The Capital Spectator: November 2007 Archives

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November 30, 2007

THE NUMBERS GAME

For the naive alien only just arrived on planet Earth, yesterday's GDP report might be considered a great triumph. Indeed, taking the numbers at face value, there's reason to celebrate. Real annualized GDP for the U.S. surged by 4.9% in the third quarter, according to the revision dispatched yesterday by the Bureau of Economic Analysis. That's the fastest pace in four years by the standard of the past 20 years it looks sizzling. In short, the economy appears to be growing at a strong pace.

With that out of the way, we can now begin to address why the last statement may be irrelevant, or at least sufficiently misleading so as to require additional explanation. Let's begin with the usual caveat that the GDP number is now and always a lagging figure. The third quarter might as well be the Jurassic Period for anxious investors in the here and now. Yes, GDP reports are always out of date, but that's not a problem if the trend is fairly smooth and last month looks pretty much like this month and provides some fairly sturdy clues about next month.

Alas, the economy's outlook these days is changing faster than a politician's core beliefs. Suffice to say, there's an excess of conflicting news out there. To take one example, consider the hot GDP number relative to the trend for initial jobless claims. While Q3 witnessed impressive growth, one has to wonder what Q4 will bring if the labor market is weakening, as the jobless claims data now suggest.

As our chart below shows, new filings for unemployment benefits have taken wing. Granted, it's still within the range of recent history, but the trend doesn't look encouraging. From mid-September through last week, jobless claims are up 40% and now reside at a nine-month high.

No wonder, then, that the Fed is now widely expected to cut interest rates again. Although Fed funds are currently at 4.50%, down from 5.25% a few months back, the dismal scientists tell us that it'll take more cuts to head off the mounting economic weakness that appears to be taking root.

Ultimately, the primary support that's kept the economy bubbling through thick and thin in the 21st century is consumer spending. As long as the labor market was reasonably robust, Joe Sixpack has been happy to spend, aided and abetted by a central bank willing and able to maintain easy credit. If the labor market is in fact weakening, consumer spending may face its biggest test in years and it's not clear that a fresh round of rate cuts will save the day once more.

"When you look at consumer confidence and jobs measures you have to think that whatever you thought of in terms of consumer spending has to be given a haircut,'' John Silvia, chief economist at Wachovia, told Bloomberg News yesterday. "That jump in jobless claims isn't good news.''

This morning's news on personal income and spending only lends additional support to the view that the slowdown has legs and is starting to have consequences for the man on the street. Higher energy prices, falling home prices and a number of other headwinds have conspired to trim consumer spending in October, the government reported today. Although personal consumption advanced by 0.2% last month, the pace was down from 0.4% in September. In fact, after adjusting for inflation, consumer spending was flat in November.

But, wait: there's more--or less, actually. Disposable personal income rose only 0.1% last month, a sharp slowdown from September's 0.4% rise. Once again, adjusting for inflation darkens the trend: real disposable income dropped 0.1% in October, the first decline since April.

So, yes, it's good news that the economy was bubbling in the summer. The question is, how hot will it be next July?

Posted by jp at 10:01 AM | Comments (0)

November 29, 2007

THE FED TO THE RESCUE? AGAIN?

The economy may or may not be slowing, but it's clear that the stock market still loves the idea of lower interest rates.

Exhibit A is yesterday's commentary from one Fed vice chairman. "Uncertainties about the economic outlook are unusually high right now," Don Kohn advised the Council on Foreign Relations yesterday, according to Reuters. "These uncertainties require flexible and pragmatic policy-making -- nimble is the adjective I used a few weeks ago."

For the uninitiated, this may sound like casual chit chat on the rubber-chicken circuit. But for the savvy trader, this was insider code for: the Fed will CUT rates at the December 11 FOMC meeting. Fed funds futures have no reason to argue: as we write, the January contract is leaning closer to the idea that a 25-basis-point reduction is in the offing.

Perhaps at some point in the coming days another Fed head will take to the podium and give the stock market another reason to run equities up another 300 or so points on the Dow. This, dear readers, is the age of speculative opportunity in the stock market, albeit a wobbly one that's increasing dependent on obscure commentary by central bankers.

Fortunately, ours is a multi-asset class world that's accessible by ETFs and other publicly traded securities. For strategic-minded investors, there's always a varied mix of relative risk and return opportunities. U.S. stocks, for our money, don't look all that attractive, although they don't appear overly expensive either. This is not early 2000, when valuations were in the stratosphere. But neither is it 1982, when equity shares were about as popular as yellow fever.

For what it's worth, we expect U.S. stocks to tread water for the foreseeable future. Yes, on any given day there may be a pop (keep the Fed's speaking schedule handy, just in case). There's bound to be sharp tumbles too. All of which suggests to us that this is probably a time to keep U.S. equity weights average, if not slightly conservative. In fact, we're inclined to buy a bit on the dips and sell on surges, but only on the margins.

Meanwhile, we're keeping an eye on opportunities elsewhere. One quick example comes by way of high yield bonds. Comparing the historical yield spread for Citi US High Yield Index less the 10-year Treasury reveals that junk bonds are beginning to look attractive again, as our chart below shows.

The yield premium for junk is currently the highest in about four years. No, we're not suggesting it's time to pile in. The rising spread, after all, is a sign that the market expects higher default rates. Nonetheless, the asset class is starting to catch our attention once more. Sure, we're still cautious if only because history reminds that a risk premium of 5.4% pales next to the 10% posted back in 2002. Of course, waiting for 10% may be hopeless, unless you're expecting a deep and enduring U.S. recession.

We don't. Granted, we could be wrong. It wouldn't be the first time. But if the economy just slows, or even temporarily contracts, we think that default rates for U.S. companies issuing high yield bonds won't soar. And don't forget that the Fed seems inclined to pull out all the stops to keep a recession at bay.

Meanwhile, if you're considering rebalancing your portfolio by paring back on the big winners, there's the question of where to redeploy. Cash is always an option, although if more Fed cuts are coming, the payment for sitting on the sidelines will continue to diminish.

So, what about junk? Consider that the asset class has barely budged this year. Using the Vanguard High-Yield Corporate mutual fund as a proxy, junk bond total returns are 0.7% so far this year through yesterday, according to Morningstar. In fact, it's quite possible that high yield debt this year is on track to post is lowest annual gain since 2002's rise of 1.7%.

