May 31, 2007
IT'S ALWAYS SUNNY ON WALL STREET
It was old news that the economy slowed by more than a little in the first quarter. In fact, it slowed by quite a bit more than initially thought.
The second of three updates on 1Q GDP was released this morning, revealing that growth was only 0.6%. That's down from the earlier estimate of 1.3%, based on annualized, real rates of expansion. The notion that the economy expanded at a pace that was less than half as fast as the government previously said puts the idea of an interest rate cut back on the table. Or does it?
Nothing's quite so simple these days with monetary policy in connection with trying to second guess the path of least resistance in the dismal science. Recent economic data has suggested that maybe the economy's not as weak as some said. For example, last week's report on April's new home sales showed a rise of nearly 11% over March, suggesting that the worst of the real estate fallout may be past. Meanwhile, April's durable goods
update offered mild encouragement after stripping out the volatile aircraft orders. Another bright spot was industrial production for April, which was unambiguously buoyant last month.
Still, there's no shortage of things to worry about, starting with the upward bias in jobless claims and the opposite in nonfarm payrolls.
You can see anything you want in the sea of economic reports that routinely spill out on the digital plate of news and commentary. But by one influential guess on what's coming, the status quo on monetary policy looks set to continue. Fed funds futures continue to forecast a steady-as-she-goes outlook for the central bank: through November contracts, 5.25% remains the consensus prediction on the mother of all interest rates.
Today's GDP update certainly won't increase the pressure for hiking rates. Then again, given the mix of good and bad news in recent weeks, one could argue that keeping rates steady has a certain appeal until something more definite comes along.
But while the past offers clarity, it's the future that complicates the analysis, and it's the future that the central bank must focus on. By that reasoning, there's still plenty of room for play in what GDP in the 2Q will bring, to say nothing of the narrower reports that will precede it in the coming weeks.
"We're looking for a gradual firming in growth," Michael Feroli, an economist at JPMorgan Chase & Co., told Bloomberg News today. "The inventory situation is a lot more favorable, and the drag from housing will be reduced.'' And there's more who think like that. Lots more.
Indeed, if one steps back and considers the broader context, it's easy to conclude that in a world still awash in liquidity, sans an overt, immediate threat to consumer spending and corporate profits, the economy will continue to chug along. It may not impress, but for the moment that's of no consequence, as all the bulls need to see is a modest expansion.
The S&P 500, after all, hit an all-time high yesterday, and is up in early trading today, despite the GDP news. The 1Q is ancient history for traders eager to find reasons for why the first three months were an economic anomaly. In short, it's going to take a lot more than bad news in the rear-view mirror to bring a material change in Mr. Market's sunny disposition and derail the momentum.
May 29, 2007
There may be a relationship between M2 money supply and the benchmark 10-year Treasury yield. Then again, maybe not. But interest rates are rising once again, and it's time to round up the usual suspects.
On that note, may we suggest that money in circulation influences the price of said money? Yes, it's true that such thinking has gone the way of formal dress at baseball games and putting tailfins on cars. But nostalgia beckons here at the world headquarters of CS, and so we provide a retro notion of what may be gnawing at traders in the bond pits these days...
We're the first to admit that there are more variables in heaven and earth that move the price of money, Horatio, than we could ever hope to quantify within a single post within these digital pages. Nonetheless, perhaps ours is a case that's not completely lacking in merit. Consider that the real yield on the 10-year TIPS, which closed last Friday at 2.51%, is now the highest since last October.
We can debate the causes and the consequences, and whether the trend has legs, but there's no doubt that interest rates are taking flight once more. Let the deliberation begin, with your host, Mr. Market....
May 25, 2007
A NEW LOOK AT AN OLD IDEA
Few investment books make it to a ninth edition. One that's beat the odds is Burton Malkiel’s A Random Walk Down Wall Street. Released anew earlier this year, Random Walk is the original treatise on indexing and its allure as an investment strategy. The first edition was released more than 30 years ago, but the message has withstood the test of time for the simple reason that it works. In short, it's hard to beat the market over time, and if you can't beat 'em, join 'em. The argument is now in middle age, but the inherent wisdom is as relevant as ever. With that in mind, we recently interviewed Malkiel for the May issue of WM and asked him what's new in the 9th edition and how the update compares with the original.
May 24, 2007
THE ETF TRAIN
There may be no one left on the planet who hasn't already heard that ETFs are reordering the business of investing. What's less obvious is where this train is headed and what it means for investors. Yes, innovation in the ETF space is alive and well. That's the good news, based on the theory that a wider menu of betas enhances opportunity for building portfolios.
