The Capital Spectator

Angell went on to say that there's a risk that the Fed remains too focused on the recent past. The rise in core inflation is in fact a lagging indicator. As he pointed out, the jump in core CPI was baked into the system 24 months ago. The challenge, as always, for the Fed is balancing lagging indicators with monetary decisions today--decisions that will have an impact over the next 24 months or so. To the extent the Fed stumbles with finding the right balance, the result can be recession, he noted.

Angell was also asked by another journalist if he'd cut interest rates now. His answer was "no." He reasoned that the "Fed must prepare the markets" before a cut, which he suggested will come in the first quarter. The preparation will come through communications by Fed Chairman Bernanke and other representatives of the central bank. Perhaps a fresh clue will come in today's FOMC announcement, due in a few hours as we write.

Meanwhile, speaking of housing prices, the national median price for single-family homes dropped 2.5% in September 2006 vs. the year-earlier figure, the National Association of Realtors announced today. That's the largest decline on record. The good news, such as it is: we're still a long way from a 15% or 30% decline.

Posted by jp at 12:43 PM | Comments (0)

October 24, 2006

RETHINKING EMERGING MARKETS

Emerging markets have been a staple for at least a decade among investors who value portfolio diversification. The asset class went mainstream in the mid-1990s with the launch of a variety of mutual funds targeting the stock markets in the developing world.

The last several years have been especially sweet for the asset class, delivering double-digit gains for three years in a row through 2005. This year doesn't look too shabby either. Despite the correction in the MSCI Emerging Markets Index earlier this year, the stocks are up nearly 14% so far in 2006 through yesterday.

Adding luster to the asset class is the growing stack of research that sings a familiar song: emerging markets stocks are a valuable diversification tool for conventional domestic stock/bond portfolios. A familiar argument is of a type found in an essay by George Hoguet, the emerging markets investment strategist at State Street Global Advisors. Diversification, return enhancement and a general expansion of the so-called investable opportunity set are the main benefits, he wrote. In the long term, Houget counseled, "adding emerging markets to your portfolio can both increase return and lead to diversification."

Houget's far from alone in promoting emerging markets of late. That's the nature of bull markets. But while the crowd loves the asset class these days, Jeff Troutner has another view, namely: emerging markets haven't lived up to expectations and so it's time look elsewhere for diversification benefits.

Emerging markets have delivered mediocre returns, high volatility and rising correlations with U.S. stocks during 1994 through 2005, wrote Troutner, who runs TAM Asset Management, in the August issue of his newsletter Asset Class.

Inspired by an article penned by financial planner Bill Bernstein, Troutner crunched the numbers and found that emerging markets delivered an annualized return of 6.5% for 1994-2005. That's a fraction of the 45.1% annual gain logged in 1988-1993 (returns are based on the DFA Emerging Markets Equally Weighted index). It was in the mid-1990s, in fact, when Troutner first started putting clients into emerging markets. It all looked so enticing back then. Not only were trailing returns stellar at the time, the correlation between emerging markets and the S&P 500 was only 0.25 (0.0 is no correlation, 1.0 is perfect correlation). Yes, volatility was high, but that was tolerable, given the expected diversification and return boost from emerging markets.

But the asset class stumbled, Troutner discovered. Correlation with the S&P 500 rose to 0.67 for 1994-2005 while the average annual return for the asset class sunk to 6.5% during that stretch. Meanwhile, volatility remained high.

What's behind the stumble? Perhaps the rising popularity of the asset class diminished its formerly alluring profile? It wouldn't be the first time that a hot new asset class attracted loads of money only to fall short of expectations later on. "That could be," Troutner told us yesterday in an interview on the chance that popularity killed this golden goose of an asset class. "I think that it could be a lot of hot capital flowing in and out of these markets. It's flighty capital," he reasoned. "As an investment advisor, I'm asking, why, from 1994 to 2005, were the returns [in emerging markets] so crummy? I think it is speculative money, for the most part. And speculative money moves fast. If speculators believe a market's going to drop, they pull their capital out."

Speculators have a hand in every market, of course. So, why are emerging markets any different? "Because I think there's a hell of a lot more investors in U.S. stocks than speculators on the whole; but in emerging markets there are far more speculators than true investors."

Troutner also said that "investors don't think about the fact that bidding up the prices of high-growth investments lowers expected returns." Emerging markets are considered high-growth investments, of course. But everyone knows that. As a result, high growth doesn't necessarily lead to high returns. "A lot of capital's gone into these markets in anticipation of higher growth, and that's driven up prices and therefore expected returns are lower."

Whatever the reason, the asset class no longer impresses Troutner. He's not rushing for the exits, although he said he's no longer putting new clients into emerging markets. And for established accounts, he's selling into strength. As he told CS:

"I'm asking the question: Should we continue to invest in emerging markets. My inclination is to say 'no.' Emerging markets are on a watch list for me. They're on probation."

What, if anything, could replace emerging markets? Small value stocks in the U.S. and in developed countries are a good alternative, according to Troutner's analysis, as per the chart below. "I can invest in U.S. small value, and get almost as high returns with half the volatility of emerging markets."

Source: Jeff Troutner, Asset Class, Aug. 2006.

Of course, with emerging markets still firmly in the black this year, the crowd isn't likely to follow Troutner's lead. Not today, anyway. But somewhere in the future another bear market lurks, along with a fresh round of attitude adjustment for the masses.

Posted by jp at 10:40 AM | Comments (0)

October 23, 2006

ANOTHER LOOK BACK

In a year when positive returns are widespread, the job of rebalancing is a thankless task. It's also an increasingly burdensome one. Your editor, as a result, pines for the past.

Take 1998, for example. Now that was a year of variety. U.S. stocks, measured by the Russell 3000, enjoyed a robust 24.1% total return that year--the best among the major, broad asset classes. On the opposite extreme: emerging markets, which shed nearly 30%, as per the MSCI Emerging Markets Index. There was also a wide dispersion among the other asset classes. REITs, for instance, were down 17% in 1998 while U.S. bonds added 9.7%. Ah, yes, those were the days.

