February 28, 2007
A SHORT HOLIDAY IN A ROUGH MARKET
Pardon the timing, but your editor is about to step out for a few days. Wouldn't 'ya know it? Just as we're heading for Los Angeles, Mr. Market decides to take a dive. So it goes. Maybe the brief interlude from blogging will dispense some additional perspective. Insightful or not, we'll be returning on Monday, March 5 for another round of fun. Meanwhile, Tuesday's crumble in stocks reminds once again that there's a reason to include bonds as part of a comprehensive asset allocation strategy: low correlation with equities. That profile was in all its glory today. The iShares Lehman Aggregate Bond ETF managed to post a modest gain on Tuesday. No big deal, except for the fact that the modest gain came amid a roaring sell off in stocks. Diversification among asset classes has merit after all.
February 27, 2007
CANARIES IN THE COAL MINE?
What's the link between the Chinese stock market and U.S. subprime mortgage market? Nothing, really. Well, almost nothing, except that both had previously been soaring and have recently hit some speed bumps.
That leads us to an astonishing conclusion: markets that have enjoyed long and robust bull markets eventually hit a wall. Bear markets, in short, haven't been banished, even if it appears otherwise.
Full disclosure: we don't have a clue about what's coming. But we do have a firm grasp of history, which is conveniently available for all to see in full clarity.
The fact that China and subprime mortgage markets have slipped may be dismissed as marginal events of no real relevance to the capital markets. But we think such stumbles are early warning signs of things to come. Granted, this is a highly speculative notion and so readers should proceed accordingly. Nonetheless, we think our view has merit if only because bull markets have flourished across the spectrum of asset classes for some time and, well, nothing lasts forever.
As such, we're keeping a diary of market corrections large and small. If and when they accumulate, the broader investment community may become jittery. It's virtually impossible to predict market peaks and troughs, but at this late stage in the bull market cycle we're increasingly anxious and so we're keeping an eye out for additional warning signs. Having built up a tidy nest egg, we're in no rush to watch it evaporate. Been there, done that. Wealth preservation, in short, is at the top of our financial priorities at the moment.
It's never clear what might trigger a broader sell off, but we're mindful that it could be seemingly low-risk events when the supply of optimism reigns supreme around the world. History suggests no less. No, the financial gods don't wave flags or ring bells at market tops or bottoms, although sometimes they whisper in your ear and suggest things.
And while we're confessing to events that have delivered a fresh dose of modesty to our thinking is this morning's report on durable goods, which slumped 7.8% last month--the biggest monthly drop since July 2000.
The point of all this is not to induce panic. On the contrary, ours is a mission of embracing the Boy Scout motto to "be prepared." Financially speaking, that arguably translates into having cash at the ready to take advantage of any bargains. Executing such a strategy successfully also requires patience, and lots of it.
Regular readers of this blog know that your editor has been recommending above-average allocations to cash and below-average allocations to almost everything else. That's been exactly the wrong thing to do, measured by history as of last night. It may prove to be wrong going forward as well, perhaps for years. But we suspect otherwise.
There are many asset classes in the universe, and none of them look particularly appealing as targets for committing new investments. Cash, on the other hand, looks attractive, and it pays a decent waiting fee of 5% or so. No, you won't get rich with cash. But we think that it may come in handy for picking up assets on the cheap. One day. Maybe. Perhaps.
February 26, 2007
ALAN TURNS GLOOMY
The yield curve has been inverted for long enough for investors to get used to its presence without worrying about its historical implications. But just when it seemed that a 10-year Treasury yield trading below Fed funds was irrelevant, along comes former Fed Chairman Alan Greenspan to suggest otherwise.
"When you get this far away from a recession invariably forces build up for the next recession, and indeed we are beginning to see that sign," Greenspan told a business conference today. "For example in the U.S., profit margins ... have begun to stabilize, which is an early sign we are in the later stages of a cycle," he said via The International Herald Tribune. "While, yes, it is possible we can get a recession in the latter months of 2007, most forecasters are not making that judgment and indeed are projecting forward into 2008 ... with some slowdown."
The maestro's comments today come in the wake of his observations last fall, when he advised that the worst of the housing correction was behind us. Not long after, various commentators began saying that the economy looked stronger than expected. And in fact, the fourth-quarter GDP report was surprisingly strong, suggesting that growth would continue to dominate.
It's debatable how much sway Greenspan retains over popular imagination on economic thinking, but perhaps we'll find out this week. By our reckoning, the stock market's looking for an excuse for a correction, and Alan's opining is as good as any.
