January 31, 2008
REFLATION IS ALL THE RAGE (AGAIN)
It's too soon to say if the bond market will stay on board with the Fed's new world order. From 10 miles up, however, all looks fine, as our chart below suggests. Rates and spreads have both dropped considerably, delivering an upward sloping yield curve along the way. Mr. Bernanke's big adventure, in short, appears to be on track.
After yesterday's cut, Fed funds are now at 3.0%, well below the benchmark 10-year Treasury's 3.78%, as of last night's close. The decline and fall of the 10-year yield has been fairly steep and swift. Indeed, the yield at one point last June reached as high as 5.23%. After a subsequent loss of nearly 150 basis points, it's safe to say that a lot's changed.
Surely no one can misread the central bank's new strategy of reflating. That may or may not be the ideal prescription, but a hefty dosage is comine just the same. The rate on Fed funds rarely crumbles this far this quickly. And it's not clear that we're done. The May '08 Fed funds futures contract is priced in anticipation of another 50-basis-point cut, which would bring us down to 2.5%.
So far, the bond market has been happy to tag along with the prevailing monetary winds. This is no small point. One can only imagine the chaos that might erupt if the Fed's aggressive cutting was scaring the heck out of bond investors. In fact, just the opposite has been the norm. One example of the bond market's vote of support can be seen in the 2.8% rise in the iShares Lehman 7-10 Year Treasury ETF (IEF) this month alone. Since last June, this ETF is up about nearly 15%, which, of course, is an extraordinary run for what's essentially a risk-free asset if--a big if--in a world where inflation is largely mute.
The question is whether the bond market will continue accepting the Fed's reflation efforts? There's always reason to wonder, of course, and all the more so in the wake of recent trading sessions. It's too soon to say if the Treasury market is having second thoughts. On the other hand, the 10-year's yield is 27 basis points higher from January 23's close, when the Fed funds rate was 50--yes, 50--basis points higher.
In fact, we're reluctant to say that the bullish momentum in Treasuries has run its course. The Fed's still calling the shots and will continue to do so. Or so it seems. But keep in mind that a large share of Treasury owners are foreigners, which is to say investors who live and breath in currencies other than greenbacks. Meanwhile, lower rates in the current economic climate are sure to bring a lower dollar in the forex markets. That, of course, is probably Bernanke and company's goal, at least partly. A weaker dollar will help boost exports, which has been a bright spot for the economy, albeit a weakening bright spot in the fourth quarter.
But how much pain will foreign dollar holders endure? Will they ride the reflation train all the way to the last station? Maybe, maybe not. But as the game of financial chicken rolls on, we're inclined to reallocate money away from domestic bonds into more attractively priced asset classes. No, we don't know when the party will end. In fact, it wouldn't surprise us to watch the good times roll on for months, perhaps through 2009. Much will depend on the degree of weakness in the U.S. economy, and the future path of inflation, all of which will be updated daily, one data point at a time. Fortunately, asset allocation doesn't require dramatic all-or-none, one-day decisions.
January 30, 2008
IT'S STILL ALL ABOUT REAL ESTATE
Today's first guess at fourth-quarter GDP revealed what everyone already knew: the economy slowed sharply in the last three months of 2007 to a 0.6% annual pace in real (inflation-adjusted) terms, the Bureau of Economic Analysis reported. That's a world or two below the third quarter's 4.9% surge.
What's the source of the downshift? Real estate--residential real estate, to be precise, as the table below shows. Spending on construction of new houses, apartment buildings and all the associated products and services took another hit in the fourth quarter, tumbling nearly 24%. Even worse, that follows a 20.5% tumble in the third quarter. In fact, you have to go back to the fourth quarter of 2005 to find a positive number in the residential real estate investment column in GDP reports. Since then, the sector's been mired in red for each and every quarter and the toll has grown on the overall economy. The only difference this time: the 23.9% slump in housing investment in last year's fourth quarter is the deepest yet for this cycle, and the mounting pressure is obvious via the weak economic growth generally.
