March 30, 2007
THE GREENER-FIELD FACTOR
Investing in the real world faces a number of challenges, one of which is the human inclination for juicing returns, beating the crowd and (hopefully) delivering results that make for engaging conversation at cocktail parties. In practice, however, stuff happens that alter the best laid plans of mice, men and, yes, even mutual fund managers.
The latter come to mind after reading a story in today's Wall Street Journal (subscription required), which reports, "Mutual-fund companies are proposing big investment-policy changes this year, with many asking shareholders for permission to put more of their money into foreign stocks and real estate just as those once-hot investments are slowing down."
Opportunities often appear brighter elsewhere for active managers, particularly those wedded to the relatively efficient world of domestic stocks. It's getting harder to look good by swimming in mid- and large-cap American equities. The realities of expenses, trading costs, taxes and unexpected events conspire to turn an otherwise impressive paper strategy into something less by the time the net results filter down to the end user--i.e., you and me. The challenge isn't limited to U.S. stocks, although arguably it burns brightest there.
For those who agree, index funds are an obvious alternative. There is a long list of reasons for using index funds. By our reckoning, the case is overwhelming, or so the real-world results inform us. We won't revisit the details here, other than to note that today's Journal article provides one more reason to consider passive investing.
Indeed, one has to step back and ask, Why would a manager want to expand the mandate of the existing policy? A forgiving answer may be that the world of opportunities has expanded and therefore so should the manager's capacity for exploiting those opportunities. There are, however, competing theories as to what's behind the motivations. That includes the possibility that the manager's track record isn't all that impressive of late and so something new is required.
There are several ways one could potentially improve a lackluster record. One, work harder and/or hire better managers. Two, look to more fertile investment fields. The latter seems to be the preferred route of late, or so the Journal article suggests. Adding the capacity to trade foreign stocks, real estate securities and even commodities are among the favored changes on the docket of late. Franklin Templeton, for instance, reportedly held a meeting last week on proposals for altering fund rules on borrowing, lending and commodities limits in some 30 funds.
Theoretically, we don't have a problem with such ideas. For all we know, the changes mean that fund companies are poised to enhance the return/reward profiles of their portfolios. Hope springs eternal.
We're second to none in expanding one's asset allocation horizons when it comes to incorporating more asset classes in search of superior risk-adjusted returns. That said, our preferred approach to an enlightened mix of low and negatively correlated asset classes is through low-cost index funds that target a broad definition of their respective investment quarry.
For example, owning a low-cost Russell 3000 index fund for tapping U.S. equity returns is eminently reasonable to our way of thinking. There are several reasons, and one that stands out at the moment is the expectation that such a fund will deliver what it claims today, tomorrow, next year and so on. From a strategic, asset allocation-crafting perspective, that's a plus--a big plus.
A Russell 3000 fund won't ask shareholders to add commodities to the mandate, or ask for the ability to add long/short strategies next month. We may be in the minority, but we prize the long-term strategic visibility that flows from owning a Russell 3000 fund. Building asset allocation strategies is hard enough with the individual components changing direction with every turn in the investment cycle.
Granted, a Russell 3000 fund may or may not excite at any given time. Fortunately, a Russell 3000 index is but one piece of a broader asset allocation puzzle. It's the pie overall, not the slices, that engage us. That said, strategic success demands that each one of the slices is robust, consistent and generally effective at delivering the targeted beta.
As readers of this site know, we're of a mind to own multiple asset classes via broad index funds on a routine basis over time. The crux of the challenge (and potential opportunity) comes from spending time choosing strategic weights among the asset classes and opportunistically rebalancing when the weights move sharply away (up or down) from the targets.
Simple though such a strategy sounds, it's fairly complex in practice. The point, however, is this: there's enough opportunity in such an index-based strategy to offer satisfaction for investors of all risk tolerances. And as the financial services industry adds new index funds tapping formerly untapped asset classes, the opportunities continue to improve.
In short, we have our hands full with our preferred strategy. Adding in the active manager factor only makes the job that much tougher and, we suspect, marginally less productive over time. We take no comfort from the possibility that active managers can potentially change strategic directions mid-way through the horse race, as the Journal article reminds.
March 28, 2007
INFLATION, MEDICINE & LIABILITIES
Inflation may appear contained these days, but the future is always unclear.
As we discussed in our previous post, there's a persuasive new report making the rounds that extends further support for the notion that human beings are in control of their own monetary fate. That, at least, is true in a world where fiat currencies prevail and the gold standard is considered the financial equivalent of the horse and buggy.
If central bankers can excel (as they have in recent years) at their appointed task of controlling inflation through enlightened monetary policy, they can also stumble (as the decade through the early 1980s reminds). Perhaps success will continue into perpetuity for the grand task facing the Fed and its counterparts around the world. Alas, we're unsure of the outcome one way or the other in the long run. So it goes in matters where human beings are in charge.
Consider a few numbers from the Congressional Budget Office. Last year, the combined spending for Medicare and Medicaid (M&M) was $555 billion, or about 21% of the federal government's total outlays for the year. The CBO projects M&M spending will jump to $756 billion by 2010, representing nearly 25% of outlays. By 2017, M&M spending will hit $1.26 trillion and consume 31% of outlays. In short, rising absolute and relative M&M spending looks likely.
