December 27, 2007
The Capital Spectator is taking a holiday recess to recharge, recline and relax. But there's no permanent rest for the financially obsessed, and so we'll return on January 2 with another round of observation and analysis.
Meantime, here's wishing our readers a healthy, profitable and productive 2008.
Happy New Year!
December 25, 2007
Ring out, wild bells, to the wild sky,
The flying cloud, the frosty light;
The year is dying in the night;
Ring out, wild bells, and let him die.
Ring out the old, ring in the new,
Ring, happy bells, across the snow:
The year is going, let him go;
Ring out the false, ring in the true.
Ring out the grief that saps the mind,
For those that here we see no more,
Ring out the feud of rich and poor,
Ring in redress to all mankind.
Ring out a slowly dying cause,
And ancient forms of party strife;
Ring in the nobler modes of life,
With sweeter manners, purer laws.
Ring out the want, the care the sin,
The faithless coldness of the times;
Ring out, ring out my mournful rhymes,
But ring the fuller minstrel in.
Ring out false pride in place and blood,
The civic slander and the spite;
Ring in the love of truth and right,
Ring in the common love of good.
Ring out old shapes of foul disease,
Ring out the narrowing lust of gold;
Ring out the thousand wars of old,
Ring in the thousand years of peace.
Ring in the valiant man and free,
The larger heart, the kindlier hand;
Ring out the darkness of the land,
Ring in the Christ that is to be.
December 21, 2007
JOE DOES IT AGAIN
They say that you should never underestimate the consumer, and this morning's update on personal income and spending reminds just how practical that proverb can be. Yes, recession may be coming, but if the gloomy analysis is having an impact on Joe Sixpack, it's not obvious in the latest data from Bureau of Economic Analysis.
Admittedly, disposable personal income isn't exactly soaring, although it rose at a higher pace last month vs. October (0.4% compared to 0.2%). At least the trend is encouraging given that we're told an economic slowdown is upon us.
But the real news is in the spending column. In particular, personal consumption expenditures soared by 1.1% last month. As our chart below shows, that's impressive by recent standards. In fact, the last time PCE jumped so high was more than two years ago.
Granted, November always enjoys a seasonal burst of holiday shopping, although even by that standard holiday cheer of late is running considerably hotter in 2007.
It's debatable if the fun can continue, but for the moment there's no doubt that Joe's still spending, and then some. And since the American economy is powered primarily by consumer spending, an outlook premised on Joe being the same old Joe implies the bulls still have reason to cheer.
Nonetheless, one might wonder what 2008 will bring. Consider that in inflation-adjusted terms, disposable personal income actually dropped for the second month running in November. Even so, Joe still spent more, a lot more, last month in real terms: November's inflation-adjusted PCE climbed 0.5%, up sharply from October's 0.1%.
As always, the data's open to interpretation. The optimistic view is that consumer spending reigns supreme. And with the Federal Reserve still leaning toward more rather than less liquidity, one might be persuaded that the tail wind for spending is still blowing rather strongly. Joe, it seems, is in no mood to fight the Fed.
But for those who prefer to worry, there's the question of whether Joe's spending can maintain a hefty pace next year when there's so much trouble brewing elsewhere in the economy. Then again, consumers haven't been shy about running up a credit card bill or two. Will such inclinations fade in '08? Will the central bank keep lowering interest rates? Does that mean that even higher inflation is coming? Questions, questions, always the questions.
December 20, 2007
ANOTHER SIGN OF SLOWDOWN
If there's any one still wondering if the economy's slowing, this morning's update on weekly jobless claims may help blow some of the clouds of doubt away.
For the week through December 14, initial jobless claims rose to 346,000, up 12,000 from the previous week, the Labor Department reported. That's not the high point in recent history, which was November 14's 353,000. Nonetheless, the trend is telling. And as our chart below illustrates, the trend definitely isn't our friend lately when it comes to jobless claims. The 10-week moving average of new weekly filings for unemployment insurance rose to 334,500. That's the highest in two years.
Of course, one might say that jobless claims are still within the range that's prevailed for several years, and on that basis the trend signifies only statistical noise. Perhaps. In fact, economic slowdowns are only obvious in hindsight. Then again, given the broader economic context of late, which is less than encouraging, the warning sign emanating from the jobless numbers today suggests that the risk of trouble for 2008 is still rising.