The good news is that the pain is still largely contained to real estate, at least it was in the fourth quarter. That may or may not continue this year, but as we write consumer spending, while slower in 2007's last three months relative to the previous quarter, still appears to be rising. Alas, the 2.0% rise in consumer spending is unimpressive relative to the past few years, but beggars can't be choosy. With that in mind, we note that Joe Sixpack's spending pace comfortably exceeded the economy's growth rate as of late last year. Perhaps we should all be thankful for small (and increasingly precarious?) favors.
In fact, focusing on the durable goods component of consumer spending shows an even brighter profile in last year's fourth quarter. As you can see from the table above, spending on big-ticket items remained fairly brisk, advancing 4.2%, down only slightly from 4.5% previously. But that's tempered by the slowing in the consumer spending tied to nondurable goods and services.
And, of course, real estate woes continue to weigh heavily on this economy. For some time now the debate has rightly focused on whether the housing slump will infect the larger economy. The answer is clearly "yes," as the fourth quarter numbers reveal. But the pain, so far, has been mild as measured in broad terms. And with Congress and the Federal Reserve moving heaven and Earth in an attempt to limit if not end the housing infection, perhaps there's reason for hope.
The great unknown is whether the worst of the real estate woes are now past. There's a case to be made on both sides of the debate. Indeed, economists seem to be all over the map. Of course, someone will be wrong, and perhaps by more than a little.
Risk, in short, still stalks the economy, the capital markets and investors. It's tempting to think the danger has passed. The rising U.S. stock market of late looks especially confident that the all-clear bell has been rung. We don't dismiss the possibility, but nor do we necessarily embrace the idea.
We are, however, inclined to nibble where the values look favorable among the major asset classes, which include REITs and junk bonds and, yes, U.S. stocks. But we don't know if this is a bottom or just a bear-market head fake that will lead to even lower prices and more-enticing valuations. We're always clueless about the future, of course, but that state of affairs is especially risky at this point. As such, our portfolio allocations to risk remain relatively low while our buying is opportunistic and limited.
We're fully prepared that our cautious stance may come at an opportunity cost if bull markets sweep the globe once more. Nonetheless, risk management remains our foremost concern and for the time being we're willing to forgo big gains in exchange for the possibility of finding even greater bargains later. It's an imperfect world and so we're fated to make what may be imperfect decisions.
Others will no doubt see the opportunities and risk horizons differently. Given the fluid climate of late, that's no surprise. This much, at least, is clear: Each and every investor must decide if they're more comfortable with a lesser expected return or a higher expected risk and then act accordingly.
January 29, 2008
A BIT OF PERSPECTIVE FOR DURABLE GOODS ORDERS
The economic report du jour can be dramatic, it may spawn a sea of commentary and it may move markets. The latest numerical update sometimes reflects the larger trend in the data series, too. But one has to remember that statistical noise all too often clouds the true story.
That's worth considering in the wake of today's encouraging report on durable goods orders. We can’t say for sure if the data’s pulling a fast one on investors today or if the upturn is the real deal. For that matter, we can’t ever be sure until the passage of time delivers its always flawless dose of clarity. So, what’s a strategic-minded investor to do? Waiting a year isn’t practical, but neither is rushing to judgment based on the last number to hit the Street. The middle ground is taking a longer term view of the cycle in the here and now. True, the future is still unclear regardless, but at the very least it pays to have solid insight about where we’ve been and how the latest report fits in with the trend as it’s unfolded so far.
With that in mind we offer the following chart, which graphs the 12-month rolling percentage change in new orders for manufactured durable goods right up through today’s December 2007 update. First, take note that new durable goods orders last month posted a strong 5.2% rise from the previous month. In fact, December’s jump was the highest since July. In addition, a monthly gain north of 5% is fairly rare, occurring only 10% of the time over the past 10 years. Clearly, one shouldn’t undervalue the potential significance in last month’s report. In addition, December’s gain marks the second straight monthly gain in new durable goods orders, which is considered a gauge of future economic activity.
But the bullish aura described above is tempered when you put last month’s gain in broader context with durable goods orders over the years. As the above chart reminds, the strength in December’s report doesn’t reverse the overall trend of the past two years, which is unmistakably down. Smoothing the volatile durable goods orders reports by comparing annual changes over time reveals a slowdown that appears to have momentum. The good news is that the slide remains mild, so far, compared to the previous slump in 2000 and 2001, when new orders for durable goods routinely shrunk by 5% to 20% on an annual basis.
