August 30, 2007
A FISTFUL OF DOLLARS
Red ink on the government's ledger may not be the topic du jour, but it's destined for greater scrutiny by Mr. Market. The timing and the relevance is an open debate. Meantime, the dollar value of America's future promises (primarily Medicare/Medicaid and Social Security) continues to rise. As your editor details in the current issue of Wealth Manager, the prospective deficit born of all future government promises stands at a staggering $64 trillion, according to one estimate. That's several times larger than last year's GDP of $13 trillion-plus. On the other hand, $64 trillion comes with several caveats, starting with the fact that it's calculated as the total long-run claim for the infinite future that's facing the federal government less the anticipated tax revenues. The sum also assumes a corporate-style accounting system for assessing the future financial demands on the government. Such a system, however, doesn't really apply to Washington. Or does it? In any case, no one will be shocked to learn that the dire projection for debt noted above is far from universally accepted, which leaves a wide variety of predictions as to just how much red ink awaits. Regardless of your view, the details are worth reviewing if only as a starting point for debate and education. If you're game, you can dive into the particulars here….
August 29, 2007
THANK YOU, SIR, MAY I HAVE ANOTHER?
The rejuvenating effects from the shot of monetary adrenaline are fading. The surprise cut in the Discount rate on August 17 gave the patient a lift, but it looks like another dose is needed. In fact, it would come as no great shock to learn that increasingly larger dosages will be required for comparable if not diminishing results.
The futures market expects that more liquidity is imminent. Fed funds futures are now priced in anticipation for a 25-basis-point cut. The prospect of lower rates hasn't been lost on forex traders, who have been selling the dollar with renewed gusto this month. Inspired by the outlook for lower rates, the U.S. Dollar Index looks set to challenge its previous intraday low from early August. If that floor gives way, the index will sink to lows unseen in more than a decade.
Meanwhile, the Fed continues pumping up the money supply at a healthy clip, as our chart below observes. M2 money supply was running higher by 6.3% on an annual basis for the week through August 13. By comparison, nominal GDP growth was pegged at roughly the same pace of 6.2% for the second quarter, based on an annual seasonally adjusted pace.
The question is whether the economy is poised to slow considerably, in which case a 6% rate of increase in money supply will look considerably higher in relative terms. Tomorrow's update on Q2 GDP may throw out a few clues, although the official number for Q3 won't be known for some time. That leaves no choice but to scratch around for signs in the lesser numbers about what comes next on the macro scene in the months and quarters ahead.
Judging by the bond market's review of affairs, one can reason that a slowdown of some degree is coming. To be sure, the bond ghouls have been wrong before and there's no guarantee that the fixed-income set's forecasting powers are intact now. That said, the 10-year Treasury yield sunk to 4.53% yesterday, the lowest in more than a year. Right or wrong, the bond market foresees a rate cut and a sharp slowdown in GDP growth in the second half of this year and perhaps into '08.
The stock market seems of a similar mind. The S&P 500 closed down 2.4% yesterday, erasing most of the bounce dispense by August 17 cut in the Discount rate.
Liquidity has been the solution in recent years to keep the economy humming. No less will be required going forward. So far, the liquidity boost has looked like a free lunch. But strategic-minded investors may see some value in taking a fresh look at the question of whether a free lunch can stay free indefinitely. As always, there's a variety of opinion but only one answer.
August 27, 2007
WHEN DOES A YIELD BECOME "HIGH"?
At what point does junk start to look like diamonds in the rough?
There's no clear answer, but it's a topical question whenever a financial squall blows through the capital markets and risk is repriced. It's clear that we've suffered a storm of late, but it's debatable if risk has been repriced on a dramatic scale.
Risk, for purposes of this post, is defined as the spread in high yield bonds over 10-year Treasuries. By that measure, junk commands a premium of 4.37% over the 10-year as of Friday's close, as per Citigroup High Yield Index over Treasuries. The 4%-plus is significantly higher than the 2.6% spread offered by Mr. Market at the end of June, as our chart below shows. But while the rise looks impressive in the context of recent history, it's still debatable on whether it also looks compelling enough to commit fresh capital to the asset class.
Deciding if junk's spread now looks rich enough to compensate for risk depends on one's confidence in the future. For those who believe that the economy will continue growing at a healthy if not necessarily exciting pace well into next year, the prospect of earning 400-plus basis points over Treasuries may entice. Indeed, the current spread is the highest in more than two years. And 400 basis points of additional yield is nothing to sneeze at when compounded over, say, a decade.
But for those who worry that the economy is vulnerable to the real estate fallout, the current premium in junk doesn't suffice, i.e., the threat of capital losses in junk still looks poised to overwhelm any extra yield. There are two ways to change that. One, the economic forecast turns brighter. Two, the spread runs higher.
In fact, the spread's been higher--much higher in recent years, as our chart illustrates. No, we're not waiting for a return to the extreme levels that prevailed in 2002 and 2003. But current levels are not yet a no-brainer buy either.
If GDP's growth slows by more than a little, or certainly if it contracts, worries about less-than-investment-grade bonds will surely suffer. All the more so given the recent anxieties of late over securities with less-than-stellar credit ratings.
In fact, one can argue that investors generally remain cautious when it comes to high yield bonds. Morningstar's high yield fund category posted a 0.6% loss for the four weeks through Friday. Meanwhile, intermediate government bond funds gained 0.7% over the same period and long government bond funds jumped 2.6%.
The preference for quality is clear. Of course, the past always is clear. Deciding if the storm has blown over or not is the question. We're as clueless about the future as always. Making a bet that all's well has its place, of course, and for some this may be the moment to act. But our guarded brand of contrarian-minded nibbling doesn't yet find the junk menu sufficiently tasty. That's not necessarily indicative of the prospective opportunity in the asset class, but it's our view and we're sticking with it, at least for the moment.
Your editor, in short, has an affinity for letting others lead the charge into risk at moments of higher-than-normal uncertainty. That philosophy necessarily precludes big gains born of rushing in ahead of the crowd. It also keeps us whole when opportunities are less than they appear.