This year, by contrast, is a study is relative consistency. Save for the recently battered commodities, everything is up, as our table below reminds. And on a three-year trailing basis, even commodities show a gain, and a healthy one to boot. And who knows? Maybe OPEC will gain more respect when it comes to production cuts, helping elevate commodities' performance into the black for 2006 after all.

Ours is not to question why, ours is but to rebalance or die (apologies to Tennyson). Unfortunately, the low-hanging fruit that availed itself in '98 (or '00 through '02, for that matter) looks sparse by comparison.

To be sure, we're not so naive as to think that a sizable loss in a given calendar year for an asset class invariably leads to a gain the next. There's plenty of history to suggest that such a one-factor world doesn't exist. And so we're forced to seek out value in asset classes as well.

And we're also mindful that momentum is a potent force too. Indeed, except for 1999, emerging markets posted losses for each an every year from 1998 through 2002. Meanwhile, REITs are on track again this year to post a gain, as they've done consistently for each full calendar year so far in the 21st century.

True enlightenment for the necessary task of rebalancing doesn't come easy. Nor does it fit nicely into little tables. But past performance, while no guarantee of future return, is at least a start.

Posted by jp at 11:20 AM | Comments (0)

October 19, 2006

THE FUTURE ACCORDING TO GITLITZ

David Gitlitz has been predicting for some time now that the economy will stay robust and that inflation's still a problem. The bond market may be forecasting recession and falling inflation, but that's a bet that will be proven wrong, says the chief economist for TrendMacrolytics.

A few weeks back, Gitlitz's view looked mistaken. In late September, the yield on the 10-year Treasury dropped to under 4.6%--the lowest since February. With Fed funds at 5.25%, a 4.6% 10-year yield created an inverted yield curve in no uncertain terms. Recession, in other words, was coming, the fixed-income set predicted, and inflation was winding down.

But in the wake of yesterday's report on consumer prices for September, investors are again wondering if inflation is still a threat. Yes, top-line CPI fell 0.5% last month, and the yield curve's still inverted. But the 10-year's yield has been rising of late, and so is core inflation. In fact, core CPI advanced 2.9% for the year through September--the highest in nearly a decade.

With the latest inflation report hot off the government's press, we thought it was a timely moment to chat with Gitlitz and get the details on his latest thinking. What follows is an edited transcript of our phone conversation from late-yesterday afternoon.

Q: What's your take on the consumer price report for September? The top-line measure of CPI fell, but CPI ex-food and energy advanced by 2.9% for the year through last month, the fastest pace since 1996.

A: The suggestion that somehow…there's nothing to worry about [regarding inflation] is off the mark.

Q: Why?

A: Because a 2.9% annual core inflation rate…can hardly be considered benign. The top end of the Fed's comfort zone [for core inflation] is 2.0%.

Q: We're way above the Fed's comfort zone.

A: That's right. I think it's likely to get worse before it gets better.

Q: Why?

A: Because the price pressures that are embedded in the system, as a result of the Fed being as easy as it's been for as long as it's been, are feeding through. Within the next year there's a very good chance that we'll be running something like a 3.5% core. And that's just based on what the Fed's already done. There's basically nothing they can do to reverse that. The only thing they can do is get to an equilibrium posture so that they don't continue to make it worse. And from everything we monitor, they're still not [at equilibrium]. So we think the Fed will be raising rates.

Q: You've been saying for some time that you think the bond market's been underestimating the future strength of the economy.

A: Yes. Bond yields are now running on the order of 25 basis points above where they bottomed out a few weeks ago. At that point the bond market was discounting two or more Fed rate cuts over the next year. Now they've cut that down to one or more. But I think even that's still going to end up being the wrong bet. Not only is the Fed not going to cut rates, I think it'll go back to hiking rates again sometime within the next several months.

Q: Where do you see Fed funds topping out in the current cycle?

A: Probably at something like 6%, maybe even higher, depending on how bad the data gets.

Q: To revisit a point you made, you're convinced that a future of higher core inflation is virtually a done deal. The Fed can't change that future because it's a byproduct of its "easy" monetary policy of recent years. Monetary policy, in other words, takes a long time to play out, and the monetary chickens are now coming home to roost.

A: Monetary policy works with long lags. Once it's there, once the Fed puts in the kind of inflationary impulses that's already embedded in the system, it's there. All you can do is wait for it to feed through the system and get to a point where you're not continuing to feed additional impulses into the system.

Q: How concerned are you that the housing market will continue to soften and perhaps trigger a recession?

A: I'm not concerned about that at all. I think it's a non-issue. The bond market's bet that housing was going to be a disaster that pulled down the rest of the economy. But that's not happening. And, frankly, I thought it was the wrong bet right from the start.

Q: Even though the yield curve is inverted? Traditionally, that's a sign that a recession is coming. What does the inverted yield curve say to you?

A: It says that there's a bond market bet that the economy's going to crater, and so the Fed's going to have to cut rates. But that isn't going to happen. We're going to see a steepening of the yield curve in the next several months.

Q: If the economy's growing and continues to remain strong, that makes it easier for the Fed to raise rates.

A: Yes. In the Fed's model, if the economy's growing more than they expect, they regard that as an inflation risk, and that adds to the pressure to raise rates again.

Q: On the other hand, if the economy weakens, the Fed will be in a bigger bind because it'll be tougher to raise rates under those conditions.

A: If the economy turns out to be weaker at the same time that inflation continues rising, that puts the Fed in a tough spot. Eventually, they're going to have to choose inflation as the problem to deal with. When push comes to shove, there's no way out for central banks on that issue. But I don't really think that's the way it's going to play out; I don't think the economy's going to weaken much going into the fourth quarter and into next year.

Q: What are the signs that support your prediction?

A: Well, there are very few signs that don't support it. Consumption is strong, investment is strong. I look carefully at indications of risk preference in the system. When you have signs that investors are willing to bear risk, it suggests that they see a pretty positive growth outlook. If they weren't positive on growth, they wouldn't be putting capital at risk, especially in high-risk instruments like junk bonds. All those signs tell me that growth expectations remain solid. When growth expectations are solid, it becomes a self-fulfilling prophecy because people do things to realize those expectations. They put capital at risk to reap the available return. That's what creates growth. All those things tell me that the economy is chugging along nicely.