The S&P 500, to cite the obvious benchmark, has been on a roll for some time and perhaps it's significant that it's closing in on its old high set back in March 2000. Mr. Market has a nasty habit of retracing old bull markets only to stumble at the 11th hour. We have no doubt that the S&P will one day ascend to greater levels, but we're not so sure a new record will come by the seventh anniversary of its old zenith.
February 23, 2007
PUT (A CELLULOSIC-ETHANOL-BASED) TIGER IN YOUR TANK
In his State of the Union address last month, President Bush announced a grand objective of reducing gasoline use in the U.S. by 20% by 2017. In an effort to keep the spotlight on the issue, the President yesterday visited a plant in North Carolina that's researching the science of alternative fuels. He's been making tech/energy media trips lately, playing up the notion that America can R&D its way out of its growing reliance on foreign oil.
The sky's the limit for alternative fuels, the President advised on Wednesday. "Someday you're going to be able to get in your car, particularly if you're a big city person, and drive 40 miles on a battery,'' he said via The Guardian. "And by the way, your car doesn't have to look like a golf cart. It could be a pickup truck."
The notion of using corn and other domestic supplies of home-grown materials to produce fuel is an optimist's dream. The stakes are certainly high. If the United States could reduce imports of foreign oil, the savings would be huge, delivering a massive windfall on the economy.
But this rosy scenario isn't imminent. That's the message in Energy Information Administration's recently published update on the long-term outlook for U.S. energy use. Looking out to 2030, EIA projects that that consumption of so-called liquid fuels (primarily gasoline) will grow by an average of 1.1% a year (see chart below). Even if gasoline prices rose sharply, the EIA still expects that demand will rise by 0.9% a year. What's the source of the demand? Transportation, which is to say cars and light trucks. Collectively, transportation accounts for 94% of liquids consumption, EIA reports. The bottom line: consumption of liquid fuel in America will continue to dominate the country's energy profile.
It's worth noting that liquid fuel is expected to remain a staple despite the overall trend of increasing energy efficiency in the U.S. Energy use per dollar of GDP will continue to fall in the years ahead, EIA projects, as the graph below illustrates. Nonetheless, energy use per capita will rise by 0.3% in the future, and consumption of gasoline will increase three times as fast. Why the difference? The population keeps growing, as do consumers' energy demand for powering computers, appliances and, of course, cars. Consumption, conspicuous or otherwise, requires energy. In the aggregate, higher energy efficiency is offset and then some by such trends.
All of which leads to the odd profile of a country that's becoming more energy efficient while it relies more and more on foreign sources of oil. As the EIA explains, "Although the Nation’s reliance on imported fuel has been growing, the economy is becoming less dependent on energy in general."
The bottom line: the enhanced energy efficiency in all its various forms will have little impact on the country's energy profile for the foreseeable future. All the talk of alternative fuels and technology-based improvements that push gasoline mileage higher will bring s-l-o-w progress on the energy front. There'll be reports of astonishing advances, but there'll be precious little progress in terms of noticeable results on a macro scale.
That doesn't mean America should give up. On the contrary, the nation needs to work harder to solve its long-term energy challenge. But one must also be realistic.
Technically, it's possible to create practical solutions to gasoline. A large share of Brazil's cars (roughly one-fifth as of 2005) runs on alternative fuels. Of course, Brazil is relatively small economy compared to the U.S. In addition, Brazil's move to alternative fuels has been years in the making. The U.S., by comparison, has barely begun to explore alternative fuels. Even a modest goal of running 20% of U.S. cars and light trucks on alternative energy is a decade or more away. Assuming, of course, we start in earnest now, today, this minute.
And then there's the money. Retrofitting gasoline stations and selling alternative-fuel-based vehicles requires someone to put up the investment now for an expected (but not guaranteed) payoff down the road, perhaps way down the road. That probably requires a government-led initiative of considerable size, which also means considerable political risk.
Don't hold your breath. The status quo prevails in the United States when it comes to energy. Short of some massive realignment in political backbone, that will continue until and if the pain of higher and sustained energy prices creates grass-roots momentum for change. Weighing the odds of each, the latter looks more likely to unfold. Progress, in other words, is coming, eventually, but the transition could be rough.
February 21, 2007
THE HOUSE OF THE RISING CORE
Since Ben Bernanke became chairman of the Federal Reserve a year ago, he's been talking up the moderating influence that a slowing economy will bestow on general price trends. In that time the economy has in fact slowed, but the jury's still out on whether the moderating forces will deliver salvation on the inflation front.
Today's report on January consumer prices offers one more reason to reserve judgment. Yes, top-line inflation appears contained, but core inflation (which excludes energy and food prices) continues to inch higher, as our chart below shows.
Core CPI is now running at a 2.7% annual pace through last month. That's up from 2.6% for 2006 and close to the peak of recent years (2.9%) set last September. The rising pace of core inflation is a problem because the Fed is widely reported to have a target of 1-2% for core. By that standard, the central bank is behind the monetary eight ball.