The optimistic view is that December’s rise signals that better times are coming for durable goods orders and the economy overall. Perhaps. No one really knows. At the very least, durable goods orders should be compared in context with other economic reports. By that standard, there’s still reason to be cautious. Notably, new home sales tanked last year by more than 26%, the largest annual decline on record, the Census Bureau reported yesterday.
Yes, the Federal Reserve, the Congress and all the financial gods will be working over time to diminish the cyclical downturn that's apparently upon us. But corrections can't be rushed and solutions can't be assured. Sometimes it's best to be patient and let the process unwind while keeping one's financial powder dry and an eye open for opportunities as they arise—over time. Market tops and bottoms, like economic cycles and bad novels, are obvious only in hindsight. As such, prudence suggests buying the seemingly bargain-priced assets slowly, throughout a down cycle so as to manage risk while tapping into what hopefully is higher expected returns born of lower prices.
We all know that the rebound is coming, but not today. That's good news for strategic-minded investors because it means that even better opportunities are coming.
January 25, 2008
THE PARTY IN BONDS ROLLS ON
Sometimes it's best to let the numbers do the talking. Without further adieu, we offer the following statistical recap on the 10-year Treasury yield, its counterpart in the 10-year real yield a.k.a. TIPS, and the spread between the two.
As always, minds will differ as to the implications of the above chart, and so what follows is your editor's view, which may or may not be relevant for the foreseeable future. That caveat aside, consider the persistent decline in 10-year yields in both nominal and real measures since last July. On this point, at least, all can agree: the bond market's become increasingly giddy, bidding up the price of government debt, which, of course, results in pushing yields down.
The 10-year Treasury's nominal yield was comfortably north of 5.0% midway in 2007; at last night's close it was 3.68%.
For the 10-year TIPS, a similar story has been unfolding, albeit at lower rates, which is typical for real relative to nominal. Back in June 2007, the 10-year TIPS yield was as high as 2.83% at one point; now it's 1.44%.
Meanwhile, consider the spread between yields on nominal Treasuries and TIPs, a gap that's considered a measure (albeit not the only one or necessarily an infallible one) of Mr. Market's inflation outlook. As such, the two Treasury markets are priced in anticipation of inflation of 2.24%, defined as the current 10-year yield (3.68%) less the current 10-year TIPS yield (1.44%). Oh, and by the way, the spread has remained fairly constant for the past six months or so, as the chart above reminds. The implication: the inflation outlook hasn't change much, if at all since last summer.
Ah, but here's where it gets interesting, or frightening, depending on your perspective. The latest Consumer Price Index numbers, which are widely accepted (tolerated?) as the U.S. inflation rate reveals prices rising by 4.1% for 2007. That's far above the 2.24% inflation rate implied by the spread in nominal and real Treasury yields.
Adding to worries is the fact that the core rate of CPI inflation, which the Fed says is a more useful measure of divining future pricing trends, is running at 2.4%. Lower, but still above the 2.24% forecast drawn from the spread in Treasuries.
To be fair, there's no shortage of dismal scientists who think inflation will behave in the months and years ahead. It goes without saying that many if not most bond investors agree, or so the associated plunge in yields suggest.
But it's only fair to point out that the dissenters are growing in number, starting with the gold market, which just happened to run prices of the precious metal up to an all-time closing high yesterday at just under $913 an ounce. Adding to the inflation fears is the fact that the dollar remains weak, hovering just above record lows, as measured by the U.S. Dollar Index. Of course, a weaker dollar whips up the winds of import inflation, starting with the massive and growing quantities of oil shipped in to the U.S. from foreign suppliers. And then there's the Fed's massive 75-basis-point rate cut on Tuesday and expectations that more easing is coming when the FOMC meets next week. Call us crazy, but maybe just maybe inflation may be at risk of ticking up a notch or two down the road.