Yet not every new arrival represents genuine progress. In fact, some ETF launches look more like tools for cashing in on the frenzy of demand for exchange-listed products (gasp, gasp). That, of course, is par for the course in finance, which has a less-than-perfect history of giving investors what they need at a fair price. All of which reminds that rule number one when kicking the tires of new securities is caveat emptor! Yes, that applies to ETFs. As we reported in the May issue of WM, the ETF revolution is in high gear, but investors should be increasingly selective when it comes to the launch du jour.
May 23, 2007
HARD FACTS & NET RESULTS
Investment performance is often less than it appears. The top-line number may impress, but after adjusting for real-world frictions, the net result may disappoint.
Everyone knows this and, for the most part, everyone ignores it. Maintaining a sunny disposition is essential when it comes to deploying capital, and so who wants to let reality muck up the fun?
Meanwhile, even for those who demand nothing less than the unadulterated truth, it's unclear how to adjust top-line returns to calculate something closer to reality. Although it's easy to generalize for everyone, the final numbers may be applicable to no one. So it goes with investing when you move from paper to reality.
That said, in those rare instances when someone takes the time to estimate the damage, the reality burst can be shocking, even if it's not precisely accurate. One example was dispensed yesterday, deep within the walls of New York's celebrated 21 Club, where Garrett Thornburg, CEO of Thornburg Investment Management, spoke to a room of journalists (including yours truly) on the hard facts of net results.
Consider the S&P 500, for instance. According to Thornburg, the 11.7% annualized total return for the index over past 20 years through 2006's close fades considerably after deducting for a variety of monetary abrasions that cut into investors' take.
Indeed, the annualized 11.7% for the S&P 500 falls to 6.5% after investment management fees, dividend and capital gains taxes and inflation, according to Thornburg. The dynamic is at work in other asset classes too. Again using Thornburg's numbers, we're told that annualized total returns over 20 years are smaller than they appear. In particular,
* small cap stocks (as per the Russell 2000) fade to 5.9% from 10.9%
* foreign stocks (MSCI EAFE) drop to 3.5% from 8.4%
* long term government bonds (20 year Treasuries) slip to 2.1% from 8.3%
* commodities end up with a negative 0.9% from a nominal 3.1%.
Perhaps the most astonishing evolution is the one assigned to single family homes. The nominal 4.8% return posted over the 20 years through the end of last was sliced to a measly real return of 1.2% after taxes, fees and inflation, according to Thornburg.
Among the conclusions the analysis inspires: "Taxable fixed-income securities only make sense for the tax-exempt of tax-deferred investor....", according to the handout that accompanied yesterday's chat. Meanwhile, "...a 3% real return is a fair objective. More volatile stocks should aim for more than 3%. Less volatile bonds might aim for less than 3% (although, high-grade, tax-free bonds have actually exceeded that over the past 20 years)."
Of course, the past is only a guide, and perhaps a poor one at that. There's also some play in how one might estimate taxes, fees and inflation. Meanwhile, an investor's expectations about the future will dominate strategic design in the here and now. On that note, we might move the debate along by asking if readers think inflation, taxes and nominal returns over the next 20 years will be a) higher, b) lower, or c) about the same? Take your time. This, after all, is a trick question.
May 21, 2007
CHINA DISCOVERS PRIVATE EQUITY
Minds will differ on the implications, but the fact that the Chinese government has jumped on the private equity/alternative assets bandwagon is a sign of the times.
It remains to be seen if China's $3 billion investment in the Blackstone Group signals a top, or the next bull phase in liquidity's big adventure. While the world ponders the issue, we can at least state the obvious: the global economy has more cash than it knows what to do with. Beijing in particular is swimming in it, so why not put a bit into private equity?
"With all the money that has flowed to China and the cash they've built up, they're looking for ways to put it to work,'' Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth College, told Bloomberg News.
Strategic-minded investors can only sit back and wonder what the effect of all the liquidity will be down the road. Perhaps there really is a pot of gold at the end of this rainbow. For the time being, notions of anything less are out of favor.
One can certainly make the case that it's all perfectly reasonable. China already holds $1 trillion-plus in dollar reserves, and let's face it: how many more Treasuries can a retooled communist state buy? The fact that the American dollar suffers bearish expectations for the long run certainly won't inspire going off the deep end to buy something approaching pure greenback exposure.
Diversifying one's portfolio is, of course, reasonable and essential. For those of us who assume the future's full of surprises, multi-asset class investing is the only way to fly, an idea that's now grabbed the thinking of those who run the world's fastest-growing big economy. But the question of what to buy, when to buy, and how much of the portfolio to commit are questions that are perennially topical and forever unclear. So it goes with managing risk.
