November 30, 2006
WAITING FOR A BLINK
Consumers elevated spending last month, the Bureau of Economic Analysis reported this morning. But a closer look at the numbers suggests that there's still reason to fear for 2007's economic performance.
Let's start with October's rise in personal consumption expenditures (PCE). Yes, it inched up by 0.2% over September, but the performance was at the low end for monthly reports this year. In fact, revised data show that the initial report of September's PCE 0.1% advance has evaporated, turning into a 0.2% decline. The month before, August, offered the slimmest of increases at just 0.1%. Perhaps the most distressing news in the revised data is that nondurable goods spending dropped for the second month in a row in October. Nor does it boost one's optimism to learn that initial claims for unemployment benefits jumped to a 14-month high of 357,000 last week, the Labor Department advised today.
Stepping back and looking at the trend, as per our chart below, it's clear that Joe Sixpack is rethinking his former appetite for spending. Yes, the pause may be temporary. In fact, we're sure it's temporary. Alas, we just don't know when Joe will return to form. And neither does anybody else. At this stage in the economic cycle, when worries over continued real estate fallout and other items lurks, a slowdown in consumer spending in the months ahead could take a toll on investor sentiment.
What's clear now, today, this minute is that there's reason to wonder about the near term. This, ladies and gentlemen, is what's known as a transition. To wit: if an economic transition arrives, does it make an impact?
Apparently not, at least from the stock market's perspective. Measured by the S&P 500, the theme is onward and upward. Yes, there was a distracting correction last Friday that spilled over to Monday. But since Tuesday, the bulls have returned and are intent on pushing on to new highs. Momentum may not always be enlightened, but it's a force that isn't easily dismissed either.
The bond market, meanwhile, is quietly placing bets that the pause has legs. Momentum, in other words, is alive and kicking in fixed-income trading. Bulls are keeping the yield on the benchmark 10-year Treasury at just above 4.5%, the lowest since February.
Sooner or later, either stocks or bonds will blink, and we think we know which one. But we're not sure. Diversification has never looked more comforting.
November 29, 2006
FASTER GROWTH, LESS FILLING
The economy grew faster in the third quarter than initially estimated, the Bureau of Economic Analysis reported today. Higher is better, although yesterday's anxieties about the economic outlook continue to plague.
Arguably, those anxieties should have marginally lessened on the news that GDP rose by 2.2% during July through September, higher than the 1.6% initially estimated. The source of the upward revision was a combination of a downward estimate of imports and a hike in calculations of private inventory management and personal consumption expenditures.
That's all well and good, but it doesn't change the strategic issue of: what's up for 2007? Indeed, the economy grew faster in the third quarter, but the 2.2% pace was still slower than the second quarter's 2.6%, which in turn was much slower than the first quarter's 5.6%.
The trend, to cut to the chase, remains intact: the economy's slowing. To reiterate the obvious: how much it slows, for how long, and if it leads to an outright contraction are the great questions. Next year is likely to dispense an answer, and by this time in 2007 (if not sooner) we'll all have something meatier to chew on in terms of a definitive answer. Getting from here to there, of course, is the challenge and the peril.
That issue, in fact, was front and center this morning at a press conference in New York, hosted by Deutsche Bank's private wealth management division. Your editor was in attendance, and among the comments that caught our attention was the intention in the near term for "taking risk out of portfolios rather than putting it in."
So said Ben Pace, Deutsche Bank's U.S. chief investment officer. Among the potential trouble spots, he explained: the ongoing correction in the housing market. Yes, some have said the worst is behind us, he admitted. But Pace isn't yet convinced, warning that there could yet be an impact on consumer spending from the deflating housing market.
Yesterday's report on existing home sales for October offers a reason for staying wary, he pointed out. Although much attention (including ours) yesterday was given to the fact that the number of houses sold last month inched higher for the first time since February, the reason for the boost in units sold is less than encouraging. Pace noted the average price of homes sold was 3.5% lower in October vs. a year earlier. That's the third straight year-over-year decline and the largest in the 38-year history of the data series. So, yes, lower prices tend to move product, but deciding if it's not necessarily a thing to cheer about, at least not yet.
Another speaker, Klaus Martini, global chief investment officer for DB's wealth management division, pointed to another factor that gives pause: low yield spreads. "If economic growth turns down," he opined, "spreads will widen." Given the low spreads of late, that risk has convinced Martini to steer clear of high-yield bonds completely in client asset allocations at the moment.
To be fair, Martini and Pace also spoke of the positives as they see it. That includes a bullish outlook on emerging markets and a prediction that inflation will remain contained. Considering the latter, Fed Chairman Bernanke yesterday said he too was still concerned about inflation. Meanwhile, the DB team today said inflation has been tamed, in part because of the disinflationary winds blowing from low-cost products from China and elsewhere. So while a rate hike or two may be coming early next year, the DB team sees Fed funds somewhere in the 4.50% neighborhood by the end of 2007, which would amount to a 75-basis-point cut from current levels.
Of course, the tricky part of projecting inflation may turn heavily on where U.S. economic productivity goes from here. For the moment, productivity appears to be slipping. That's no trivial trend, since rising productivity of recent vintage has generally been considered one of the key factors putting a lid on inflation. As one journalist at the DB meeting reminded, productivity gains in the past have been largely a byproduct of large inputs of new technology. Will new technology inputs in the future suffice to keep productivity bubbling?
Questions, questions, questions, and all without fully satisfying answers at the moment. Perhaps then there's no mystery as to why Deutsche Bank's private wealth management team is focused on educating its high-net-worth clients about the merits of asset allocation strategies that go beyond the typical stocks/bonds/cash. Private equity, hedge funds, commodities, real estate, and so on are all the rage these days among forward-looking investors who think strategically. It's a different world, the DB folk emphasized, and that requires thinking differently when it comes to designing portfolios. Perhaps that's the only bit of advice that's not subject to data revisions.