You don't have to expect inflation to surge skyward to think that lightening up on bonds seems reasonable. For our money, we're more convinced than ever that bonds, at best, offer limited value. Yes, economic apocalypse may be coming, in which case bonds may deliver another run of robust returns. But what if the recession (if in fact one's coming) is relatively mild and brief, as has been the trend for the past 20 years? If so, one shouldn't expect pricing power to evaporate for 2009 and beyond.
In any case, there's no getting around the fact that Treasuries are priced for something approximating perfection in future inflation. If you think that's likely, you're part of the majority, and there's always room for one more in the crowd.
January 23, 2008
THE MORNING AFTER
No one knows if the Fed's aggressive 75-basis-point cut in interest rates yesterday will soothe the markets and stabilize the economy. But slicing the price of money so deeply in one fell swoop rearranges risk, creating new opportunities and new pitfalls in the process.
Let's start with the suspicion that the central bank's latest easing was motivated by the tumble in stock markets around the world. The case looks fairly compelling. With only a week before the regularly scheduled FOMC meeting, when a rate cut was widely expected, the Fed lowered its key Fed funds rate early and deeply. Was the move solely about shoring up a weakening economy? Partly, although there's more to the story. Otherwise, why didn't the Fed cut last week? Was there some new economic news moving to Fed to action? No, but stocks around the world were collapsing and so the central bank decided to minimize the damage yesterday, the first day of U.S. trading since Friday.
No central bank can afford to ignore the signals emanating from financial markets. But there's a fine line between ignoring and pandering. Only history will decide if the Fed is deploying monetary policy judiciously in pursuit of balancing its dual mandate of maximizing economic growth and minimizing inflation. Meantime, it's hard to shake the suspicion that the Fed's reacting to Wall Street rather than Main Street. Correct or not, the central bank can't afford to let such a perception take root without creating a bull market in expectations that the Fed ultimately can't satisfy.
Ill-conceived or not, the Fed cut is reality, and when you slash rates that much that fast the action reorders risk. One example is REITs, which popped yesterday amid falling stock prices. The Vanguard REIT Index ETF (VNQ) on Tuesday jumped 2.3%. Not bad on a day when U.S. stocks fell more than 1%. Why were REITs a safe harbor yesterday? Some of it has to do with the fact that real estate securities have been declining for some time. Perhaps more important is that the relatively rich yields in REITs suddenly look that much more alluring in the wake of a massive rate cut.
Speaking of income, bonds enjoyed a boost yesterday, as one would expect when interest rates fall dramatically in a single trading session. Demand for the benchmark 10-year Treasury was brisk on Tuesday, pushing down its yield to 3.48%, the lowest since July 2003. In fact, the 10 year's yield is now within shouting distance of the generational low of 3.07% set back in June 2003--a trough that some thought would stand for decades. But with talk that the Fed will cut again at next week's FOMC meeting, the idea that the 10-year Treasury yield may yet dip to new record lows is becoming more plausible by the day.
The prospect of such skimpy yields makes us skeptical of bonds as an asset class, at least when it comes to Treasuries. Unless you're expecting an extraordinarily long and deep recession (and we don't), the idea of locking in nominal yields just north of 3.0% looks like a loser for the long haul. Yes, the comfort of owning investment grade bonds will attract buyers for the foreseeable future. And the tailwind of more Fed cuts will only enhance the attraction. But we don't see bonds at this point as anything more than a tactical weapon. Prudence requires that most portfolios hold a fixed-income allocation. But if bond prices keep rising, and yields keep sinking, we'd be inclined to rebalance by shifting money to shorter maturities and other asset classes with a more enticing long-term outlook.
Indeed, all the chatter about lower interest rates and juicing monetary liquidity inevitably raises the specter of inflation, which has been inching higher in recent history. With nominal yields so low and the possibility that inflation may be higher in the years ahead, we're increasingly cautious on bonds. The Fed, rightly or wrongly, isn't worried about inflation these days and instead is focused on giving the economy (and the stock market) a helping hand. The assumption is that once the danger has passed, Bernanke and company can raise interest rates and soak up any excess inflationary pressure.