Yes, you get a number here and there that's a little soft. But that doesn't tell me there's anything to worry about. We had an industrial production number earlier this week that was a little soft. But if you look beyond the headlines for that data, there's a lot of good stuff going on within the world of industrial production. The technology sector's growing at a very rapid pace. That's part and parcel of the risk-preference notion that when you see that kind of activity strengthening it means that people are putting capital at risk…and you have to have pretty good expected returns to justify the investment. That tells me that the basic foundations of this economy remain very healthy.

Q: So, in your view, there's no recession on the horizon.

A: The chance of a recession is nil based on what we see with current conditions and current indicators.

Posted by jp at 9:27 AM | Comments (10)

October 18, 2006

A TALE OF TWO PRICE INDICES

Today's update on consumer prices for September looks like a poster child for biopolar disorder.

On the one hand, top-line inflation is conspicuous in its absence. Consumer prices actually dropped last month, posting a sizable -0.5% loss for September. Monthly plummets of this magnitude are rare for CPI, with only a handful arriving in the past generation on a month-to-month basis. But while top line inflation has, for the moment, vanished, core inflation (which excludes the volatile food and energy sectors) shows every indication of staying put.

Core consumer prices rose 0.2% last month, matching the pace in the previous two months. More ominously, the annual rate of core prices edged up to 2.9% in September vs. the year-earlier month, up from 2.8% in August. In short, core inflation is now running at the highest annual rate since 1996, as the graph below shows.

STILL CLIMBING
Rolling 12-month % change in core CPI

Source: Bureau of Labor Statistics

The reason for the divergence between top-line and core prices is an energy story. The sharp correction in oil and gasoline prices last month dragged down the broad CPI index. Energy prices dropped a hefty -7.2% last month, a tumble that helped pare transportation prices by -4.1% in September.

Alas, this kind of relief is probably as ephemeral as political promises in an election year. Energy prices have suffered big corrections relative to past months, but at some point a price floor will be reached, and we're a lot closer to that floor today than we were a month or two back. Anything's possible in the 21st century, but $20-a-barrel-oil exists at the outer edge of possibilities.

The inflation problem, in other words, isn't going away. With core CPI continuing to inch higher, the Fed needs to prove that it can control price momentum. So far, that proof is lacking. Declining energy prices are no substitute for muscular monetary policy. For the moment, the distinction is lost on Mr. Market. But if core CPI continues to creep up in coming months, the markets will be forced to reprice risk.

The dilemma, of course, is that getting tough with inflation is risky at this point in the economic cycle. If the economy continues to slow, Bernanke and company will be faced with the thankless task of choosing between containing inflation and keeping the economy bubbling. It's been said that central banks can have both, simultaneously. The record, however, is mixed, at best.

Mr. Bernanke's big adventure has only just begun. The consensus believes that he'll be able to pull a monetary rabbit out of the hat. Giving him the benefit of the doubt has been easy of late, thanks to declining energy prices. When that support fades, as it soon will, the crowd is likely to become less forgiving. The clock is ticking.

Posted by jp at 9:29 AM | Comments (3)

October 17, 2006

LOOSE CHANGE

Are rare coins a good investment? It certainly looks that way if you consider the past 10 years of the PCGS 3000, a price benchmark for a variety of rare coins that's exploded skyward. But for newcomers, investing in rare coins can be tricky, not to mention dangerous to one's net worth. That's true of any asset class, and doubly so for rare coins and other collectibles. Nonetheless, the stellar returns in recent years have attracted growing interest in coins. In our "day job," we recently interviewed an expert on the subject. Robert Brown, chief investment officer of Genworth Financial, has studied rare coins as an asset class and written several papers on the subject. In the September issue of Wealth Manager, your editor asked him to share some of his findings. For the details, read on. To find the article ("Minting Money," Sep 2006), scroll down to the bottom of the WM archive page.

Posted by jp at 9:38 AM | Comments (0)

October 16, 2006

CARTEL TALK

Winter's coming and oil prices have been falling. That makes OPEC anxious. A quick remedy is an "emergency" meeting of the cartel's members, with a goal of hammering out an agreement on a production cut.

Easier said than done. Oh, sure, there'll be an announcement from the meeting in Qatar later this week. The message for consumption from the confab, which starts on Wednesday, will no doubt be a one-million-barrel-a-day reduction promised (threatened?) by various sources. Algerian Energy Minister Chehib Khelil yesterday said that OPEC will officially unveil such a cut. Meanwhile, Qatar Energy Minister Abdullah bin Hamad al-Attiyah said that OPEC will discuss "the possibility of reducing total oil output by one million barrels a day (b/d) to stop any further decline in prices."

So far, Mr. Market isn't overly impressed. The November crude futures contract in early New York trading today was largely unchanged from its Friday close of $58.57. That doesn't mean that OPEC won't be able to talk up the price this week, or even over the coming weeks and months. With the onset of winter buying, demand is likely to become increasingly robust.

That said, consensus is easier for cartels when prices are rising. It's a whole other ball game when selling dominates. Indeed, OPEC's history is more than a little blemished when it comes to keeping member promises intact on the matter of cutting production in the face of lower prices.

The challenge is hardly unique to OPEC. Human nature being what it is, profit maximizing actions invariably overshadow those that emphasize a group over the individual Adam Smith is always happy to explain the concept in more detail for those who're interested. Suffice to say, past experience suggests that maintaining quotas on new production cuts will be a bit like keeping water from following downhill.

Consider that Iran's reported share of a future one-million b/d cut for OPEC will amount to a decline of 140,000 b/d, according to TehranTimes.com. Embracing such a cut makes a price decline that much more difficult. Back in early September, oil was around $70 a barrel; today it's under $59, as we write. Assuming Iranian exports of 2.5 million b/d, the price decrease shaves $27.5 million a day. That's more than $190 million a week and $825 million a month--figures that are sure to catch the attention of even the most pious theocracy.

Agreeing to more financial pain--self-inflicted, no less--is the essence of a production cut. How much pain? Once again, let's run the numbers for some perspective. Returning again to Iran's 2.5 million b/d export machine, assume it agrees to pare that by 140,000 b/d. That's an addition revenue cut of $1.5 million a day, or a loss of nearly $11 million a week or $46 million a month.