The bond market seems inclined to agree. A new rally appears to be brewing in the 10-year Treasury, pushing the yield down again to 4.07% at yesterday's close. In fact, one could argue that fixed-income traders now have the "all clear" sign to run bond prices up (and yields down) amid the mounting evidence that a slowdown is upon us. But there's a complicating factor: inflation.
A number of pundits have invoked the "S" word (stagflation) recently, and so the prospect of a slowing economy and higher inflation will haunt the bond market even as it rallies on the outlook that more interest rates are coming as an economic stimulative. No wonder, then, the iShares Lehman TIPS ETF (a proxy for inflation-indexed Treasuries) is up more than 4% in the last three months, more than double the gain for bonds generally, as per the iShares Lehman Aggregate ETF.
No doubt we'll all be keeping a close eye on the incoming economic numbers to figure out what comes next. We're all still data dependent, and the forecast calls for more of the same well into the new year.
December 19, 2007
What's true for stocks also applies for bonds: Most of the planet's debt is issued outside of America. As of this past spring, roughly 53% of the outstanding value of the world's bonds with maturities of one or more years was issued in a currency other than the dollar, according to the Bank for International Settlements.
The implication: diversified portfolios for U.S. investors should have bond allocations that are more or less evenly split between domestic and foreign debt. In practice, it's very few U.S. investors take such a global approach to strategic bond allocations. But shunning foreign bonds is a bet, and a pretty big one, relative to Mr. Market's recommendation.
Yes, putting 50% of your bond allocation into foreign debt may seem extreme, although doing so would merely match the market's mix. Then again, a zero percent allocation to foreign bonds looks severe as well. Diversification, after all, is the only antidote to living in a world where the future's forever uncertain.
Whatever seems reasonable as a bond allocation, there's a strong case for having some exposure to non-dollar debt. That, in essence, is the theme in an article your editor penned for the December issue of Wealth Manager. As a preview, we argue that holding foreign bonds (and their ETF and mutual fund equivalents) denominated in local currencies improves the expected risk-adjusted performance for the long run. For the reasons, read on....
December 17, 2007
STABLE PRICES WON'T COME CHEAP
Last week's troubling news on inflation (as detailed in the November reports for consumer and wholesale prices) should come as no shock to readers of these digital pages (assuming, of course, you've agreed with our thesis). For some time now, we've been expecting that pricing pressures were set to rise. The only question: when? We can answer that question with a confident "now," allowing us to move on to the next batch of questions: how long will it last, and how high will it go?
The answers are yet to be determined. While we wait to see how the central bank reacts, we can review the lessons that the past imparts. That begins with the recognition that inflation never dies, although it does go into long stretches of hibernation. Even then, it's always waiting to pounce, looking to exploit any temporary lapse in central banking judgment or the occasional exogenous event, such as oil running higher.
For much of the 1990s, and deep into the 21st century, prices have been relatively contained. But your editor has a deep and abiding respect for cycles, and so one might wonder if the great disinflationary cycle has finally turned, or at least ended? Twenty years or so, after all, is a long time, and nothing lasts forever in economics.
Certainly it's getting easier to make a persuasive case that risk outlook for inflation has notched higher. Indeed, with producer prices rising in November at the highest annual rate since the 1970s, and consumer prices also bubbling strongly last month, the numbers speak for themselves.
We don't know what's coming, of course, but this much is clear: inflation remains a monetary phenomenon, as Milton Friedman long ago preached. To the extent that prices rise or fall far out of line with what shifting demand and supply trends imply, the effect is almost certainly due to decisions by central bankers. So it goes in a world of fiat currencies, where printing presses eventually determine the value of dollars, euros, yen and so forth.
With that in mind, we turn to those printing presses overlooked by the Federal Reserve. As our chart below reveals, the annual pace of M2 money supply (the broadest measure of printing press activity published by the Fed) has been steadily climbing in recent years. For the 52 weeks through this past December 3, M2 is up 6.2% in nominal terms. That's almost certainly higher (perhaps much higher) than the pace of growth for GDP this quarter.
Why is the Fed creating what some might say is excess liquidity? The usual suspects come to mind, starting with efforts to juice the economy to circumvent sluggish growth or recession. There are also some liquidity problems in the credit markets, spawned by housing correction and the ills associated with subprime mortgages. In fact, it's never hard to rationalize a little extra liquidity to tide the economy over until the outlook is brighter. The challenge is keep a little nip every now and then from turning into a drunken binge.