November 28, 2006
THIS OR THAT, UP OR DOWN, & ALL AROUND
Optimists say that yesterday's sharp selloff in the stock market was merely a healthy bout of profit taking. Perhaps, although this morning's durable goods report for October offers a fresh dose of caution about the economy.
New orders for durable goods fell 8.3% last month from September, according to the Census Bureau. One has to go back to 2000 to see monthly declines of that magnitude. The year-over-year comparison isn't that encouraging either. October's new orders rose just 2.3% over the previous 12 months--the slowest annual pace this year.
But the news wasn't all bad in the latest batch of number updates. The National Association of Realtors reports that existing home sales last month rose from the previous month for the first time February. Yes, even a dead cat has to bounce, as the saying goes. But can this kitty also start walking again? Never say never. Indeed, total existing-home sales – including single-family, townhomes, condominiums and co-ops – rose 0.5% last month over September, NAR's press release advised.
A rise of any degree comes as a welcome change from the relentless declines in recent months. Before anyone gets too excited, it's important to note that October's new home sales were still down a hefty 11.5% from a year earlier. Nonetheless, those who think the worst is past in the real estate correction can point to today's existing home sales for support. NAR's chief economist, David Lereah did just that, offering a ray of cautious optimism by opining:
The present level of home sales demonstrates some confidence in the market, but sales are lower than sustainable due to psychological factors. The demographics of our growing population, historically low and declining mortgage interest rates, and healthy job creation mean the wherewithal is there to buy homes in most of the country, but many buyers remain on the sidelines. After a period of price adjustment, we’ll see more confidence in the market and a lift to home sales should be apparent in the first quarter of 2007.
Then again, a stabilizing housing market doesn't necessarily translate into a booming economy. Risk is still very much in the air at the moment, as suggested by the latest OECD forecast, which calls for a “mild and short-lived weakening" in the world economy in 2007. Adding to the odds of a slowdown for the United States, the OECD noted, is the task of bringing core inflation down to 2.0% from the current 2.8%, which "may require maintaining the current restrictive stance for some time."
Translated: don't hold your breath for an interest rate cut at the Fed's next FOMC meeting next month. Fed funds futures traders certainly aren't: the January '07 contract is priced in anticipation of holding Fed funds steady at the current 5.25%.
The outlook may suggest that it's too close to call for what happens to economic growth or interest rates, but sitting on the fence just won't do for the bond market. Indeed, the fixed-income set continues to exude confidence that slower growth, or worse is coming and that inflation won't be a problem. A tall order, but one that the bond market is inclined to predict.
Indeed, the yield on the benchmark 10-year Treasury has slipped below it's previous, intraday low of 4.53% set back on September 25. As we write, the 10 year trades at 4.52%--the lowest in more than a year.
Alas, growth isn't slow or strong enough to skew the odds heavily in one direction or the next. Diversification across asset classes, as a result, has never looked so good in concept, and felt so vulnerable based on valuation and trailing performance. Cash may still be your only friend if you're planning on picking up bargains in 2007. But for the bond bulls, there's no time like the present.
November 27, 2006
LET THE GOOD TIMES ROLL
Stocks are up, bonds are up. Hey, it doesn't take a brain surgeon to see that 2006 is shaping up to be a pretty good year for investors. But how good is good? And what does it mean for the future?
In pursuit of an answer, or at least some perspective, we crunched the numbers and found that the past three years aren't all that extraordinary when compared with equity performance history over the past generation. Compare the results for yourself:
The S&P 500's total return this year is 14.1% through November 24, and the index's three-year annualized performance is 12.0%. In both cases, that's above the long-run average of about 10%. Does the recent run therefore offer a reason to worry? Has the market overextended itself?
Not necessarily, at least not based solely on the historical context. Looking at rolling three-year total returns for the S&P 500 through the end of October 2006 (courtesy of Morningstar's Principia software), the latest 36-month stretch looks middling. For the three years through October 31, the S&P 500 advanced by 11.4% a year. Not bad, although it pales by the best trailing 36-month run through July 1987, which posted an astounding 33.3% annualized gain.
Looking at the opposite extreme, the three years through March 2003 rank as the greatest bloodletting since 1979, with the S&P 500 shedding an annualized 16.1%.
Based on those extremes, the S&P's performance of late looks fairly unspectacular. Of course, statistics will tell you anything you want. With that in mind, the question is whether the recent gain looks encouraging based on the future rather than the past? By that standard, the analysis becomes more complicated.
Consider earnings and valuation. First, the rate of earnings growth for the S&P 500: it's been stellar of late, rising 10%-15% in each of the past six quarters through this past June, according to an article in yesterday's New York Times that cites Thomson Financial data. Even better: the S&P in this year's third quarter is expected to post a nearly 20% rise--which would be the highest in nearly two year. But the party downshifts considerably thereafter: the outlook calls for a sharp slowdown in earnings growth as 2007 unfolds.
As for valuation, the S&P 500's p/e is around 17, which is the lowest in years, according BullandBearWise.com. A bargain? Yes, based on recent history.
But it's the future that counts. History is a guide, and as we see it a poor one at the moment. Looking to the recent past has rarely offered less insight about what comes next, in our view. Economic, financial and political upheaval is everywhere these days, although you wouldn't know it by looking to Mr. Market, who appears relatively calm and comforted. That will change, perhaps soon. Meanwhile, our over weighted cash allocation continues to burn a hole in our pocket. No matter: we can stand to blaze a bit longer.
November 22, 2006
TAKING A LITTLE TURKEY TIME
Your editor has flown the coop for an extended gobbler's holiday. After a brief respite, laden with turkey-related gastronomic recreation, we'll return to the scene of the rhetorical crime on Monday, November 27. In the meantime, Happy Thanksgiving!
November 21, 2006
A NEW DAY, A NEW DEAL
There are several theories about what keeps REITs flying. There's also a growing chorus of bears who warn that we're near a top for the asset class. But whatever your view, the news of a private-equity fund's unsolicited buyout offer on Sunday for Equity Office Properties (NYSE: EOP) offers one more reason to think that the game's not quite up in the long-running bull market for publicly traded real estate securities.