The impact on future inflation may be more than trivial. Indeed, M&M is a big chunk of the budget, but it's hardly the only source of rising spending liabilities. But we digress. Returning to M&M, consider that for the seven years through last month, the broad consumer price index rose by 19.8% on a cumulative, not seasonally adjusted basis, according to the Bureau of Labor Statistics. The sub-category of medical care advanced nearly twice as much, by 34.8% over that span.
The growing pressure on the government to spend more will be most pronounced in medicine. As new technologies offer advances in health care, the political pressure will likely increase on new spending initiatives as well. Add in the other liability pieces and the picture becomes frightening.
A new study published in the March/April 2007 issue of Financial Analysts Journal offers some sobering perspective. "If the U.S. federal government properly accounted for its explicit and promised liabilities," the paper advises, "it would record a national debt of $64 trillion and a national deficit of $2.4 trillion in 2006." One example: "The recent
retiree prescription drug law... added more than $15 trillion to the federal government’s
shortfall...." Overall, the study warns that "the U.S. federal government has promised much more than it can deliver with its existing tax base."
Yes, that may be shocking news for some, but let's compose ourselves and put on our risk-manager hat for a moment and consider what might trip up the business of central banking. A story this morning inspired such ghoulish thinking on our part and it relates to spending on health care in general and testing for breast cancer in particular.
A study published yesterday by the New England Journal of Medicine recommends broader and more frequent use of MRI scans for breast cancer in women who already have the disease or who are considered high-risk candidates for such. As a health issue, it all seems perfectly logical, at least from our layman's perspective on medical matters. If there's a superior approach for detecting, treating and perhaps preventing the worst-case scenarios for cancer, it's a classic no-brainer situation. In short, just do it.
But when we consider the macro financial implications, our anxiety level goes up a notch. According to a New York Times story today on the new advice, breast MRIs are ten times more expensive than mammography, the current standard for screening. In addition, MRI imaging is far more sensitive than mammography, and so additional scans are more common with MRIs to distinguish between false alarms and actual threats. Beyond that, MRI scans "require special equipment, software and trained radiologists to read the results." The Times story also reported that the new advice on MRI scans "could add a million or more women a year to those who need breast magnetic resonance imaging — a demand that radiologists are not yet equipped to meet, researchers say."
The larger point is that the federal government faces enormous spending pressures in the years ahead as the demand for medical services grows. The MRI issue is just one small example of what's coming, namely, much higher health care spending by the government in absolute and relative terms.
Perhaps even more worrisome is that the financial markets have barely noticed, the paper observes. The additional liabilities assumed by the government in the prescription drug program "had no appreciable effect on long-term interest rates."
The question is whether all the debt will have an impact on such things as inflation and the price of money. We have some very definite, albeit speculative ideas on the issue for the long run. And we're preparing accordingly. Yes, we may be in the minority in that regard, but we're used to it.
March 26, 2007
Of all the days to pick for chatting up optimism on inflation's outlook, this past Friday wasn't ideal. Nonetheless, two voices from the Fed were on the rubber chicken circuit on March 23, expounding on the benefits that flow from enlightened monetary policy.
Philadelphia Fed President Charles Plosser told a bankers conference that "I anticipate that the yield curve is likely to be flatter, on average, than at comparable points in past business cycles. This is not to say that the yield curve is going to be inverted all the time, but, on average, I believe the curve will be flatter."
The reason, he opined, was because inflation expectations had become less volatile. "My case for a flatter yield curve is based on two premises: first, inflation and inflation expectations are likely to be lower and more stable, and hence, the inflation premium will be smaller than in the past; and second, inflation and the real economy are likely to be less volatile, so the risk premium will be smaller."
Although Plosser didn't think an inverted yield curve would be a permanent fixture, he said he had "confidence in the fact that inflation in the United States is going to stay low and more stable [and that] means there is less reason for long-term rates to be above short-term rates."
On the same day, Frederic Mishkin, a Fed governor, advised in a speech, "the data suggest to me that long-run inflation expectations are currently around 2%." He went on to predict that core PCE "will gradually drift down from its latest twelve-month reading of 2.25%."
To be fair, both men tempered their commentary with the usual caveats. Mishkin, for instance, spoke of the risks of trying to put a precise number on inflation expectations, which is by nature a warm and fuzzy concept. "We still face some uncertainty in this regard, and policymakers must be cautious about placing too much confidence in any one estimate," he said.
As it happened, the market's view of inflation expectations ticked up on Friday to its highest since January. Based on the spread between the nominal 10-year Treasury and its inflation-indexed counterpart, the crowd prices future inflation at 2.43%. As recently as January 4, this measure of inflation expectations was as low as 2.26%. And if you go back to 2003, inflation expectations were under 2%. As a result, one could argue that expectations are going in the wrong direction lately.
It's true, of course, that market-based predictions of inflation are in constant flux. And since the TIPS market has only a decade of history, it's not yet clear that inflation expectations pulled from this corner are any better (or worse) than those dispensed by other formulas.
Still, various Fed heads have made it known that the central bank considers inflation expectations to be a critical driver of price trends over time. Mishkin on Friday offered the latest testimony to such thinking. "When we think about what drives trend inflation," he said, "inflation expectations--particularly long-run expectations--come to mind."