Nonetheless, we're watching and waiting. Market sentiment has clearly changed. So too have the valuations. But what of the economic outlook? Has that changed? And if so, for the better or worse? We'll never know for sure, but we'll need another notch or two of confidence before we make a decision.
As such, we're not yet convinced that strategic opportunities are convincing in the highest-risk spectrum of assets. What's more, we're reluctant to state a particular number for when the spread will entice for the simple reason that context is everything. One spread number may look juicy, but the economic tailwind must be sufficiently encouraging too. Yes, we may be wrong. If so, it wouldn't be the first time. But sometimes being comfortable takes precedence.
August 24, 2007
SO FAR, SO GOOD...MAYBE
The stock market's calmer, but the jury's still out on what the mortgage mayhem means for the economy. So far, however, there's scant sign of trouble in the numbers.
Yesterday's report on initial jobless claims, for instance, offered more of the same of late, which is to say that a middling performance remains the status quo. For the week through August 18, new filings for unemployment insurance actually slipped by 2,000 to 322,000, which is virtually unchanged from a year ago. There may be great drama unfolding in the capital markets, but yawns still dominate analysis of employment's leading indicators.
Of course, this may be the calm before the storm for the economy. Morgan Stanley's chief U.S. economist, Richard Berner, told The Wall Street Journal in a story published today that economic trouble is brewing, even if it's not yet obvious. He predicted that "the housing downturn is going to be more prolonged and deeper than people might have imagined."
Nigel Gault of Global Insight echoed the sentiment. He warned in a research note yesterday that "the economic outlook has dimmed," the New York Times reported. The firm predicted that GDP for the third quarter will rise by 1.9%, down from Global Insight's previous forecast of 2.1%.
Adding to the gloom was Countrywide Financial's darker assessment that a recession is approaching. “This is one of the greatest panics I’ve seen in 55 years in financial services.” The forecast came from Angelo Mozilo, chief executive of Countrywide, the biggest mortgage lender in the U.S., who opined on CNBC via NY Times. "I just don’t see a light here at the moment. I can’t believe when you’re having this level of delinquencies—equity is gone, the tide has gone out — that this doesn’t have material effect on the psyche of the American people and eventually on their wallets." Of course, when you're look at the world from the ground zero of mortgage implosion, as Countrywide does, sunny dispositions are hard to come by regardless of climate.
In contrast, the Congressional Budget Office offered a more upbeat take on the economy for the near term. CBO advised that the fallout from the mortgage crisis so far had been "quite muted," according to Reuters. CBO Director Peter Orszag said market turbulence may continue, but the economy still looked robust, he said. Of course, he repeated his concern that the nation's budget deficit looks unsustainable in the long run, but we'll leave that one for another day.
Meanwhile, statistical support for Orszag's optimism for the near term came in this morning's durable goods report for July. There's no other way to describe it other than to say that new orders for durable manufactured products soared last month, popping 5.9% in July vs. June. In fact, last month's increase was the fifth gain in the last six months and the pace was the strongest since the current series was first calculated in 1992, the U.S. Census Bureau advised. What's more, there was no obvious fine print undermining the surge. For example, excluding transportation, new orders increased 3.7 percent; excluding defense, new orders increased 4.9 percent.
But make no mistake: there's plenty of debate about what comes next. Last month's durable goods orders only capture the front end of mortgage-related fallout. It will take months to confirm (or deny) the message embedded in the durable goods report. But at least we know that the economy was bubbling as it headed into the unrest of August. At this point, that's about all we can say.
August 23, 2007
WATCHING, WAITING & NIBBLING
It's probably too soon to decide if the market tsunami has past or is just taking a breather. But it's not too soon to start assessing the damage among the major asset classes.
As always, such surveys are a mix of looking at the past but with the hope of finding clues about what's coming. Indeed, future returns are minted from events in the present. Of course, recognizing that is only the first step in a long strategy journey, which is why we keep turning over rocks wherever we find them. Most of the time the effort's for naught. But if there's ever a chance to mine intelligence about prospective returns, the opportunity may be highest directly following periods of extreme stress in the capital markets.
That's just another way of saying that in the rare cases when prices and valuations move to excess, the actions modestly elevate the clarity about future returns and risks. Or so history suggests.
With that in mind, how have the major asset classes fared in recent weeks? As our table below suggests, the answer can be summarized by the central principle of the capital asset pricing model: risk matters. Higher risk has been a costly attribute in recent weeks. Cash, a realm where risk is minimal, was the best performer in the past four weeks. In contrast, asset classes with higher risks have lived up to their profile by dispensing higher losses.
High returns are the other facet at times of high risk, as the past five years remind. But the tables have turned this summer, although that's hardly an extraordinary or unexpected change for anyone who understands the CAPM-inspired notions of risk and reward.
The biggest loser of late has been foreign stocks, as measured in dollar-based returns. Commodities are faring poorly too. In fact, commodities have been taking it on the chin for longer than any other major asset class, as the red ink across the three time periods in our chart reveals. Of course, U.S. stocks and REITs look weak as well based on recent price momentum.
Arguably, there's opportunity in all the asset classes noted above. For what it's worth, we're inclined only to nibble at such opportunities and only on a tactical basis. Admittedly, that sentiment may be more a reflection of our innate caution than a commentary about prospective returns. Nonetheless, there's still a case to remain defensive, if only because there's a bit more uncertainty in the air than we'd prefer. Will the Fed lower rates or not? How dependent are capital markets' near-term future returns tied to the FOMC decisions in coming days and weeks? And the big question--will the economy stumble by more than Mr. Market expects?
We don't yet have a good sense of what's coming on those topics. The future's always unclear, of course, but it looks especially dicey at the moment. The fog will lift, however, and quite soon, we think. It may or may not be encouraging, but a bit more transparency will go a long way in fleshing out our strategic portfolio adjustments.
Keep in mind, too, that valuation will play a large role in our decision making. Price trends are important, but they're only part of the strategic picture. How, then, does the valuation outlook stack up? Alas, that's a question we'll have to leave aside for the moment as it goes beyond the scope (and time) available to this reporter in this post. Indeed, some analysis just takes more time than the give-it-to-me-now world of blogging allows.
August 22, 2007
ONE PHOTO'S WORTH A THOUSAND QUESTIONS
The photo op didn't help.