EOP, the largest REIT and one that's in the S&P 500, accepted a $36 billion buyout offer from an affiliate of the Blackstone Group, a New York private equity firm. Blackstone will acquire all the outstanding common stock of EOP at $48.50, or an 8.5% premium over last Friday's close.
The deal for the nation's largest office landlord raises eyebrows on a number of levels. For starters, it's reportedly the largest buyout package in history. The Wall Street Journal (subscription required) reported that the price tag "implies a 'cap rate', or rental yield, of about 6% -- well below the 10% at which real-estate investment trusts, or REITS, have historically traded." The article adds that the terms suggest that Blackstone is valuing EOP at a 17% premium to net asset value, according to analysis by Citigroup. "That's unusual -- even for Blackstone," the story advised. "It paid no more than 4% premiums to NAV when it acquired Trizec Properties and CarrAmerica. And even those were seen as pricy at the time."
Rich or not, the EOP deal is a sign of the times. Indeed, this year has witnessed a surge in mergers and acquisitions of REITs. Keven Lindemann, director of real estate for SNL Financial, told the New York Times today that 21 REITs in 2006 have announced that they're being bought by another REIT or private firm, and that more were probably coming.
No doubt that the buyers see value and opportunity. The sellers are feeling pretty good too. Sam Zell, EOP's founder, is reported to have said that Blackstone's deal to take his company private is "a validation of the public real estate markets. This suggests that REITs have become part of the overall capital markets. That's a very positive thing."
Positive, that is, for veteran shareholders who are selling. As for the validation of public markets, yes and no. True, EOP is being bought whole hog, a transaction that owes much to the firm's public listing. But in the process, EOP bids farewell to the public markets. Of course, in its remaining days as a publicly traded entity, the firm's record as a security is nothing if not impressive this year. As of last night's close, EOP shares were up more than 60% year to date. In fact, REITs generally have continued to soar. The Vanguard REIT ETF (AMEX: VNQ) is up 34% through yesterday, or more than double the S&P 500's 14.1% total return so far in 2006.
Although some critics say that EOP's deal is pricey, that's hardly a universal view. In the Times story noted above, James Corl, CIO of Cohen & Steers, a real estate-focused money manager that owns EOP shares, said the deal price for the stock represented a bargain for Blackstone. Corl cited rising office rents and bullish momentum for REITs in foreign markets. In addition, Barry Vinocur, editor of Realty Stock Review, told the Times that he's heard several real estate professionals say that Blackstone didn't overpay.
In any case, EOP's buyout reflects the fact that there's lots of money in the private-equity world--money that's looking for a home and appears, overall, to be chasing deals. Is this a seller's market? It's starting to look like one, and REITs are only the tip of the financial iceberg.
Private equity funding as a percentage of total M&As this year through October more than doubled to 18% from 8% in the same period in 2005, and from 3% in 2004, according to UBS numbers via the Sydney Morning Herald.
Indeed, investors are poring money into private equity funds at record rates. The fear of mediocre equity returns and relatively low bond yields are two reasons. Managers of private equity funds aren't asking questions, however, and instead are simply fulfilling their mandates by searching the world for fresh takeover material. A similar appetite can be found in corporations, which are also flush with cash thanks to rising profits that, as a share of the economy, are at 40-year highs.
"There's an enormous wall of money that has been raised...and that money needs to be invested," Ted Scott, director at F&C Asset Management, opined in Scotsman.com yesterday. What might end, or at least slow the private-equity money train? Perhaps if a deal fails on some level, Scott speculated. Meanwhile, full speed ahead, albeit with caveats. The deals increasingly "are becoming more risky and marginal gains are being made," Scott warned. "Some of the valuations are quite toppy, to say the least."
There are several signs supporting that claim. That includes a risk premium that's' barely worth the name in junk bonds relative to Treasuries. Consider that the spread in U.S. high yield bonds over U.S. governments is under 300 basis points, a thin margin of error that's historically low and fueled by strong gains in junk. Year to date, the Lehman Corporate High Yield Index has climbed 10.3% vs. 3.7% for U.S. Government/Credit, according to Lehman.com.
But it all looks appealing to private equity funds and corporations, which are funding buyouts with low-cost loans and investor monies desperate for higher returns. For now, no one's complaining. There's lots of money, and it's being put to work. Never mind that finding bargain-priced deals is getting harder by the day. The money will keep flowing until Mr. Market (or Ben Bernanke) yells stop. For the moment, however, there are only celebrations. Looking for historically healthy risk premiums, as a result, remains a thankless task.
November 20, 2006
The search for fallen angels continues to be a fruitless exercise in 2006. As our table below reminds, all the major asset classes continue to stay afloat.
Yes, there's a touch of red ink on the ledger, with commodities bleeding a bit this year. But the tumble isn't quite what it seems, at least not yet.
For starters, we're using the Goldman Sachs Commodity Index as a proxy, by way of the Oppenheimer Real Assets mutual fund. Alas, this benchmark is heavily concentrated in energy, which comprises more than 69% of the weighting. We prefer the DJ-AIG Commodity Index, which caps energy at a 33% weighting and in the process makes for a more diversified mix of raw materials. There are mutual funds and a recently launched exchange-traded note that track DJ-AIG, but none go back three years, and so for the moment we're still using Oppenheimer to fill out that slot in our table. In any case, DJ-AIG is up slightly this year, with the Credit Suisse Commodity Return Strategy climbing 1.4% this year through last Friday.
For investors who are widely diversified, the above table offers great news, namely: your portfolio has done well. Diversification is a risk-management system that often means holding asset classes that have retreated. Not this year. But while that makes looking at trailing returns a happy occasion, it complicates the task of rebalancing, i.e., selling winners and redeploying capital to losers (or winners that haven't won quite as much as others).