The Fed, in sum, has more work to do to bring core CPI down, or at least convince the market that core CPI is no longer rising. There's reason to wonder how this task will play out. As we reported on Monday, the pace of growth is rising for M2 money supply. Coincidence? For the moment, we prefer to err on the side of caution and answer "no."
"This is kind of a wake-up call,'' Mickey Levy, chief economist at Bank of America Corp., said of the latest CPI report. Inflation, he told Bloomberg News today, "is sticky, so it's still on the front burner of concerns for the Fed."
The leading driver of January's rise in core CPI was medical care. That's all the more troubling given today's news from the Wall Street Journal (subscription required) that reports that the government's share of financing for the nation's healthcare continues to take wing. "As pressure grows for the government to pick up more of the nation's health-care tab, new data show its contribution is already at 45% and is expected to approach 50% within 10 years," the article advised. Add in the other big-ticket liabilities weighing on the government's shoulders (Social Security, war-related spending in Iraq), and the pressure looks set to increase on the Fed for keeping the monetary printing presses rolling.
So far, the bond market has been inclined to look the other way when factoring in such risks when putting a price on money. As of yesterday's close, the 10-year Treasury yield was near the lows for the year at 4.68%. The stock market doesn't look worried either: the S&P 500 yesterday closed at its highest level since 2000.
Fear, in short, has been banished from the stock and bond markets. The optimism may roll on for some time. Bull markets don't vanish in the wake of one economic report. But there's a risk that Mr. Market may one day ask the Fed to show more muscle.
February 20, 2007
THE CASE FOR FUNDAMENTAL ANALYSIS OF ETFs
ETFs trade like stocks, but should they be analyzed as such? Yes, says Michael Krause, who runs AltaVista Independent Research, a boutique firm that specializes in ETF analysis. Your editor interviewed Krause in the February issue of Wealth Manager magazine, where he explains his research methodology and the general case for applying fundamental analysis to ETFs. Here's a sample of his thinking: "If you were considering buying shares of General Electric or IBM, you’d want to look at more than a price chart; you’d want to know the earnings growth and so on," he says in the article. "I don’t see any reason why you’d go from fundamentally analyzing one or two stocks to ignoring such questions for a basket of stocks in an ETF."
For the rest of the story, click here....
February 19, 2007
MONEY QUESTIONS (AGAIN)
Bull markets can be found everywhere, and the M2 money supply is no exception.
Measured on a rolling 52-week basis, seasonally adjusted M2 rose by 5.6% for the year through February 5, according to Federal Reserve data. That's the fastest annual pace in two years, as our chart below shows.
How fast is 5.6%? For perspective, the economy expanded at a 5.0% annual rate during last year's fourth quarter (measured in seasonally adjusted nominal terms, as per the Bureau of Economic Analysis). The point, dear readers, is that money supply is expanding at a rate faster than the economy's.
This isn't a problem, at least not yet. But depending on where we go from here, it may be a warning sign. As a recent Cleveland Fed piece reminded, inflation is a monetary phenomenon. Milton Friedman famously made that observation, and the Cleveland Fed essay offers some supporting numbers. The article cites a 0.85 correlation (1.0 is perfect positive correlation) of inflation with average M2 growth for 132 countries for the 40 years through 2000, concluding "that prices move almost proportionally with the stock of money."
From our perch, that looks fairly definitive. Nonetheless, worries about inflation are less than common these days. The benchmark 10-year Treasury Note's yield is engaged in yet another run south, closing 4.7% on Friday for the first time since January 10. Meanwhile, the implied inflation rate for the next decade, drawn from the spread between the 10-year nominal and 10-year TIPS, is a modest 2.34%, or slightly below last year's 2.5% rise in consumer prices. What's more, the futures market expects no change in Fed funds any time soon. If and when the central bank changes Fed funds, the next adjustment is likely to be a cut in the price of money, or so futures contracts maturing late this year predict.
In sum, the crowd believes that inflation's dead and buried. As a result, the Fed appears to have a free hand to elevate the rate of growth in M2 without fear of retribution from the bond market. All of which raises questions: How long will the Fed raise M2 above the rate of economic growth? Does it matter? Does any one care? Is Milton Friedman's observation about money supply and inflation no longer relevant?
To some extent, the answer depends on who's talking. For what it's worth, when the gold market chatters these days, it speaks of anxiety about the future. Consider, for instance, streetTRACKS Gold Shares (GLD), a gold-linked ETF that's been climbing this year and is now trading at its highest since last spring.