Yes, the Fed has reasons for being aggressive in the matter of printing money above and beyond what economic growth require. Perhaps those reasons are compelling, perhaps not. But there's a price to be paid in using liquidity as a tool for repairing damage wrought by imprudent financial decisions made elsewhere.
We can remain agnostic on whether the Fed's doing the right thing or not and still recognize that there will be a cost to the use of liquidity as a treatment for financial sector's problems. The cost, of course, is inflation.
Granted, it's unclear how high inflation will go or whether it'll endure as a long-term proposition. That said, history suggests that letting the inflationary cat out of the bag is asking for trouble. Indeed, containing inflation before it gains a head of steam is much easier than trying to beat it down once it's bubbling.
The good news is that there's still time to battle the beast. Inflation is higher, and the warning signs are clear, but we're still in the early innings of what may be a long game. Alas, the opportunity to keep prices under control won't last forever, nor will the choice be politically easy.
If the inflationary winds are blowing once again, and the Fed resolves to lean into the bluster to slow the pricing momentum, the cost will likely be an economy that's slower growing and more prone to recession in the short term. In the long run, however, the dividends will be obvious, as they were for years in the wake of Paul Volcker's heroic but initially under-appreciated efforts to stem inflation's tide in the early 1980s.
Students of financial history will recognize that it's much easier to sacrifice long-term price stability on the altar of short-term growth. Politicians and the average consumer inevitably favor good times today. Inflation, by contrast, is a slow-moving monster and its bite is typically mild and easily overlooked at any short stretch of time. As the years drift by, however, inflation slowly, persistently eats away at wealth like termites feasting on unprotected wood. One morning you wake up and find that bread costs $5 a loaf and your bank account totals $3.50.
The conceit is that inflation can be fought tomorrow. Sometimes it can, as Volcker proved. But sometimes tomorrow never comes. Meanwhile, one shouldn't assume there'll always be a Paul Volcker waiting in the wings.
December 14, 2007
A BULL MARKET FOR SURPRISES?
The crowd expects an economic slowdown. Even former Fed chairman Alan Greenspan has hopped on the bandwagon, warning yesterday that the risk of recession is "clearly rising."
And so it is by a number of statistical measures. But even if we all think we know what's coming, there's still plenty of risk to waylay strategic-oriented investment portfolios. This, in short, is no time for complacency or immoderate confidence.
The primary challenge for the next several months is less about a slowing economy. Rather, the potential for surprises--positive or negative--are considerable, which could bring dramatic spikes in volatility. Ultimately, higher vol presents opportunity, as well as risks, although the price of entry will be making decisions that are in conflict with the crowd.
Our thinking about the possibilities arising from a new round of drama in the capital markets was inspired at yesterday's press briefing at the New York office of Barclays Capital, where your editor heard presentations from several analysts on a broad array of economic and investment topics. On the matter of the U.S. market, the Barclays team, led by Larry Kantor, head of economics and market strategy, was in agreement: economic growth in America is turning sluggish. Barclays predicts that growth will slow to 1% in this year's Q4 and 2008's Q1. If so, that would be a sharp slowdown from Q3's 4.9% rise.
The challenge is deciding how much variation is possible (or not) in this outlook. Yes, the economy's rate of growth is surely decelerating as we write. But as yesterday's strong retail sales report for November reminds, there's still a fair amount of strength percolating from the all-important consumer sector. The 1.2% rise in retail sales last month was double the consensus forecast, suggesting to some that the slowdown could end up being mild.
"We should still see reasonable sales growth and no recession,'' Allan Meltzer, professor of political economy at Carnegie Mellon University, told Bloomberg News. "It's quite reasonable to expect high energy prices will slow business investment and, eventually, consumer spending, but people are working, the unemployment rate is low and Christmas is Christmas.''
Also giving optimists hope is the export machine, which is providing a timely offset to the weakness elsewhere that's weighing on GDP. Consider this year's Q3, when exports surged at a real annualized 18.9% rate--the highest since Q4 2003. The weak dollar, which makes U.S. exports less expensive in foreign-currency terms, is obviously at work here. Until and if the buck mounts a considerable rebound, the export boom is likely to continue. Yes, a number of forex strategists think the dollar may now tread water for a time as the market digests the currency's sharp decline this year. But we've yet to hear of any one predicting a new bull market for the buck any time soon.