Bernanke meeting yesterday with Sen. Dodd and Treasury Secretary Paulson
There's much debate about how to proceed on monetary policy, but on at least one basic point there can be no argument: history clearly shows that central banks must be independent if they're to be effective stewards of a nation's currency. Simply put, the political factor has no place in central banking. Yes, it leaks in from time to time, but every effort should be made to keep it at arm's length. The issue is more than window dressing. A large body of evidence shows that central banking works better when the political influence is reduced, ideally to zero.
With that in mind, a central bank's independence flows from two fonts of power and influence. Ultimately, one is at risk when the other's threatened, or is perceived to be threatened. The first is the fundamental autonomy that's driven by the opportunity to weigh decisions based solely on the economics, i.e., monetary decisions that are unbound from the political aura that otherwise informs government action. The second source of a central bank's authority and efficacy is what one might call soft power: the ability to shape perceptions in the market by tools other than the hard power of changing interest rates, adjusting money supply, etc. Giving speeches, for instance. Soft power draws heavily on the prevailing pool of respect for the central bank and a belief in its integrity for effecting change based on the economic merits. And the market's belief in that integrity relies in no small part on the assumption that the Fed's impervious to the political winds du jour.
Make no mistake: we're not worried that Fed Chairman Ben Bernanke is suddenly in the pocket of Senator Chris Dodd and Treasury Secretary Hank Paulson. The Fed's still independent and we have no doubt that it will continue to set policy based on the merits. But the image projected at yesterday's public meeting of the three men at this particular moment will, we think, raise awkward questions if the central bank cuts the Fed funds rate in the near future.
Yes, it's important for the various branches of government to communicate. Given what's going on in the capital markets these days, more communication is better. But, hey, a private phone call or confab would work just as well, right? What, we wonder, was accomplished by a very public highlighting of the fact that politicians and their representatives are keen on seeing the Fed lower interest rates? On the eve of what may be emergency cuts in Fed funds, does it help to see the Fed head being pressured to lower rates by the Senate banking committee chairman, who just happens to be running for president and represents a state that's home to more than a few hedge funds?
To be fair, in a news conference yesterday after meeting with Bernanke, Dodd said he applied no direct pressure on the Fed chairman to lower rates. The Senator did say, however, that "it's time to act. The ball is really in their court." But there's no pressure.
It will shock no one to remind that politicians always and forever think interest rates should be lower. That's the nature of politics: provide relief now, soon and preferably before the next election. If there's any fallout, well, that can be addressed later.
The Federal Reserve, by contrast, is in the business of making decisions that will echo in the financial markets and the economy a year, two years, even five or more years down the road. As such, the enormous power that resides in the world's most important central bank should be dispensed thoughtfully, carefully and with much deliberation and respect for the numbers. In addition, the decisions should be as free of political influence, in both reality and perception, as possible. That's why the Fed chairman isn't elected by popular vote. Why? More often than not, doing the right thing in central banking isn't popular.
That said, lowering interest rates may or may not be wise at this point. But whether the Fed cuts, raises or stands pat, every effort should be made to insure that the decision is driven exclusively by economics and not politics. We're sure that standard will be maintained. There is no quid pro quo, even though someone might now think otherwise in the wake of the new imagery. Yesterday's photo op, in short, didn't help.
August 21, 2007
CLUESS IN EQUITIES?
Relative tranquility returned to equity trading yesterday. The S&P 500 moved within a fairly tight range on Monday relative to recent history and closed down by only a small fraction vs. Friday. That's progress next to last week's turmoil: yesterday's session was calm, cool and...clueless.
Clueless? Yes, if you were judging sentiment by what unfolded in the credit markets yesterday. In particular, a heightened state of fear gripped trading on the short end of the maturity spectrum. With a growing penchant to kick anything of less-than-stellar credit quality, investors rushed to safety by purchasing Treasury bills, the ultimate zone of security among paper assets. In the process, commercial paper of questionable quality took it on the chin.
The net result: the 3-month T-bill yield fell to around 3.12%, down from 3.76% on Friday's close according to U.S. Treasury numbers. The commensurate rise in the price of a 3-month T-bill yesterday (bond prices move inversely to yields) has been widely reported as the biggest since the 1987 stock market crash. Even more striking is the fact that as recently as late July, 3-month T-bills yielded more than 5%.
Meanwhile, yields rose sharply yesterday on certain 30-day commercial paper issues backed by home loans and other financial assets that have suddenly come under fresh scrutiny. In some cases, 30-day paper was yielding 6% by the day's end, or nearly 300 basis points over T-bills.
The spectacle of short-term paper yields moving higher while T-bill yields dropped is unnerving by itself. This, after all, is the cash market. Yes, high-grade corporate paper always carries a modest premium over T-bills in the best of times, but usually the spread is relatively modest, stable and predictable--features that evaporated yesterday in a flash.
Simply put, yesterday reminds that raising cash is still a priority. That's another way of saying that volatility still lurks. It's any one's guess what comes next. But it's a safe bet that well worn assumptions and rules drawn from history may not hold at any given moment. That's the nature of repricing risk: nothing's sacred.
That leaves the world to embrace the next best thing. "Nobody can actually quantify the risk right now," Robert Millikan of BB&T Asset Management told The New York Times, "so investors are requiring a somewhat exaggerated level of compensation."
August 20, 2007
Take your pick: inflation or recession. Or, if your outlook is especially surly, perhaps you'll opt for choice three: a bit of both, otherwise known as stagflation.
We're not sure which one will prevail and, unfortunately, neither does the central bank. If pressed, our prediction is one of modestly slower growth, which might take the edge off inflation without derailing the economy. The lesser of several evils, if you will. But is that just wishful thinking? Who knows? In times like these, when well-founded assumptions about the morrow fold like cheap cameras, one has to take predictions with an increasingly skeptical mindset. And why not? That's the nature of the future: it's unknown, leaving investors, central banks, butchers and bakers with the unpleasant task of guessing, or forecasting, as it's called in civilized conversations.