Compare that with the soaring 35.5% year-to-date total return for emerging market stocks, as per iShares MSCI Emerging Markets Index. No, we're not predicting that emerging market equities are set to crash and junk will soar. We don't know what's coming. But taking a little from the big winners and redeploying it to the relative laggards every now and then probably boosts a diversified portfolio's expected returns and lowers its expected risk.

The amount one redeploys depends on the depth of the apparent risk and reward potential in the given asset classes. By that standard, emerging markets look quite risky at this point while high yield bonds look, at most, only modestly attractive. That's hardly the greatest scenario for rebalancing, and so we'll still tread carefully. Fortunately, there are other asset classes to consider, although we'll stop here for the moment.

Of course, there's always speculating on what the Fed will do and what the immediate reaction will be. Best of luck with that one.

Posted by jp at 10:32 AM | Comments (1)

November 27, 2007

THE RETURN OF THE BOND GHOULS

Some may doubt that a recession's coming, but the bond market has already made up its mind.

The yield on the benchmark 10-year Treasury sunk to 3.85% yesterday, the lowest in three years. The rush to buy bonds, and thereby lower yields, reflects the growing sentiment that more trouble awaits the American economy. In short, fixed-income investors couldn't be happier.

The sharp drop in yield brings up the subject of whether the previous low might be revisited. Back in June 2003, the 10-year yield briefly dipped to 3.07%. The dramatic fall in the price of money at the time inspired forecasts that the 3.07% would stand as the low mark for a generation or more. It sounded like a plausible argument at the time. Indeed, a month later, in July 2003, the 10-year yield reversed course and closed the month at 4.47%.

As for today, it's any one's guess if a similar rebound is coming any time soon. Meanwhile, the bull market in bonds has boosted fixed-income weights this year. Investors who shunned bonds earlier have paid the price. With U.S. equities suffering, debt has lived up to its traditional reputation as a potent diversification tool.

The difference is striking on a year-to-date basis. U.S. stocks, measured by the S&P 500, are just barely in positive territory this year through yesterday's close, posting a 0.9% rise. In contrast, the Lehman Brothers Aggregate U.S. Bond Index is up a bit more than 7% year to date.

Foreign bonds are looking even better, in part due to the currency bonus born of a falling dollar. By almost any standard, debt denominated in euros, yen and other currencies have enjoyed a good year. The Citigroup World Government Bond Index, a measure of foreign debt issued by developed nations, has climbed 13.3% this year through yesterday, in unhedged currency terms based in dollars.

It's interesting to note that foreign developed-market bonds as an asset class were out of favor by more than a little at the close of 2005. Debt from the large economies lost ground that year while equities were flying. In 2006, foreign bonds rebounded some, and the rebound continues as we write.

The lesson once again seems to be that owning a diversified portfolio of the major asset classes (there are 10 by our count, plus cash) is a founding principle for long-term investment success. So too is the logic of favoring asset classes that have fallen on hard times while lightening up on those that have soared.

The great debate is how to weight each of the asset classes, when to rebalance, and so on. On that score, investors who have continued to own bonds now have the enviable challenge of deciding if it's time to trim their collective weight. Indeed, if you've had any bond allocation of substance this year, it's probably grown as a share of portfolio assets. Meanwhile, the U.S. equity weight may very well have fallen.

Is it time to pare bonds and buy U.S. stocks? Maybe, but we think it's still a bit early. Of course, we don't know for sure so there's a case to start nibbling by way of reweighting the portfolio.

Meanwhile, in the coming weeks and months strategic-minded investors will want to watch the asset classes closely for opportunities. To that end, your correspondent keeps a close eye on fundamental measures such as dividend yields and interest rates, among others, to weigh the prospective opportunities and risks. In that regard, it's just another day. But with volatility in a new bull market, some days promise to better than others for investors hoping to exploit the rebalancing bonus.

Posted by jp at 9:52 AM | Comments (0)

November 26, 2007

A RECESSION FORECAST IS STILL A FORECAST

We're told that a recession is coming, or something that looks and feels like a recession. In fact, we're told a lot of things. Some of the predictions actually pan out; most just fade into oblivion. Alas, distinguishing one from the other is always a problem, and at times like this it threatens to be a bigger problem than usual.

The economy, after all, faces a number of risks, starting with ongoing pain inflicted from the housing correction. The collective toll promises to be substantial in the quarters ahead, or so we're told by a fair number of dismal scientists and former government officials.

In the latter category is one Larry Summers, who's receiving a fresh bout of media attention with his prediction that a recession awaits the U.S. economy. As the former Treasury Secretary wrote in yesterday's Financial Times, "the odds now favour a US recession that slows growth significantly on a global basis." He cited a number of reasons, starting with the housing sector, which he feared may be in "free fall." The proper response, he counseled, may be one of cutting interest rates again, along with some other prescriptions. But even if his recommendations are carried out, he admits that there's no guarantee that a recession will be averted.

Or, we might add, that a recession is coming. Yes, we agree that the warning flags are waving and that only a fool would ignore the economic risks at this moment. We're of a mind to think that the risks are higher than usual and so a strategic-oriented portfolio should, within reason, be positioned to take advantage of any future volatility. But don't confuse danger signs with absolute clarity about what comes next.

With so many pundits emphasizing risk over return these days, some may be inclined to think that it's now a sure thing that a recession will arrive. But is it really that easy? Is economic forecasting now obvious and transparent?

No, of course not. Forecasting is as messy and difficult as ever, perhaps more so. That doesn't minimize the risks at hand, but it reminds mere mortals such as your correspondent to keep the future in its proper prospective, in good times as well as bad. Consider, for instance, GDP's quarterly history. As our chart below shows, the trend is rarely obvious at any given point in time.

Note how quarterly GDP growth fell sharply in 2006. By this year's first quarter, GDP's pace was down to a scant 0.6% rise. The future, some argued, looked clear at that point and so the remainder of 2007 would suffer recession. And who could argue? After four years or so of robust GDP growth, it appeared that the cycle was due to change, or so an observer in, say, May, might have reasoned. How could the economy rebound with so much weighing on it? But as the subsequent GDP reports show, rebound it did.

Ah, but now it's due to reverse course, right? Maybe. There's still some debate about whether recession or just slower growth awaits. That raises the question: Depending on which future awaits, how should stocks and bonds be priced?