The combination of exports and consumer spending, in short, look set to provide some degree of offset to the weakness in other areas, including the ongoing housing-related ills. Lending confidence that consumer spending may hold up for the next few months is the buoyant labor market. Although job creation is slowing, it's yet to deteriorate in any meaningful way. The unemployment rate remains a low 4.7%. To be sure, that could change quickly in this environment. But if Joe Sixpack can keep his job, he'll keep spending--perhaps at a lesser pace--and continue to pay the mortgage, even if his house is worth less. It may be a close call on this one, but the game isn't over yet.
Another positive, according to Barclays, is the outlook for foreign economies. Although the forecast is for slower growth for overseas, the downshift will be milder compared with the U.S., providing support for American exports, or so we're told.
The complication in all this is that the Fed has been cutting rates in a pre-emptive effort to head off recession. The risk is that the economy turns out to be stronger than expected, thereby exacerbating inflation. Pricing pressures are already bubbling, and so another uptick or two may roil investor sentiment. Yesterday's update on producer prices showed wholesale inflation at the highest rate in 34 years, although after carving out food and energy costs the pace was only the highest since February. The trend was confirmed with this morning's report on consumer prices, which increased by 4.3% for the year through last month--the highest in more than a year.
If the economy still holds the power to surprise on the upside, inflation will continue to be a risk factor for the markets. The Fed, as a result, may be inclined to reverse its liquidity injections at some point in Q1 2008 once it's clear that the immediate risk of recession has passed. That opens the possibility for a sharp selloff in equities. Bonds, too, may be subject to revised thinking on the inflationary risks. Indeed, the 10-year Treasury yield was 4.17% at yesterday's close--below the current annual rise in CPI inflation.
At the same, it's not obvious that the economy can avoid the ongoing troubles related to housing. The Barclays team yesterday advised that there are still more mortgage-related ills to come in 2008. What's more, higher inflation tends to trim consumer spending in real terms, research from Barclays shows. If pricing pressures move up much more from here, Joe's anticipated lesser spending habits may be amplified as a negative through the economy in inflation-adjusted terms.
Unfortunately, it's impossible to know if the negatives or the positives will prevail in next year's Q1. Surprises of one sort or another, as a result, seem likely, and so the markets may be roughed up from time to time. Strategic-minded investors with an appetite for contrarianism should be prepared to exploit any surge in volatility for rebalancing portfolios. For what it's worth, this writer thinks the opportunities on that front will be considerable in the weeks and months ahead.
December 12, 2007
The Fed dropped interest rates yesterday, as expected. The 25-basis-point cut looked overly cautious in the eyes of some. But after reading this morning's report on import prices, the question is whether a 1/4-point cut is a 1/4-point too much?
Yes, there's the problem of credit crunching and a slowing economy. By that standard, the central bank is doing its job of easing the pain. But then there's the issue of the Fed's other mandate: price stability.
The subject promises to be topical today and in the days ahead after investors digest the fact that import prices last month rose 2.7%--the largest monthly increase since 1990, the Bureau of Labor Statistics reported. That elevates the 12-month gain in the import index to an extraordinary 11.4% through the end of November. Such levels haven't been seen since the 1980s, as our chart below reveals.
Of course, we can almost hear the optimists countering that the rise was due largely to the surge in energy prices in November. Quite true, and if you exclude petroleum from the figures, import prices rose by a substantially lesser pace of 0.7% last month. Yet the fact remains that prices paid for imports are on the rise generally, and in more than a few cases the pace is in the upper range for recent if not distant history. Indeed, a review of the various categories of imports shows that the annual pace of price increases through November is generally advancing at or above the 3.5% annual inflation rate for the U.S. consumer price index.
The U.S., in short, runs the risk of importing inflation at a higher dosage than we've seen in quite a few years. It's not a huge problem today, next week or next month. But over time, left untended, the disease will take its toll. The U.S., after all, is the world's biggest economy with a taste for imports to the tune of nearly $200 billion a month, and growing at more than 6% a year, according to the latest numbers from the Commerce Department.
It's possible that the import price problem may fade away, but don't count on it. Yes, the month-to-month numbers change with the wind. We could very well see import prices for December decline. But the larger, longer trend has been long coming, and reversing the economic forces that brought this problem aren't easily or quickly reversed.