But no matter what you call it, the Federal Reserve has no choice but to indulge in it, for better or worse. Even under the best of circumstances, divining the future so as to reverse engineer an informed monetary policy today is a job with more than a trivial dose of risk. With disinflationary winds blowing hard in recent years, the job has looked easy in hindsight. But the jig is up and a far more complicated and risky climate has imposed itself on the business of central banking. Volatility has returned with gale force winds in some corners of the capital markets. The Fed has only a supply of blunt weaponry to battle the storm, but one makes due with the arsenal at hand.
In fact, the Fed has been consumed with tactical issues of liquidity, or the lack thereof, in recent weeks. In response, the central bank has responded with modest but targeted injections of liquidity to stave off what, so far, has been a mostly financial-industry credit squeeze. The Fed's extended credit to those who needed it without lowering interest rates. In other words, the focus has shifted from inflation to recession as a tactical matter. Will the same attitude adjustment now inform the strategic outlook, which would reveal itself as cuts in the target Fed funds rate?
If so, the next question becomes: will long term interest rates, starting with the benchmark 10-year Treasury yield, fall further? Mr. Market has already seen fit to drop the 10-year to under 4.7%, down from an intraday 5.3%-plus back in mid-June. As such, the yield curve is heavily inverted to the tune of 55 basis points. Is that in anticipation of a cut in Fed funds, or just a prelude to more of the same once rumor becomes fact?
If sharply slower economic growth, or worse, is coming, the case for lowering rates soon is persuasive. But if the economy continues bubbling, lowering rates runs the risk of generating more liquidity for an economy that's already suffering from the hangover effects of easy money and loaning money with minimal conditions.
The futures market has already made up its mind, betting heavily that a 25-basis-point cut in Fed funds is on the near horizon. Looking further out, judging by the January '08 contract, Fed funds are projected to fall more, to 4.50% by the new year--75 basis points below the current target rate.
Such cuts are likely to be a timely dose of liquidity that eases the pain of economic slowdown or contraction. But if the economy surprises on the upside, and the mortgage mess stays relatively contained, dropping the price of money runs the risk of creating bigger monetary headaches down the road by fanning inflation's fires. All the more so given the fact that global liquidity is still alive and kicking, as we discussed on Friday.
The point here is mainly that investors should be aware of the larger context that awaits the Fed, the economy and ultimately the prices of stocks, bonds and commodities. More to the point, the Fed must make a decision that will affect financial and economic conditions in '08 and beyond. But it must do so with imperfect knowledge of the future. That's always the challenge, of course. The only difference is that the stakes have risen dramatically in recent weeks. Volatility has jumped sharply, elevating the risk that today's choices will bring trouble tomorrow.
Mr. Bernanke, it seems, may have found his defining test as Fed head. If he can successfully navigate the tactical risks in the coming days and weeks, his reputation will soar. For his sake and ours, let's hope he chooses wisely.
August 17, 2007
These are the times that try investors' souls, pinch their wallets and raise questions about what constitutes sound thinking on investment strategy.
No, we don't have definitive answers, but we can at least take a stab at dispensing some perspective, albeit informed by limited information that afflicts the mortal senses. With that caveat out of the way, perspective starts with the fact that volatility, as much as it scares us, is a good thing for strategic-minded investors. And the market has been nothing of late if not volatile.
The VIX index, a measure of S&P 500's price volatility, has taken wing in recent weeks, effectively tripling from its close at the end of last year, as the chart below illustrates. Dramatic as the new trend is, the resurrection of risk isn't all that surprising.
This past January we asked: Is Volatility Set for a Comeback? At the time, pondering a future of revived risk was widely dismissed as misguided ramblings. The bulls, you may recall, were then basking in a rare state of total control over asset classes. Everything had been rising for five years or more, and in the process price volatility fell sharply. The markets, in short, were priced for perfection, as they say. The fact that the perfection came after five years of fun suggested that it was time to prepare for something else. The timing and catalyst that would usher in change were still mysteries in January 2007. But the future seemed clear for those who believed that risk can't stumble and stay abnormally low forever.
Today, the cloud of unknowing has been withdrawn, leaving volatility in an elevated state. Par for the course with dramatic market declines. What does it mean? From a strategic standpoint, the lesson for us is one of shifting the mindset from raising cash (which we've been inclined to do, albeit slowly, for the last year or so) to looking for opportunities to start nibbling at the major asset classes.
For the moment, the shift in sentiment is academic. Having made no purchases in recent weeks, we're still all talk and no action. But one shouldn't underestimate the importance of changing one's intentions from that of a net buyer of liquidity to a net deployer. Buying on the margins when markets are falling is as emotionally difficult as raising cash on the margins when markets are rising. Contrarianism--even a slow-moving, risk-averse variety such as ours--tends to be a thankless task in the short run, particularly in roaring bull markets. Regardless of the backdrop, it's emotionally difficult to alter one's strategic thinking on a dime. Rethinking and revising one's big-picture portfolio plans takes time because the process starts in the last great black box in the universe: the control center of the central nervous system. But the revision becomes essential at various moments over time for the simple reason that buying low and selling high is still the only game in town for the long run.
Alas, your editor is as clueless as everyone else about the precise timing of bottoms and tops. The next best thing is adding a strategic overlay of time diversification to asset diversification. Having created a pile of cash, we now aim to use it, albeit methodically, deliberately and in pieces. Ideally, the cash will be deployed at moments of extreme stress in the coming weeks, months and years.
Of course, perhaps the selling will blow over. As we write, we read that the Federal Reserve this morning has cut the discount rate by 50 basis points. S&P 500 futures responded with a dramatic 2% rise. Perhaps the financial crisis has passed. Perhaps not. We don't know. But from out perch, the crisis wasn't triggered because interest rates were too high by 50 basis points. As such, it's hard to imagine that a 50 basis-point cut in the discount rate will cure what ails the financial system. Yes, it may bring temporary relief. But it's our belief, naive perhaps, that something more fundamental has upset the former rosy state of affairs. Until and if that's addressed, one might wonder if the recent turmoil still reflects deeper issues.
Even assuming that the bulls resume control, the inevitable correction will be that much bigger. With that in mind, it's our guess that many investors have not been raising cash these past months. For those who are still fully invested, a market decline leaves no option other than to sell. In contrast, those with cash will be willing and able to help out for those on the other side of the trade...at a price.