For strategic-minded investors, there's opportunity embedded in the debating. The potential for surprise lives on, which suggests that Mr. Market may overreact one way or another. Perhaps the recession will be deeper and longer than expected. Or, maybe modest growth will survive.

Whatever comes, the market's overreaction may be offset by investor emotions run amuck. Excess confidence, for instance, is always a risk and its presence can be identified by an asset allocation strategy in the extreme. Remember the hefty overweighting in tech stocks circa 1999? The emotional inclination has been known to work in reverse, too, such as the inordinate fondness for cash in the early 1980s.

Opportunity may be coming in one or more of the major asset classes, but no one can be sure. Yes, an overweight in cash looks increasingly savvy. But how much of an overweight is too much? Or too little? No one knows, which is another way of saying that diversification still reigns supreme, for all seasons. And if you're only confident that you don't know, Mr. Market's weights will do quite nicely as a long-term proposition. To the extent that you think Mr. Market's wrong, your allocations will differ. But tread carefully. In the long run, Mr. Market's strategic mix has been tough to beat. Why? It's not because he's so smart. Rather, investors tend to go to extremes. Investing, in short, is still a loser's game, even if a recession looms.

Posted by jp at 10:00 AM | Comments (0)

November 20, 2007

A GLIMMER OF LIGHT

It's been a while since there's been good news for housing, which makes this morning's update on October's housing starts especially welcome.

Privately owned housing starts in October rose 3% percent above the revised September estimate, the Census Bureau reported today. The increase, which is the first after three straight months of declines, was the biggest gain since February. As an added treat, the advance in housing starts were comfortably above the consensus forecast, according to TheStreet.com. In addition, the government revised September's starts up a notch.

Alas, the housing correction (or should we say recession?) isn't over. It'll take more than one month in one data series to reverse the battered state of affairs that continues to roil the sector. Indeed, if we look at year-over-year trends, last month's housing starts are more than 16% below the levels from October 2006.

In fact, the more we look at today's housing report, the more the modest rise in October starts look like an anomaly. For example, although starts generally increased last month, a closer look reveals continued weakness within single-family housing starts, which dropped 7.3% in October vs. September. In other words, most of the gain in overall starts last month was due to multi-family housing. Condos are keeping hope alive in the construction of new housing.

Meanwhile, building permits, which are considered a gauge of future construction activity for housing, fell again last month by 6.6% from September's level. Permits are now at the lowest levels since 1993.

"We have not hit a bottom [in housing]," Keith Hembre, chief economist at FAF Advisors in Minneapolis, told Reuters. "We need to see starts fall to a one-million unit rate, or roughly a 20 percent drop from current levels, before building activities stabilize. And we need to see that rate for about one to two years."

Another dismal scientist also prescribed caution in the wake of this morning's housing report. "All of us are ratcheting down our expectations for the bottom of the housing sector and I don't think we're there yet,'' David Resler, chief economist at Nomura Securities in New York, told Bloomberg News today.

Indeed, single-family housing starts aren't likely to recover to any great degree in the coming months for the simple reason that the inventory of single-family homes for sale remains hefty. That means that house prices are likely to remain under pressure for the near term. Home builders know that and so do potential home buyers.

Waiting, in other words, still looks like the preferred strategy when it comes to housing. At the same time, there's the glimmer of light at the end of the tunnel. It's a dim beam and it may yet flicker out again. But maybe, just maybe, a bottom awaits in '08.

Posted by jp at 9:47 AM | Comments (1)

November 19, 2007

DEBATING THE ROLE (AND TAX RATES) OF THE RICH...AGAIN

The wealthy are in the crosshairs again. From suspicious columnists to populist politicians, debating the proper tax rate for individuals with more than a little extra disposable spending power has again become fashionable.

So it goes after a long bull market that's only suffered brief interruptions over the past generation. No wonder, then, that lots of people have made lots of money, a trend that starts to skew wealth generation in favor of those who more than an average share of it. Add to the mix the drop in tax rates over the past few decades and it all adds up to what could be thought of as a golden age for minting money.

That, at least, is how it looks in the rearview mirror. And who can argue that some elites have enjoyed a tax loophole here or there that looks suspect to fair-minded citizens of modest means? But before we go off the deep end and push the pendulum too far in the opposite direction, perhaps it's time to step back and consider the big picture in an effort to optimize government levies so that they maximize economic growth while delivering the requisite services that we, as a society, deem appropriate. And while we're at it, the United States needs tax reform if only to simplify the mess that otherwise passes as the current tax code.

But we digress. The body politic sees the tax code as something more than a source of revenue. For some, there's a moral issue here, namely: How best to serve the wants and aims of the society without killing the golden economic goose in the process? No, we won't even begin to tackle such a question on these digital pages. At least not today.

But in the interest of sparking a wider debate, we turn to a conversation your editor had with one Hunter Lewis, a co-founder of Cambridge Associates, a global investment consultancy, published in the November issue of Wealth Manager. In his recently published book (Are the Rich Necessary) he makes a case for tweaking the tax code to promote more--much more--charitable giving by those who generally suffer the upper levels of tax rates. You may or may not find the author's arguments compelling, but they're as good a place as any to start a (hopefully) constructive debate for what promises to be a topical issue in 2008. To jump on the debating bandwagon, click here.

Posted by jp at 9:40 AM | Comments (0)

November 16, 2007

SECTOR SCORECARD

Mr. Market isn't always right, but quite often he imparts valuable information. No, he won't whisper the secret to easy money in your ear. But he's always willing to provide some perspective, which comes in handy every now and again if only to remind investors that capital flows are forever evolving.

With that in mind, we crunched the numbers on the 10 major sectors that comprise the S&P 500 in search of a closer look at the internal dynamics of the U.S. stock market. All data is courtesy of Standard and Poors as of the close of trading on Tuesday, November 13.

First up is everyone favorite's metric: performance. For the year through this past Tuesday, the energy sector remained firmly in the lead among the S&P sectors, as our chart below shows. Following in close pursuit was the second-place materials sector with information technology in a respectable third-place showing. Financials, by contrast, were dead last, posting a loss for the year of nearly 14%. Consumer discretionary stocks are the only other sector with red ink this year as of this past Tuesday.