Mishkin also commented, "If inflation has indeed become less persistent because better monetary policy has anchored inflation expectations more solidly, the monetary authorities may find that they have less need to induce large swings in economic activity to control inflation."
But if inflation expectations are second to none for monetary policy, does the rise of the nominal-TIPS spread bode ill? Not necessarily, Plosser suggested. Indeed, there's a variety of methods for plotting inflation expectations, and the one cited by Plosser on Friday shows that "long-term inflationary expectations have come down and have become more stable."
Meanwhile, a recent paper that's caught the attention of central bankers the world over reminds once again that inflation is ultimately a monetary phenomenon, as Milton Friedman advised. But, the paper warns against relying on inflation expectations. That was fine when inflation was higher in decades past. But now that inflation has fallen to generational lows, such metrics are no longer as valuable for monetary policy.
The bottom line: central banks are running the show. The inflation buck stops at the Fed, and its counterparts around the world. By that standard, central bankers deserve praise for the decline and fall of inflation over the years. But the future looms, and on that front there's always reason to worry, particularly now that central bankers seem to be patting themselves on the back about the past. As The Economist recently observed,
...today's central bankers have little room for complacency. Inflation remains low and stable because policymakers are vigilant, not because any deep, structural changes insulate the modern economy from price pressure. If central bankers relax, higher, more volatile inflation could easily return.
March 23, 2007
ASSET CLASS REVIEW
Financial noise can be disorienting. This week was no exception. Between the Fed's FOMC statement and the various economic reports, there's been enough play in the numbers to see whatever you want to see.
But while the economy remains a gray area, Mr. Market continues to speak, as he always does, with numerical precision. Economists may hedge their forecasts, but traders must put a definite number on their sentiment, either in the affirmative or negative. Market prices, in short, prevail. They may be wrong, right or something in between, but for those of us without a crystal ball, we can't afford to dismiss the trend in pricing assets.
With that in mind, here's a quick look at how the latest market profile stacks up across the broad asset classes. What's striking these days is the fact that the red ink is starting to pile up when measured by recent history. As our table below shows, the biggest loser over the past month has been REITs, which shed 5%. Even so, REITs are still up by that amount and more for the year. The asset class has been second to none in resiliency in the 21st century. No one knows if REITs can weather the storm one more time, but it's clear that if economic and real estate risks linger, the group may be vulnerable.
Another group to watch is emerging markets, which have tumbled by nearly 2% in the past month. Like REITs, emerging markets returns are still firmly in the black on a year-to-date basis. But as a high-risk corner of equities, this would not be a great time to go to sleep in monitoring the group.
In fact, everything save U.S. bonds, TIPS and cash has fallen over the past month. The fact that the selling has been across-the-board in recent weeks is a sign, at least to us, that returns won't come as easily, if at all, going forward. Ours is a new era of rising risks and potentially lower returns for the foreseeable future compared with the last few years. You wouldn't necessarily know that by looking at last year's returns, which we list in the above table. But investors should remain vigilant to the fact that recent history can distort perceptions about what's coming.
Yes, diversification across asset classes is still your only friend in the long run. Then again, it's no guarantee. The inherent risk, by our reckoning, in choosing the right mix of asset classes is on the rise. But since there's really no alternative to owning multiple asset classes for the long haul, it's a risk that strategic investors must face. To paraphrase Churchill, asset allocation is the worst possible strategy except when compared to the alternatives.
March 22, 2007
EXUBERANCE DU JOUR
As rallies go, yesterday's pop in equity and bond prices was impressive. Shortly after the Fed's FOMC announcement hit the street, which confirmed that interest rates would remain unchanged, buyers took control. In the final two hours of yesterday's trading session, the S&P 500 jumped 1.7% while the bulls pushed the yield on the 10-year Treasury down to 4.52%, the lowest in more than a week.
But rather than seeing yesterday as an end, the session was the start of a new gambit on predicting the next phase of the business cycle, which increasingly looks long in the tooth. Consider yesterday's comments from Gail Fosler, chief economist of The Conference Board. Although the economy continues growing and still looks healthy, there are warning signs to consider, especially in connection with inflation. "The forces driving corporate profitability will likely become more adverse as we get further into 2007," Fosler said. "Slowing productivity and rising costs do not bode well for the future."
Indeed. But investors yesterday had other ideas. For bond traders, the source of buying optimism was the Fed's formal recognition that the economy is slowing. In the FOMC statement, the central bank announced: "Recent indicators have been mixed and the adjustment in the housing sector is ongoing." In addition, the bond bulls focused on the absence of the "additional firming" language in yesterday's press release regarding monetary policy--a phrase that was present in the previous statement.
But did the buyers overlook the rest of the FOMC statement? For instance, this passage doesn't inspire confidence when it comes to owning bonds: "Recent readings on core inflation have been somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures. In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected."
Interest rates are unchanged, and the Fed's worried about rising core inflation. Ok, we can take a hint.
But for now, there's enough doubt about the future to justify almost any short term move in the markets. As the Fed advised, "incoming information" will determine what comes next. Nonetheless, by our reckoning, the central bank is preparing the market for what may be a new round of tightening if inflationary momentum continues. Mr. Market, however, chose to place his focus elsewhere. So be it. Optimism usually wins out when there's a choice. Most of the time, the optimism's well placed. Will it be again? Or was yesterday's buying another case of irrational exuberance?