Still, one has to be cognizant of history, even if it dispenses an imperfect guide to the future. That said, the past suggests that as money chases performance within a given asset class, opportunity recedes in proportion. The search for improved risk-adjusted returns is necessary and natural, but today's expectations for progress may become tomorrow's disappointment if the world rushes into greener pastures.
Returns are only unlimited if performance is defined broadly as a dispersion around a mean. Informed investors recognize as much, and it's that worry that's fueling the appetite for something new, something different, something uncorrelated with the usual suspects. The threat motivates investors to look further afield, which threatens to reduce risk premiums, which then spurs looking further afield. Round and round we go.
A vicious cycle, and one that's been going on for decades in its present form. In the 1950s, investment-grade bonds were equated with enlightened money management. In the 1960s, equities began attracting a wider following as an asset class worthy of more than rank speculation. In the late-1980s, David Swensen began pushing the boundaries further by redeploying the Yale University endowment portfolio into areas that were truly alternative at the time. Twenty years later, private equity, venture capital, real estate and hedge funds are virtually mainstream ideas.
The appetite for risk, in short, has been in a constant bull market for 50-plus years. Investors have kept the game going by continually adding inherently riskier asset classes to the mix. One question that comes to mind in surveying the trend: is there an unlimited supply of new risks? Financial engineers say there is.
Such treats may not be available in pure form to the man on the street, at least not yet. But tapping asset classes beyond domestic stocks and bonds is getting easier, thanks to innovations in ETFs, mutual funds and other securities such as exchange traded notes and structured products. What was available only to institutional investors in years past becomes available to the masses. And if the strategy or asset class isn't currently offered in a packaged product, be patient: it's probably coming soon.
The logic driving the trend of diversifying into a wider spectrum of assets is compelling, but the end result may disappoint relative to what we can see in the rear-view mirror. Nonetheless, the triumphs of the David Swensens keeps investors looking, and the financial industry is only too happy to assist by rolling out more product--or shares.
Indeed, Blackstone's IPO plans for going public next month originally anticipated minting new shares worth $4 billion. But now that China wants a piece of the action, Blackstone has raised its IPO deal to $7 billion, according to The Wall Street Journal.
Supply invariably expands to meet demand in a bull market. Alas, the game has shown an annoying tendency to work in reverse during the alternative market condition that also starts with a "b".
May 18, 2007
OPTIMISM TODAY, TOMORROW...FOREVER?
The stock market reflects a variety of emotions over time, but no one can say that it suffers from excess pessimism at the moment.
In the face of what might be labeled as conflicting trends, Mr. Market chooses to err on the side of optimism, and by more than a little. The S&P 500 was up 4.4% in April, and has climbed more than 15% over the past year through last month. We've all heard that the stock market's a forward-looking animal. But is the confidence warranted, based on the latest economic numbers?
No one really can say for sure, but we can at least revisit what's already set in stone. By that measure, one could argue that the jury's still out on the economic outlook, as per the numbers released for April. As our table below reminds, red ink still plagues the statistical tally, albeit only marginally. Last month, weekly hours of production workers slipped by 0.3% while retail sales contracted by 0.2%. For the past year through April, the big loser was housing starts, which plunged by more than 16%.
If any of this demands caution in one's view of the future, there's not much sign of it in the equity market, as defined by the S&P 500. To be sure, gloom and doom hardly dominate the economic reports. Notably, housing starts turned up last month, and growth still dominates overall. Perhaps that's why the S&P continues to favor optimism this month, with the index up another 2% so far in May, through last night's close.
For all we know, the stock market's correct in predicting that the economy will keep bubbling. Of course, it's possible that equity traders are dead wrong.
Alas, we don't know the answer. (We can't seem to find the oracular truth among the digital pages of the usual suspects to which we subscribe.) But on one issue our view is clear, our confidence high: The longer the bull market in stocks (and pretty much everything else) rolls on, the higher our allocation to cash and alternative betas will go. Granted, the rise in holdings of cash and more defensive areas is slow, but it's steady. And it'll remain so until there's more compelling evidence to suggest otherwise.
Why all the caution? Simple, really. Bull markets don't last forever, and this one's no spring chicken. That, and the fact that we've done well in the last five years, informs our current thinking. No, we don't know when the end will come. But we've learned a thing or two over the years. That includes the realization that waiting for someone to ring a bell as an early warning that the cycle has decisively turned is a strategy doomed for regret, or worse.
Yes, our approach to portfolio strategy might be dismissed by some as the grounds that it sounds awful. To which we reply: Yes, except when it's compared in the long run to the alternatives.