In theory, the pain will be temporary because production cuts will boost price. But theory and practice don't always live a peaceful coexistence in OPEC. All it takes is one cagey member to play fast and loose with its lower production quota to convince the rest of the gang to squeeze a bit more cash flow out of the process by selling a tad more oil than the club officially allows. The incentive to cheat becomes that much stronger if prices continue to slip. And as more members cheat, the incentive for the rest to follow suit rises too. No self-respecting government wants to subsidize other nations by sticking to a production-cut agreement when everyone else is picking up a little extra cash on the side--especially if the economy that's sticking to the straight and narrow heavily depends on oil revenue to keep the masses happy. Not only is that bad economics, it looks foolish too, which goes over like a lead balloon in the image-conscious Middle East.

In addition, cheating has also been promoted by the internal politics of OPEC, otherwise known as the battle for market share, as detailed by WTRG Economics. The essential point: advancing one's self interest isn't easily engineered away, even in a cartel that has a substantial interest in doing just that.

Then again, perhaps things are different this time. Global excess oil-production capacity is at relatively low levels and the odds are slim that major new sources of supply are just around the corner. As such, relatively minor production cuts can have a fairly big impact on prices these days.

Nonetheless, fundamentals reign supreme in the long run. That is, supply and demand will trip up even the most disciplined cartel. Unfortunately for buyers, fundamentals work to OPEC's advantage in the years ahead. A cartel can't do much to circumvent market prices driven by bearish economic fundamentals, as the 1980s proved, but the same will prove true as fundamentals turn increasingly bullish going forward.

Simply put, oil prices are higher today than they were 10 years ago primarily because of market fundamentals rather than OPEC maneuverings.

In the short term, it's another story. If Mr. Market thinks oil prices should be $55, OPEC will have a tough time keeping a barrel at $70. But that won't stop the cartel from trying. Indeed, OPEC will issue press releases and court the media, while Mr. Market will do nothing. Manipulating perceptions is easy for a month or even a year for a cartel desperate to cloak itself in the image of power.
If you really want to know what's going on with oil prices, track the average annual price. Yes, it's been moving up, but the rise is no longer as quick as OPEC would prefer. In fact, it's reversed recently. The secular bull market in oil is alive and well, but it's recent pace can't be sustained indefinitely. Corrections are a fact of life, even for the world's most valuable commodity.

In the short run, anything's possible. That's what this week's meeting in Qatar is all about.

Posted by jp at 9:54 AM | Comments (0)

October 13, 2006

THE BIG GULP

Oil prices have been trading under $60 a barrel for much of October, the first time that the commodity's been that "cheap" since February. Some bulls say that the mid-$50 range represents a floor for the foreseeable future, while the bears say that even lower prices are coming.

But while the future for a barrel of crude is hotly debated, the past at least is crystal clear, and from that history we can draw some fairly basic conclusions. To wit, the fundamental drivers that have brought us to the present state of energy pricing remain intact, as the latest Energy Information Administration data suggest. With the publication earlier this week of EIA's Petroleum Supply Annual for 2005, the government has started finalizing its annual energy data for 2005, and the various trends embedded in those numbers look all too familiar and none too pretty.

As the chart below illustrates, which graphs EIA data with the newly dispensed 2005 numbers through the end of last year, not much has changed in the American economy when it comes to the big-picture analysis of oil when viewed from 10,000 feet. To summarize: domestic production keeps falling and domestic consumption keeps rising. Filling the gap is the old standby of imports, which continue to run higher.

Short-term analysis, by contrast, leaves room for hope. Quixotic hope, perhaps, but hope nonetheless. Consider the monthly data for 2006. Domestic production was up 7.5% in July 2006 vs. December 2005, while imports climbed just 2.1% over that span. Meanwhile, consumption slipped by more than 4% in July from the previous December.

In fact, a slowing economy will pare consumption every time. As such, if the slowdown has legs, overall consumption is likely to fall--temporarily. As the chart above reminds, temporary blips don't change the secular trend. Domestic oil production has been generally falling since the 1970s, and that's not likely to change. That's not to say that secular trends can't be redirected, subverted or even abolished, but it's highly unlikely that such a change will come by way of major discoveries on U.S. territory. Meanwhile, it'll take more than even a recession can muster to alter the basic facts of life for energy in these United States, which has is basically one of consume more, import more.

But the trend is starting to attract attention--even in Washington. President Bush is warning against energy complacency now that oil prices have fallen from all-time highs of late. "My worry is ... that a low price of gasoline will make us complacent about our future when it comes to energy, because I fully understand that energy is going to help determine whether or not this nation remains the economic leader in the world," he said yesterday. "We envision a day in which light and powerful batteries will become available in the marketplace so that you can drive the first 40 miles on electricity, on batteries, and your car won't have to look like a golf cart."

Such hopeful comments about alternative energy will inevitably be dismissed by some as just another instance of politicking. Maybe so, but sometimes reality intrudes even into the inner sanctum of politics.

Supply and demand, in short, will dictate the future when it comes to oil and energy in general. That future may not arrive next month, but it's coming, and we're pretty sure what it'll look like. Only the timing and magnitude of the transition is in doubt.

Posted by jp at 10:35 AM | Comments (0)

October 12, 2006

IN PRAISE OF VOLATILITY

Standard deviation is on the defensive these days as a valued risk measure. Although it's been a staple in modern portfolio theory and for quantifying risk generally by way of price volatility for securities and asset classes, there's a concerted effort of late to attack, diminish and otherwise banish the venerable metric.

A leading complaint is that standard deviation doesn't reflect the true risk that threatens investors. The woman investing for retirement 20 years on faces a variety of risks, starting with the possibility that she will spend all of her savings before dying. Standard deviation, as a result, is of no consequence to someone trying to avoid outliving her savings.

There are technical complaints as well. The basic calculation of standard deviation assumes a normal distribution. Normal distributions work great in physics and general statistics, but are flawed when it comes to picking up the tendency of investment returns to suffer distributions that are less than normal. The so-called fat tails distribution forever haunts the world of investing, a risk that effectively means that dramatic events can and do happen every once in a while, and that risk isn't captured in a normal distribution world that defines the basic concept of standard deviation.