Deciding where to redeploy begins with looking at trailing performance, although it hardly ends there. Putting a valuation on the various asset classes and coming up with a reasonable outlook for returns completes the task.
In the here and now, we present only the first step of the thousand-mile journey. Sometime in the near future we plan on launching a premium service that goes the extra miles--an event that will be duly noted on these pages. In the meantime, we're watching the trends, crunching the numbers and wondering where new opportunities will emerge. Mr. Market will eventually offer a new deal, but for now his lips are sealed and allure is limited.
November 17, 2006
ANOTHER HOUSING STUMBLE
Earlier this month, former Fed Chairman Alan Greenspan dispensed some widely reported optimism by opining that "the worst is behind us" in the housing correction of late. The forecast may yet prove accurate, but the skeptics are snickering a little louder today after reading this morning's update on housing starts for October.
New construction of privately owned housing units fell sharply last month, the Census Bureau reported. So-called housing starts dropped 14.6% in October from the previous month, measured on an annualized, seasonally adjusted basis. That's the biggest single-monthly percentage loss since May 2005.
On an absolute basis, the trend doesn't look any better, as the chart below illustrates. The annualized rate of 1.486 million new starts last month is the lowest in more than six years. If there's a bottom coming in housing starts, it's not obvious at the moment. Free fall might be a more accurate term.
Housing starts, of course, are but one of several metrics documenting trends in real estate. But until and if the data starts supporting Greenspan's prediction, prudence suggests adopting the philosophy of "Look out below."
Meanwhile, the great question of the moment is deciding how much more fallout will harass the economy as housing corrects. The jury's still out on this score, although there's still reason to be mildly optimistic, argues
Ed Yardeni, chief investment strategist at Oak Associates. In a research note sent to client this morning, he writes:
The housing recession isn't likely to spill over to the broad economy. Despite the steep decline in housing starts and in auto production, the Philadelphia Fed's survey of manufacturers in November showed improvement with its business conditions index unexpectedly rising to 5.1 from October's minus 0.7. U.S. jobless claims fell to 308,000 last week suggesting that the labor market remains strong. The ABC/Washington Post Consumer Comfort Index jumped again this week and is up 20 points since late August to the highest reading since April 2002.
Yes, the housing recession is "steep," Yardeni admits. But like Greenspan, he believes that it "may be over sooner rather than later." In support, he cites the recent rise in an index of builder confidence for sales of new single-family homes, which is published by The National Association of Homebuilders. In addition, he notes that "mortgage applications for purchases of both new and existing homes seem to be stabilizing in the past few weeks."
The next big stress test for optimism comes at the end of this month, when a fresh batch of economic data is updated, including existing and new home sales and the all-important personal income and spending series. In the meantime, there's plenty of opportunity to speculate. Definitive conclusions about 2007, however, remain on hold.
The great economist Milton Friedman died yesterday. But like all great thinkers, he left an intellectual legacy that will endure.
Friedman's métier was documenting and espousing the libertarian cause in economics and, by extension politics. Free markets and democracy are inextricably linked, he taught. One can't long survive without the other, an empirical observation that's still far from universally accepted in the 21st century.
Unlike some in the dismal science, Friedman was no ideologue, even if he was easily caricatured as such by those who don't understand the academic foundation sustaining his views. Indeed, Milton didn't preach utopian visions in the hope that the empirical record would lend support. Rather, Friedman looked at the evidence and drew conclusions about how the world worked. As a result, his analysis is both practical and scientifically sound, at least to the extent that any economic theory can be. Reality, in sum, is a mighty potent tool in the pursuit of the truth.
Of particular relevance to CS is Friedman's pioneering work on money supply theory. His lucid analysis on that front has been widely celebrated and so we'll simply close by referencing his final essay on the subject, which appears in today's Wall Street Journal (subscription required): "Why Money Matters." To summarize the piece, keep your eye on the quantity of money, Milton asserts last time.
November 16, 2006
INFLATION TAKES A HOLIDAY
Inflation's still a threat, but for the moment it's in remission.
This morning's update on consumer prices for October echoed yesterday's report on producer prices by taking a sharp turn south. Consumer prices fell 0.5% last month, the second consecutive descent of that magnitude and the first back-to-back monthly declines since 2005's November/December. The bottom line: top-line inflation for the past year through October was running at just 1.3%, the slowest annual pace since early 2002.
But wait, there's more. The encouraging inflation report looks even better with news of cooling core CPI, which ignores food and energy prices. Although core CPI was worrisome in September's report, it's less so for October. Core CPI advanced 0.1% last month, the lowest since February and down from September's 0.2% rate. For the past year through October, core CPI was chugging ahead by 2.8%.
Before we become too giddy, it's worth pointing out that a 2.8% core inflation rate is still too high. As the chart below reminds, core CPI has climbed sharply over the past two years, reaching a recent peak in September. It's too soon to tell if October's downshift is temporary or the start of a secular decline in core pricing pressures. For our money, we're hopeful, but still wary.
Meanwhile, there's a bit less pressure on the Fed, although not enough to warrant a rate cut. That appears to be the market's conclusion as well for the Fed's next FOMC meeting on December 12. The January '07 Fed funds futures contract this morning is priced in anticipation of keeping Fed funds at the current 5.25%. And prudently so, as one month a trend does not make. Indeed, it's important to point out that top-line consumer prices eased for the same reason that wholesale prices did last month: energy prices fell. Seasonally adjusted, CPI's energy index dropped a hefty 7% last month, following September's 7.2% tumble. That's one gift, rest assured, that won't keep giving.
As for core inflation, there's reason to remain hopeful. Apparel and transportation prices fell substantially last month, while housing costs were flat, as per CPI's methodology. Alas, the only thing to do is wait and see if this trend has legs.
November 15, 2006
ANOTHER CAVEAT FROM THE DATA TRENCHES
The consumers' capacity for spending come hell or high water is widely recognized and celebrated. But yesterday's retail sales report for October offers another excuse to pause and reconsider if more of the same is in store for 2007.