February 16, 2007
A FRESH CASE OF WINTER BLUES
It's only been a few weeks since optimism about the economy bloomed anew. But it's not too early to rethink what was previously rethought. This is the golden age of revise, revisit, rework and rewrite in the realm of economic forecasting.
The latest batch of numbers lends fresh incentive to ask if the on-again-off-again growth story for the economy is off again. Let's start with this morning's news that January's new housing starts fell 14% from December to a nine-year low. Next, the Federal Reserve yesterday announced that industrial production fell 0.5% last month from December. Zeroing in on the weakness, the accompanying press release noted that "output in the manufacturing sector declined 0.7 percent in January; about one-half of the decrease was a result of a drop of 6 percent in motor vehicles and parts."
Adding to the fresh bout of gloom is yesterday's update on the latest weekly jobless claims, which jumped to the highest since last November in the week through February 10.
Is it time to, then, for a new flip-flop to embrace the recession theory anew? "There was a general sense that housing had stabilized,'' Amitabh Arora, head of U.S. interest-rate strategy at Lehman Brothers Inc., told Bloomberg News today. "This will cause some reassessment of that view.''
If we go back a few months, the gloom was much thicker about 2007's prospects. A fair degree of that gloom lifted when December's housing starts rebounded mildly from November, sending the message that the housing slump had passed.
With the benefit of another month's data, it's now looks like December's bounce back was due in fair measure to an unusually mild wealth for December, or so David Resler, chief economist at Nomura Securities in New York advised this morning in a note to clients. "The weather may have been a factor in the January drop too," he wrote, "especially in the West, which accounted for more than one-half of the drop and where an unusual combination of wet (in the North), cold (in California), and dry (also S. Cal.) may have impaired builders."
Housing permits are less vulnerable to weather, Resler continued, but the trend there is down as well for January: single-family-home permits descended to levels last month not seen since 1997.
Resler and others believe that housing will continue to remain a force of contraction on the economy. Of course, few have been arguing otherwise. Rather, the argument that brought some sunshine was that housing wouldn't implode after all. Yes, weakness was clear, but maybe the lion's share of that weakness had passed.
If housing has indeed bottomed out, the economy would probably stay afloat in 2007. It's worth noting that the economy expanded by 3.4% in real terms last year, up from 3.2% in 2005. Considering that housing suffered a potent, but so far not-devastating drop in 2006 makes last year's 3.4% GDP jump all the more impressive. If you expect housing's correction to slow (or deliver a bit of growth?) this year, and if the economy's other cylinders (consumer, corporate) continue to roll along, the apocalypse may still be a ways off.
Hey, anything's possible, but hope's not dead yet. And if the U.S. economy ends up disappointing anyway, there's always Paris, or Europe, to be more precise.
February 15, 2007
IS DIVERSIFICATION DEAD?
In 1997 and 1998, emerging markets and commodities crumbled. But the pain was offset by gains in U.S. and foreign developed markets stocks. Bonds did well in those two years too.
During the great bear market of 2000-2002, stocks in general were bleeding. REITs offered a rare exception, posting tidy gains in those otherwise dark three years for the stock market. Another bright spot in 2000-2002: In two of the three years, commodities posted solid gains and bonds did well too.
Diversification, in short, has proven its worth in the recent past. The question is whether the strategy of owning a broad mix of asset classes will continue to impress? We pose the question because the recent past has witnessed an extraordinary rise in, well, everything. Starting in 2003, most of the broad asset classes have enjoyed gains for each and every calendar year. Yes, there have been some exceptions and a fair amount of variation within the asset classes. There are enough indices out there to prove (or disprove) whatever you want in money management. But by our reckoning, bull markets have more or less prevailed across the board for the past three years.
Such uniformity in positive performance is a rare spectacle and one that raises some disturbing issues. If everything goes up together, does it now follow that everything will also share in the losses when red ink inevitably returns?
At least we can count on cash as an asset class to deliver positive gains. Feeble returns, perhaps, and only when measured in nominal terms. But gains nonetheless. No wonder, then, that our asset allocation has increasingly been defined by a rising slice of cash and cash equivalents. It's distressing to watch the other asset classes continue to fly while an ever larger share of the portfolio is anchored in cash. It's tempting to jump on the hot bandwagon(s) of the moment. So what else is new?
Our emotions tell us otherwise, but our head continues to listen to Mr. Market's signals. As a result, the longer the bull markets roll on in stocks, bonds, REITS and commodities, the more we move to cash.
No, we haven't abandoned stocks, bonds, REITs, commodities, and their various subgroups. In fact, we never will. Owning some of each is an enduring strategy. The only questions are how much and when? Where in this troubled world can we find some conflict-free guidance?