True enough. Standard deviation isn't a real-world risk in saving for retirement, and it doesn't fully reflect what happens in the capital markets in terms of how returns are distributed around the mean. But after accepting the wisdom of the observation, the analysis shouldn't end there. Standard deviation, or the volatility of prices around the mean, still offers a reasonably valuable tool for comparing one type of risk (although hardly the only type) among various asset classes. It's less than perfect; in fact it's flawed. But it's still useful for getting a general sense of the risks that loom.

Should investors use standard deviation exclusively and ignore all other measures and definitions of risk? Absolutely not. But neither should one dispose of standard deviation simply by recognizing that the metric can't be all things to all investors at all times. If that's the bar by which risk measures must reach, then nothing would suffice. Something, we submit, is better than nothing. In fact, the imperfections of the real world demand that we use a collection of flawed risk measures to piece together an outline of the overall risk that looms.

Here now begins our admittedly underdog attempt at defending and, perhaps, partially restoring standard deviation's once-good name in the world of risk analytics. The effort consists of simply showing that price volatility, while flawed, is nonetheless valuable still for assessing the nature of a particular asset class relative to another.

Exhibit A is the table below, which ranks the major asset classes by their respective 3-year annualized standard deviation, based on monthly total returns through last month. Note that the asset classes that rank highest in volatility are indeed, by most accounts, the riskier of the bunch. Meanwhile, those at the bottom, including cash, are the least risky by this measure.

To restate the obvious, there's a world of difference with the low risk of cash to the high risk of emerging market stocks. High risk isn't inherently bad, nor is low risk inherently good. In fact, mixing risks together with a strategic purpose is the only way to fly. But we digress.

The pairing of standard deviation against trailing 3-year annualized total return shows that the relationship between the two is eminently logical. Consider the graph below, which plots the trailing 3-year returns for each of the asset classes listed above against their respective standard deviation. The key revelation is that returns generally rise along with risk, even when the risk is measured as standard deviation. There is no free lunch, as the graph reminds. This iron law of the investment universe is sometimes thrown out of whack in the short run, but as a long-term proposition it's virtually impervious to change.

Obviously, standard deviation is only one risk measure in an ever-expanding sea of competing metrics, both quantitative and qualitative. No single measure fully encompasses the concept of "risk" in all its nuance and variety. An accurate profile of the risk that inhabits the investment landscape requires more than crunching the numbers by any one gauge.

But for our money, we begin with standard deviation, and do so regularly. Price volatility, after all, ebbs and flows, just as returns do. The ongoing shifting sands of return and risk warrant keeping a close eye on the relationship between the two. The moral of the story: Enlightenment in the investment game comes one metric at a time.

Posted by jp at 10:31 AM | Comments (7)

October 11, 2006

FAITH & COMFORT MEET LOCKED & LOADED

Federal Reserve Bank of Dallas President Richard Fisher thinks inflation is "too high." Nonetheless, he's "comfortable" with the current Fed funds rate, he said yesterday at a conference. But he noted too that the Fed is prepared to hike rates if the central bank's strategy doesn't show results in paring the upward move in inflation of late.

This strategy includes expecting that a slowing economy will take the edge off of inflationary momentum (a notion that monetarists dispute). Still, Fed Chairman Ben Bernanke has said as much, and Fisher reiterated the notion yesterday. Of course, nothing is perfect when it comes to monetary policy, and the risk of error is always lurking.

Since the Fed's birth in 1913, the institution has made more than a few mistakes in misjudging inflation and its capacity for circumventing the best-laid plans of central bankers. But the bad old days are gone, we're told; the Fed is a far-more enlightened entity in the 21st century.

Let's hope so, as the stakes aren't getting any smaller, at least not yet. As last month's World Economic Outlook from the IMF reminds, it's not yet clear that inflation has lost its penchant for rising, albeit from unusually low levels from a few years back.

Consider two charts from the IMF report, republished below. The first one reminds that while inflation overall is still low relative to the past 20 years, by 21st century standards pricing pressure is moving up. Labor costs are beginning to move upward too. Will the combination force the Fed to begin raising rates again? Perhaps. It all depends on the data, of course.

Source: IMF World Economic Outlook, Sep 2006

In fact, Fisher reminded that while the housing market is cooling, the rest of the economy appears to be doing just fine. "With a decline in housing market activity, you will dent but not destroy consumer confidence," he said, via The Wall Street Journal. "I don't think it will lead to a recession." For those who subscribe to the Fed's belief that a slowing economy will nip inflation in the bud, Fisher's outlook raises questions about the future for monetary policy.

In any case, bond traders have started rethinking (again) the yield on the benchmark 10-year Treasury. Selling in the last two trading sessions has boosted the 10-year's yield to around 4.75% at yesterday's close, up from last Thursday's 4.57%.

But if there's any fear of another rate hike at the next FOMC meeting on October 24/25, it's not showing up in Fed funds futures. Trading in the November contract remains placid, anticipating Fed funds will remain unchanged at 5.25% at the monetary confab later this month.

Overall, optimism and tranquility reign supreme on the monetary front. Even stock market volatility, measured by the VIX, is near its lowest levels of recent years. Betting on whether the serenity continues or not is the great wager du jour. Speaking of which, what's the old saw about the calm before the storm?

Posted by jp at 8:36 AM | Comments (0)

October 10, 2006

CONSUMER SPENDING WILL CONTINUE TO FLUCTUATE

Jim Cramer, writing in an op-ed in yesterday's Wall Street Journal, disparaged the notion that there was anything to fear when it comes to the outlook for consumer spending.

"In 25 years of trading stocks," Cramer wrote, "I've read the consumer's obituary more times than I care to imagine; each time the facts have proven the obit premature." He went on to explain, "We are seeing numbers from the major retailers -- both high-end and low, mass and teen -- so strong that the consumer is not only not dead, but he's at the peak of health."

There is no question that Joe and his counterparts across the country are as intent on spending as ever, or so it seems. And while we agree with Cramer that the consumer isn't dead, that doesn't mean there are no worries regarding Joe's spendthrift ways. Indeed, Cramer failed to mention that consumer spending, while it may be eternal, does suffer cycles. Joe's spending habits, in other words, wax and wane, and the resulting impact on the economy is more than trivial.