May 16, 2007
A WHIFF OF STABILITY, OR A PAUSE IN THE CORRECTION?
No one disputes that the housing market has been suffering a sharp correction, but the jury's out on when the recovery will commence.
For those who lean toward the idea that it'll arrive sooner rather than later, today's report on April housing starts offers a statistical club to beat back the pessimists. Privately-owned housing starts rose by 2.5% last month over the March tally, based on seasonally adjusted annual rates. As our chart below shows, that puts April's annualized total at 1.528 million units--the highest since December.
No one will confuse the rebound (if we can call it that) with a new bull market in housing. At least not yet. The wounds still smart from the fallout of the former decline, which cut starts by nearly 40% in 12 months from January 2006's peak to the trough a year later. But by 2007's reduced standards, this year's looking up...so far.
It's any one's guess if the modest gains this year reveal the seeds of a genuine recovery, or just the wheezings of a dead cat bouncing. But beggars can't be choosy when it comes to making a case for economic optimism.
In fact, there are still reasons to worry. One economist says that April's rebound in starts is something less than it appears. The "milder weather appears to have enabled builders in the Northeast to catch up on projects that had been delayed during the winter months," wrote David Resler, chief economist at Nomura Securities in New York, in a note to clients this morning. He opined that "most" of last month's jump "was the result of a revival of starts -- particularly multi-family starts in the Northeast. With the nor'easter that hit the Eastern U.S. early in [April], the region may continue the catch-up process for another month. Starts were also up in the West but elsewhere the data reveal a continuing downward trend."
Especially worrisome, Resler continued, is the 8.9% fall in building permits in April, pushing the pace down to its lowest since 1997. "The permits data also reinforce the notion that the increase in starts mainly reflected a catch-up to permits that had been issued during the previous three months but whose start had been delayed," he advised. The bottom line, he concluded: home construction will remain a drag on the economy through the summer.
On that note, now's a good time to remind our readers that September's housing starts will be announced on October 17.
May 15, 2007
IS THE REPRIEVE REAL?
There was no mention of "inflation" or "consumer prices" in Fed Chairman Ben Bernanke's speech this morning. Of course, his prepared remarks were focused elsewhere: regulation and financial innovation, to be precise. No matter, as inflation was probably on the chairman's mind just the same, especially after 8:30 this morning, Washington time, when the April update on consumer prices was released.
For a refreshing bit of change, the latest numbers offer reason for cautious optimism, along with some fresh hope for optimism on the future course of Bernanke's authority on matters of price trends. The core CPI through April rose by 2.4% on a 12-month basis, down from 2.5% previously. In fact, April's 2.4% annual pace is the lowest annual rate in nearly a year, as our chart below shows.
But if inflation is moderating, as Bernanke has been predicting, what will we worry about now? Slowing growth, of course. In fact, some argue that inflation's downshift is a byproduct of the economy's slowdown. "It is now becoming more apparent that core inflation has peaked and is moving lower in response to anemic economic activity," Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities, told Bloomberg News before the CPI report's release.
At the very least, the recent fall in core CPI gives the Fed some breathing room for considering the potential for lowering interest rates if the economy needs a jolt of liquidity to offset any further slowdown. For the moment, though, traders aren't rushing to that conclusion. Fed funds futures didn't move much after the CPI report. The November contract, for instance, is still priced in anticipation for 5.25% Fed funds.
Does that mean the market remains skeptical about moderating inflation? Or, perhaps the crowd thinks the economy's not about to fade, despite some predictions to the contrary?
Of course, one could make the case that inflation's still a problem by way of the headline number. If you add energy and food back into the equation, CPI advanced by 0.4% in April, mirroring the pace in March. David Resler, chief economist at Nomura Securities in New York, labels headline inflation's pace "uncomfortably large," in a note to clients this morning.
The jury's never really out when it comes to inflation. But for the moment, at least, Bernanke and company have a reprieve, assuming you're looking at the world through core-filtered glasses.
May 14, 2007
A SHORT TREATISE FOR A TWO-FACTOR WORLD
Investing is subject to the emotions of the moment, the analysis du jour and the exogenous event that unexpectedly and instantly delivers yesterday's pearls of wisdom to the trash heap of history. What then can the strategic investor rely on for true perspective?
In search of an answer, we suggest reviewing the basic forces that propel markets, which your editor believes to be momentum and value factors.
A number of studies over the years have boiled the primary engine of market forces down to these two drivers. And to a degree, common sense suggests no less. Momentum is simply the tendency of price trends to continue, up or down--autocorrelation, as it's called. Value, by contrast, is a condition of excess asset valuation, either or high or low, which leads to a correction in price.