August 16, 2007
ANOTHER DISCOURAGING REAL ESTATE REPORT
A number of dismal scientists and market strategists have been advising for some time that the real estate market was set to stabilize. It wasn't poised to grow necessarily, but that was just fine as far as the broader economy was concerned. The prediction fit nicely with the idea that if real estate simply stopped being a drag on the GDP calculation, the second half of 2007 into early 2008 would look pretty good in terms of growth.
That may yet prove accurate. But after reading this morning's news on housing starts for July, new doubts arise about the momentum of real estate's correction and, by extension, GDP's prospects in the second half.
The Census Bureau reported today that housing starts dropped again last month, falling 6% from June, on a seasonally adjusted annualized basis. More dramatically, July's 1.381 million annualized starts are down 21% from a year ago, as our chart below shows. Permits issued for new private housing construction is also off sharply on a monthly and annual basis through July.
The housing starts and permits trends suggest that the pain continues. Until and if the numbers show some stability, there's reason to expect more of the same, namely, declines. That may or may not be the right thing to do, but short of knowing the future, what else can a prudent investor to do these days?
Combined with the mortgage ills of late, it's all starting to look like a perfect storm for real estate. Consider how the chain of events may be playing out. A builder sets out to construct a new house. In recent years, there was no trouble finding willing buyers who would sign a contract to pay, say, $500,000 nine month from now, when the home was finished. Between today and nine months from now, there was a halfway decent chance that the $500,000 house would be worth more. That combined with easy credit made banks and other financial institutions eager to back the home buyer with a loan, regardless of the buyer's credit history. The deal was beneficial for all involved.
But the game has changed. The builder isn't so sure that he'll have a buyer who can find the necessary credit. One reason: it's not clear that the $500,000 house will be worth $500,000 nine months from now. And with mortgages tougher to come by, it's a lot easier to delay purchases, which only inspires builders to become defensive and cut back on construction plans.
It's too early to say if the real estate troubles will derail the former optimism about economic growth in the second half of 2007, but it's not too early to worry. Or to hedge the risk of slower growth than recently predicted.
Alas, all mere mortals can do is watch the trends and make a decision based on incomplete information, which is a perennial state of affairs in managing money and discerning tomorrow's economic trend today.
On that note, we take no encouragement from today's update on initial jobless claims, which the Labor Department advised jumped to 322,000 for the week through August 11--the highest since mid-June. Granted, this series is volatile; it's also true that 322,000 is still quite middling in terms of recent history. But in these anxious times, any excuse will do.
Raising cash has been a focus of ours for some time now. For the moment, there's no compelling reason to change that bias. In fact, it seems that more investors are coming to a similar conclusion. That by itself is a significant change in sentiment, and a sign of the times.
August 15, 2007
CPI VS. GLOBAL LIQUIDITY
Today's report on July consumer prices gives the Federal Reserve a bit more elbow room for lowering rates. This alone doesn't insure a rate cut's imminent, but at least one can reason that the CPI news alone doesn't preclude the central bank from unleashing a fresh round of monetary easing.
The Labor Department reported that seasonally adjusted headline CPI rose by a mere 0.1% last month. For the year to July, CPI climbed by just 2.4%, the slowest annual pace since February.
Core CPI also looks contained. On an annual basis, CPI ex-food and energy advanced 2.2% for the year through July, unchanged from the annual rate posted in June.
On its face, the CPI news comes just in time to counter yesterday's whiff of trouble embedded in the report on producer prices. As we wrote yesterday, there was reason to worry that core PPI was starting to look robust once more. But with no corroborating evidence in today's CPI, one can breathe a sigh of relief. Taken together, PPI and CPI offer a mostly encouraging review about general price trends.
But for those who look beyond inflation measures proper, there are still gads of liquidity in the global economy. This despite the recent liquidity crunch roiling the mortgage market at the moment. The question for strategic-minded investors is whether to take the CPI report as gospel and dismiss the still-robust growth in liquidity in countries near and far. Alternatively, is there reason to fear that global liquidity presents a threat for the Fed and its mandate to keep inflation contained? If so, does that mean that Bernanke and company have less room to ease rates than the CPI report alone suggests?
For some perspective, the current issue of The Economist details the extent of the global liquidity in an article, accompanied by a graphic illustration of the trend, which we reproduce below. The essence of the report is that nominal and real money supply around the world has been growing by leaps and bounds in recent years.
Source: The Economist
The primary source of the currency printing has come from emerging market nations, starting with China. Indeed, The Economist reported that a broad measure of Chinese money supply has risen by 20% over the past year, or about four times as fast as America's. What's more, China's robust money supply growth is far from atypical among developing economies these days. Russia's increase in money supply is racing ahead by more than 50%, based on the past year, while India's expanded by almost 25%.
Overall, emerging market's money supply has climbed by 21% over the past year, The Economist reported, citing numbers from Goldman Sachs. Adjusting money supply growth for inflation doesn't temper the trend. Real money supply expansion is advancing at nearly 16% a year, the fastest in decades and far above what seems reasonable given the associated inflation-adjusted GDP growth in the world.
All of this matters for a planet that's hyperlinked through economic and financial globalization. As a result, the notion that Federal Reserve alone controls America's liquidity is the stuff of history. True, the Fed is still relevant, and by more than a little. But global forces are increasingly running the monetary show. At the same time, the effects of global liquidity move slowly, glacially. There are no sudden warning bells or fallouts to alert the average observer. But a creeping threat, if that is what the bull market in global liquidity can be called is still a threat and one day its effects will out.
Meanwhile, U.S. investors are consumed with the latest news on the liquidity squeeze du jour. The notion that the world's still awash in liquidity appears to be yesterday's news. Perhaps. But central banks from Beijing to Moscow keep printing currencies at a pace that's unprecedented in recent decades.
The great unknown is how this will impact the U.S. economy in general, and Fed policy in particular in the months and years ahead. We don't know the answer, but we have a few theories. Embracing those theories leads us to believe that maybe, just maybe, today's CPI report may not be all it's cracked up to be as a clue of what's coming.