History tells the story. Inflation-adjusted personal consumption expenditures (PCE) in the first quarter of 1991, for instance, dropped by 0.4% from the year-earlier level, according to data from the Bureau of Economic Analysis. It's no accident that the decline accompanied a recession at the time. First-quarter GDP in 1991 was off 1% from a year earlier.

A recovery ensued, and by the late-1990s the PCE in some quarters was advancing at 5% or more over the year-earlier quarter. Again, no one should be surprised to learn that the return of relatively robust spending paralleled an extraordinary period of economic boom.

PCE's pace has been more middling of late, compared with the highs of the late-1990s. Still, the 3% jump in PCE in this year's second quarter over the same period in 2005 is nothing to sneeze at.

The point is that while consumer spending is alive and well for the moment, its level and rate of change isn't written in stone. As the chart below details, the pace of growth in consumer spending continues to fluctuate. And that is the real issue. The reason: consumer spending drives the economy. As a result, a slowdown in consumer spending to, say, 1% in future quarters relative to year-earlier levels may trigger a sharp slowdown in GDP growth, perhaps even bringing recession. And as the chart suggests, such a future isn't exactly beyond the pale.

Yes, we can all agree that the consumer isn't dead, nor is he likely to expire anytime soon, if ever. But that's a false topic of discussion.

Posted by jp at 10:09 PM | Comments (0)

October 9, 2006

HE'S B-A-A-A-C-K

Kim Jong Il is among the world's most reclusive leaders, but he knows how to send a loud calling card.

The latest example came packaged in yesterday's underground nuclear test, which North Korea announced on Sunday. The political reverberations came quick. "We expect the U.N. Security Council to take immediate actions to respond to this unprovoked act," White House spokesman Tony Snow said. The new Japanese prime minister, Shinzo Abe, while in South Korea, declared "...that if North Korea's nuclear test is confirmed, it would be a grave threat not only to Japan and South Korea and neighboring countries, but to international peace and security."

While the world struggles with what to do next, there's a report this morning that the chief of South Korea's intelligence agency told lawmakers on Monday that Kim's North Korea might unleash a second nuclear test.

As we write this morning, it's too early to know how the markets will react, but we have our suspicions. Predictably, South Korean stocks dropped on the news while gold and oil prices jumped.

Market reaction, in fact, may continue for days and weeks. For starters, we would expect that when the bond market reopens tomorrow (it's closed today in the U.S. for the Columbus Day holiday), a burst of fresh demand for the safety of Treasuries will push yields lower once more. Meanwhile, news from the Korean peninsula probably won't do much to drive up the price of U.S. stocks any time soon.

Volatility, in sum, looks set for a rebound in several asset classes, courtesy of Kim's big adventure in splitting atoms. It's likely that the volatility won't last, however. Mr. Market has become increasingly comfortable in learning to live with heightened risk in the global economy. That's not to say that a crisis-induced selloff isn't possible, although it's less likely these days. Nonetheless, for the long-term strategic investor, volatility is good, even if it's short-lived. The reason: volatility can deliver some temporary bargains.

Indeed, history shows that when the world gets nervous, spreads widen and riskier assets are disposed of with haste. It's too early to say if a similar scenario awaits this time around, but we'll be watching in case fresh opportunity avails itself. Cash is burning a hole in our pocket, as it has been for some time now. But while we're not ready to part with a heavy overweight in the asset class just yet, we're mindful that at some point a substantial rebalancing is necessary to fend off the performance drag that cash invariably delivers over time. Timing, of course, is the great variable that weighs on our decision, and that in turn will be driven by valuations, trailing returns and a number of other variables.

But let's not minimize the challenge of finding value. As the table below reminds, screaming buys are an endangered species. Everything has rallied to one degree or another, and so nothing looks particularly compelling. Take note that negative returns are listed in red, and on that front there are only two instances, and both are in commodities, and both are of recent vintage. Of course, given today's news, along with reports of OPEC's efforts to reverse the drop in oil prices of late by paring output, the commodities-related red ink may soon turn black once again.

In which case, where will red numbers be most likely to appear next on our table? Inquiring, opportunistic and strategic-minded investors want to know.

Posted by jp at 9:16 AM | Comments (1)

October 6, 2006

OUCH! THE LABOR MARKET TAKES A HIT

Yesterday we said we were impressed by the labor market's ability to hold up relatively well against what some said was an approaching recession. What a difference a day makes! Today, we're far less impressed. In fact, we're surprised by the sharp downturn in job creation last month. Score one more for those who think the Fed will soon begin cutting interest rates.

Meanwhile, we can ponder the implications of September's meager rise of 51,000 in nonfarm payrolls. A lesser number on this front hasn't been seen since October 2005's 37,000 advance. Of course, one could write off the previous dip as the extraordinary fallout from Katrina, which temporarily threw the labor market off its stride in September and October of last year. Indeed, the slide was more than reversed in November 2005, when nonfarm payrolls soared by 354,000, followed by a string of lesser but still robust months of job creation.

Alas, that kind of rebound from last month's dip looks remote this time. With the real estate market cooling and a number of other economic metrics softening, job creation is now taking it on the chin.

The sectors of the economy that posted outright declines in jobs were in the cyclical corners of goods producing, manufacturing and retail, collectively shedding 42,000 positions last month. As usual, the service portion of the economy came to the rescue by delivering the lion's share of the gains: a total of 62,000, although that's a bit thin by the service sector's standards.

The other bit of encouraging news in today's employment report is that August's payrolls rose by 188,000, up significantly from the initial estimate of 128,000. Meanwhile, the national unemployment rate fell to 4.6% in September from August's 4.7%. The implication: jobs are still growing faster than the population, wrote Charles Dumas of Lombard Street Research in a note to clients today.

There's also some technical number-crunching going on related to so-called benchmark revisions. Reportedly, the annual revision will be unusually large, perhaps giving a new bullish aura to the past profile of job creation.

Hope springs eternal, even if it's technical in nature. These days, the stock market bulls aren't picky about where they get their inspiration. Regardless, it's all about the future now, and the trend of slowdown increasingly looks baked into the economic cake. The bond market will cheer, as it has been doing for months. Until and if some new report changes the perception, we think we know what we'll be getting for Christmas.