Mr. Market speaks with several voices, of course, and performance is but one. Another is market capitalization, a related by not necessarily mirror image to performance. Now is as good a time as any to gauge market cap trends over time and by that measure energy is again the big winner over time. As our second chart below shows, the relative share of energy sector in the S&P 500's market cap jumped 20% for the five years through this past Tuesday. Meanwhile, financials and consumer discretionary shed nearly 15% of their respective market caps over that stretch.

But don't cry for financials just yet. Although they've been battered recently, the sector remained firmly in the lead in terms of absolute market capitalization. For good or ill, investors still think financials deserve the lion's share of market capitalization, as our third chart below illustrates. Energy stocks, for all their success in recent years, are only slightly better than middling on this scale. Meanwhile, the materials sector is valued slightly by investors, as it often has been in recent years.

The fact that financials remain the biggest slice of the market cap pie raises a few questions. One is whether that leadership position means that the mighty still have plenty of room to fall? On the other hand, financials have long dominated the S&P's market cap. Has that been a sign of Mr. Market's wisdom all along? Or has the old boy finally overextended his hand? Questions, questions, always questions.

Posted by jp at 9:37 AM | Comments (1)

November 15, 2007

WHAT'S UP WITH INFLATION?

It should come as no surprise to learn that headline inflation continues to creep higher. The Federal Reserve has been aiding and abetting this trend for some time now, as these pages have long suggested.

This morning's update on consumer prices advises that inflation is now running at a 3.5% annual pace through last month--the highest in over a year. As our chart below suggests, the trend of higher inflation looks like more than a temporary blip. After bottoming out at a 1.3% annual rate in October 2006, pricing pressures have been on the march upward ever since.

Yes, the core rate of inflation (which the Fed favors as a gauge for monetary policy) looks better, although questions on this front abound too. Stripping out energy and food reveals an annual rate of inflation through last month at 2.1%, unchanged from September. It's unclear if core CPI's sideways behavior of late is a prelude to a fall or a rise. Much depends on what the Fed does in the coming months.

That said, the Fed seems inclined to err on the side of more liquidity these days, and that may be the deciding factor for 2008. Indeed, as we noted on Monday, nominal M2 money supply is rising at a rate well above GDP's nominal pace, a trend supported by the drop in Fed funds since September.

In fact, another rate cut may be coming, or so the futures markets is predicting. As we write this morning, the January '08 Fed funds contract is priced in anticipation that the central bank will cut rates by another 25 basis points when the FOMC meets on December 11.

Nonetheless, no one should assume that forecasting is easy at this juncture. Divining the future is especially complicated at the moment by a number of financial and economic cross currents. To name but a few:

1) The dollar in recent days has staged a mini rebound, prompting some pundits to predict that the battered buck may be due for higher terrain against its paper counterparts. If so, that may give the Fed room for cutting rates without sparking cries of inflation.

2) Oil prices have dropped in recent days. A number of analysts have said (again) that the underlying fundamentals don't support $90-plus oil. If traders agree, and oil continues falling, headline CPI may be due for a fall, thereby giving the Fed more latitude for rate cuts.

3) The expectation that the U.S. economy is slowing is widespread, which may help take the edge off the oil bull market. But while a slowdown seems likely, there's a fair degree of disagreement of how far GDP's pace will fall and how long it will last. In fact, one might wonder if some are too pessimistic when it comes to the economic outlook. Consider a story today from The Wall Street Journal, which reported that its latest survey of economists reflected a sharp drop in GDP for Q4 followed by a rebound in 2008, as a chart from the article (see below) illustrates. If so, what does this imply for inflation? Meanwhile, if reacceleration is coming, can the Fed justify another rate cut? Monetary policy, after all, works with a lag of several quarters if not longer. Today's rate cut, as a result, can cast a long shadow.

Source: Wall Street Journal

We don't pretend to have the definitive answer to these and related questions, but this much seems clear: the potential for volatility is alive and kicking. The economy continues to move through a transition period, which makes forecasting particularly vulnerable to fresh data these days. The good news is that volatility is the friend of strategic-minded investors who are of a mind to exploit the opportunity. The price is short-term discomfort relative to what the crowd is thinking.

That leads to our prediction that most if not all of the major asset classes will be hit with volatility spikes in the coming weeks and months as the markets are whipsawed with surprises of one kind or another. For our money, we're increasingly inclined to take advantage of the spikes when it suits our long-term objectives. Lower prices, in short, imply higher expected returns. Everything else is open for debate.

Posted by jp at 9:31 AM | Comments (0)

November 13, 2007

REITs & JUNK: TAKING A CLOSER LOOK

Volatility has returned to the capital markets and that's good news for strategic-minded investors. Higher volatility is usually associated with lower prices, which in turn can generate more favorable valuations. Deciding when the valuations look sufficiently tempting, however, is never easy.

Consider two asset classes that have been under pressure of late: REITs and high-yield bonds. Of the two, REITs have been hit harder. For the year through the end of last month, REITs suffered a 2.5% loss, based on the Vanguard REIT ETF (VNQ). High yield bonds fared better by posting a 3.6% rise YTD through October, as per Vanguard High Yield Corporate (VWEHX). Even so, junk took a heavy blow in the July/August correction and since then has only recovered a portion of its former glory.

Both asset classes are distinctive for their yields. By that standard, the price declines in each have brought higher yields. (As always, price and yield move inversely for bonds and equities.) Are the yields tempting?

Unfortunately, there's no easy answer. If you look at a 20-year history of yields, almost nothing looks compelling today. Then again, we're told that inflation is contained and will no longer threaten. If you believe that, then maybe lower yields look ok after all. But then one might ask: Do I believe the inflation-is-history story?

On and on it goes. If you wait for definitive proof, you'll be sitting in 100% cash forever. Hardly an enlightened strategy. As such, some degree of risk is necessary for every portfolio. But how much? And do REITs and junk now fit the bill for redeploying cash?

In search of clues, let's start by looking at the trailing annual yields for each. As our chart below shows, yields have recently popped up although no one should confuse the trend with a massive buy signal. U.S. REITs, for instance, recently offered a yield that's only slightly higher than the levels of late-2006/early 2007, when the REIT bull market was still riding high. As for junk bonds, yields are higher and the jump in payout in recent months has been stronger.