The reasoning starts with the dollar, which has been weak relative to most of the leading foreign currencies, as the U.S. Dollar Index reminds. A weaker dollar, of course, brings higher import prices, and so to the extent that the buck continues to suffer in the forex market, import prices will stay high and/or rise.
In the short term, the great hope for temporary relief comes from oil. Although imports of crude have a large and growing impact on the overall import price level, it's not beyond the pale to think that energy prices could fall in the short term, all the more so if the U.S. economy weakens, which would pare demand for energy and other imports at the margins. For a time. But in the long run, the U.S. will continue to import more oil, which will put pressure on the dollar, which supports higher import prices. And as far we can tell, no economist is predicting U.S. imports in non-petroleum items will decline or stay flat as a long-term proposition.
But what of the Fed? Can the central bank ride to the rescue? Perhaps, although that would require a hawkish stance for monetary policy. Alas, just the opposite is in play at the moment, and the odds of that changing any time soon look dim. And so as the Fed drops interest rates, the bearish pressure on the greenback looks set to rise.
The great squeeze play, in short, is upon us. The Fed has the thankless task of picking its poison and living with the consequences. The potential for a short-term economic boost, or inoculation against deeper trouble is one choice, and lower interest rates are the means. Defending the dollar and keeping inflation at bay is the other. The inherent conflict in the choice is always lurking, of course, but until recently the stakes have been fairly low, thanks to disinflationary winds blowing. The future, however, may not be so agreeable when it comes to monetary policy.
December 10, 2007
ANOTHER LESSON IN RISK
The housing crisis, like all crises, imparts lessons. The most important one is also the oldest: risk never takes a holiday, even though it may appear excessively sleepy for long stretches.
It's a simple yet powerful message, although that doesn't stop any one from ignoring it, as many do. But the warning signs are almost always evident, as they were all along in the housing boom that's now turned into some degree of bust.
Indeed, any time you hear that a financial strategy or investment product is predicated on the notion that the underlying market is largely immune to the bears, one should assume the appropriate response by running for the hills.
Alas, such caution was arguably in short supply as Wall Street securitized $2 trillion worth of home mortgages over the past 10 years, built partly on the idea that the average home sweet home would never suffer a material decline in price. But as the Wall Street Journal reports today,
much of the promise of the new financial architecture -- together with its underlying assumptions -- has proven to be a mirage. As house prices fall and homeowners default on mortgages at troubling rates, the pain has spread far and wide. An examination of the resulting crisis shows that it is comparable to some of the biggest financial disasters of the past half-century.
Turning assets into securities is nothing new, of course. From credit card debt to commodities, the boom in securitization has been percolating in the financial industry for 20 years. Arguably the difference this time around is that the underlying asset was thought to be impervious to the bears.
It's understandable how someone might think so. Looking at year-over-year prices for housing on a national basis, for instance, shows no losses for decades. Indeed, you have to go back to the 1960s to find red ink by this standard, and even then the dip was slight and brief. If we stop there, housing as an asset class exhibits the stuff of legend: enduring and virtually uninterrupted gain.
There's just one problem with that conviction: it's wrong. True, housing prices rarely go down, or at least much of the second half of the 20th century tells us. But rarely isn't never. In fact, there were periods of steep price declines, albeit one has to look back to the 1930s and 1940s for the evidence, which readers can do by glancing at a long-term chart of housing prices courtesy of Professor Robert Shiller via Grant's Interest Rate Observer.
Alas, such warnings come too late for those suffering from the assumption that housing is a bullet-proof asset. Again quoting the Journal story noted above, "House prices are down by 0.5% to 10% now, depending on the measure used. If they fell 30% -- what it would take to restore their historic relationship to inflation, rents and incomes -- $6 trillion worth of housing wealth would be wiped out."
Now that we're knee-deep in a housing correction, and the crowd is conscious to the fact that no one decreed a holiday for bear markets in real estate, the only question is what to do about it? Minds differ, as always, although it should comfort no one that the debate ranges far and wide on the necessary tonic for the economy. As a sample, in one corner is New York Times columnist Paul Krugman, who today charges that the Bush administration's mortgage relief plan falls far short of what's needed to stem the tide of rising foreclosures and financial havoc.