Enter rebalancing. We're of a mind to periodically rebalance, taking from the winning asset classes and redeploying to the losers. Ah, but wait a minute, you say. In fact, there are no losers; only winners. No matter, as that state of affairs brings us to Plan B: rebalance from the relative winners to the asset classes that haven't won quite as much.
We do this not as some mindless exercise that we dreamed up in a vacuum. Rather, a careful reading of history suggests that rebalancing across a broadly diversified mix of asset classes will smooth the ride in the short run and deliver superior results in the long run compared to, say, everyone's favorite benchmark, the S&P 500.
Granted, there are no guarantees. No matter how deeply you've modeled history, no matter how far back in history you peer, even enlightened investors suffer from the fact that stuff still happens. Indeed, ours is an imperfect world. Nonetheless, our only recourse is to embrace imperfect investment strategies, preferably those that are somewhat less imperfect than others.
In short, diversification remains our only friend. Sort of. Alas, our old buddy appears to be going off the deep end of late. Diversification may not be quite the defense mechanism it's been in the past, although eventually its worth will prove itself. Or so we believe. In the short term, however, there's reason to wonder how we'll fare. No matter, since we've another pal who goes by the name of rebalancing.
Diversification and rebalancing, each in their own way, are powerful tools. But as recent history suggests, the two together may add up to more than the sum of their respective parts. Who of us, after all, can afford to have just one friend these days?
February 13, 2007
Investing (speculating?) in oil has gone mainstream. The recent arrival of several exchange-traded products has opened up the commodity to the masses (iPath Goldman Sachs Crude Oil and U.S. Oil Fund.) There are also a growing number of ETFs and mutual funds that track broad commodity indices, which routinely have a significant portion of assets committed to oil. Beyond that, institutional investors in recent years have made strategic allocations to commodities in general and oil in particular. In sum, there's a lot of new money pouring into oil.
The reason, of course, is stems from reading the newspapers and seeing that a bull market in energy has prevailed in recent years. Nothing spurs new investments like upward price spikes.
In years past, this web site has been among the promoters of oil as the next big thing. But the word is out, the money has poured in, Wall Street is launching products to exploit the trend, and so there's reason to wonder if there's a correction coming.
Before we discuss the future, let's be clear on one thing: our view of energy as a long-term play remains intact. To summarize what we've written about many, many times in the past, the low-hanging fruit of oil discoveries are behind us, or so the data suggest. New discoveries of oil, when measured over the decades, have proven to be smaller and in more-remote locations. The prospects for discovery are further complicated by the geopolitical risk that hangs over the commodity. Iraq, to cite the obvious example, sits on massive amounts of untapped oil. Pumping it and shipping it is a problem, and probably will be for many years, for reasons that everyone presumably understands at this late date.
But while we're bullish on energy for the long haul (10-20 years), the question is whether it makes sense to jump in now? Perhaps not. Even secular bull markets suffer setbacks. The peculiar nature of pricing oil in the futures markets provides the basis for our caution. To cut to the chase, the oil futures market remains in what's known as contango, which means that oil futures maturing further out in time are priced higher than those that mature earlier.
For example, as we write this morning, the March 2007 oil contract on the New York Mercantile Exchange is priced at $57.81 a barrel; the March 2008 contract is priced at $63.10. Maintaining a constant exposure to oil, as per the standard operating procedure at most commodity-linked ETFs and mutual funds, requires selling maturing contracts and buying ones that mature further out. The problem is that when contango prevails, selling near-term contracts and buying those that mature down the road produces what's called negative roll, otherwise known as a loss. Indeed, if you sold the March '07 contract at $57.81 this morning and bought the March '08 contract at $63.81, you'd be sitting on a 9% loss.
Now, we fully recognize that the loss can turn into a gain if oil prices generally rise enough to offset the negative roll. But expecting oil prices at this point to maintain the upward trend indefinitely may be asking for too much.
We're hardly the only observer of the energy markets to make this warning. Indeed, an incisive analysis of the oil situation comes by way of the energy team in the London office of Sanford Bernstein & Co. In the firm's newly published "Energy Investing: Beware the Ides of March," the researchers note that "Forecasts of oil prices have a new variable to consider: passive investment." They go on to explain, "Before 2002, you could project the commodity’s fate by estimating the outlook for spare capacity and inventories — but now you also need to figure out the timing and amount of funds flowing into commodity futures."
Indeed, as the graph below illustrates (courtesy of the Bernstein report), the flow of funds into commodity funds has been robust in recent years.
In fact, the surge in passive index money flowing into commodity futures has "distorted the oil futures market, driving the curve into contango, causing it to diverge from fundamentals," Bernstein & Co. writes. The question then is when the contango unwinds. The folks at Bernstein predict that it will unwind. Believing the rise of the contango to be driven by a speculative bubble, they predict that the bubble will burst, as most bubbles eventually do.