But how do the yields compare with the benchmark 10-year Treasury? In fact, the FTSE NAREIT US REIT Index closed out last month at a yield of just 4.17%, which was slightly below the 10-year Treasury yield, as our second chart below illustrates. Junk bonds look more encouraging now that the spread over the 10-year rose above 400 basis points as of last month's close.

In the long run, it's all about spreads for yield-sensitive securities. To be precise, how much yield does a security or asset class offer over the risk-free rate? It's an iron law of finance that there's no reward without risk. At the same time, investors should ask for sufficient compensation for embracing risk. For REITs, recent history suggests that 200 basis points over the 10-year is a reasonable standard at which to at least start looking closer at the asset class. Alas, we're still well below that risk premium.

For high yield bonds, recent experience tells us that a risk premium above 400 basis points looks relatively intriguing. As such, we're more encouraged that value's returning to junk bonds. The wider the spread above 400 basis points, the more enticing junk looks, in which case it may be deserving of a higher weight for long-term-oriented portfolios. For now, the asset class is worth a nibble but nothing more. REIT yields, by contrast, still have a long ride upward before the asset class looks compelling.

Of course, none of this means that's junk's a sure winner from here on out or that REIT prices won't soar. We can't see the future but we can at least read the fine print and decide if risk premiums look attractive. Do they? Not really, but as this year reminds, nothing ever stays the same in finance, and so we're still cautious but hopeful.

Posted by jp at 10:09 AM | Comments (0)

November 12, 2007

DEVILISH DETAILS

The pace of growth in money supply is a number that's meaningless in a vacuum. To quote a rate of expansion offers no more insight than looking a stock or bond and having no knowledge of valuations beyond. With that in mind, what can we say of the 6.6% advance (in nominal terms) over the past year in M2 money supply, based on the latest data for the week through October 29?

We can begin to search for an answer by considering the speed of the economy. For the third quarter, the government's current estimate tells us that nominal GDP grew by an annualized 4.7%. Using those figures in combination, it's clear that the Fed's printing money at a significantly higher rate than economic growth.

So, what have we learned? On its face, the data suggest that money supply is rising faster than prudence suggests. But again, additional context is necessary lest we make a hasty judgment.

Let's also add to the record that the 4.7% nominal GDP pace fell from 6.6% in Q2. For additional perspective, take note that the benchmark 10-year Treasury yield now stands at 4.23% and the Fed funds rate is 4.50%. In sum, interest rates are generally lower than the economy's rate of growth while money supply is rising at a pace that's substantially higher than GDP's growth.

All of which might be considered perfectly reasonably if the goal is to juice the economy and head off a slowdown. To be fair, a slowdown for Q4 and beyond is now on everyone's lips; only the degree seems to be in question. But once again, additional context casts a cloud of uncertainty over an otherwise obvious decision to err on the side of monetary stimulus.

Enter the humble dollar. Battered and bruised, the world's reserve currency continues to take it on the chin these days. The U.S. Dollar Index plumbs new lows virtually on a daily basis of late, and the greenback against the euro looks even worse.

Everyone knows that capital prefers to reside in currencies where interest rates are higher rather than lower, thus the enduring possibilities of the so-called carry trade. The Fed seems inclined to dismiss such inclinations for the moment in favor of hedging against the possibility of recession. That may be wise, it may not be, depending on what happens. In particular, the question is whether a continued rout in the dollar feeds on itself and triggers economic and financial repercussions that are unexpected. No one expects the Spanish Inquisition, as the old Monty Python bit went. But that doesn't mitigate the pain if and when it arrives.

Such is a central banker's task in life: picking a poison and hoping for the best. But with soaring commodity prices one might wonder if the threat of recession is only part of the hazards stalking macro strategy.

"We continue to believe the greatest risk lies with the Federal Reserve orchestrating easier monetary policy to address the excesses in the financial sectors of the economy," Edward Jong, a portfolio manager with FrontierAlt All Terrain Bond fund in Canada, told The Globe and Mail in story dated today.

The challenge is compounded by the growing pressure on the Fed for yet another rate cut. "The market is almost forcing the Fed's hand [to cut rates]," Robert Marcus, another portfolio manager at FrontierAlt All Terrain Bond said in the G&M article. "But it's not a slam dunk," he added.

Indeed, the current story has no obvious ending yet. Various outcomes are still possible. The Fed could print too much money and exacerbate inflation, or perhaps it'll add just the right amount of liquidity to keep the economy bubbling without overdoing it. Meanwhile, the dollar seems due for a technical rebound, and oil prices have probably run too high too fast, at least for the short term. Perhaps there's a bit of respite coming, offering strategic-minded investors and central bankers alike a chance to catch their breath and reassess.

Maybe, maybe not. We don't know and neither does any one else. We can guess, of course. Meantime, we'll be watching the numbers. No doubt one asset class or another will fall prey to some excess or another. In fact, there are already some encouraging signs, albeit early signs that value is creeping back into some corners of the capital markets. Nothing dramatic, but at this stage of the game the mere sight of valuation trends moving in favor of buyers is a rare bird after the virtually non-stop bull markets of the past five years that have delivered the opposite.

For now, we're watching and waiting, eager to redeploy our overweight of cash. But not quite yet, at least nothing of consequence. A nibble here and there. Stay tuned for details....

Posted by jp at 9:35 AM | Comments (4)

November 8, 2007

JOBLESS CLAIMS FALL AGAIN, BUT...

The scent of recession may be in the air, but it's not yet creating a stink in jobless claims.

New filings for jobless benefits fell last week to 317,000, the lowest in a month, the Labor Department reported. As you can see from the chart below, the trend doesn't look particularly ominous. In fact, it looks quite middling by the standard of recent history.

The future may bring darker trends, but for the moment the status quo prevails. In fact, it's not too hard to find an economist who'll tell you that initial jobless claims running consistently below ~330,000 a week suggests a bubbling U.S. economy. And while we're looking at trends, let's not forget that initial claims have now fallen for three weeks running.

"It's still consistent with a moderate expansion of the labor base." Richard DeKaser, chief economist for National City Corp. in Cleveland, told Reuters today.

But let's not get too excited. Jobless claims numbers not necessarily dispense timely warnings far in advance. Going back to the last time Wall Street and the economy ran into trouble, it's worth remembering that initial jobless claims stayed calm long after the stock market bubble burst in March 2000. It wasn't until December of that year and into the first quarter of 2001 that jobless claims reflected the dangers that had been brewing for some time.