As the chart below illustrates, there's reason to wonder if Joe Sixpack's finally met his match and is now in the process of turning a new leaf that deemphasizes spending. For the second month running, retail sales slipped. Considering that August sales were flat, you have to go back to July to find a month when consumption overall advanced over the previous month.
And, no, stripping out the volatile motor vehicle sales doesn't alter the downward bias in retail sales.
Similarly, a closer look at October's retail sales doesn't offer much improvement over the big picture. Yes, on a 12-month basis, growth is still evident. But what have you done for us lately? At best, the answer is mixed as the red ink in the one-month column below reveals.
If consumer spending continues to slow, the stakes will rise in the forecast by some that the worst of the real estate correction is behind us. If that proves to be a premature notion, Joe will have to step up to the plate once more to keep the economy afloat. With the holiday-spending season upon us, there's a chance that a fresh surge of consumption may be coming. Even so, with real estate and consumption moderating, the economy can't afford much else to go wrong now.
November 14, 2006
CAN ENERGY PRICES KEEP FALLING?
This morning's update on producer prices couldn't be any clearer: disinflation (deflation?) is alive and well in the wholesale marketplace.
Producer prices fell 1.6% last month, the largest monthly decline in five years, and the second in a row, coming on the heels of September's 1.3% stumble. As a result, wholesale prices for the past 12 months through October are off 1.5%--the first year-over-year decline in four years.
Once again, the descent of energy prices is the major catalyst for a lower producer price index. Energy-related goods tumbled 5.0% in October, following an 8.4% decline in September.
Alas, energy prices can't fall indefinitely. In fact, there are signs that prices of crude oil and gasoline are stabilizing. For oil, the $60-a-barrel level appears to be a floor, at least for the moment. The December '06 crude contract on the NYMEX was changing hands at around $59 this morning. That's down from around $80 in July. Gasoline, meanwhile, seems intent on hovering in the $1.50-$1.60 range (as per the December '06 contract), which is also down sharply from around $2 a gallon back in July.
But lest we think that price stability seems the path of least resistance for energy at the moment, one analyst crunches the numbers and contemplates an alternative future. "The distortion of the commodity futures curve by financial investment is the greatest challenge to the stability of the crude and natural gas markets in the last 10 years," wrote Ben Dell, a member of the energy research team in the London office of Sanford Bernstein, in a research note to clients today.
Indeed, from ETFs to hedge funds, financial players have piled into oil futures in a big, big way. Passive investment in the Goldman Sachs Commodity Index and the Dow Jones-AIG index (both heavily weighted in oil) have grown to nearly $120 billion this year from under $20 billion in 2003, according to Dell's report. Is this passive investment impacting the futures market for crude? Absolutely, says our man in London.
Dell noted that the oil futures curve currently exhibits a record-high level of contango. Contango means that futures prices are higher than spot, or cash prices. Although contango does happen from time to time, the current episode is "decoupled" from economic fundamentals, he opined. In sum, there's too much oil supply to warrant oil futures prices rising the further out in time one goes. "On a weighted average basis, commercial independent storage is now 97% full, or effectively full compared to storage contracted capacity 18 months ago at 85% full and around 70% full in 2003," Dell wrote.
He found it odd that the premium in future oil prices over spot have continued to widen recently even as the outlook for OPEC's spare capacity in oil production has increased in 2006 and is expected to continue improving next year and again in 2008. In particular, this year's spare OPEC capacity is predicted to be slightly above 2 million barrels a day, up slightly from less than 2 million b/d in 2005. Next year, OPEC spare capacity is forecast to be close to 4 million b/d, and above that level in 2008.
Running an historical correlation analysis of oil prices relative to spare capacity data shows that $60-plus-a-barrel oil reflects jibes with the current estimate of spare capacity, according to Dell's numbers. But if next year's higher estimate of spare capacity is assumed, the relevant oil price is around $30 a barrel.
Does that mean that oil prices are set to fall by 50% soon? Probably not. Oil is a commodity, but one that comes with more than its fair share of geopolitical baggage that distorts and manipulates free-market pricing. Nonetheless, Dell's analysis suggests that pressure for further price declines in oil are growing. If so, the news on inflation may be due for more good news going forward which, in turn, may give a boost to bonds and stocks. Yes, there are any number of scenarios that could render that outlook moot. But for the moment, Dell's analysis isn't easily dismissed.
November 13, 2006
ONE CONSULTANT'S VIEW OF THE FUTURE
In the November issue of Wealth Manager, your editor quizzed Armand Yambao, head of financial modeling at EnnisKnupp & Associates, a Chicago institutional investment consultancy that oversees $700 billion in assets. The subject of our exchange is everyone's perennial favorite on matters financial: the future. In particular, what is EnnisKnupp telling clients to expect for risk and reward among the major asset classes? All the usual caveats apply, of course, when it comes to predictions. Indeed, no one knows what's coming, but that doesn't mean we shouldn't talk about the tomorrow and beyond. Just don't confuse forecasting with fate. Otherwise, enjoy....
November 10, 2006
NEW THINKING ON AN OLD SUBJECT?
With core inflation creeping higher, the focus on monetary policy necessarily increases. The question, of course: What is the right monetary policy?
Fed Chairman Ben Bernanke is the strategist in chief for managing the nation's money supply. On paper, he's eminently qualified, courtesy of his career as a professor of monetary economics at Princeton. The jury's still out on his talents as practiced in the real world, however. But each day, another round of deliberations commence.
The latest exhibit offered for review comes by way of a
speech Bernanke gave today in Frankfurt, Germany. For those who give the chief the benefit of the doubt, the latest lecture merely reflects an academic's overview of the history of monetary policy. No less was expected for a talk labeled "Monetary Aggregates and Monetary Policy at the Federal Reserve: A Historical Perspective."