August 14, 2007
THE NEW PROBLEM WITH CORE PPI
This morning's update on wholesale prices brings news that inflation may not be going quietly into the sunset just yet.
Producer prices rose 0.6% last month, up sharply from the 0.2% decline in June, the Bureau of Labor Statistics reported today. But that's a straw man. Energy was the culprit, courtesy of July's sharp rise in crude oil--a rise that's since pulled back.
It'll be tougher explaining away the rising trend in core PPI, however. As our chart below illustrates, PPI excluding food and energy continues bubbling higher on a rolling 12-month basis. For the year through July, core PPI jumped 2.4%, the highest pace in nearly two years.
The optimistic view is that the surge in 12-month core CPI is due to "technical reasons"--the falling off of a negative number in the rolling calculation. In other words, the -0.5% for July 2005 drops out of the latest update for the last 12 months, replaced by 0.4% for August 2005. Meanwhile, last month's core PPI was just 0.1%, down from 0.3% in June. Of course, it's the longer-term trend that ultimately matters rather than the number from a given month. As such, the above chart is what it is. Perhaps next month will provide evidence that the current 12-month surge was a one-time event; perhaps not.
Meanwhile, the trend as it currently stands seemed to have caught the attention of traders in Fed funds futures. A number of contracts dropped sharply in price in early trading this morning after the PPI news, suggesting that the prospects for a rate cut may have dimmed, at least for the moment.
That's not surprising, given the news on PPI today, at least when viewed through the prism of rolling 12-month changes. Still, one metric alone doesn't tell us much, which is why all eyes now turn to tomorrow's July consumer price report. The consensus forecast calls for a slower pace in headline CPI and about the same for core. We'll see.
Given the initial reaction in Fed funds futures, however, it's clear that Bernanke and company will have to tread carefully. The least jitter about inflation is enough to bring bond bears out from hiding.
Indeed, the notion that a rate cut's needed strikes this reporter as more of a gift to Wall Street than Main Street at this juncture. That, of course, could change if the subprime ills start spilling over into the broader economy in a larger way. Until and if that happens, today's PPI gives the Fed a notch less credibility on cutting rates. But in these volatile times, today's logic can easily become tomorrow's statistical garbage. Much depends on CPI. Stay tuned....
August 13, 2007
ANXIOUS & CLUELESS
The only thing worse than a financial crisis is a financial crisis that hits when the economy's in or near recession. Fortunately, the economy's still growing, and for the moment there's no reason to think the expansion is in imminent danger of evaporating.
The latest evidence comes in this morning's July report of retail sales, which rose 0.3% last month, reversing June's nasty 0.7% tumble, the U.S. Census Bureau reported today. For the year through July, retail sales climbed 3.2%.
On its face, the numbers suggest, albeit modestly, that the growth machine remains intact. But the worries start to set in when you consider the historical context, which we've laid out for retail sales in the following chart.
It's clear that when retail sales are viewed through the prism of recent history, there's reason to wonder if Joe Sixpack can continue to spend at yesterday's levels tomorrow. Graphically, the rate of retail sales growth is slowing--on that there's no debate, as the linear progression trend (the blue line) indicates. Adding to the potency of the trend is the fact that the latest reading is well the trend line, not to mention near the absolute low of late set back in January and about half as much as the latest reading for the nominal rate of annualized GDP growth. All of which raises a few questions: Are retail sales unusually low for the current economic climate? Or is the pace of economic expansion too high given the trend in retail sales?
The debate is, of course, what comes next, and not just in retail sales. But now there's a complication. As we write, a tidy little crisis is blowing through the financial markets. Perhaps it's over, perhaps not. We don't know, and neither does anybody else. But this much is clear: whatever ails the capital markets, the disorder will surely be of a far greater magnitude if the economy weakens. With that in mind, we expect Mr. Market to pay ever closer attention to the numbers dispatched.
Alas, economic forecasting is art as much as science. Although we can crunch the numbers and apply deep logic to the trends, the next input remains a mystery, in part because consumer spending arrives one credit card-decision at a time. All we can do is watch as the economic reports roll out. But while history doesn't predict the future, it does offer some perspective. On that note, it's worth remembering the consumer spending is the primary, if not the only game in town for the economy, representing 70% of GDP. If and when that source of spending slows, the reverberations will be felt directly in the next GDP report. We say that with the gnawing sense that the cycle is turning and that there's more negative surprises than positive ones waiting in the wings.
Judging by the trend in retail sales, one is tempted to extrapolate the past into the future. All the more so, given the fallout in the mortgage market of late. It's not yet clear if this fallout will spill over, if ever, into the general psyche of consumer spending, but at this point we'd be foolish to dismiss the notion entirely.
In fact, that line of worry inspires some to call for an interest rate cut by the Fed, which so far refuses to budge. Nonetheless, the pressure is growing for easier monetary policy, and the market now expects no less. Traders have bit up the price of Fed funds futures contracts in recent days in anticipation that a 25-basis-point cut is coming soon. Perhaps, although the decision isn't yet a no-brainer, at least from a central banking perspective. Yes, the market's correcting in some spots, and it may yet correct more. But in the here and now, slicing interest rates still looks more like a Wall Street bailout than a prescription for Main Street.
That perception is vulnerable to change, of course, and perhaps in short order. But that requires fresh data. Fortunately, or unfortunately (depending on what the numbers tell us), there's plenty of reports to keep us glued to our computer screens this week, including updates on consumer and producer prices, industrial production and housing starts.
Our greatest worry, however, is that while a fresh dose of liquidity may calm nerves and keep Joe spending a bit longer, it's not clear that in the longer run (the next 1-3 years) more liquidity is the superior choice. True, it's worked wonders when applied in 2001-2005. A repeat performance is expected in some circles one the Fed acts. But as they say in the mutual fund literature, past performance is no guarantee of future results.
The business cycle will eventually have its way. The idea that it can be postponed indefinitely is folly. But it matters not what your editor thinks on this topic. Rather, the views of Ben Bernanke and company are ground zero for the relevant opining du jour. And on that front, the world is still clueless.