Momentum and value have a long history of generating returns, albeit in sharply different ways, with sharply different types of risks and under varying time periods. Momentum of the bull market variety can stretch out for long periods and render investors complacent with the view that what's past will roll on indefinitely.
By contrast, bear-market momentum has a nasty habit of arriving suddenly and, save for those with a contrarian mindset, without clear warning. In addition, bear-market momentum tends to be relatively short, albeit decisive. In turn, the rapidity of its emergence delivers a fair share of what we'll label the deer-in-the-headlight syndrome, which poses a challenge for fully exploiting the trend.
Meanwhile, the value factor exists in varying degrees over time, wedged in between the fading of bull market momentum and the soon-to-be emergence of bear-market momentum. Value's power and influence, in short, are at a peak during periods of extreme excess in the market. At that point, and for some time after, value decisively overwhelms momentum, slowly giving way to momentum's charms anew.
The two most recent examples of value in its acute and fleeting forms in the equity market came early in this century: March 2000 and October 2002, which captured the crest and trough, respectively, of the S&P 500. At those points, momentum gave way to value, and the latter became the only game in town.
But while momentum eventually gives way to value, value too soon gives way to momentum. In fact, one could argue that value tends to give way sooner than momentum.
Regardless, momentum and value factors are the seeds of opportunity, each in their own right. The two arguably comprise the foundation on which all successful investment strategies are built. (For simplicity, we've conveniently left out such engineered strategies such as merger arbitrage and market-neutral investing.) But while it's easy to identify the laws of nature, turning the knowledge into real-world profit is something else. The reason has more to do with what ails the human mind than for any lack of opportunity in the marketplace.
Indeed, a key risk with bull-market momentum is becoming lulled into its lengthy duration and believing that the trend will continue for longer than fate intends. The danger is giving back some or all of the accumulated profits born of riding a momentum wave. Failing to recognize that momentum is destined to become a value play has tripped up many investors over the generations, and no one has yet presented evidence to suggest otherwise in the 21st century.
Value harbors its own risks too, including the inability to recognize its arrival. That's unsurprising given hat value's onset tends to accompany chaos because it represents a break with the past, a detour from the familiar. In turn, that reverberates with fear in the human mind. If there's one thing the human condition doesn't process efficiently, it's change.
Another danger that forever hangs on the value factor is the inability or unwillingness of investors to recognize when it's out of favor as a driver of returns, meaning that momentum prevails. In fact, value and momentum factors rarely coexist in equal strength, as one always suffers a relatively diminutive role compared to the other. No wonder, then, that investors who excel in one strategy or the other have been known to falter when the other reasserts its historical, albeit temporary reign.
But even among the rarest of birds that can fly in either universe, there is always the challenge posed by the transition's timing. It's never clear in the heat of the moment that momentum is about to give way to value, or value to momentum. Yes, everybody saw it coming after the fact. But when it's unfolding, the true investment oracle on that front is an exceptional breed. To be sure, some will have their suspicions. Even then, some faith is essential since the future invariably remains unclear and full of surprises, even for those skilled at reading balance sheets and dissecting central bank decisions.
Hindsight, of course, reveals all. It's now clear to all that the key to robust gains was focusing on value factors in October 2002. Not long after, momentum became the principal factor that defines the financial universe. In fact, as 2007 nears its halfway market, momentum remains the foremost driver of investment success.
The question of when momentum will give way to value should today be on every investor's mind. With each passing day, the point of transition draws closer. No one knows if it's tomorrow or five years hence. But no one should think that momentum will no longer give way to value, or value to momentum. This is the natural order of markets. It's also the basis for embracing the tenets of strategic investing, which we define as asset allocation, diversification within asset classes and routinely rebalancing the weights of asset classes.
Opportunity is always knocking in money management. But before you answer the door, think about who may be on the other side and be prepared to respond if it's not the guest you expect.
May 10, 2007
AN ANXIOUS CALM SETTLES IN
The Federal Reserve yesterday left no doubt that it's worried about inflation. Not worried enough to raise interest rates, but worried nonetheless.
Announcing that it would keep Fed funds at 5.25%, the FOMC advised that the "predominant policy concern remains the risk that inflation will fail to moderate as expected." True, the central bank believes otherwise, predicting that inflation pressures appear "likely to moderate." But it's sleeping with one policy eye open just the same.
Or so we're told. It's debatable whether the back and forth is comforting or frightening. In any case, the Fed will have to act eventually, for good or ill. Meanwhile, they're watching and so we can all sleep peacefully.