"Timing will depend on intricate relationships among Saudi Arabia’s production targets, the limits of physical storage and passive investors’ willingness to accommodate losses," Bernstein admits. The researchers recognize that the demand for commodities as a strategic diversification tool remains strong, and so contango isn't necessarily doomed to evaporate tomorrow. Once again we're reminded of the old saw that the market can stay irrational longer than we can stay solvent.
Nonetheless, the risks of a price reversal are quite real, if not necessarily imminent, Bernstein warned. By the company's reckoning, much will depend on Saudi Arabia's willingness to cut production further. Even so, the natural order will eventually out. Such a cutback, the report concluded,
will only delay the inevitable because the country’s action would, in effect, create temporary underground storage. The longer commodity prices stay inflated, the greater the overbuild in capacity will be and the larger the eventual negative correction. A sharp and quick unwinding in the futures curve could force oil prices to $30-$35/bbl,
according to our analysis.
True, that's one firm's forecast, and so all the usual caveats apply. That said, if oil dropped to such a level, a lot of recent investors in commodity-linked index funds would take heavy losses, as would those who bought energy-related equities in the recent past. Then again, if oil dropped into the $30-$40 range, the opportunity to buy as a strategic long-term holding would be compelling. Perhaps, then, it's time to raise one's allocation to cash on the assumption that better values are coming.
February 12, 2007
INFLATION'S IN REMISSION. BUT FOR HOW LONG?
"We think that the U.S. economic slowdown underway will put downward pressure on inflation for the next four to six quarters. Inflation is a lagging indicator of economic growth, and it will likely reach the point this year where it ceases to be a major concern for Federal Reserve policy makers, who will then shift their focus to easing monetary policy to address a soft economy."
So wrote John Brynjolfsson, managing director and portfolio manager at the giant bond shop PIMCO in his February commentary. The bond market this month seems to agree with Brynjolfsson's bullish scenario for fixed income. The return of buying the 10-year Treasury Note pushed the yield to under 4.80% by last week's close, down from around 4.90% in late January. The buying may or may not have legs, but for the moment, a cautious optimism has the floor.
Nonetheless, this is no time to take a nap or mindlessly commit gads of long-term money to bonds. Consider that while Brynjolfsson sees 2007 as a generally positive year for bonds, the longer-term outlook isn't quite so rosy. "Beyond the five-year horizon," he wrote, "we are very concerned about inflation, largely based on the growing mountain of obligations, liabilities and unfunded promises being heaped upon the government and corporations by demographic shifts."
In other words, to pay for the government's growing pile of unfunded obligations, such as Medicare, Medicaid, Social Security, and so on, the likely course will be printing more money. Firing up the printing presses has historically had a strong appeal for a politically driven town like Washington. After all, printing money to fill a financial gap isn't immediately obvious nor especially painful early on--attributes that have massive appeal for pols trying to extract themselves from tight political corners.
But if there's no blatant price to pay in the short term for dispensing freshly minted dollars to pay for increasing demand on government services, the strategy reveals itself in time. Inflation, in short, rises when governments print more money than economic growth requires.
Of course, expecting higher inflation based on this scenario requires buying into the party line of monetarism, to which your editor subscribes. As it happens, so does PIMCO's leadership. Again quoting Brynjolfsson, "There is a broad array of economic thinking going on at PIMCO—Keynesian, Monetarist, Neoclassical to name a few. But nearly all of us concur with the late great Milton Friedman, who argued that 'inflation is always and everywhere a monetary phenomenon.'"
By our reckoning, the bond market isn't pricing in the longer-term threat of inflation that Brynjolfsson speaks of. Maybe that's because long yields are lower because of an excess of foreign purchases of Treasuries. Or maybe investors overall are overly focused on tomorrow vs. 10 years hence. Nonetheless, the inflation risks spawned by government spending are quite real, and strategic investors should pay heed. For supporting evidence, start by looking at the following chart, courtesy of the Congressional Budget Office:
February 8, 2007
WHAT'S THE DEAL WITH EXCHANGE TRADED NOTES?
Last year, Barclays launched its iPath brand of exchange traded notes. On the surface, they resemble exchange-traded funds. But ETNs and ETFs are in fact quite different, even though the both look like exchange-listed index funds, as your editor observed in the February issue of Wealth Manager. At the moment, there are four ETNs:
iPath GSCI Total Return Index (GSP)
iPath Dow Jones-AIG Commodity Index Total Return (DJP)
iPath Goldman Sachs Crude Oil Total Return Index (OIL)
iPath MSCI India Index (INP)
More are coming. In fact, there's talk that ETNs may eventually track indices and asset classes that aren't viable for the ETF structure. Maybe. Meanwhile, the burning questions include: Are ETNs superior to ETFs? Are they riskier? Are they a worthwhile alternative to ETFs? In short, What's the deal with ETNs? In search of some answers, here's my report from the latest issue of WM….