August 10, 2007
GREED TAKES A HOLIDAY
Liquidity crunch. The mere mention of the phrase raises fear among the highly leveraged, the overextended and anyone else who's betting heavily on the notion that the bullish momentum of recent history will last one more day.
With textbook-like regularity, yesterday's worries over the fading of liquidity in some corners of finance replaced greed with fear, inducing a dramatic bout of selling around the world. Ground zero for the liquidity squeeze was Europe, where the ECB yesterday loaned a record $131 billion to 49 banks in an effort to minimize the fallout arising from subprime-mortgage ills in the United States, MarketWatch.com reported. The Federal Reserve was compelled to engineer a similar injection of liquidity, albeit at a much lower dosage of $12 billion. Other central banks are said to have advanced loans as well yesterday.
It's hard to judge what the larger trend will be based on just one day. But the idea that the sea of liquidity that's been bubbling in the 21st century might reverse, and with negative consequences, is hardly a hair-brained nightmare imagined by outcasts to mainstream economics. Much to the chagrin of some, perhaps most investors, cycles are still alive and well. Central banks, in short, haven't dispatched cycles to oblivion, even if it's looked otherwise in recent years.
In fact, the latest bout of credit crunching has been years in the making. The law of financial gravity predicted that the Fed's decisions to favor easy money in the extreme earlier in this decade would come back to haunt the capital markets. In fact, the cornucopia of liquidity has been the elephant in the room for several years, setting the stage for bull markets (inflation?) across the asset spectrum. True, the elephant has been ignored, but a pachyderm won't suffer obscurity indefinitely, as yesterday's actions suggest.
Meanwhile, let's be clear: the Fed and its counterparts around the world have been major players in fueling the bull markets by supplying the necessary credit. Arguably, that credit has been supplied to excess. Few have complained, at least those who've been long. Bull markets, after all, have a habit of quieting complaints, easing fear and elevating the demand for martinis and Ferraris. No one wants to spoil a good party, but at some point it's time to call a cab and head home.
If the corrective power of the bears has returned for an extended stay, a new era of criticism about what central banking has wrought may be in the offing. While we wait for the debate, let's step back and consider the broader perspective: It's more than a little ironic that the central banking establishment's solution for what ails markets is, so far, another dose of the same medicine that brought us to this point. Namely, yesterday's liquidity injections follow years of the same, albeit in varying forms. Tactically, yesterday's efforts to ease anxieties by effectively printing more money are really just more of the same policy biases that have been in effect for years. Arguably, the Fed and ECB don't have much choice at the moment. But that raises questions anew: How did we get pushed into a corner where printing money is at once the problem and the solution? More importantly, what does the constraint imply for the future?
The answer, as always, will arrive one day at a time.
August 9, 2007
BETTING ON THE STATUS QUO (AGAIN)
No one will be inspired by this morning's update on initial jobless claims. Then again, the numbers won't frighten investors either. And that, perhaps, is the point. New applications for jobless benefits aren't necessarily encouraging, but they don't they look especially portentous.
That, at least, is our take. But judge for yourself. For the week through August 4, initial claims rose slightly to 316,000 from 309,000 in the previous week, the Labor Department reported. In the context of recent history, 316,000 looks middling, as our chart below shows. True, the bias leans to the upside of late, if only slightly. The four-week moving average of jobless claims is 307,500, modestly below last week's number.
Judging by the broader trend, the news for jobless claims is that there's no news. And that, arguably, is good news.
Betting on the status quo is a popular choice these days among movers and shakers, including the mover-and-shaker-in-chief: Fed Chairman Ben Bernanke. The central bank on Tuesday continued to hold steady on interest rates, keeping Fed funds at 5.25%, the prevailing number since June 2006. What's striking about the ongoing preference for doing nothing with the price of money is the fact that in recent weeks the calls for a rate cut have grown louder. Subprime mortgage anxiety has been the immediate catalyst for the thinking that the economy needs a fresh injection of liquidity to keep growth bubbling. But the Fed has resisted, a decision that's gaining support among pundits, including today's lead editorial in The Wall Street Journal:
"...Mr. Bernanke did the right thing on Tuesday and refused to pander to the many pleas to rescue credit markets by printing more money."
The economy, in short, continues to bubble, despite the recent fears driven by the real estate sector. A recession will eventually arrive. The central bank, for all its powers, is run by mortals, not gods. For the immediate future, however, it's folly to think the economy will contract. There's ample support for the idea that GDP growth for all of 2007, once the final number is published, will look decent by recent standards.
The "catch" is that time will inexorably take a toll on growth. That's the nature of business cycles: eventually, they plant the seeds of their own destruction. True, the Fed has learned how to minimize the cyclical risk. Volatility in GDP is a shadow of its former variance. Some ambitious types have even advanced the idea that central banks have assumed the talents to dispatch business cycles to the dustbin of history. We're highly skeptical of the belief, although for the foreseeable future the inherent allure of that notion will continue to resonate with the bulls.
But financial sobriety is quickly restored if one remembers that ours is a world where the overwhelming majority of forecasts are dependent on the past, and that the past informs the future until it suddenly doesn't. At some point tomorrow will offer a sharp break with yesterday. The reversal will, of course, look obvious in hindsight while remaining virtually invisible in the here and now. Only by overlooking that monster of a caveat can we say with confidence that the status quo looks likely to prevail. That and $2, as they say, gets you a cup of coffee. And that, dear readers, is why diversification is still your only friend today, tomorrow and forever and regardless of what tomorrow's headlines proclaim.
August 8, 2007
IS THERE A CUT IN YOUR FUTURE?
The stock market was surprised and shocked yesterday to learn that the Fed wasn't cutting interest rates. The initial reaction to the news of standing pat with Fed funds: sell first and ask questions later. But the surprise and shock was fleeting, and investors did a volte face and decided that holding rates steady was the best course after all. Buyers proceeded to bid prices up.
The net effect was that the stock market was on a roller coaster yesterday even though the central bank continued its long-standing policy of sitting on its hands, as defined by Fed funds, which still stands at 5.25%. For those who watch Fed funds futures for clues, yesterday's news of letting it ride was a yawn. The futures market has long anticipated that 5.25% would remain the standard.
