "this information should be ignored when predicting across-fund variation in future fund returns. In fact, we construct our fund menu so that annualized returns since inception are positively correlated with fees; chasing past returns since inception lowers expected future returns. Nevertheless, this is what our subjects do."
The disturbing result shows that simply by showing investors higher performance numbers--even when those numbers are clearly irrelevant to the choice at hand--the investors make decisions based largely, if not exclusively on those immaterial numbers.
What makes these dismal results all the more frightening is the fact that the test subjects are educated people--most are MBA students at Wharton, among the most prestigious of business schools. The rest are college students at Harvard, a university that requires no introduction. "Our MBA subjects report an average combined SAT score of 1453, which is at the 98th percentile nationally, and our college subjects reported an average score of 1499, which is at the 99th percentile," the professors report.
Suffice to say, the students in question are better educated and therefore better equipped (in theory, at least) to make investment decisions compared with the general population. Why, then, do these students fail so miserably? And while we're asking questions, let's ponder the reality that the general population faces far more complicated investment issues (asset allocation, rebalancing, etc.) in managing real money.
If nothing else, this study underscores the fact that there are more than a few pitfalls in the democratization of finance. Fortunately, there's an easy solution: secure informed counsel on matters of investment strategy. But that introduces another challenge: picking competent advisors. Getting rich, it seems, is just as tough as it's always been.
July 10, 2006
VOLATILITY EQUALS OPPORTUNITY. BUT WILL IT ADD UP TO RESULTS?
The stock market's been a yawn this year, but the sport of water treading that dominates the broad indices masks the price volatility that lurks below.
The S&P 500 has climbed 1.4% through July 7, but this drowsy performance profile is hardly common within the ten sectors that comprise the broad market. As the chart below shows, the range of returns within the market index has been wide this year. At the head of the horse race is energy--still. Rising by more than 13% year-to-date, the ongoing bull market in all things energy related stands in stark contrast to equities generally. Ditto for the bottom-performing sector in 2006, albeit in reverse. The tech slice of the S&P 500 has been no wallflower when it comes to dispensing red ink: the tech stocks have shed nearly 8% this year.
Between those two extremes lie the various shades of gray that add up to a mixed market and building blocks that, in theory, can lead to besting beta with superior equity selection skills. Success in stock picking requires choosing the right sectors more so than usual this year--advice that's born out in the outlook for sector earnings. As Zacks reported last week, the median firm in the S&P 500 is expected to report earnings growth of 8.1% for the second quarter. But far-greater drama resides in the sector-specific tally, as the table below reveals (courtesy of Zacks.com). Energy is on top with anticipated earning growth of 40% for the second quarter; on the opposite extreme is consumer staples, with is projected to post a mere 4.0% rise in earnings.
Such variation in price returns and earnings expectations should give traders just what they need to prove their worth in doing something other than holding the index. But as veteran investors know, opportunity doesn't easily translate into results. Bashing beta is a perennial habit, but leaving it in the dust is still the bane of most active managers.
July 7, 2006
ANOTHER PAYROLL REPORT, ANOTHER QUESTION MARK
Sometimes the data enlightens, sometimes it frightens. And sometimes it simply tortures Mr. Market. The latter seems to be the operative theme with today's release of the June employment report.
If anyone was expecting a clear signal from this morning's update from the Bureau of Labor Statistics to lift the fog harassing the economic outlook, the numbers were something of a letdown. On the one hand, there's fresh reason to think that inflationary pressures are still bubbling, as per the uptick in average hourly earnings, which posted a 3.9% rise last month over the year-earlier rate--the highest in five years. Score another point for thinking the Fed may still raise the price of money.
But the analysis is getting trickier by the day. Indeed, the job-creation machine continues to sputter, or so it seems, perhaps to the point of offsetting the inflationary worry that currently resides in the minds of the Fed governors. Consider that a Reuters poll called for a gain of 185,000 in today's update on nonfarm job growth, based on the median estimate. What was dispersed was a number significantly lower than the crowd's best guess. The government advised that 121,000 new nonfarm jobs were created last month, slightly ahead of May's rise, but only slightly.