February 7, 2007
MAYBE I'M AMAZED
Never underestimate the power of momentum.
That's a timely observation as we gaze at the year-to-date returns for the major asset classes through last night's close. Save for commodities, which have been struggling for months, red ink remains in exile on the performance ledger for the broad asset classes.
As our table below reveals, it's been hard to lose money so far this year. In some corners, it's been really, really hard.
Perhaps the most extraordinary number on the board above is the 10.9% return, which is claimed by REITs. Yes, dear readers, that's 10.9% for year so far--and we're only halfway through February!
As impressive as REITs are so far in 2007, it's even more so when you consider that 1999 was the calendar year last when the asset class suffered a bout of red ink. Suffice to say, after rallying for so long and so hard, the year-to-date gain for REITs looks excessive at the moment. No, we're not predicting a bear market in REITs (that may not happen until every last man, woman and child on the planet has committed money to the asset class). That will come...one day. Meanwhile, perhaps a bit of water-treading in store for REITs. But, hey, what do we know?
Returns so far this year are otherwise relatively modest, but again, it's only February. That said, what's striking is the fact that everything beyond commodities is running higher--again. Starting in 2003, the asset classes listed above have posted gains for each and every calendar year. (Commodities arguably lost money last year, although that depends on the index. The oil-heavy Goldman Sachs Commodity Index slipped in 2006, but the Dow Jones-AIG Commodity Index posted a small rise).
The generally ongoing bull-markets-as-far-as-the-eye-can-see trend compels one investment strategist to gaze in wonder when it comes to equities. "The global stock market meltup up is turning into a global stock market blastoff," wrote Ed Yardeni, chief investment strategist at Yardeni Research, in an email to clients this morning. "It shows perhaps one of the Great Wonders of the modern world," he continued. "I don't ever recall seeing so many stock markets going straight up. I take that back: The same thing happened at the beginning of last year."
February 6, 2007
A BIAS FOR GROWTH...SORT OF
The Institute for Supply Management publishes indices that are widely followed on Wall Street. Two in particular receive quite a bit of attention. Both were updated in recent days, and both offer conflicting signs for the economy.
The ISM Manufacturing Index for January was released last week and its message is anything but upbeat. As our chart below illustrates, this measure of manufacturing has fallen to its lowest in nearly four years. What's more, the downward bias has been intact for a year or so, suggesting that the weakness is more than a temporary blip. Readings below 50 indicate that manufacturing activity generally is contracting, and so January's reading of 49.3 is nothing if not clear.
But don't give up hope just yet. The ISM Services index offers a cheery counterpoint to manufacturing. The non-manufacturing index, as it's known, climbed to 59 in January, the highest since last May. Returning to the chart above, it's obvious that the rise in this measure of the services piece of the economy has been expanding at an accelerating clip since last fall.
Although our graph suggests the two indices are equal, in fact they could hardly be less so. Manufacturing is but a minor share of the American economy in the 21st century. The lion's share of the nation's business is now in services. If one of the indices has to turn down, manufacturing's descent will presumably have less negative influence on the general direction of the economy.
"The real strength in the economy is the service sectors and they do not seem to be dragged down in any way by the housing and auto sectors,'' Nigel Gault, chief economist for Global Insight Inc., told Bloomberg News yesterday.
But the bond market isn't quite so sure. A bullish outlook on the economy usually spells trouble for bonds, i.e., higher yields. So far in February, however, the yield on the 10-year Treasury has shown a penchant for falling. Yesterday, the 10-year closed at roughly 4.81%, down from nearly 4.90% last week.
In fact, the ISM Services index may be less than it appears, suggested David Resler, chief economist at Nomura Securities in New York, in a note he wrote to clients yesterday. For instance, "several indices of key dimensions of activity -- including orders, inventories, export orders and employment -- showed signs of deterioration," he explained.
All of this can be said to be favoring a sweet spot for the Federal Reserve's monetary policy. Growth that's modest keeps optimism bubbling but without inflationary fears. The fact that the pessimists and optimists continue to argue suggests that something approaching a middling outlook remains probable for 2007.
Indeed, trading in Fed funds futures contracts continues to anticipate a Federal Reserve that keeps interest rates steady through the summer. Not too hot, not too cold is still the mantra, and there's fresh data to expect no less.
February 5, 2007
IS MEDIAN CORE CPI A BETTER MEASURE OF INFLATION? (Corrected version)
Note: An earlier version of this story incorrectly identified the median CPI as a top-line index when in fact it's an alternative measure of core inflation. Below, we offer a corrected version of the story and data.