But if futures prices can be trusted, a cut of 25 basis points to 5.0% is coming by late this year or early in '08. One school of thought thinks a cut makes sense in part because of the current credit crunch that's thrown the capital markets into a tizzy. But while the Fed has a history of coming to the rescue in times of liquidity squeezes, there's reason to wonder if erring on the side of monetary caution remains the better choice at this juncture. The credit crunch for the time being isn't all that crunchy. Liquidity has dried up some, but that's only relative to the recent levels of excess. In any case, so far there's still lots of cash looking for a home in the global markets.
Meanwhile, consider the Fed's preferred measure of inflation, a.k.a. the personal consumption expenditures index less food and energy. The latest report shows the gauge rising at 1.9% for the year through June, which is within the upper range of the central bank's reported comfort zone of 1%-to-2% core inflation. That's the first time in more than three years that the annual rate of core PCE has dropped below 2%.
Why, then, is the Fed still worried about inflation? Yesterday's FOMC statement advised: "Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures."
Perhaps the Fed's keeping an eye on headline inflation, which has been running hotter than core inflation for some time. Arguably, this is of no consequence. The academic literature argues that core inflation is superior predicator of headline inflation than headline itself is. In addition, some studies also show that rising energy prices alone aren't fated to elevate inflation. Bernanke is a party to this line of thought and has co-authored studies to that effect. All of which gives the Fed some cover in light of the fact that energy has been driving headline inflation higher at a faster pace than core.
But there's a potential glitch in the pay-no-attention-to-headline-inflation theory. The gap in headline inflation over core inflation is fairly wide and persistent by the standards of the past 15 years. Does this mean that things are different this time and that headline inflation is now a better indicator of inflation? If so, does headline's faster pace imply that that the Fed has much less room to cut interest rates than some believe?
The market will have to sort this out, of course. Meanwhile, we're looking at the data. Consider the graph below showing the accumulated impact of headline inflation's pace over core. It's clear that headline PCE has been running faster than core PCE. In the previous economic cycles, the two measures eventually converged. This time, however, there's precious little sign of a conversion.
Some of the disparity between now and then comes out in a comparison of annualized changes in inflation. For the five years through this past June, headline PCE rose by 2.6% a year, well above the roughly 2.0% rate for core PCE. In the previous five-year span (1997-2002), headline's edge over core was much smaller at about 10 basis points. And in the 1992-1997 stretch, headline PCE actually ran slightly below core PCE's pace on an annualized basis.
It's unclear if headline's higher, persistent pace is a temporary anomaly or a trend that foreshadows trouble. For the moment, the Fed's not dismissing the latter notion.
August 7, 2007
LOOKING FOR BARGAINS
Your editor has been absent from these digital pages for just 11 days, but a lot can happen in 11 days.
Consider the table below, which summarizes the performance of the major asset classes of late. In particular, note the prevalence of red under the 4-weeks column. Risk has been showing its other face to investors, many of whom formerly thought that there was but one outcome to embracing the four-letter word.
The fact that markets have retreated in earnest should come as no surprise. After a multi-year run of dispensing mostly gains, the major asset classes have reintroduced the notion of humility to the masses. As readers of this site will recall, we've been expecting no less for some time. Granted, even a broken clock is right twice a day, and so we're vulnerable to criticism that our warnings were early. True, although we've advised all along that our preferred strategy has been one of raising cash methodically as markets continued moving higher.
As a result, our own personal allocation to cash is well above levels we're comfortable with as a long-term proposition. The idea of continuing to elevate the cash weighting was always with an eye toward redeploying it when prospects looked more attractive elsewhere. Now that red ink has arrived, is it time to redeploy? Yes, sort of. But in addition to diversifying across asset classes, we're of a mind to diversify across time as well, for both buying and selling. The reason: we can't see the future. Yes, we can make some educated guesses, in part driven by quantitative clues handed down by the markets. Those clues, however, aren't foolproof.
Meantime, let's be clear: the correction so far, painful as it seems, hardly amounts to an earth-shattering buy signal across the board. Blood is starting to trickle, but it's still not running in the streets.
Take a look at REITs, which are the hardest hit among the major asset classes. Surely, this is where value bursts loud and clear. Yes and no. Having shed nearly 12% so far this year, REITs are clearly battered but the selling still looks modest in context with history. Indeed, REITs have only returned to price levels of mid-2006. Meanwhile, the current trailing yield on VNQ (our proxy for REITs) is a modest 3.84%, according to Morningstar. That's nearly 100 basis points below the yield on the benchmark 10-year Treasury. For our money, we'd prefer to see REITs yielding a premium over the 10 year before we go rolling back into the asset class with any searing conviction. Although it's still somewhat out of favor, ours is a philosophy of requiring compensation for assuming risk. Crazy, perhaps, but that's our story and we're sticking to it.
Yes, the prospective capital gains for REITs may ultimately combine with the yield to outperform the 10 year. But at this stage, when the markets are anxious and just beginning to become reacquainted with the fuller persona that is risk, we're inclined to wait a bit more. At the same time, with cash at the ready, we'd start nibbling at REITs if a further dip of some magnitude arrives in the coming weeks and months.
All of which reminds that our strategy of slowly but consistently raising cash as markets climbed will be mirrored with a strategy of slowly but consistently redeploying cash as markets fall. This carries no appeal to short-term traders, but for our strategic-minded focus, it suits us just fine. The degree and focus of the future redeployments will depend on where the red ink burns the brightest.
For now, though, we're still content to watch and wait, nibbling here and there but making no major buys. Indeed, some markets have barely corrected at all, the recent selloff notwithstanding. The S&P 500, for instance, despite its sharp decline in recent weeks, has retreated only to levels considered healthy back in April. We don't recall many bulls worrying that 1400 or so on the S&P was the end of the world in the spring. Meanwhile, the ~1460 level on the index currently elicits fear that equities are weak. Same price, different emotions.
Perhaps the only refreshing exercise in times like these is to remind oneself of the iron law of investing: lower prices equate to higher expected returns while higher prices imply lower expected returns. That principle can either work for or against investors, and the outcome resides completely within. We're of a mind to make it work for us, which requires a commitment to the ancient wisdom of buying low and selling high. Everything else is noise.