Well, almost everyone. The gold market, for one, is skeptical. An ounce changes hands for around $680, just under generational highs set a year ago. Commodities generally haven't thrown in the towel on the inflation debate either. The CRB Index, although well off its highs in 2006, looks intent on keeping an open mind about the future path of pricing pressures.
Adding to the anxiety over future inflation is the trend in the U.S. Dollar Index of late. A weaker dollar implies higher inflation to the extent that the country imports goods and services. And the last time we checked, importing was second to none as a favored economic sport in these United States. Imports totaled $184.2 billion in February, up by 33% from a year earlier, according to the U.S. Census Bureau.
If the dollar keeps falling, as some think it will, the trend carries the potential to fan the flames of higher inflation. Curiously, there's nary a worry in the one market where all of this should theoretically be a primary concern: the bond market. The yield on the benchmark 10-year Treasury has been content to trade in a tight range this year, closing yesterday at around 4.67%. That's about where it was at last year's close and for all we know that's where it may be when we celebrate New Year's.
The great debate is whether this is irrational or the reflection of market logic that's drawing on some deeper efficiency that's otherwise unclear to mere mortals. Or perhaps it really is just about Asian central banks stuffed to the gills with greenbacks and thereby deciding to buy up Treasuries no matter what happens.
Then again, traders take signals from the central bank that's closest to their trading post. "In our opinion, dollar weakness is not a problem for markets until it causes the Fed to raise rates," a CreditSuisse economist wrote recently, Reuters reported via The China Post. By that standard, all's well.
May 7, 2007
LOOKING FOR A SIGN, WAITING FOR A CLUE
Strategic investors looking for explicit opportunities for rebalancing portfolios among the major asset classes are still faced with modest opportunities, at best, so far in 2007. As our table below documents, bull markets continue to prevail across the spectrum. That's good news for tabulating past performance. It also gives diversification a good name. But the trend doesn't necessarily impress when it comes to formulating a guess about expected returns.
Asset allocation is nothing if not a strategy for deploying capital that assumes humility about forecasting the future. Indeed, if investors knew what was coming, asset allocation would be about as relevant as carrying back-up ice cubes in Antarctica. But the future is, in fact, unknown, contrary to what you may have heard elsewhere. As such, owning a variety of assets, preferably those that move with a degree of independence from the others, is the only game in town for investors intent on the twin goals of growing capital while minimizing the associated risks.
That brings us to the current dilemma of finding alluring asset classes for fresh injections of capital, or redeploying money from assets that have run up to those that have fallen. On the one hand, there are obvious areas to pare, particularly for investors that long ago made commitments to some or all of the markets noted above. The problem comes in deciding how to redeploy. Alas, there are no asset classes that have fallen recently, at least not among the publicly traded ones with related index funds and ETFs.
This is a bit of an unusual state of affairs for asset allocation strategy. Quite often, there's always something that's fallen, which is why asset allocation has a history of delivering smoother risk-adjusted returns. But ours is not a world where history provides an easy guide. True in politics, true in economics and, as is becoming clear, in finance too.
So, what's an investor mindful of risk management to do? There's always cash, an asset class that promises what its competitors don't: clarity on the future. The tradeoff is that the clarity is all but assured to provide modest returns that may end up being negative after adjusting for inflation. Accordingly, there's a limit to how much one should allocate to cash.
Of course, when the competition's prospects look modest, at best, one might reason that forgoing reasonable cash limits has a certain appeal. Minds may differ over whether this is one of those moments, but the case for overweighting cash is arguably higher today than it was a year ago.
Meanwhile, among the remaining asset classes, we find that equities around the world are leading the race. Foreign developed stocks have been especially strong, with the iShares MSCI EAFE advancing by 10% so far this year. Even by the impressive standards of recent years, that's an amazing record. Emerging market stocks aren't far behind. U.S. stocks, while trailing, have still managed to deliver a stellar performance so far in 2007, relative to the historical record.
Commodities continue to roll higher as well. Although there has been a belief recently that commodities were due to correct, so far that expectation has been dashed on the rocks of global demand. And for all we know, the buying won't stop any time soon, or so suggests one of the world's great investors in a new interview.
"The best way to profit from the rise of China is to buy commodities," advises Jim Rogers in the latest issue of CreditSuisse's online magazine. "Because the Chinese NEED commodities....You can of course also buy the shares of natural-resource companies, and if you are really good at it and pick the right stocks, you will make a fortune in China. But then you will have to worry about the stock market, the management, the central bank, labor unions and a hundred other things. If you simply buy nickel, you don't have to worry about any of that."