The report on consumer prices for January isn't due for release until February 21, but it's never too early to start thinking about inflation.
Judging by the last update on inflation through December, there's still reason to wonder what's coming. Core consumer prices (which exclude the volatile food and energy prices) advanced by 2.6% last year. That's up from 2.2% in 2005. Will the upside momentum persist?
No one knows, but if you're looking for one more reason to be wary, consider an alternative (and arguably superior) measure of core inflation. The Federal Reserve Bank of Cleveland calculates the median core consumer price index, which is said to minimize temporary "distortions" in measuring price trends that bedevil the conventional core CPI index. The median approach, as an alternative to the core CPI measure, provides a "better" forecast of inflation, the Cleveland Fed opines. "The weighted median CPI is easy to calculate and has a higher correlation with past money growth than other inflation measures, resulting in improved forecasts of future inflation," the bank explains on its web site.
With that in mind, we took the current numbers on the median core CPI and compared them to the conventional CPI. The result: inflation is significantly higher by way of the median benchmark compared to the standard measure issued by the Department of Labor. To be precise, the Cleveland Fed's median core CPI advanced 3.5% last year, vs. 2.6% for the conventional core CPI. (There's a discrepency in some of the Cleveland Fed's median data, but we're using the historical series that shows the latest 12-month change in median CPI at 3.5%, although other portions of the web site quote 3.7%.)
In fact, as our chart below illustrates, the median core inflation rate has been relatively higher in recent history compared to the usual measure. In sum, here's one more reason to delay judgment on whether inflation will be an issue or not in 2007.
February 2, 2007
WILL THE LABOR MARKET KEEP BUBBLING?
A funny thing happened on the way to the mid-cycle slowdown. The slowdown wasn't quite as slow as some in the Federal Reserve expected. That at least has been the new new thinking this week, courtesy of the surprisingly strong rise in GDP for the fourth quarter, as we discussed in our previous post.
Into the mix comes this morning's employment report for December. Nonfarm payroll rose by 111,000 last month, the smallest rise since last May's 103,000 increase. Is it time to rethink the economic growth story that seemed to bloom anew? No, at least not yet.
January's rise in nonfarm jobs works out to a 0.08% rise over the previous month. That's on the low end in recent history, but still within the band of growth posted in 2006. Last May and October witnessed identical rates of nonfarm job increases. Previously, such relative dips in growth inspired warning that job growth was about to stall in absolute terms, to be followed by recession. It didn't happen then, and it may not happen now.
Indeed, as our chart below reminds, the labor market doesn't move from growth to contraction overnight. The warning signals will build over months and quarters. Consider that the deterioration in the labor market in 2000-01 was fairly rapid, unfolding over about a year or so. But the type of blatant catalyst at the time--the bursting of the tech bubble--doesn't offend in the here and now. Corporate profits are high, consumers are spending, the labor market's growing, and investors are far more cautious. A recession may be coming, but now's not the time to hold one's proverbial breath.
A year ago, in January 2006, total nonfarm payrolls totaled 135.11 million. Last month, nonfarm payrolls reached 137.26 million, or a gain of a bit over 2 million. In percentage terms, nonfarm payrolls climbed by 1.6% over the year-earlier month. Yes, that's the slowest pace since mid-2005. But given the strong GDP number for the fourth quarter, and the continued strength in consumer spending (the government yesterday reported that consumer purchases in December rose by the most in five months), there's a fair amount of momentum in the economy. Add to that all the liquidity that's still sloshing around, and the Fed's willingness to let interest rates ride, and you've got a nice blend of factors suggesting that growth will remain the path of least resistance for the next quarter or two. In turn, that should keep the stock market bubbling and bonds on the defensive.
Keep in mind that the last several months have been a test or sorts for the economy. The fallout in housing, we were told, was supposed to derail the economy. It's looking increasingly clear that the real estate train wreck was more of a speed bump. If real estate couldn't produce a recession, what could? Yes, there's always something lurking that could potentially create havoc. But for the moment, there's no obvious catalyst for disaster.
Nonetheless, there's still enough doubt out there about what's coming to keep traders wondering. Fed funds futures contracts are currently priced in anticipation that the current 5.25% Fed funds rate will remain unchanged through August. Fence sitting is in vogue at the Fed and around the financial markets, with a bit of pessimistic icing on the edges. "The overall economy is weak and it's far too early to discount the possibility of rate cuts this year," Richard Iley, an economist at BNP PARIBAS in New York, told Reuters yesterday.
Stock markets are said to climb walls of worry. The next several months offer plenty of opportunity to put that notion to the test.