Of course, every economic challenge is different. The troubles stalking the economy these days are of a slow-moving variety. The on again/off again nature of the current creeping threat can all too easily lull investors to thinking that the storm has passed. Indeed, investing perspectives have been whipsawed in recent months. Rest assured, more of the same is likely.

"Any major changes in hiring and firing may not be seen for a few more months,'' Joel Naroff, president of Naroff Economic Advisors told Bloomberg News. "The full impact of the housing losses on financial firms and their reactions to their lower earnings are still to be felt.''

In any case, initial jobless claims aren't the only statistic in town. Competing with the encouraging news from the Labor Department is the increasing gloom in the retail sector. As earnings reports fall short of forecasts, the trend in spending seems headed down. "Overall, the sales trend continues to slow," Ken Perkins, president of RetailMetrics LLC, said today via
AP. "I think the consumer is certainly feeling the (economic) pressure heading into the holidays."

Any one number may or may not confirm the broader trend on any given day. But no matter the statistic du jour, it's getting harder to see how the economy evade a slowdown this time. And therein lies opportunity. Once everyone buys into the idea that the economy will weaken, the expectations will be lopsided once more. At some point, strategic-minded investors should be putting cash to work. Not yet, and perhaps not for some time. There's more bad news to come, of that we're sure.

Gauging maximum pessimism is more art than science, of course. The good news is that you don't have to call a bottom precisely in order to profit from it. But for now, patience.

Posted by jp at 9:06 AM | Comments (2)

November 7, 2007

ARGUING WITH THE CROWD

On September 17, the benchmark 10-year Treasury yield ended the trading session at 4.47%, or nearly 80 basis points below the target Fed funds rate, which was 5.25% at the time. The yield curve, in short, was inverted and by more than a little. The next day, the Fed cut rates by 50 basis points, which was followed by another 25 basis point cut at the end of October.

Today, the Fed funds rate is 4.50% and the yield on the 10-year Treasury yield is 4.36%, as per last night's close. The yield curve is still inverted, albeit by a smaller margin compared with September 17.

Meanwhile, the market for Fed funds futures seems to be inclined to think that another rate cut is coming. Perhaps, although the easy cutting is now behind us.

Lower interest rates invariably come as a package deal, with positive and negative effects. Enhanced liquidity has the power to boost spending, at least in the short term. But lower rates come at a cost elsewhere. Those costs have been minimized and largely overlooked in past years. But that was a function of the moment.

Times have changed and now lower rates aren't the clear winner they've been in the past. Consider the battered dollar, which continues to plumb new lows against the world's leading currencies, as the sinking U.S. Dollar Index shows. Yes, what ails the dollar goes far beyond lower rates, but the cuts certainly don't help and may at this point be accelerating the rush out of the greenback.

In turn, the falling dollar is a contributing factor in the rise of commodities prices. The S&P GSCI Index, a benchmark of commodities, continues to reach for the stars. Notably, oil and gold prices are key elements in this ascent. The fact that oil and gold are priced in dollars suggests that as the greenback is devalued against competing currencies, the blowback will be pricing raw materials higher in dollar terms.

None of this seems to be worrying the stock market, which seems hard wired to accept only good news while ignoring the bad. If there's some point that soaring commodities prices and a sinking dollar will affect Wall Street, that point has yet to be found.

But at some point the equity bulls will realize that stocks don't trade in a vacuum. The trend of late in the dollar and commodities ultimately carry ramifications for the U.S. economy and, by extension, shares of U.S. companies. In fact, some corners of the stock market appear to be taking the hint. Of the 10 sectors that comprise the S&P 500, financials and consumer discretionary are down substantially on a year-to-date basis through yesterday. Everything else is running higher.

Indeed, the S&P is up 8.83% YTD. At this rate, 2007 may end up being one another strong year for U.S. stocks. Yes, the market has been known to climb a wall of worry. As such, one would be wise not to discount domestic stocks entirely. But the global portfolio of risky assets encompasses a broad array of choices in the 21st century. Meanwhile, if you've done nothing in your asset allocation in recent years, U.S. stocks' weight in the portfolio have probably climbed. Rebalancing has never looked more alluring.

Of course, that's a contrarian perspective at the moment. But if rebalancing doesn't make sense now for U.S. stocks, when will it? Only the future can answer with definitive clarity. For the rest of us, we'll have to work with imperfect information. Given the timing, we prefer to err on the side of caution. Does that mindset ensure that we'll generate the highest gains? Probably not. But that's not our goal at this point. Instead, we're trying to preserve the wealth that's been created in the past five years while trying to make sure we don't end up in the bottom quartile of relative performance in the next five.

This, of course, is our bias, and it may or may not prove to be worthwhile. But one thing we're reasonably sure of: achieving our objective from here on out won't be easy or comfortable. Arguing with the crowd never is. Granted, sometimes it doesn't pay to be quarrelsome, but sometimes it does. And this, we think, is one of those times.

Posted by jp at 9:40 AM | Comments (0)

November 6, 2007

RANTING ABOUT RISK (AGAIN)

The strategies that increase the odds of achieving investment success too often get a bum rap. Drowned out by the advice du jour, financial prudence is forever getting trampled in the latest news cycle as more enticing notions grab the crowd's attention. Buy this, sell that. Oh, look, XYZ Corp. posted an unexpected rise in earnings last quarter. But, wait, look over there: same store sales are down and Uncle Billy's Medical Supply Inc.

So it goes in the 21st century, which is awash in investment advice, analysis and outright guessing. Some of its ok, most of it isn't, and only a small minority of it's worthy of being enshrined as enduring principles. Only today your editor stumbled across a column of questionable value published by one of the major outlets in the so-called new media. The basic message: mutual funds are for those who don't know any better. Far better, the column recommended, that investors pick a handful of stocks and forget about it. Not just any stocks, of course, but those that have durable brands and businesses that will stand the test of time and that are selling on the cheap. In short, you don't need a mutual fund.

The rationale given is that Warren Buffett doesn't use mutual funds and so neither should you. In fact, the author quoted Buffett directly, lest there be any doubt of the true road to investment success: "Diversification is a protection against ignorance."