March 21, 2007
THE CALM BEFORE THE YAWN
Almost no one expects the Federal Reserve to announce an interest-rate cut this afternoon, when the FOMC is scheduled to make a public announcement on the price of money and the economy.
The sentiment is quantified in Fed funds futures. As we write this morning, the April contract is priced for the status quo of 5.25%. By the end of the year, however, the market expects that rates will be lower, or so the futures contracts predict. But that doesn't help in the here and now.
"What is likely is no change at all," said Jim Russell, director of core equity strategy for Fifth-Third Asset Management in Cincinnati, in the Mercury News Wire. "We might get a little commentary on the housing market nationwide ... but we don't think there's much action in the cards."
Nonetheless, some observers are looking for calming words from the Fed in the wake of jitters over the subprime mortgage market. "There's been uncertainty in the market about where the U.S. economy is heading," Oscar Gonzalez, economist at John Hancock Financial Services,
told AP via The Baltimore Sun. "I think the Fed's message will be one of stability."
The question is: What constitutes enlightened thinking on stability these days when it comes to monetary policy. Martin Crutsinger, economics writer for AP, puts his finger on the quandary facing the Fed in his column today via The Houston Chronicle:
...the economy has turned weaker with business investment, which had been expected to take up the slack from a weakening home market, faltering. And consumer spending is weaker as well.
That is why some economists have been pushing the possibility of a recession higher this year. Greenspan put the odds at one in three.
Normally, the central bank would respond to spreading economic weakness by cutting interest rates. However, two reports on inflation last week showed that price pressures remain a problem with both wholesale and retail prices rising more rapidly in February.
Ed Yardeni, CIO of Yardeni Research, weighs in today on the economic outlook in an email to clients. "Real GDP growth is likely to remain subpar during the first two quarters of 2007," he wrote. "The culprit is residential investment, which chopped a full percentage point off of real GDP growth during the last two quarters of 2006, and is likely to do the same to Q1 and Q2 of this year."
If rates are held steady, and the slowdown/inflation threat remains, the task du jour later today will be parsing the FOMC statement for crumbs of insight about what's coming in monetary policy. Beyond that, tomorrow's initial jobless claims update promises to attract attention, as will Friday's report on existing home sales for February.
We're still data dependent, but for the moment there's precious little new data to dissect.
March 20, 2007
A TIMELY BOUNCE
You can almost hear a collective sigh of relief.
After this morning's update on housing starts for February, there's reason to think that a thin ray of optimism is in order when it comes to pondering real estate for 2007. It may be fleeting, but for a few hours, at least, hope has a new lease on life.
The source of the cheer comes by way of the Census Bureau, which reported today that new privately owned housing units rose by 9% last month over January, based on a seasonally adjusted annual rate. In raw numbers, that translates into 1.525 million new starts in February. As the chart below shows, that delivered a much-needed bounce to the battered housing market.
Clearly, it's too early to say that all's well. Even after last month's pop, it's not yet clear that the decline that began more than a year ago has bottomed out. Nonetheless, there are other reasons to be cheerful with today's report, including the fact that the housing starts total delivered a substantial upside surprise compared to the consensus forecast, which predicted 1.440 million units, according to TheStreet.com.
Another bit of encouraging news can be found in the housing-start numbers for the South and West. The harsher winter conditions in the Northeast and Midwest inevitably slow housing related activities. By contrast, the weather is much less of a stumbling block in the South and West. As such, focusing on those areas may offer a better picture of the underlying trends for housing. With that in mind, consider that new housing starts surged 26.4% in the West last month over January; in the South, starts climbed by 18%.
As the last major economic update before the Fed's FOMC speaks publicly tomorrow afternoon, the housing starts report offers one more reason to think that a cut in interest rates is off the table of possibilities. But while this morning's news is encouraging, the real estate ills aren't necessarily over.
A closer reading of today's housing report suggests that there's still a fair degree of weakness in the real estate market beyond housing starts. For example, while housing starts jumped 9% last month, today's report shows that:
* New building permits issued fell 2.5% last month from January's pace (based on a seasonally adjusted annual rate, as are all numbers below).
* The number of new privately owned housing units under construction last month fell 0.7%.
* New privately owned housing units completed slipped 9.4% in February.
One report doesn't mean much in the grand scheme of the economy. Then again, optimism and pessimism, bull and bear markets, are created one data point at a time. And for today, at least, the optimists and bulls have a few new reasons to cheer.
March 19, 2007
WATCHING, WAITING... TRADING?
The combination of last week's renewed fears that inflation might not be quite dead after all and this week's Fed FOMC meeting means that speculation on prices will dominate the talking and trading points this week in the financial markets.
The anxiety is spilling over into the equity markets. The S&P 500 last week continued to wander sideways, waiting for a clearer picture of what this week will bring. The market for the benchmark 10-year Treasury Note has also become cautious now that inflation has returned as a topic of discussion.
Inflationary talk may be good news for commodities, but the prospect that pricing pressure is still on at a time when U.S. economic growth is forecast to slow has kept raw materials treading water if not slipping in recent sessions.
But while inflation talk is back, investors should put the trend du jour in perspective. As the chart below reminds, the market's expectations for inflation are higher but only marginally so. That may change in the coming days and weeks. Much depends on the Fed FOMC confab on Tuesday and Wednesday.