On first reading, the printed version of the talk lives up to its billing. Ben takes us on a whirlwind tour of monetary policy since the Fed's 1913 founding. From the mistakes in the Great Depression to Friedman and Volcker and beyond, the current Fed head is nothing if not well-grounded in the evolutionary past that's brought us to this monetary moment.
But skeptics, conspiracists and cranks may see things differently in today's chat. For instance, might the Fed chief be laying the foundation to argue that the central bank's influence on monetary policy is less than assumed? Consider, for instance, the following statements, as per today's Frankfurt dialogue:
As I have already suggested, the rapid pace of financial innovation in the United States has been an important reason for the instability of the relationships between monetary aggregates and other macroeconomic variables.14 In response to regulatory changes and technological progress, U.S. banks have created new kinds of accounts and added features to existing accounts. More broadly, payments technologies and practices have changed substantially over the past few decades, and innovations (such as Internet banking) continue. As a result, patterns of usage of different types of transactions accounts have at times shifted rapidly and unpredictably.
Various special factors have also contributed to the observed instability. For example, between one-half and two-thirds of U.S. currency is held abroad. As a consequence, cross-border currency flows, which can be estimated only imprecisely, may lead to sharp changes in currency outstanding and in the monetary base that are largely unrelated to domestic conditions.
Also, consider this tidbit: "Although a heavy reliance on monetary aggregates as a guide to policy would seem to be unwise in the U.S. context, money growth may still contain important information about future economic developments."
May? Hmmm. Sounds like one academic in government has a new strategy in mind. Details to follow...perhaps.
November 9, 2006
It's not falling, but neither is it rising. Initial claims for unemployment insurance are more or less treading water relative to recent history.
This morning's update from the Labor Department reveals that new filings for jobless benefits dropped by 20,000 for the week through November 4 from the previous week, on a seasonally adjusted basis. To put that in perspective, the 308,000 who filed for unemployment last week total slightly less than the weekly average stretching back over the past 10 weeks.
One implication: the economy's not poised to fall into recession any time soon. Then again, growth doesn't look set for a fresh burst either, based recent data from other corners of the economy. Of course, one can't draw too many (if any) conclusions from one data series. In fact, prudence dictates to draw no conclusions for the moment until clearer signs emerge.
The bond market seems to be doing just that. After the yield on the 10-year Treasury consistently fell from July through September, tread water has become fashionable. The 10-year's yield was 4.63% at yesterday's close. Although the yield's had a bit of a ride up and down over the past month or so, not much has changed since the bond bull market ran out of steam in mid-September.
Yes, we know that the economy's slowing, based on recent data. But it's not yet obvious how much it's slowing, or how deeply. Finding an answer to that question will take time, and our guess is that we'll all be celebrating New Year's without much more concrete insight than we have here and now.
And so, absent extraordinary new economic numbers, the next few months could end up being a lot of light and heat without much new information. With the Democratic transition in Congress underway, all eyes are on what awaits in Washington for 2007. But the fun won't start until February at the earliest.
Meanwhile, there's plenty of economic data to pore over. Just don't confuse new numbers with new information, at least not yet. Nap time anyone?
November 8, 2006
PROFILING THE GLOBAL EQUITY MARKETS
The world is a big place, but there's a fair amount of uniformity when it comes to equity returns in 2006. Bull markets are everywhere. They vary in degree, of course. But from a regional perspective, at least, black ink ruled this year through October 31.
Fundamental valuation is another matter. There's a bit more disparity when it comes to the usual array of valuation metrics. Let's dive in and take a look, using data supplied by S&P/Citigroup Global Equity Indices through October 31, 2006.
Starting with total returns, European Emerging markets continue to lead the pack with a 36% total return (this and all returns quoted are dollar based). Even the worst performing region--Mid-East and Africa--is up 5.8%. A bullish tailwind, in other words, can be found in almost every corner of the globe's stock markets, and so investors have had to work hard to lose money this year. Indeed, the World index has climbed 16.3% through last month. Meanwhile, U.S. stocks--although near the bottom of horse race in 2006 on a global basis--have advanced 12.3%, which is above-average on an historical basis.
The global equity profile becomes more complicated once we start looking at valuation. Latin America is the least expensive on a trailing 12-month price-earnings ratio basis. Trading at slightly above 12-times earnings, Latin America offers the best investor-friendly pricing by this measure when compared to everything else. U.S. stocks represent the highest-priced market by this definition in our survey, trading at nearly 18 times earnings.
The p/e ranking holds up when we look at equity markets on a price-to-cashflow basis too. Once again, Latin America is the least expensive. The United States has the second-highest p/cf measure after European Emerging.
Dissecting markets by return on equity alters the ranking a bit, with the Mid-East and Africa scoring highest on ROE. The U.S., however, remains near the bottom.
For investors looking for relatively high dividends, Europe offers the most enticing prospects at nearly 3.1%. The U.S., by contrast, pales with a spare 1.5% dividend yield.
No matter how you slice it, compelling buys based on deep value are scarce at the moment. Mr. Market will no doubt correct that at some point, giving cash-laden investors the first crack at the best opportunities. Volatility, like MacArthur, promises to return... eventually. Meanwhile, the best one can hope for are the mixed opportunities born of relative value. Unimpressive, perhaps, but then again beggars can't be choosy. That is, unless you're willing to sit on fairly large amounts of cash and wait for a better deal in the form of absolute value.
November 7, 2006
OPTIMISM AND OMENS FROM A FORMER FED HEAD
Former Fed Chairman Alan Greenspan spoke yesterday to an audience of roughly 3,000 at a financial advisor conference in Washington, D.C. hosted by Schwab Institutional. Your editor, attending on a press pass, was audience member 2,986.
Alan talked far and wide on matters fiscal and economic, but his commentary about the housing market was particularly intriguing. To cut to the chase, the maestro thinks that much of the correction in real estate has passed. To quote the former central banker: "It looks like the worst is behind us." He expects a continuation of the current correction--or inventory adjustment, as Greenspan termed it. But a collapse doesn’t look imminent, nor does he think that the downdraft in housing will push the economy into a recession.