Of course, investing isn't quite so simple. For starters, Buffett has also gone on the record as saying that index funds are a pretty good investment after all. As the Oracle of Omaha advised earlier this year, "A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money."
The strategies that increase the odds of achieving investment success too often get a bum rap. Drowned out by the advice du jour, financial prudence is forever getting trampled in the latest news cycle as more enticing notions grab the crowd's attention. Buy this, sell that. Oh, look, ABC Corp. posted an unexpected rise in earnings last quarter. But, wait, look over there: same store sales are down.

To be fair, the columnist we cite above also recommended passive investing in the form of broad ETFs, although he qualified the advice by suggesting that indexing was most appropriate for greenhorns.

But let's go back to the first quote from Buffett, the one about how diversification's only relevant if you're ignorant. In fact, we couldn't agree more. And let's be clear about one thing: mere mortals are ignorant on the most important variable in the investment universe: the future.

No amount of analysis of the past (which is the only analysis we have) and extrapolating into the future can divine what's coming. Yes, it's true that studying history and gaining perspective on where the markets have been is useful if not necessary for becoming an informed investor. But the future is ultimately mysterious and that mystery generates a massive amount of risk. Most of the time that risk looks benign, even friendly. Looking back over the past five years suggests that there was little point to diversification. If only we'd known! But we didn’t. Nor do we now. We can guess, we can speculate, we can confidently project that company A's real estate holdings will be valued higher next year, or that it's new widget will grab a 50% market share overnight. But we don't know, and we'll never know until the future unfolds.

Risk, of course, is a good thing, if you exploit it intelligently. For some, the definition of "intelligently" varies far and wide. For our money, owning a broad mix of betas (stocks, real estate, commodities, etc.) and managing those betas (i.e., adjusting the weights) is the only game in town. Why? Because of that risk thing, which tends to pop up at the most inconvenient times. Indeed, if we knew what was coming, we wouldn't need diversification.

But in the real world, one has to balance greed with fear. And the challenge is even more complicated by the fact that humans make mistakes. Even intelligent humans. Yes, that includes Warren Buffett. Remember his investment in US Airways in 1989? Not exactly his finest moment. Fortunately, he was diversified.

Of course, we're second to none in recognizing that Buffett is arguably the best stock picker the world has ever known. But we only know that by looking at the past, and so it's easy to point to Buffett now and say, do what he does. Would you have said that in 1970, when Buffett was relatively unknown and far less tested, at least by his current iconic status? Maybe, maybe not. As a test, who's the new Warren Buffett? Do you see him? You do? If so, how much of your net worth do you plan on giving him? Well, take your time. Maybe you'll want to think this over for a while.

Yes, for the truly gifted investors diversification is of limited value. You know who you are. But as a general rule, most of us are mediocre or worse, at least when our investment results are measured over the long term and we factor in taxes and expenses. As such, it's best to keep investment costs low, defer taxes and diversify. That's easy by owning a multi-asset-class portfolio built with low-cost index mutual funds and/or ETFs. If you think you're smarter than the average investor, maybe you'll play with the asset allocation a bit more than most. You might even indulge in tactical strategies such as portable alpha, shorting and leverage, all of which can be facilitated with ETFs and index mutual funds.

But if you're not confident that you have what it takes to be an exceptional investor over the next 20 years, or you simply don't want to spend the time, effort and risk testing the idea with real money, Mr. Market's asset allocation across broadly diversified betas of stocks, bonds, real estate and commodities will do pretty well over time. One reason is that a prudently diversified portfolio will almost certainly never lose massive amounts of money over time, or collapse into dust because of some unexpected crisis. Asset classes don't go out of business. Avoiding that risk is more than half of how you win the money game.

Yes, you might be able to achieve more by picking individual securities. But before you do, ask yourself: am I an extraordinarily talented investor? Not sort of talented, not slightly talented every now and again. But over time, and in moments of crisis as well as soaring bull markets. Warren Buffett clearly is. Are you?

Posted by jp at 10:39 AM | Comments (0)

November 5, 2007

A NEW BULL MARKET IN VOLATILITY, A.K.A. OPPORTUNITY?

Judging by this morning's update of the ISM services industry index for October, the economy doesn't look all that bad. But there are an infinite number of ways to judge the economic outlook and it appears that for the moment more investors are inclined to judge the glass as half empty rather than half full.

The stock market certainly found no reason to cheer in the wake of today's ISM news. Yes, services now dominate the U.S. economy compared with the diminishing role of manufacturing. In fact, the October rise in the ISM services index exceeded expectations as upward momentum in the sector took root last month, as the chart below shows. "The [ISM services index] numbers are pretty good," David Sloan, an economist at 4Cast Ltd., told Reuters. "It suggests the service sector is growing at a decent pace so the economy is not in too much trouble overall, at least for the moment, despite the weakness in housing."

As such, one might think that a favorable reading for the index would dispense a bit of optimism. Not today, at least not as we write at roughly halfway through Monday's trading in New York. U.S. stocks opened sharply lower this morning, although the losses were pared by noon.

What's going on? Part of the explanation is that the news on the continued health in services was overlooked in the face of fears that Citigroup's credit-related losses are far larger than initially thought. In turn, that's inspired a new round of worries that the pain in the financial sector will get worse before it gets better. That dark thought, combined with ongoing problems in real estate, suggests to some that the odds of a recession are still rising.

"The continued housing weakness, coupled with the ongoing credit crunch and rising oil prices have increased the risk of recession to about 40%," wrote Kurt Karl, chief U.S. economist for Swiss Re in his November economic outlook. "Though the Federal Reserve Board continued its monetary easing with another 25 basis point cut in October, it is too early to determine if the economy will escape a recession." He recognizes that the latest employment report was "strong." On the other hand, Karl adds, "many near-term indicators are weak, implying growth will slow from its 3.9% third quarter pace. At this time, the next few months of data releases are likely to be dismal, forcing the Fed to lower the federal funds rate to 4.0%."

What's more, some of the problems that are worrying the market aren't limited to the U.S. "Concerns about European bank exposure to the subprime market have resurfaced after last week's announcements from U.S. banks," Isabelle Delattre, fund manager at Raymond James Asset Management, told AFP. "The full truth (on banks' subprime exposure) has yet to be fully uncovered."

If the jury's out about what's coming, it's getting easier to think that higher volatility in the capital markets will be with us for some time until the future becomes a bit clearer, one way or the other. For instance, the Chicago Board Options Exchange Volatility Index, or VIX, is on the rise again. Given the uncertainty swirling of late, one could imagine that the VIX will climb higher still.