Meantime, the market's outlook is that the central bank will keep Fed funds unchanged at 5.25%, with a prediction of a 25-basis-point cut later this year, based on futures trading. That leaves the great unknown at the moment: the wording of the accompanying press release from the FOMC on Wednesday afternoon.
Between now and then, the speculators have the floor.
March 16, 2007
Mr. Market won't be happy with today's inflation report. Consumer prices rose 0.4% on a seasonally adjusted basis last month, double the pace of January and above the 0.3% that the crowd was expecting.
Using the new numbers, the consumer price index advanced by 2.4% for the past year through February, the Bureau of Labor Statistics reported. A 2.4% annual rise in inflation may not look all that threatening, but when you take a closer look at the numbers, there's reason to wonder what's coming.
Consider the core rate of inflation, which strips out energy and inflation. The Fed's target for core CPI is widely reported as a range of 1% to 2% year. But as today's update reminds, core CPI is rising by 2.7% a year as of February. That's nearly as high as it's been in recent years. In fact, the last time core CPI was within the Fed's range was August 2004.
More ominously than the level is the direction: core CPI continues to inch higher, a drift that's been under way more or less for nearly three years. As warning bells go, this one looks pretty convincing. To be sure, in any given month there's no dramatic story for core CPI. But viewed over time, it's clear that core inflation aspires to higher elevations, as our chart below shows.
Or does it? Alas, no one really knows. But based on recent history, it's clear that upside inflation momentum, though slight, appears to have the upper hand.
Nipping that momentum in the bud isn't a problem. Tightening monetary policy is the accepted prescription. That's what central banks are supposed to do. The question is whether the Fed's prepared to unsheathe that monetary weapon again. The economy just happens to be slowing at this point. The prospect of raising interest rates is sure to go over like lead balloon in Washington and throughout the country. Then again, central bankers are hired for results, not popularity.
Bernanke's Fed last raised Fed funds by 25 basis points last June to 5.25%. We don't have a clue as to what the central bank's thinking, other than to read the public tea leaves that are available to everyone else. But this much, at least, seems clear: Bernanke and company will be taking another hard look at monetary policy between now and next week's FOMC meeting.
March 15, 2007
A WARNING, OR JUST A BLIP?
This morning's update on February wholesale prices should give the Federal Reserve something to think about.
At its worst, the continued rise in core producer prices last month is another sign that inflationary momentum is building in the manufacturing pipeline. Perhaps it's just a temporary blip. But until and if future reports suggest otherwise, prudence dictates that monetary policy should err on the side of caution. Inflation isn't easily put back in the proverbial bottle. Meanwhile, keeping it from seeping out in the first place is much easier and, in the long run, more productive for the economy.
As for today's PPI numbers, here's how it stacks up. Top-line PPI jumped 1.3% in February, the highest last November and near the highest monthly figures posted in recent years. On a 12-month basis, PPI is now rising by 2.6% a year, the highest since last summer. The respite in upward wholesale pricing pressure from last July through October now appears to be fading.
It's tempting to say that energy is the sole cause for the latest price surge. Indeed, energy prices jumped 3.5% for finished goods last month, nearly reversing the 4.6% decline in January. But if you strip out food and energy from PPI, there's still something to worry about. Core PPI last month rose by 0.4%, twice as much as January's increase. On a 12-month basis, core PPI is advancing by 1.8%. That's not the end of the world, but it's up sharply from last summer. The question is whether the momentum has legs.
It's too early to hike rates, although it's also too soon to start cutting. For the moment, we can only wait for tomorrow's consumer price report for February for a deeper understanding of price trends. But after looking at the latest PPI numbers, we'll be that much more skeptical when digesting the CPI update for February.
March 14, 2007
A NEW REASON TO STAY WORRIED ABOUT AN OLD CHALLENGE
Amid yesterday's selling of equities and fresh worries over subprime mortgages, you might have missed the latest from the International Energy Agency. Stockpiles of crude in developed countries is poised to drop to the lowest levels in 10 years, the group warned. The solution, as if you didn't already know, is that OPEC will need to come to the rescue by pumping more oil.
"Preliminary data suggest that OECD stocks have fallen by over 1.26 million [barrels per day] over the first two months of the year, and could be heading for the largest first quarter stock draw for over 10 years," the IEA report advised, via Reuters. "In reality, stock trends and prices are signaling that higher OPEC exports will be needed in the months ahead."
As it happens, OPEC is scheduled to meet in Vienna tomorrow to discuss anew the group's output plans. Reports are circulating that the group's preference is for keeping output steady. So much for a rescue plans. For example, Shokri M. Ghanem, head of the National Oil Corp. of Libya, said according to AP via the International Herald Tribune: "I don't think there is a real need for doing anything." The article also quoted oil analyst Kamel A. Al-Harami, former president of Q8, the retail arm of the Kuwait Petroleum Corp.: "I think [OPEC is] comfortable ... because prices are at [an] acceptable level."
Weighing the foreseeable future for oil prices probably depends on the crowd's outlook for economic growth in the U.S. and the world. As economies slow, so too does the growth in oil demand, perhaps to the point of an outright decline. Absolute drops in oil consumption aren't common, however. The United States, the single largest user of oil and the biggest importer of crude, consumed a slightly lower amount of oil in 2003 and 2005 vs. the respective previous years, according to BP data. But you have to go back 1990 and 1991 to find annual declines of more than 1%, based on average daily consumption. In fact, during the 40 years through 2005, U.S. consumption on an annual basis dropped on nine times.