As the chart below illustrates, plotting monthly payroll changes on a rolling 12-month percentage basis shows that for the moment we're going nowhere fast. Nonfarm payrolls rose by 1.4% last month over June 2005--the same rate of change that prevailed in April and May.
What's more, June's payroll advance was even closer to April's 112,000 tally of new jobs. As signals go, the one being dispensed by the employment report has become a yawn of late. Even the jobless rate remained unchanged for June. What's more, at 4.6%, last month's unemployment rate has barely budged at all in 2006, remaining in a tight range of 4.6% to 4.8% in the first half of this year.
Expectations were primed for so much more, or at least something materially different after Wednesday's dose of stats. In particular, that was the day when the National Employment Report from Automatic Data Processing (ADP) advised that private sector jobs exploded upward by 368,000 in June--the highest monthly rise in the five-year history of the somewhat obscure data series. The news attracted more than passing interest from the bond market, which reasoned that the Labor Department's tally would follow suit, thereby setting the stage for more interest-rate hikes at the hand of the Federal Reserve. But the anxiety will no doubt wane for the moment after the anticlimactic news dispensed by the Labor Department today.
The divergence between the ADP report and the Labor Department's survey raises more than a few questions, of course. Some of it has to do with variations in methodology, and we can already hear the grapevine buzzing with debate about which employment series captures the true essence of the economic trend.
In the meantime, Fed Chairman Bernanke and associates look poised to continue to stew in their statistical juices. The central bank has counseled recently that incoming data would play an increasingly important role in monetary policy going forward. As today's report reminds, however, that heightened role isn't guaranteed to be dramatically enlightening on any given day. Perhaps next week's data will prove more enlightening.
July 6, 2006
The spot price of oil touched a new high yesterday, running above $75 a barrel. The world's most valuable commodity may be vulnerable to a correction if U.S. economic growth downshifts in the months ahead, but for the moment oil traders can only say buy. Some of that has to do with geopolitical tension, of which there is no shortage these days.
Alas, separating the fundamental from the political is no easy task when it comes to analyzing crude. Nonetheless, the oil giant BP recently updated its annual review of all things energy, once again making a valiant effort to emphasize the quantitative over the qualitative via its 2006 Statistical Review of World Energy.
Poring over the data, we found an array of profiles and trends, ranging from the expected to the surprising. Here's a sampling:
Perhaps the most predictable item in crunching energy numbers is the recurring theme of Saudi Arabia as the world's leading repository of proved oil reserves, or so official statistics tell us. Equally unsurprising is the fact that the top-five nations for proven oil reserves are also in the Middle East. Who says the oil business is always unpredictable?
Moving over to the not-so-obvious category we discovered that India and Brazil post the biggest percentage gains in proven oil reserves last year over 2004. The biggest loser, in percentage terms, was Mexico--a country that just happens to be one of the main suppliers to the energy-hungry United States. For perspective, the global change in proven reserves was 0.6% last year. It's worth noting that proven reserves can be manipulated, depending on the country in question. In fact, it's a safe bet that politics has more than a little influence in many countries regarding the numbers dispensed for public consumption.
Proven reserves don't always dictate production, but it helps. Indeed, Saudi Arabia is the leader in reserves and production, pumping nearly 14% of world output last year.
TOP 5 PRODUCERS
2005 Production (thousands of barrels daily)
Saudi Arabia 11,035
Percentage changes in oil production last year v. 2004 deliver a more eclectic list. The country with the biggest relative change in output was Azerbaijan, a tiny nation that was formerly part of the old Soviet Union. The biggest loser in 2005, in percentage terms, was Vietnam, which witnessed an 8.2% decline in oil production.
PRODUCTION LEADERS & LAGGARDS
Changes in daily 2005 production (thousands of barrels daily) for the top- and bottom-five producers.
Returning to the realm of predictability, BP data informs that the U.S. remained the world's biggest guzzler of oil last year. America's crude habit ran at nearly 21 million barrels a day.