Meanwhile, Peter Schiff of Euro Pacific Capital warns in a December 6 commentary that an ill-conceived cure may be worst than the disease:
Without question, the Bush administration’s mortgage rescue plan will exacerbate, not alleviate, the problems in the housing market. As the plan will sharply reduce the ability of new buyers to make purchases, it really amounts to a stay of execution and not a pardon.
Although there are mountains of uncertainty as to how the plan will be structured and implemented, there is no question that as lenders factor in the added risk of having their contracts re-written or of being held liable for defaulting borrowers, lending standards for new loans will become increasingly severe (higher down payments, mortgage rates, and required Fico scores, lower loan to income ratios, and perhaps the death of adjustable rate loans altogether). The result will be additional downward pressure on home prices, despite the fact that in the short term fewer homes will be sold in foreclosure than what might have been without the rescue plan.
Your editor doesn't pretend to know what prescription, if any, will cure the housing hangover, or prevent the related pain from turning into a calamity. It's taken 10 years or so to get into this mess and it'll take more than another paragraph of opining and some hastily written bit of legislation to get us out. But this much is clear: believing that the future's clear and that risk estimates are forever accurate is dangerous--especially when your own hard-earned money's at stake. Few things on the planet are as transparent or as pertinent as that tidy observation when it comes to finance, which is why they invented diversification. The curious thing is that such lessons will continue to be lost on a fair share of institutions and individuals. All of which suggests that the biggest risk continues to emanate from within because homo economicus continues to stalk the financial landscape.
December 7, 2007
A TROUBLING TREND
This morning's update on payrolls for November confirms what was already obvious: employment growth is slowing.
The economy created 94,000 net new jobs last month, the Labor Department reported. Yes, there have been months with lesser gains, such as September's sluggish 44,000 rise, although compared with the last few years it's hard to get excited about 94,000 new jobs in a labor force of nearly 154 million.
But rather than focusing on any one month, consider the larger trend. As our chart below illustrates, there's no mistaking the slowdown in the jobs creation machine.
The only question is the magnitude and duration of the deceleration and whether it deteriorates into outright job losses. In the previous downturn in 2000-2003, the economy at one point was shedding in excess of 300,000 jobs a month. We're a long way from such levels of pain. In fact, the steep monthly losses the last time was in large part related to the bursting of the tech bubble. This time, the labor market's leaner and meaner and so the prospect of a sudden collapse in employment creation looks unlikely. Then again, it's not fully clear how the headwinds from the real estate correction and other problems will unfold next year.
The good news is that the unemployment rate continues to hold steady at 4.7%. In fact, the jobless rate hasn't been over 5.0% since late 2005.
Nonetheless, we expect that the slowdown in jobs creation will progress through at least Q1 2008. The cycle is turning and, given the size of the U.S. labor market, cyclical turns are generated for broad and deep economic reasons. Momentum, in short, usually has the upper hand with macro trends that affect the labor market. The Fed seems inclined to agree, or so another rate cut at next Tuesday's FOMC meeting would suggest.
December 6, 2007
KEEP HOPE ALIVE
Will the Fed cut interest rates again at its December 11 FOMC meeting next week? There's plenty of chatter suggesting the answer will be "yes" and Fed funds futures are in agreement.
The January '08 contract is priced, as we write this morning, for Fed funds at just under 4.14%, which is to say about 36 basis points below the current 4.50%. To extrapolate the message further: a 25-basis-point cut is likely, but there's debate about whether a 50-basis-point slash is possible.
Nonetheless, bond guru Bill Gross of Pimco predicts the central bank will have to go much lower. "To restart a near recessionary economy we may need to eventually go down to 3% or lower," he wrote in his latest missive that was published yesterday.
Wall Street couldn't be happier. The prospect of another rate cut, and perhaps another and another, fired up the buyers yesterday. "Everyone pretty much expects a cut and that's been contributing an underlying upward bias to equity prices during the recent rallies," William Hummer of Wayne Hummer Investments told CNNMoney.com yesterday.
Prices may be going higher. But what of earnings? In particular, the Q4 earnings. According to Zacks.com, the S&P 500 will continue to post higher earnings in this year's final quarter. But comparisons with the previous quarter will be tough. Zacks reports that S&P earnings rose a strong 11.3% in Q3. Expectations for Q4 call for a drop by one-third to a 7.7% rate of growth. Given the bearish talk about the economy, one might reason that a 7.7% jump in earnings isn't all that bad. Quite so. But is the stock market priced in anticipation of 7.7%?