The key questions now: How can the stock market maintain its cheery outlook in the wake of this morning's news? Also, now that the slowdown looks closer to fact rather than speculation, will it produce what the Fed desperately needs: a commensurate slowdown in core inflation?

Posted by jp at 9:13 AM | Comments (3)

WM ARCHIVE UPDATE

Today's addition to the WM library is an interview with Ross Miller, a professor of finance at the State University of New York at Albany and president of Miller Risk Advisors. In our chat, he discusses his active expense ratio with your editor in the October issue of Wealth Manager. Miller designed the quantitative measure to shine a light on the true cost of active management. As he sees it, his gauge offers much improvement over the gross expense ratio that's typically used for comparing costs among mutual funds. The metric's details are outlined in his original working paper, “Active Expense Ratios and Active Alphas,” which is available via a link on his web site and is forthcoming in the Journal of Investment Management.

Posted by jp at 7:39 AM | Comments (0)

October 5, 2006

BULLISH, BEARISH AND A LITTLE IN BETWEEN

No one needs reminding that the housing market is softening; the data are doing just fine with that task, thank you very much. Nonetheless, Fed Chairman Ben Bernanke yesterday decided that the masses needed reminding, and he made his point clearly. Whether it was a productive point is debatable.

This much, at least, is clear, Bernanke told us: the housing market is now in "substantial correction," and the result will be a drop in U.S. economic growth by around one percentage point in the second half of this year, reported USA Today. The effect will "probably" linger next year, taking a toll on growth in 2007, he added.

The message was clear enough. Or, so one might think. In fact, nothing's what it seems these days when it comes to reading the economic tea leaves of numbers and commentary.

Equity traders listened to Bernanke speak and found reason to buy, driving stocks up. The S&P 500 delivered a robust 1.2% gain yesterday, one of its better days in recent memory. The bond market, meanwhile, was inspired to again drive the yield on the 10-year Treasury lower, to 4.565% by the close.

The fixed-income set heard Bernanke and took the hint by deciding that another rate hike looks unlikely. Holding Fed funds steady seems the path of least resistance for the moment, although some are talking about the prospect of a rate cut in the near future. All of which stirred bond traders to buy, and thereby lower the 10-year's yield.

The stock market too found reason to cheer at the notion that the odds of another rate hike further receded into the financial woodwork. And, yes, chatter about a rate cut was present in the equity realm too, producing a giddy session yesterday that stirred some to visions of financial sugar plums.

In sum, the stock market offers a crisp counterpoint to the bond market. The former thinks the future economic scenario will favor equities, which is to say, growth. The bond market begs to differ. How long can this go on? Perhaps longer than reasonable minds think possible.

In the meantime, Bernanke's outlook for a slowing economy is complicated by the fact that inflation remains higher than the Fed would prefer. Indeed, Bernanke said as much yesterday, explaining that inflation remains "above what we would consider price stability."

Everywhere, it seems, there is a dualism, offering this on one hand, and that on the other. On Monday, we learned that construction spending last month bounced back unexpectedly. On the same day, however, news broke that manufacturing's pace of growth continued to slow. The tea leaves turned even more ambiguous yesterday with the report that orders for manufactured goods in August were flat.

Meanwhile, this morning we learned that the labor market continues to hold up rather impressively. The number of people filing for new jobless claims fell to 302,000 last week--the lowest since July, and 20% below the year-earlier tally.

The data's telling us many things, but that's not making the job of predicting what comes next any easier.

Posted by jp at 9:36 AM | Comments (3)

October 4, 2006

AN OLD INDEX MAKES A NEW HIGH

It's widely quoted, represents the face of the stock market to the masses, and closed at a new all-time high yesterday. But that doesn't change the fact that the Dow Jones Industrial Average, for all its storied history, is irrelevant.

The observation is unchanged by yesterday's news that it eclipsed its old high of 11,722.98 set on January 14, 2000 by settling at 11,727.34. Yes, the Dow makes for interesting copy in the newspapers, as a review of the media today reveals. Nonetheless, the hoopla is misplaced. Indeed, the Dow's ascent into record territory stands alone today among the broad measures of U.S. stocks. Notably, the S&P 500 and the Russell 3000 remain well below their peaks of early 2000.

Ditto for the Nasdaq Composite, the fallen poster boy for tech stocks. In fact, a new high for the Nasdaq may have a long, long wait. Breaching the 5000 level briefly in March 2000, the Nasdaq is still more than 50% below that ancient summit.

The S&P 500 and Russell 3000 are much closer to their previous crests. Nonetheless, equities would have to rally long and hard from here to deliver a new high in these indices, both of which command far more respect and money in the institutional investor community than the Dow. In fact, no one in their right mind would consider using the Dow Industrials as the basis for an index fund for serious money, which is why there's precious little money attached to the benchmark compared to the alternatives.

The value of the Dow, if one can call it that, is mainly that of an antique curiosity. The world's first stock index, the Dow Industrials trace a history back to 1884, when Charles Dow began publishing a measure of market activity in the "Customer's Afternoon Letter," the forerunner to what would become The Wall Street Journal. In the 19th century, the limitations of technology demanded a relatively simple methodology for sampling equity price changes writ large. The Dow, as a result, is today a prisoner of those archaic confines.

The modern Dow Industrials is the world's most recognized stock index, but the benchmark exists by virtue of its lengthy history as opposed to any compelling relevance. Looking at the Dow is like peering back into time. This, dear readers, is an index that is bottled in a methodological formaldehyde, preserved for the ages for no particular reason beyond the fact that it's been around longer than its competitors. Even Dow Jones & Co., which owns the index, has long since recognized the obvious by publishing a modern suite of benchmarks of relevance.

Yet for all its flaws, we still have a warm spot for this old index, which conjures a time of researching the market by poring over the evening newspaper and breaking out graph paper to mark the latest high, low and closing price of the day's market action. And so, like many investors, we still keep an eye on our old friend, respectful of its past and mindful of its irrelevance for deploying capital in the 21st century.