One reason for the optimism, he explained, is that single-family housing sales are running slightly ahead of new construction. Although sales are still vulnerable to falling, he said that it's the rate of change that matters most for divining the future, as opposed to focusing on the actual number of sales now vs. some point in the past.
The National Association of Realtors said as much last week in a press release that accompanied the monthly update of its Pending Home Sales Index. NAR said that home sales are expected to hold "fairly steady," based on it PHS Index, which tracks signed contracts for existing-home purchases. In September, PHS dropped 1.1%. Although that's a sharp reversal from August's 4.5% rise, the pace of decline has slowed considerably since July's 7.0% tumble.
Greenspan was also upbeat about the American economy overall. He admitted that there are warning flags to consider, including low household saving and a rise in manufacturing inventories. On the other hand, profit margins for corporate America are still high, he observed. History, he noted, suggested that the odds for a recession were quite low with high profit margins gracing the business world of late. Greenspan also reminded that consumer spending continues to roll on, prompting him to comment, "Things don't look bad."
But for all his optimism, his longer-term outlook offered a more sobering reflection. The disinflationary boon, which has arguably kept interest rates and inflation lower than they otherwise would be, isn't written in stone. "It's a one shot event, not a permanent change," he said of the surge in inexpensive imports from China and other developing nations.
As emerging markets have entered the global economy over the last decade or so, the low-wage-based creation of goods and increasingly services has unleashed a disinflationary wind. That's helped put a lid on inflation. But the future may be more challenging on that front. China's economy, for example, is growing rapidly, and that's starting to elevate wages there, albeit from a low based. Nonetheless, "It's going to be more difficult than when I was there," he said of running monetary policy at the Fed in the years ahead. Although he praised Bernanke and his team and said they were "very smart," there was no mistaking Greenspan's point that his successor faces a far more complicated economic environment.
As for Social Security and Medicare, both need attention, he asserted. Funding Social Security, however, is easily resolved, he said. There are 15 or so viable plans that would make the retirement fund solvent for the future. Choosing one and deciding to implement it should take about 15 minutes for a group of reasonable, non-partisan types (or politicians who temporary put politics aside).
Medicare, by contrast, is a far bigger predicament, Greenspan advised. The central issue is the rapidly rising demand for medical services, which he believes will exceed the nation's capacity to satisfy over time. "The government is promising more than it can deliver in medical services," he charged, a trend that threatens to promote an "unstable fiscal situation." The challenge will be exacerbated by the fact that the population of retirees is growing faster than the labor force. As a result, expecting a tax hike to solve the Medicare issue isn't practical in the long run. Alas, the political powers in Washington are largely "irresponsible" in facing up to the trouble and dealing with it, he said.
Fed chairman come and Fed chairman go, but some things in Washington never change.
November 3, 2006
Eugene Fama, a founding father of the efficient market theory, has a dialogue with Nina Mehtais in the Nov/Dec 2006 issue of Financial Engineering News and the conversation stirs up an old debate anew. Are markets efficient? Is it possible to pick winning stocks? Can investors beat the market? It's an old discussion, but it promises to be a perennial one, and the latest installment from FEN is worth a look, no matter your view. A sample of the Q&A follows below. For the full interview, dive in here.
FEN: If markets are efficient, a stock price reflects the intrinsic value of a company, but does that mean the price is always right?
EF: It means you can’t figure out whether it’s wrong. It’s not always right because there’s some uncertainty about what right is, but basically you just can’t beat it.
FEN: How would you know if a market doesn’t fully reflect all available information about a stock?
EF: If you had the right risk and return story, you’d be able to identify the kinds of information that weren’t incorporated into the price. There are lots of studies where people study the adjustments of stock prices to splits, earnings announcements, mergers, everything. Another way is to look at the performance of active managers. They tout themselves as people who have information that’s not in the prices. Well, you can test that. Testing investment performance is basically testing market efficiency.
FEN: When is the market likely to be inefficient or to misprice securities?
EF: When it’s closed, I guess.
FEN: What about smaller, illiquid stocks?
EF: That’s what people claim – that smaller stocks are not priced as efficiently as bigger stocks, that emerging markets are not priced as efficiently as developed markets. But anyone who looks at it empirically can’t find any evidence to that effect.
A DEEPER SHADE OF GRAY
Monetary policy is a thankless task these days. The trends are muddled, the numbers are in doubt, and every new data point unleashes a torrent of debate about what comes next as well as what just drove by. It doesn't help that the stakes are fairly high too, i.e., inflation may or may not be a resurging threat.
Today's October employment report delivers a fresh batch of numbers and new supply of fuzzy outlooks. Nonfarm payroll jobs rose by a seasonally adjusted 92,000 last month, the Bureau of Labor Statistics reported today. That's the lowest since October 2005, when the blowback from Hurricane Katrina temporarily impaired the jobs machine. With no scapegoat this time around, last month's thin rise in employment looks like the byproduct of a slowing economy. Jared Bernstein the Economic Policy Institute assumes this view, and offers some analysis today on that score.
But the more you look at the latest jobs report, the more nuanced it appears. Yes, an increase of just 92,000 new jobs looks discouraging and dangerously close to levels that look like a precursor to recession. On the other hand, the unemployment rate fell to 4.4% last month--the lowest since May 2001. One question to ask: are the foundations of recession laid on the back of falling unemployment? Since June 2003, when unemployment in the current cycle peaked at 6.3%, the trend ever since has been fairly consistently down.
At some point the trend will end, and no doubt we're closer to the finish now than we were a year ago. Economic cycles haven't been banished, despite the Fed's best efforts. Then again, the magnitude of the cycles are smoother and less volatile, courtesy of central bank decisions that arguably have become more enlightened over the years. The goal of keeping expansions alive longer and minimizing the fallout from contractions has found a degree of success over the years. But such success has its costs, including the fact that employment booms aren't what they used to be, which suggests that contractions may be milder and shorter too.