While we ponder that question, consider too that the net income trend for S&P 500 companies looks considerably darker. Again quoting Zacks: Q4 total net income growth before nonrecurring items is projected to fall nearly 5%. That compares with a nearly 1% fall in Q3 and an 8.2% rise in Q2.
Of course, there's always the possibility for a surprise, although that can cut both ways. A few days back, Goldman, Sachs, for instance, slashed its S&P earnings estimates thanks to trouble in banking. Deutsche Bank did the same.
Does it matter? Based on yesterday and today as of mid-morning, the bulls only see opportunity.
No, the Fed can't engineer business cycles out of existence, although that won't stop it from trying.
December 5, 2007
ARE EUROPE'S EQUITIES A RELATIVE BARGAIN?
Now that volatility has returned to the global capital markets, an inquisitive investor might reasonably ask: What's vol done for me lately?
It's a good question, and it's one that this writer routinely asks as an input for weighing global equity diversification. In search of an answer, or something approximating one, we turn to the numbers. As a preview, Europe looks intriguing, at least on a relative basis. Or so November 30 data from S&P/Citigroup Global Equity Indices suggest.
Let's begin with the dividend yield. As the table below shows, Europe's trailing 3.17% boasts the highest yield among the major regions of the world. Relative to what you'll find in, say, the United States (1.7%), three and change looks pretty good. There's no guarantee that a relatively high yield will translate into superior total return performance in the future, although it helps tip the odds a bit.
The Europe story looks even better by way of price/earnings ratios (p/e). On a trailing 12-month basis, the Continent's equities change hands at the lowest p/e among the world's major regions, as our second chart below reports. Europe's 13.3 price to earnings compares favorably to the relatively expensive 16-plus in the U.S. and Japan.
What's more, earnings projections for the world's stock markets also give Europe the edge. The IBES near-term projection shows Europe's forward-looking p/e at the same level as its trailing p/e. In both cases, that's the lowest in the world on a regional basis, as we define regions in our charts.
Rest assured, Europe has "issues" that may give investors pause. For starters, the euro's value against the dollar has been soaring of late, which makes the region's exports more expensive (i.e., less competitive) in dollar terms. In addition, the euro area's workers are aging faster compared with the labor force in America's, suggesting to some that the growth prospects are stronger in the U.S.
Admittedly, p/e ratios and dividend yields are only two measures of investment opportunity. Indeed, Europe's yield and p/e look attractive in part because the Continent's equities lost the most ground last month relative to the world's other major regions. In addition, Europe's performance this year through the end of November looks middling, which has driven up valuations at a faster pace in markets outside of Europe's leading markets. Then again, lower prices imply higher prospective returns.
All of which suggests that Europe may be worthwhile as an overweight in a globally diversified portfolio. For perspective, Europe currently represents roughly 30% of the planet's available equity capitalization, as per S&P/Citigroup numbers. The question is whether it deserves a bit more?
Maybe, although keep in mind that 30% is just about Europe's highest share since the mid-1990s. In other words, Europe's already had a good run in terms of grabbing a bigger slice of global equity capitalization. That's not to say that it can't keep running, but there are limits, and much of that has to do with growth. And as the planet's outlook for long-term earnings growth goes, Europe probably ranks average, at best.
Nonetheless, we're inclined to keep a market weight for the Continent. We're more inclined on a tactical basis to trim weights in the red-hot emerging markets, although that would indirectly boost Europe's influence in a global equity portfolio.
In short, we're still not convinced this is a moment for major changes in asset allocations. But that's today. In a time of transition, opportunity and risk can shift quickly and dramatically. Stay nimble, stay prepared and keep a cash stash on hand.
December 4, 2007
THE RETURN OF VALUE IN ASSET ALLOCATION
Actually, it never left, even if it seemed otherwise. Perhaps it was hibernating for a few years. No longer. As November's tally of mixed performance among the major asset classes shows, the prospect of throwing money at virtually anything and earning a tidy return suddenly looks conspicuous by its absence as a prospective opportunity.