Globally, oil consumption is even more biased to the upside. The last time the planet's collective appetite for crude fell was 1993. In the last 40 years, annual declines for the world slipped only eight times.
With that in mind, the OECD projects that economic growth for the G7 nations will slow in this year's first quarter and then pick up speed in the second quarter. "Global rebalancing is under way," Jean-Philippe Cotis, OECD Chief Economist, said yesterday at a press conference in Paris. "The U.S. expansion has shifted into lower gear and the robustness of the recovery in Continental Europe has been confirmed. Meanwhile, growth in much of Asia is holding up well."
In other words, don't hold your breath for an imminent decline in global oil consumption. OPEC's influence, in short, continues to strengthen.
March 13, 2007
ALL THE WORLD'S NON-US EQUITIES IN ONE (OR ANOTHER) ETF
No asset allocation strategy worth the name can ignore foreign equities. More than half of the world's equity capitalization lies beyond America's shores. The challenge is figuring out where to begin when moving offshore. There are nearly 900 mutual funds (not counting different share classes) and close to 80 ETFs that fall under the heading of "international" stock portfolios, according to Morningstar. And the list keeps growing.
Two new ETFs (one from State Street, one from Vanguard) help simplify the decision by offering all the world's non-U.S. equities in one package. The SPDR MSCI ACWI ex-US (CWI) and VANGUARD FTSE ALL-WORLD EX-US (VEU) combine developed markets with emerging markets. (The Vanguard ETF is also available as a mutual fund via the ticker VFWIX). This is old hat in mutual funds, but it's something new for ETFs.
Conceptually, the idea of buying all non-U.S. equities in one fund as opposed to breaking up the allocation into developed and emerging market portfolios appeals to investors looking for a core product for foreign stocks that's comparable to the broad-minded Russell 3000 or S&P 1500 for U.S. equity market exposure.
Your editor interviewed spokesmen for State Street and Vanguard on the new international ETFs in the March issue of Wealth Manager. To learn more about these products, read on....
March 12, 2007
NO APPETITE FOR RISK
Risk may be the new new focus in the capital markets these days after the recent turmoil in equity markets around the globe, but the price of risk isn't exactly compelling when measured by yields in debt securities.
With the 10-year Treasury yield under 4.6% at the moment, there's little incentive to rush in and buy if the goal is holding until maturity. Nearly half of the current yield is slated to evaporate into the ether of inflation, based on the latest measure of annualized consumer prices.
Meanwhile, we're in no mood to reach down into lesser-graded debt in search of higher yields. Moody's Baa-rated corporate bonds (the lowest rung of investment-grade debt) last week were yielding around 6.16%, or about 166 basis points over 10-year Treasuries. As our chart below shows, that's the slimmest risk premium for Baa over the 10 year since the late-1990s.
There are, of course, rationales for the relatively slim compensation handed out these days in exchange for loaning money to the Feds and corporations. Direct your eyes to the red line in the above chart. The yield curve remains inverted, meaning that short interest rates (defined here by Fed funds) are higher than long rates (10-year Treasury). Reflecting that capsized state of affairs in the price of money, the red line (which measures the 10-year/Fed funds spread) is firmly below zero, as it has been since mid-2006.
Of course, for investors convinced that the United States is headed for a recession in the foreseeable future, the prospect of buying a 10-year Treasury or an equivalent maturity in corporate bonds holds some appeal, even at the reduced levels. A stumble in the economy would likely compel the Fed to cut interest rates, which would soon dispense capital gains in the short term to holders of debt securities. Lower interest rates, in fact, are the stuff that dreams are made of when it comes to the measuring happiness among the fixed-income set.
But we're not entirely convinced that the economy's about to take the plunge. Our own reading of momentum in the economy (based on a proprietary index of various economic factors) continues to suggest that the path of least resistance is moving sideways with a slight bias to the downside. Robust growth doesn't appear imminent, but neither does a terrifying collapse. Although we expect the economy to slow, it won't slow enough to compel the Fed to cut rates dramatically.
In fact, looking at Fed funds futures contracts through the September series suggests that the market has limited expectations of a rate cut any time soon. Inflation is still too high and the economy still too strong. Yes, the outlook could change, perhaps as soon as this week, when consumer prices for February are updated on Friday. But for now, we're content to favor money market accounts at 5%-plus until the future looks clearer. Being paid to wait won't win us any accolades at cocktail parties, but it helps us sleep at night after the celebration's over. One day our risk appetite will change, but just not today.
March 9, 2007
GLOBAL EQUITY MARKETS REVIEW
The selling wave that engulfed the world's equity markets on the last day of February and reverberated for several sessions beyond was traumatic, but not so as to carve deep losses across the board so far this year.
Looking at 2007 returns through March 8 reveals some red, but much of it has been limited to the riskier slices of the globe's equity markets. Emerging markets in particular are off 2.5% so far this year through yesterday, with European emerging leading the slide with a 7.7% loss as of March 8. By and large, however, the world's markets so far this year are mostly flat, give or take, according to S&P/Citigroup Global Equity Indices.