First among those flaws is the fact that the Dow represents a mere 30 stocks. Yes, those are blue chip stocks, as they say, but the 30 are too few to represent the mass of equity that is the American stock market. In fact, it's worth pointing out that only 10 of the 30 Dow stocks hit new highs yesterday.

Adding insult to injury, the calculation method behind the Dow is hopelessly convoluted, a vestige of trying to maintain its original simplicity as a simple average after decades of dividend payouts, mergers, stock splits, and random membership changes by the editors of The Wall Street Journal, which decides who's in and who's out.

To be sure, the S&P 500, the Russell 3000 have their own flaws. But the difference is that the Dow's flaws are fatal while the S&P and Russell's flaws are relatively minor. At least, that's the conclusion based on investors who vote with real money. Nonetheless, some argue that the market-cap thinking that informs the calculation of the S&P and Russell 3000 is in need of change. A number of alternatives are now available, including an ETF that's an equal-weighted version of the S&P 500: Rydex S&P Equal Weight ETF (AMEX: RSP); and a fundamentally weighted ETF: PowerShares FTSE RAFI US 1000 (NYSE: PRF).

Then again, for those who revel in the old days, there's always the option of buying the Dow, which is available as an ETF: Diamonds Trust (AMEX: DIA). Indeed, given the Dow's relative outperformance, the old index may be facing a renaissance of renewed interest. And for the moment, what's not to like? The elderly benchmark is showing up its younger rivals with superior performance. But for those looking for a representative sample of U.S. equities, it's best to look elsewhere.

We love the Dow, and all it represents. But just don't ask us to invest in it.

Posted by jp at 9:55 AM | Comments (1)

October 3, 2006

YOUR EDITOR'S "DAY JOB"

Today's shocking disclosure: your editor leads a double life. To be precise, I have a "day job," and one that affords me the title of senior writer at Wealth Manager, a monthly magazine for independent financial advisors with high-net-worth clients. As each new issue of WM hits the street, you'll find a notice in this space and a link to the newly updated archive of my articles for the publication. In addition, there's a permanent link to WM stories by yours truly in the upper left-hand corner of The Capital Spectator. The debut story posted in the newly minted archive is a profile of a new mutual fund that looks a lot like an investable hedge fund index. The article appears in the October issue of Wealth Manager. For the details, read on....

Posted by jp at 10:47 AM | Comments (0)

October 2, 2006

TIMING & MAGNITUDE

The head of the self-proclaimed "authority on bonds" says the rate hikes are history. PIMCO's Bill Gross wrote in his October Investment Outlook that "the Fed is done and ultimately will have to lower interest rates in order to restimulate an asset based/housing led economy that has been its primary growth hormone in recent years."

The underlying assumption in his projection is that inflation is "leveling off" and the economic growth rate is "moving towards a 2% real growth rate or less in the next year or so...." As such, the Fed "at some point in 2007 will be forced to cut short rates." Timing and magnitude are yet to be determined, he adds.

In fact, the future may be more complicated than it appears. Economist Robert Dieli of NoSpinForecast.com documents the finer points of this complexity by plotting the history of economic cycles against instances of inverted yield curves. As he illustrates in the chart below (which, alas, we've squeezed a bit from the original to fit into the confines of CS), there's a lengthy history of yield-curve inversions accompanying economic contractions and a drop in the Fed funds rate shortly after the yield inversions arrived. But that doesn't mean the past is prologue, at least not a prologue that's clear and obvious.

Federal Funds Rate. Red Squares Denote Periods when the Fed Funds
Rate was Higher than the Long Treasury

Source: NoSpinForecast.com

In any case, the last example of rate hikes and recession came early in the 21st century, identified on the above chart by "11." The red dots indicate moments when Fed funds were higher than the Long Treasury, defined here as the 20-year Treasury. As Dieli noted in the accompanying research report, "There are no cases of a yield curve inversion ending without a drop in the Fed Funds rate from the peak level attained in each episode."

(As a quick digression, the two red dots between episodes 10 and 11 were, Dieli told us this morning, were byproducts of the anomalous events associated with the implosion of Long Term Capital Management and the Treasury's decision to stop selling the 30-year.)

Ah, but what about episodes 8 and 10? Note that the Fed funds took flight in each of those cases without a commensurate yield-curve inversion, suggesting, if nothing else, that sometimes the central bank achieves something close to perfection in monetary policy. Indeed, in 8 and 10, long rates took wing but without triggering a yield curve inversion or recession.

Episode 10 is near and dear to investors' hearts. The moment came in 1994, when then-Fed Chairman Alan Greenspan elevated rates and delivered the much-sought-after but rarely delivered soft landing by way of higher rates sans recession. It was, in sum, one of Greenspan's finer moments. As Dieli wrote, "In episodes 8 and 10, the two successes, the yield curve did not invert, which allowed the FOMC to lower rates to complete the implementation of a policy accommodative of further noninflationary growth, thereby burnishing the reputations of Chairman Volker and Chairman Greenspan."

We are now firmly in the world of Episode 12, which admittedly has yet to fully play out. While the world guesses what comes next, there is at least one absolute to consider: the yield curve inversion. Fed funds today are 5.25% and the 10-year Treasury yield resides at a materially lower level of 4.63%, as of Friday's close. Beyond that, clarity necessarily blurs.

Dieli worries that episode 12 may become episode 3, which, as the chart shows, was a moment when the Fed had apparently engineered a soft landing. In fact, the early signals were misleading. The central bank hadn't tightened enough to battle inflation, and so was forced to reverse course soon after by raising rates once again, which led to a recession.

The issue, as Dieli sees it, is that the bond market has no fear of death at the moment. "I can't imagine the bond market feels any particular threat in holding long positions," he tells CS today. The problem for Bernanke and company boils down to answering this question, as put forth by Dieli: "How do you convince the bond market that you're done without starting a recession?" The history of the past 20 years suggests that bringing down the core rate of inflation requires a recession. Will that history hold? Or is something new and relatively unprecedented waiting in the wings? The incentive for answering "yes" typically comes from looking to globalization and its accompanying byproduct: disinflation/deflation argument.

In any case, the final answer may not be imminent, but it's coming. The only question is timing and magnitude.

Posted by jp at 8:43 AM | Comments (2)