The numbers, as always, tell the story. As our chart below documents, selection was everything in last month's financial horse race. Indeed, TIPS were the best performer, rising more than 4% in November. In last place: REITs, which shed a hefty 9.5%. Looking at the year-to-date returns for two shows an almost mirror image of results: TIPS are up 11.9% in 2007 through November 30; REITs have lost 11.7% YTD.
Red ink, in fact, is a growing presence on our table above. That's just another way of saying that volatility has returned. Anything's possible, of course, but it's starting to look like nuance and variability has returned to the money game. As a result, the details matter once more in building and managing diversified portfolios. The game once again favors the nimble asset allocators, or so we predict.
With less than a month to go, it looks like 2007 may be the first calendar year since 2005 when a major asset class suffered a loss. Two years ago, foreign government bonds (as per Citi Non-$ World Gov't Bond Index) tumbled more than 9% in dollar terms, although returns measured in local currencies left the benchmark with a gain of 3.9% that year. Barring gray area, the last time unambiguous pain hit was 2002, when foreign and domestic equities crumbled. If we use 2002 as the standard, it's been a long and virtually uninterrupted stretch of gains across the board.
But as we've been writing this year, the good times for all the asset classes were living on borrowed time. Expecting otherwise at this late date in the financial cycle was asking for a miracle.
No surprise, then, that a reversal of fortunes appears to have arrived in earnest. Actually, that's good news for strategic-minded investors, who recognize that lower prices translate into higher expected returns. Capturing the rebalancing bonus requires buying asset classes that have fallen on hard times and lightening up on those that have been soaring. Of course, it may be too early to mindlessly chase red ink, but if the selling continues in REITs, for instance, we'd be inclined to start nibbling.
Keep in mind, however, that the long bull market in REITs (which started in 2000, by our calculation) may take time to unwind. Patience, in other words, may be required. Meantime, consider that the yield for equity REITs (as per NAREIT) was 4.6% at last month's close. The good news: that's now comfortably above the 10-year Treasury's 3.98% yield on November 30. Does a 60-basis-point risk premium for REITs suffice? For our money, it's a bit thin, especially if you consider that REITs may be facing more selling after years of non-stop gains. Real estate generally, in case you haven't noticed, is a bit stressed these days. As such, we're waiting but watching.
As for the other big loser last month--emerging markets stocks--we're inclined to wait even longer before even thinking about a large, new commitment. Yes, we keep reading about how emerging markets have matured and are no longer dependent on the U.S. economy for a bullish tailwind. But that's still just a theory and it has yet to be tested under fire. Adding to our cautious outlook is the fact that emerging markets equities are still flying high YTD. Unless you have zero exposure to emerging markets, we'd advise waiting here as well.
Then again, we could be wrong, and it wouldn't be the first time. Recognizing our limitations as mere mortals, we trust only in broad diversification across the major asset classes, tweaking the mix every now and again. If and when an extreme move arrives, we'll be looking to take a more aggressive rebalancing posture.
Speaking of which, in considering 2008, we're expecting to redeploy some of our overweight cash allocation. Exactly where and when we'll redeploy remains an open question; we're waiting for additional clues from Mr. Market. But the winds of opportunity are starting to blow. Yes, it'll take a contrarian mindset to capitalize on the volatility. Then again, no one ever said success in investing would be comfortable and stress free.
December 3, 2007
Investing tends to promote unyielding and often conflicting ideas about what works and what doesn't. Witness the schism between those who embrace active management vs. indexers. Many use both, although some fall into one or the other camp and summarily dismiss the other. But is it wise to preemptively reject passive or active management for all of eternity? Or, maybe, is it better to keep an open mind on the off chance that the other side might come up with a useful idea every now and again?
So suggests Matthew Rice, CFA, in an recent interview with your editor. In the course of a Q&A, originally published in the December issue of Wealth Manager, Rice made a case for looking at all the options when it comes to surveying the investment possibilities. That, at least, is the guiding principle at DiMeo Schneider, a Chicago investment consultancy where Rice is a principal. As he suggests in the following interview, indexing isn't always and forever the best choice for every asset class. The same holds true for active management.
No doubt, there are many who disagree or remain suspicious of such notions. Indeed, your editor, for one, favors betas for building multi-asset class portfolios. Nonetheless, Rice has co-authored an interesting study published earlier this year that's worth reviewing if only to stress test one's core beliefs. For additional perspective, take a look at our recent conversation with Rice, which begins now....