LEADING OIL-CONSUMING NATIONS
Consumption (thousands barrels daily for 2005)
Finally, a look at the largest percentage changes in oil consumption last year v. 2004. Qatar's firmly in the lead, posting a 17.1% rise in crude consumption in 2005. At the opposite end of the spectrum is Belarus, another former member of the Soviet Union. Consumption of oil in Belarus tumbled more than 10% last year. Overall, world consumption rose by 1.3%--down sharply from the 3.5% rise in 2004 over 2003.
PERCENTAGE CHANGE IN OIL CONSUMPTION
Change in daily 2005 consumption, based on daily usage
July 5, 2006
A SUMMER OF RISK ANALYSIS
One doesn't need to remind the capital markets that risk is in the air. A cursory glance at the horse race for the past month among the major asset classes tells the story, which is predominantly one of espousing caution.
On the extreme ends of performance for the past month, through July 3, as the graph below illustrates, REITs continue to lead the way, racking up an impressive 3.6% rise, as per the Vanguard REIT Index Fund. On the losing end of the spectrum: commodities, which lost 3.8% over the past month, based on results from the PIMCO Commodity Real Return Strategy A Fund.
Asset class proxies: Vanguard REIT, iShares Russell 2000, iShares MSCI Emerging Markets, MSCI EAFE, S&P 500 SPDR, Vanguard High-Yield Corporate, PIMCO EM Bond, Morningstar Short Gov't Category, PIMCO Foreign Bond, iShares Lehman Aggregate Bond, Vanguard Inflation Protected Securities, PIMCO Commodity Real Return.
After you chop off those two extremes, the range of performance among the remaining ten asset classes is quite narrow, suggesting a heightened sensitivity for embracing prudence. A mere 131 basis points separates the second-best performer (cash, as per the Morningstar Ultra Short-Term Bond Fund category) from the second-worst (TIPS).
Investors can be forgiven for expecting the proverbial second shoe to drop. With North Korean missiles flying over the Sea of Japan, threats of higher inflation lurking in the shadows, fears of slowing growth, and any number of other crises gurgling with potential, ours is a moment to reconsider the safety that comes by watching and waiting.
In terms of economics, the great question is what the Fed will do in the weeks and months ahead. No shortage of fresh numbers await release in July, all with the potential to influence the central bank's next move, if any. Among the highlights: June's payroll update on Friday, June's retail sales on July 14, and consumer prices for June on July 19. Another number that's sure to receive broad scrutiny is the first estimate of the second-quarter's GDP, which is dispensed to the world on July 28.
Meanwhile, today there's fresh reason to see employment momentum as half full rather than half empty, thereby making a case for another interest-rate hike at the next scheduled Fed meeting on August 8. The National Employment Report, published by Automatic Data Processing (ADP), posted a 368,000 rise in private-sector jobs last month. That's a sharp increase from 122,000 in May, suggesting that employment momentum remains firmly on the upswing. "That is the largest one-month increase in the relatively brief five-year history of this indicator," writes David Resler, chief economist at Nomura Securities in New York, in a note to clients this morning.
The bond market's initial reaction was predictable: sell. The yield on the benchmark 10-year Treasury moved up to around 5.20% in early trading. That's up around five basis points from Monday's close, and within shouting distance of ~5.25% set in late-June, the highest since 2002.
Risk is alive and well as the summer begins in earnest. Figuring out how to price it is, once again, the question for a new day and new world order.
July 4, 2006
HAPPY INDEPENDENCE DAY!
The unanimous Declaration of the thirteen united States of America,
When in the Course of human events, it becomes necessary for one people to dissolve the political bands which have connected them with another, and to assume among the powers of the earth, the separate and equal station to which the Laws of Nature and of Nature's God entitle them, a decent respect to the opinions of mankind requires that they should declare the causes which impel them to the separation.
* * *
We the people of the United States, in order to form a more perfect union, establish justice, insure domestic tranquility, provide for the common defense, promote the general welfare, and secure the blessings of liberty to ourselves and our posterity, do ordain and establish this Constitution for the United States of America.