Your editor, by contrast, knows nothing of what the future will bring in terms of prices. That's hardly extraordinary, although our admission may in fact be astonishing to the extent that we actually confess our ignorance to the world. That said, our lack of knowledge about the morrow leads us to hug asset class diversification as tightly as ever.
But with the opportunities for rebalancing growing thinner by the day, even yours truly must consider alternatives. That includes what some call alternative betas, which just happen to be a growth industry in terms of dispensing packaged products for the masses. The allure, at least in theory, is that alternative betas compliment traditional betas, as listed above, by offering low and in some cases negative correlation. Yes, one must choose wisely because not all alternative betas are what they profess to be.
What are these alternative-beta products? For the moment, we'll sidestep the question by promising to return to it in more depth in a later post.
In the meantime, we'll monitor the bull markets and try to embrace the contrarian philosophy of the moment, namely, that price volatility is only dormant, not dead. Exactly when it's scheduled for a return engagement is beyond our powers, but we're expecting no less.
May 4, 2007
WHAT'S THE LABOR MARKET TELLING US?
The labor market isn't everything, but it's a lot.
In fact, if you're trying to get a handle on the big picture, you could do a lot worse than watch the economy's capacity for minting new jobs.
With that in mind, the optimists have another stumbling block to conquer with today's the release of April jobs data. Nonfarm payrolls increased by a slim 88,000 last month. For those who are still counting, that's the smallest gain since November 2004.
One month a trend does not make, of course. But the fact that the pace of creating jobs has been slowing for some time catches our attention. Consider our chart below, which shows that the net change in new nonfarm payrolls on a monthly basis has been biased to the downside for more than a few months.
No, it's not panic time. As recent history reveals, there's plenty of volatility in the month-to-month jobs report to allow for reasonable minds to differ. In fact, monthly gains in new jobs have fallen to the 100,000 range several times in recent years only to bounce higher shortly after, as the chart below shows. But the bounces have been getting weaker and the dips to the 100,000-net-gain range have become more frequent. In short, there's one more reason to be wary about 2007 and the economic cycle.
As we've written recently, there are offsetting factors that support a bullish interpretation of the foreseeable future. The latest data point suggesting the economy will still bubble comes in yesterday's update on the services sector, as profiled by the ISM Non-manufacturing index. The rebound in the services slice of the economy--which is huge--remains alive and well, according to this benchmark, and as our chart below illustrates. Ditto for the manufacturing side of the economy, a smaller but still widely monitored chunk of GDP.
So how does one square the apparent strength in manufacturing and services with the weakness in employment growth? Is the jobless recovery/growth phenomenon coming back to haunt us? Or does the slowing jobs-creation machine suggest that the economy overall is slowing and that the ISM indices will soon turn south as well?
Therein lies the debate that is at the heart of the back and forth between the bulls and the bears. For what it's worth, the stock market is firmly in the optimist camp. The S&P 500, to cite the usual benchmark suspect, yesterday broke above 1500 for the first time since 2000. The bulls are increasingly running the show in the theater of equities, and it's now conceivable that a new all-time high in the S&P is within reach.
But if we're headed for new record highs, how does that compare with the trend in jobs creation, assuming it even matters. Embracing this quixotic and perhaps erroneous task, we looked at the monthly changes in net nonfarm payrolls against the S&P 500's monthly total returns, and indexed the cumulative performance for each, beginning with a base of 100 set in January 2000, just ahead of the previous bear market (see chart below). The result (see chart below) may not be terribly insightful, but it does suggest that the stock market is increasingly predicting a future that's diverging from events on the ground in terms of jobs creation. It remains to be seen if the divergence can last, or if it even matters.
May 3, 2007
LIQUIDITY ON THE RISE
The Federal Reserve is scheduled to convene its FOMC meeting next Wednesday to decide on what happens next with the price of money. By most accounts, the assembly promises to be a yawn. Fed fund futures anticipate no change any time soon by predicting that current 5.25% will remain the standard for some time.
Perhaps that's a prudent choice for policy makers, considering that full and clear clarity on the economy remain elusive. As we wrote yesterday, there's a case to be made that the glass is half full as well as half empty. Indeed, economic data in recent months have dispensed conflicting signals.
Yes, that's always true. But the stakes seem especially high at this juncture, with the economic cycle at middle age or later. Meanwhile, the capital markets have been running for some time. Value isn't exactly gushing in abundance when it comes to such metrics as risk spreads and earnings ratios over price. Of course, if you think that the recent past will continue into the foreseeable future, there's nothing much to do but hang on and collect the capital gains.