The counterspin is that the unemployment rate understates those looking for work. But the flaws were present in the past as well, and so the unemployment rate over time offers a fairly consistent profile of trend, flawed though it may be in terms of the absolute numbers. In any case, it's reasonable to assume that the trend is reliably accurate; if so, the trend clearly reflects declining numbers of unemployed.
It's also instructive to look at a breakdown of the employment picture last month. Virtually all of the weakness in the jobs picture comes in the so-called goods-producing areas of construction and manufacturing. Combined, the two groups shed 60,000 jobs in October. But goods-producing employment is a fraction of total nonfarm employment at about 16%. Suffice to say, employment trends in the United States aren't dependent on what unfolds in the goods-producing industries. Manufacturing employment has been declining for years and so at this late dates it's not persuasive to declare that the economy's in trouble solely because this industry's losing workers. That's been true for 20 years or so, and yet the economy seems to have weathered the trend.
So, where's the growth? Services, of course. The services sector overall harbors 84% of nonfarm employment. As a result, if you want a representive sample of employment trends in America, look first and foremost to services industries, such as retail trade, professional and business services, and education and healthcare businesses. By that measure, the trend is up. Services employment rose 152,000 last month. That's a 1.6% jump, the fastest since March. Job creation is services, in other words, is alive and well, and for the moment at least the pace of creation is accelerating.
All of which leads us back to the Federal Reserve, which, we submit, faces more evidence today that the labor market continues to percolate, a trend that makes the notion of cutting interest rates that much more remote. Yes, there's a risk that fallout from real estate may still deliver more pain. But the question is whether the pain will overwhelm the jobs machine now on view in the services sector? Judging by the latest numbers, the answer seems to be "no." But pessimism, like its counterpart in hope, also springs eternal.
November 2, 2006
PRODUCTIVITY'S DISAPPEARING ACT
This morning's news that productivity unexpectedly evaporated in the third quarter is bad news that comes at a vulnerable point in the economic cycle. With core inflation and labor costs creeping up, this isn't the ideal moment to learn that productivity is missing in action.
But missing it is. The Bureau of Labor Statistics today reported that non-farm business-sector labor productivity was one large goose egg during July through September. Zero. Zilch. That's down from 1.2% in the second quarter and 4.3% in the first. The consensus outlook was looking for something around 1%-plus.
The overall trend doesn't bode well for remaining optimistic about inflation, at least for the near term. About two-thirds of the cost of manufacturing goods or delivering services is tied to labor costs. As a result, lower productivity (or the 60-minute output of one worker) raises business costs. Lower productivity gives inflation a stronger foothold in the medium term because it raises labor costs, and firms may try to pass off the higher costs by raising prices more than they otherwise would. Or so some economists reason.
Falling productivity by itself is only one factor, of course. Alas, today's productivity news comes on the heels of Tuesday's report of accelerating labor costs. The Labor Department's employment cost index jumped 1% in the third quarter, the fastest quarterly pace in more than two years.
A cut in the Fed funds target rate looks increasingly remote for the foreseeable future. The question is whether the Fed will feel compelled to raise rates when it meets next month. Once again, that depends on the numbers that come out between now and then. But if statistical salvation is coming, it needs to come soon. Monetary policy, after all, is no quick fix for bubbling inflation pressures. What Bernanke and company do today will have an effect in a year or two. The Fed can wait for more data, but it can't wait forever. The clock, as always, is ticking, and it seems to be ticking faster with every new data update.
November 1, 2006
RECONSIDERING EMPLOYMENT GROWTH (AGAIN)
No one will be impressed by this morning's report on October employment from ADP/Macroeconomic Advisers. In the history of job creation, October's pace is middling at best. But the good news is that in the current world of reduced expectations, no one will be overly discouraged by the latest ADP number either.
Total nonfarm private employment rose by 128,000 last month, the largest advance since June's 368,000 surge, the ADP National Employment Report advised. In percentage terms, October's rise measured 0.1%, a pace that's been consistent for each and every month since July. "These findings suggest a modest re-acceleration of employment in October, following three months during which...gains in private nonfarm employment averaged a slower 95,000 per month," the release opined.
October's rise came close to matching the prediction from David Resler, chief economist at Nomura Securities in New York. In a note to clients today, Resler wrote that the "somewhat bigger increase in October looks to be consistent with other broad economic indicators showing that economic activity is likely to accelerate toward 3% real GDP growth in the fourth quarter after the anemic 1.6% growth in Q3."
Meanwhile, the government's employment report for October is scheduled for release on Friday. But if recent history's a guide, no surprises are likely in terms of a large deviation in the trend relative to ADP's numbers. According to Resler, ADP's jobs tally since July has been "reasonably consistent" with the numbers from the Bureau of Labor Statistics. If anything, ADP's count has tended to be slightly under BLS's measure, as the chart below shows. Resler reported that ADP's average monthly gain in non-farm private sector payrolls averaged 95,000 per month during July through September vs. 108,000 a month in private sector job increases per the government.
In other words, the real issue is debating if the reacceleration has legs. If so, is it time to raise interest rates again? Core inflation has been inching higher, and if the trend is joined by a renewed rise in job creation, the Fed may be forced to act with a fresh round of tightening.
But for the moment, there's no sign of worry in Fed funds futures trading. The December contract remains priced in anticipation of 5.25%, which is the current target rate. Of course, a lot can happen between now and December 12, the date of the FOMC's next scheduled confab.
Meanwhile, adding to the notion that there's no monetary tightening on the horizon for the moment comes by way of the latest money supply figures. Looking at a 10-week moving average of M2 money supply shows the highest pace of increase in the first half of October (the latest numbers available) since May 2004.
It's easy to be on the fence these days about what comes next. And that means the odds are rising for higher volatility in the capital markets. Perceptions, in short, are easily adjusted when investors are on pins and needles about the next economic release.
Yes, Halloween is over, but there are still plenty of ghosts and goblins lurking in data's shadows.