Get used to it, counseled Milton Ezrati in his latest economic analysis. Senior economist and market strategist with Lord Abbett, Ezrati wrote that S&P 500 volatility, measured in standard deviations, has nearly doubled between the first six months of the year and the July–October period. What should investors do? Exploit it.

"As upsetting as downside price swings can be, investors making regular contributions to their investment plans actually have reason to welcome such price moves," Ezrati advised. "After all, the downswings do enable the plan to buy more assets at lower prices."

And, we might add, lower prices imply higher prospective returns.

Nonetheless, being a contrarian never comes easy--an iron law of investing that may be tested in the extreme in the weeks and months ahead. Of course, comfort in the here and now may come at a high price in the long run in the form of lesser performance.

Or, as Ezrati advised:

No one, whether an individual opening his or her personal statement or the head of a huge pension fund or foundation, feels comfortable watching gyrations in price and in the value of assets. But, as should be clear, the swings can work to the advantage of a steady, long-term investor. Since volatility also can provide opportunities for an active manager that would not exist if the asset were to appreciate along a steady trend line, price swings are an aspect of markets that investors could truly learn to love.

Thus the question du jour: Are we entering a new golden age of volatility inspired opportunity?

Posted by jp at 12:30 PM | Comments (0)

November 2, 2007

A TIMELY GIFT FROM THE EMPLOYMENT GODS

Here we go again? Maybe. Another economic release, another opportunity to rethink yesterday's conventional wisdom.

This morning's news that employment growth was a lot more bubbly last month than economists expected. The consensus forecast called for a rise in nonfarm payrolls of just 80,000 for October, according to TheStreet.com. That would have been one of the smallest gains in recent years.

As it turned out, the gloom was misplaced: payrolls rose by 166,000 last month, the highest pace since May, as our chart below shows. Meanwhile, the unemployment rate remained unchanged at 4.7%. Given yesterday's hefty drop in the stock market, today's news at least offers a temporary reprieve from an otherwise gloomy week of news.

The rebound in job growth in October marks a striking reversal of the sluggish rate of expansion in previous months. From June through September, monthly employment growth was under 100,000, the longest stretch of subpar increases in recent memory.

What drove October's rebound? The bulk of the employment gains were generated by the services industry, which posted a healthy rise of 190,000 new jobs last month. That's a significant trend if only because services are now the single largest source of employment in the country. There were other bright spots as well. The professional and business services industries were in second place after services with a rise of 65,000 new jobs. Meanwhile, the net losses were confined to the construction, manufacturing and retail trade. The latter three are cyclically sensitive and so no one should take comfort from ongoing job losses in those groups.

The employment weakness in goods producing industries was corroborated in yesterday's update of the October ISM manufacturing index, which fell to its lowest level since March. If nothing else, it's clear that the real estate correction continues to bring pain to the cyclical corners of the economy. Debating if that pain will spill over to services, or not, remains the great unknown.

No matter, as the payroll report seems set to define the tone for this Friday. As we write this morning, stock futures were up a few minutes before the opening of the stock market in New York.

But before we breathe a collective sigh of relief, it's important to remember that the economy's still digesting a fair amount of change these days. The potential for surprises, negative and positive, are higher than usual as a result. One example is the weak earnings from the oil patch. Who could have imagined that what is perhaps the greatest energy bull market would be bad news for the Exxons and Chevrons? Recognizing that unintended consequences may bring more surprises inspires the question: What don't we know? Perhaps more than is obvious.

Yes, today's employment numbers are encouraging. However, it's just one number and it's subject to revision. And one month a trend does not make. The general trend for many months for employment has been down. It'll take more than one month to provide convincing evidence that the slippage is no more.

Posted by jp at 9:34 AM | Comments (0)

November 1, 2007

THE PARTY ROLLS ON

October paid off once again for the optimists. Red ink was nowhere to be found among the major asset classes, as our table below shows. Even the battered REIT market posted a handsome gain last month.

What's extraordinary here is the persistence of bull markets in everything. In fact, it's downright amazing. On a 1-year basis, everything's up, and the same can be said when reviewing longer term records as well. The lone case of loss shows up only in REITs in the year-to-date column. But that's hardly a calamity, given the potent rise in the asset class for the better part of the past seven-plus years.

Meanwhile, the Federal Reserve is doing what it can to keep the bulls happy. Yesterday's 1/4 point cut in Fed funds received a warm welcome in the stock market. The S&P 500 rallied 1.2% yesterday, reaffirming once again that the equity crowd loves liquidity.

The sentiment's a bit more complicated in the bond market. The initial reaction to the Fed's cut among the fixed-income set was to sell first and ask questions later. As a result, the yield on the benchmark 10-year Treasury popped by the close of yesterday's trading, rising to 4.48%, the highest in nearly two weeks. But no one should confuse the 10-year's yield as excessive. A 4.48% rate is roughly the lowest in the past two years.

The future, of course, relies more than a little on consumer spending habits in the coming months. But here too optimism springs eternal, at least as it looks from this morning's update on personal income and spending for September. The Bureau of Economic Analysis reported today that personal income rose 0.4% in September, unchanged from the August rate. Disposable personal income--i.e., what's left over after Joe Sixpack pays the bills--also rose by 0.4% in September, although that was down slightly from August's 0.5%.

Speaking of spending, Joe continued to embrace the consuming side of his personality in September as personal consumption expenditures rose by 0.3%. Not bad, although that's notably down from August's 0.5% gain. A warning of trouble to come? Perhaps, although predictions of a sharp, sustainable pullback in consumer spending have been rolling around for years. To date, Joe's proven the pessimists wrong, suggesting that consumers can keep spending for longer than prudent bears can afford to remain consistently anxious. The latest numbers suggest no less.

The markets confirm the trend. As our chart above reminds, there's been no reward for anything other than embracing risk.

Alas, bull markets in everything at this late date are increasingly worrisome, even if the rear-view mirror suggests otherwise. Oil, to cite an increasingly obvious example, moved above $96 a barrel earlier today, to cite one example. The longer the party goes on in everything, the bigger the potential correction in something will be.

But for the moment, the party rolls on.

Posted by jp at 9:57 AM | Comments (0)

The Capital Spectator

Investing, Asset Allocation, Economics & the Search for the Bottom Line