How did the markets around the world stack up on a valuation basis at last month's end? Let's start with P/E ratios. Emerging markets were the least expensive, on a relative basis, posting a trailing P/E of 13.8 as of February 28. That's down slightly from 14.5 on December 31, 2006. The most expensive regions are in the 17-plus range. Japan, in fact, was nearing a 22 P/E as last month closed. (P/E and all fundamental data below based on
S&P/Citigroup Global Equity Indices, as of Feb. 28, 2007.)
On a price-to-cashflow basis, Latin America continues to be the value leader, as it was at the end of 2006. As of February 28, Latin America's P/CF was 5.5. On the opposite extreme: emerging markets in general at a comparably pricy 14.2.
When it comes to return on equity, the Mideast/Africa region remains in the lead position, posting a 19.6 ROE at last month's close. Japan, meanwhile, continues to hold the low end at 9.5.
Dividend-oriented investors will be encouraged to learn that yields were up a bit at the end of February relative to 2006's close. In relative terms, Europe was the last month's winner, with a 3.0% yield as Japan dragged along at the low end with a meager 1.1% dividend yield as of February 28.
March 8, 2007
A SENATOR AND HIS MONEY
The presidential election is still more than a year-and-a-half away, but it's not too early for a fresh dose of controversy. The latest wrinkle involves money. (Shocking, isn't it?)
It seems that a certain junior senator from Illinois made some questionable investments of as much as $100,000 in two small companies that just happened to be owned by two of his political contributors. Actually, Senator Barak Obama didn't personally deploy the money; his advisor did via a so-called blind trust.
The concept of a blind trust is that it's designed insulates the investor, in this case a United States Senator, from any repercussions, political or otherwise, that might arise from the investment. Oh, well--so long to that myth. Obama is being questioned, ever so subtly, in the press on the age-old issues of, What did he know and When did he know it?
Clearly, the fact that a Senator invested in small, high-risk companies that are owned by two of his more prominent financial contributors raises some eyebrows. Nonetheless, unless we hear otherwise, we'll take the Senator at his word and accept the official line that he didn't have a clue as to what he owned, courtesy of the blind trust. "At no point did I know what stocks were held," Obama said via The Chicago Tribune. "And at no point did I direct how those stocks were invested."
While the rest of the world dissects the political implications, we're content to wonder what his financial advisor was thinking. As investment counsel goes, putting Obama in two stocks--
AVI BioPharma (Nasdaq: AVII) and SkyTerra Communications (NYSE: SKY)--owned by political contributors, blind trust or not, surely ranks as one of more ill-advised ideas in recent financial history. Perhaps someone should have told the advisor that Obama has been an ambitious politician who's been known to receive a fair bit of media attention. In short, err on the side of caution when it comes to investments. But, hey, that's just us.
Ok, how did it happen? The ill-fated investments started after Obama signed a $1.9 million book deal in December 2004. According to the Chicago Tribune story, most of the money went to buying a house. In trying to figure out what to do with the rest of the cash, Obama asked George Haywood, a political supporter, for advice.
To speed the story along, we'll quote the Tribune article:
"This was very casual," Obama said, recalling that he said, "'George, I've got $100,000 that I'm interested in doing more [with] than the standard mutual fund. What recommendations or suggestions do you have?' He said, 'Why don't you go with this stockbroker who has worked well with me in the past?'"
Obama said he met with the stockbroker, whom he declined to identify.
"What I said was, 'George told me that you could invest in slightly higher-risk stock choices,' and that I didn't want to know anything about it," Obama said. "He provided us with the standard form where they ask you, 'What's your risk tolerance?' and `How long do you expect to hold these stocks?' etc. That was the extent of the conversations."
Obama said he did not give the broker specific directions about where to put the money.
Long story short, Obama invested, via a UBS account, in the two companies in question. Assuming that the Senator had $1 million left over after his house purchase, the two stocks represent 10% of the portfolio. Some might say that's fine. Of course, as it turns out, Obama lost money on the stock investments. (Another shocking disclosure.)
From our perch, it seems questionable, at best, to put such a large portion of a portfolio in such highly speculative companies. Even if the client asked for stocks, a prudent advisor might suggest otherwise. But even if you go with stocks, why those two? We're not talking General Electric here. In any case, one might suggest ETFs, which now come in a rainbow of flavors to satisfy both high-risk and risk-averse investors.
The bottom line: with all the stocks in the world, was it reasonable to put that money into two small, speculative companies--companies that just happen to have massive political risk for the client?
Clearly, blind trusts aren't all they're cracked up to be. Meanwhile, once again we've learned that choosing a financial advisor requires more than a few casual recommendations from friends.
It's no small irony that an up-and-coming politician who may become President got bum financial counsel. Alas, that's not exactly atypical in these United States.
March 7, 2007
THE FINER POINTS OF MONTE CARLO ANALYSIS
Ideas, theories and strategies are seemingly infinite when it comes to the choices for managing an investment portfolio. But no matter how you manage your nest egg, there's a growing number of independent financial advisors who counsel that Monte Carlo analysis should be an integral part of the process.