Enter the Fed, which theoretically must keep inflation at bay while juicing the economy and sidestepping a recession. A thankless task, and one that may be impossible. In short, the central bank must pick one or the other, or so one might assume.
If so, we present evidence that juicing the economy may be the preference these days. M2 money supply, the broadest measure published, has been pushing higher for some time now, as our chart below shows. Based on rolling 52-week percentage changes, M2 rose by nearly 7% for the year through April 9, although it's since slowed to 6.3% That's the fastest rate of printing money in more than three years.
The rise in the annual change in M2 has been fairly consistent this year, suggesting that the central bank is deliberately injecting money into the system in higher absolute and relative quantities. How fast is the recent 6%-plus rate of growth in money supply? More to the point: is it too fast? One might answer "yes," based on the fact that first-quarter GDP advanced by 5.3% in nominal terms (or 1.3% in real terms), according to the Bureau of Economic Analysis.
The fact that the 6% nominal pace of M2 growth is higher should turn a few heads. Those who subscribe to the monetarist view of the world may even suffer a shudder or two.
Of course, no one pays attention to money supply (hardly any one). If an accelerating M2 growth rate suggests inflation risks may be bubbling, it's a risk that the markets seem inclined to dismiss.
Yes, the jury's still out on what it all means. Meanwhile, we can only cite history. On that score, liquidity has powered the bull markets across the asset classes. Everywhere you look, there's money to burn. Whether it's News Corp.'s Rupert Murdoch pricey bid to buy Dow Jones, or private equity shops throwing money around, or the surge in prices in everything from stocks to bonds to commodities to art, it's clear that the liquidity engine is humming quite nicely. The question is whether there's a price to be paid with liquidity, assuming it isn't reined in a timely and prudent manner.
May 2, 2007
WHERE'S THE CLARITY?
Once again, it's too close to call.
The latest batch of economic data released so far this week suggests there's reason for hope. Sort of. Maybe. Perhaps.
Let's start with construction spending, which rose by 0.2% in March, the Census Bureau reported on Monday. That's the second monthly rise in a row, reversing what had been a year of declines or virtually unchanged reports on construction spending. Unfortunately, on a rolling 12-month basis, the ship is still sinking. The 2% drop in construction spending in March compared to a year earlier is one of the sharpest declines in recent history, second only to January's slightly bigger stumble.
Rather, the obvious good news on Monday was the fact that disposable personal income continued rising in March. In fact, March's numbers show that income advanced by 0.7%, among the stronger paces in recent history, the Bureau of Economic Analysis advised. Alas, Joe Sixpack seemed reluctant to spend that windfall. Personal consumption expenditures rose by only 0.3% in March, a fairly middling reading of late, and down sharply from February's 0.7% surge.
On Tuesday, more hope arrived by way of the ISM Manufacturing Index, which rebounded to 54.7 in April, the highest in nearly a year. The rise suggests that the weakness in manufacturing in recent months is giving way to a return to growth. Indeed, a reading above 50 implies growth; below 50, contraction. As such, the dip below 50 in January conveyed the notion that the economy was set for a stumble. But to the extent that the ISM Manufacturing gauge is relevant, a rebirth appears to be in the air. For the past three months, the index has been above 50.
That brings us to today's number du jour: new factory orders for March, which rose 3.1%, , the Census Bureau reported. That's stronger than February's 1.4% rise, suggesting momentum, at least for the moment. In fact, new orders for manufactured goods have risen in four of the past five months.
But the latest rise in factor orders may be less than it appears. David Resler, chief economist at Nomura Securities in New York, writes in a note to clients today that "most of the increase was attributable to higher oil prices, which boosted non-durable goods orders, and another big gain in aircraft demand, which underpinned much of the increase in durable goods orders." But in a sign of the times, there's a competing view available for your consideration. The gain in orders for durable goods, he continued, were "more broadly based than in recently months and could be a sign that the slump in capital spending was merely transitory."
Yes, the economic outlook may be too close to call, but the clues continue to pile up. One day, perhaps soon, the truth will out and even the man on the street will have confidence about what's coming. For now, just keep watching the bouncing numbers.
May 1, 2007
The future's unclear, but the past is the apex of clarity. Alas, the past is only a rough guide, at best, to what's coming. But the past is all we have, along with predictions. Putting the two together may or may not help, but beggars can't be choosy when it comes to investing.
With that in mind, your editor considered the past, as defined by equity market capital flows, volatility and correlations among the major asset classes in the April issue of Wealth Manager. There are some nuggets of perspective embedded in the data. Nothing earth shattering, perhaps, but at least we can't be charged with ignoring history. Whether that leads to tangible benefits remains to be seen. Meanwhile, here's what we found....