What is Monte Carlo analysis? A statistical tool for measuring the probability of various outcomes. (For a deeper look at MC, peruse the myriad of information on the web by
clicking here.) Thanks to the computer revolution of the past generation, Monte Carlo analysis is now widely available at affordable prices. Sophisticated investment advisors routinely use Monte Carlo analysis for judging the odds that an asset allocation strategy will live up to expectations. One popular application is using MC to adjust a portfolio in order to improve the odds that an investor won't run out of money.
But while there's much to embrace when it comes to applying Monte Carlo to finance, there are no free lunches in the land of statistics. In the February issue of Wealth Manager, your editor penned an article--"A Sure Bet?"--on Monte Carlo and its applications among financial advisors. The conclusion: MC is a powerful and potentially enlightening tool for investors intent on managing risk to their advantage. But there are pitfalls as well, starting with the fact that a fair degree of subjectivity inhabits Monte Carlo analysis. For the details, read on....
March 6, 2007
WATCHING & WAITING
Yesterday's update on the ISM Non-Manufacturing Index for February reminds that the economy is slowing and perhaps more than expected. The ISM index for the services sector, which represents 80% of the economy, slid to 54.3 from 59. (A reading above 50 indicates expansion). That's the biggest drop, in percentage terms, since September 2005.
But nothing is simple in the 21st century. Keeping the chattering classes busy, the ISM Manufacturing Index, updated for February last week, posted a rebound last month, rising to 52.3 from 49.3. The jump was significant in that it reversed the below-50 reading set in January. In short, fresh evidence has arrived that manufacturing activity in the U.S. may be poised to tread water if not rise.
The larger point is that coming to hard and fast conclusions remains a risky affair in matters of economic forecasting. That's always true, of course, and the challenge is elevated at this point in the cycle. Indeed, the ISM Manufacturing Index has twice slipped below 50 in recent months, suggesting that the sector's outlook is clouded, at best.
Then again, if you're trading for a living, you must have an opinion now, today, this minute. No wonder then that the rehabilitated doubt about what's in store for the economy in 2007 has revived hope among fixed-income traders that the Federal Reserve will cut interest rates later this year. The July Fed fund futures contract is now priced in anticipation of a 5% rate, or 25 basis points below the current level.
But lest the fixed-income set become too excited, St. Louis Fed President William Poole on Monday sought to throw cold water on the bond bulls. "To me, and I believe the mainstream forecasters both in government and out — we don't see a recession on the horizon," he said via The Herald Tribune/AP.
Former Fed Chairman Alan Greenspan continues to comment on the future these days, and in his latest outing says there's a one-third chance for a recession this year, according to a report today from Bloomberg News. In a new interview, Greenspan explained: "We are in the sixth year of a recovery; imbalances can emerge as a result. Ten-year recoveries have been part of a much broader global phenomenon. The historically normal business cycle is much shorter" and the abbreviated cycle is likely to prevail again, he noted.
Meanwhile, economist Roger Bootle predicted that the world economy would continue to grow. Bootle, who runs the London consultancy Capital Economics, told attendees at a conference today: "This year and next year growth may be weaker, because of the slow down in the US economy, but the outlook in Europe is good."
Of course, we could just as easily cite economists who think a recession is coming. The truth is, no one really knows, not even the dismal scientists. As the old joke goes, economists have predicted nine of the last five recessions.
What's an investor to do? First, stay calm and watch the signals. But above all, be patient. A week's worth of market action is only slightly more valuable than divining the morrow with a deck of cards. Last week's correction appears like a big deal only if your perspective starts in February 2007. For those with a longer view, the selling of late is, so far, a small blip, as this long-term chart of the S&P 500 reminds.
Remember, too, that stocks are but one asset class to monitor. The opportunity for strategic rebalancing will come, but it's not here yet. As such, we continue to overweight cash, a choice that delivers 5%-plus, a yield that we think of as a waiting premium.
Baron von Rothschild famously advised to buy when blood runs in the street. To date, the markets have suffered only a flesh wound. Yes, there are a few spots of blood at our feet, but the selling has yet to offer compelling values for long-term buyers when measured in broad asset-class terms. A larger, more sustained correction is coming, or so we think. Unfortunately, we don't know when. While we're waiting, we're steeling ourselves for the day when the prices look compelling and the crowd is selling. Exploiting that moment will take hefty doses of two items: cash and discipline. We have the former in hand, and we're hoping to harness the latter at the appropriate time. But for the moment, we're content to sit and watch.
March 5, 2007
PROFILES IN RED
By almost any measure, last week was a tough one for the capital markets. As our table below reminds, March arrived like a lion as investors repriced risk with a vengeance. Among the major asset classes, only cash, TIPS and bonds in general were spared the selling.
Year to date, the performance tallies don't look quite as bad. The question is whether the red ink will spread and deepen, or give way to the bulls once again? Excuses one way or the other will probably be found in this week's economic reports, including today's ISM Non-Manufacturing Index. The crowd knows that manufacturing has been weak, if not in a recession. Services, by contrast, have remained robust. And since services constitute a much bigger slice of the economy, this benchmark holds more sway as to what comes next. Adding to the statistical fun will be Friday's non-farm payrolls report February.
For the moment, volatility is back. Painful as this fact is, it's not entirely unexpected. As readers of this blog know, your editor has been sitting on overweight cash positions for some time in anticipation of exploiting rebalancing opportunities. We're not sure if the red ink offers the opportunity of a lifetime, but it's shaping up to be the best deal so far this year. Then again, the year is still young.