That's the ideal scenario, but no one should assume the central bank can pull it off. The problem is that inflation, once it takes root, isn't easily contained. Perhaps that's why investors also bid up the price of gold and inflation-indexed Treasuries yesterday.
Higher volatility, it seems, is everywhere these days, including securities prices and central banking decisions. For savvy investors who stay calm and keep a long-term focus, that's good news for the simple reason that reordering risk usually creates new opportunities. But don't kid yourself: profiting from freshly minted opportunities in this scenario still requires walking through a field of landmines. As such, stay calm, stay focused, keep an eye out for sale prices in asset classes and, most importantly, remember that diversification is still your only friend.
January 22, 2008
BLOOD IN THE STREETS?
Panic, fear, and an emergency 75-basis-point cut in the Fed funds rate. Yes, dear readers, it's time to start nibbling at asset classes that have fallen on hard times.
But let's not go crazy. We're not in the business of calling market bottoms, or tops. Nobody knows how long the selling will last. It could be over tomorrow, unless a protracted bear market extends the pain for months or years.
This much, at least, looks clear: strategic-minded investors with long horizons should be taking advantage of the selling. Timing, of course, will be critical. Alas, there's no definitive bell-ringing ceremony at the bottom of bear markets. Clarity only arrives with hindsight. Nonetheless, waiting for clarity is sure to come with an opportunity cost. Once it's obvious that the trough is past, market's may have already bounced higher.
Overall, the risk of waiting too long to exploit a cyclical repricing of securities is balanced by the risk of pulling the trigger too early. In a perfect world, investors would buy at the bottom and sell at the top. In the universe we all inhabit, however, imprecision rules and so returns suffer relative to the ideal, albeit in varying degrees depending on the investor.
Despite the risk of buying too early or too late, few can afford to stand still and watch the world pass by. Lower prices equate with higher prospective returns. And so, after five straight years of bull markets in just about everything, the cycle has turned, risk has been reshuffled and a new deck of prospective returns has been dealt. We don't pretend to have the answer as to when it's time to buy. On the other hand, we're reasonably sure that the year ahead will offer compelling opportunities for rebalancing among the major asset classes. The source of this new opportunity: the churning of economic and financial risk.
That said, let's emphasize once more that the primary risk in the months ahead is one of balancing the risk of buying too early vs. buying too late. At the same time, level-headed investors shouldn't fret over the risk. They shouldn't ignore it, either. Most of us, perhaps all of us, will err on one side or the other. The good news is that the timing risk can be mitigated. Because we don't know when prices will stop falling, or start rising, prudence suggests a bit of time diversification is in order.
Let's say you've been rebalancing these last few years, selling into strength on the margins and raising weights in lower-risk betas and cash. Now what? You could throw caution to the wind and reinvest everything in risky assets on a single day. This approach will, of course, maximize future returns--if you're right. If you're wrong, you'll maximize losses. But that's just rank speculation. An alternative approach is rebalancing gradually over the coming months by purchasing asset classes periodically--otherwise known as investing.
Perhaps the waves of selling will be isolated in one or two asset classes, perhaps not. Perhaps the waves of selling will come in one concentrated burst, or perhaps it will come in stages, separated by weeks or months. However it comes, the essential point is psychologically preparing oneself for the future and monitoring the shifting sands of risk and reward. History teaches that the greatest buying opportunities often arrive at moments of extreme stress in the financial system. Positioning one's mind, and one's portfolio, to exploit such moments is vital for generating something other than mediocre performance for the long term. For those who keep a clear head, financial blood in the street represents opportunity.
January 18, 2008
ALPHA ON THE BRAIN
Lately, we've been thinking a lot about alpha, a.k.a. investing talent. That includes the ever popular question: How much alpha's available? The standard answer is that alpha's limited, meaning that for every investor who beats a benchmark, the win must be offset with someone who trails the index. Alpha, in other words, is a zero sum game. That's a widely accepted view, although much depends on how you define your terms, as discussed in a pair of articles penned by this reporter in the January issue of Wealth Manager.
January 17, 2008
ANOTHER WEAK HOUSING REPORT
The Federal Reserve doesn't need another excuse to cut interest rates, but the economic report du jour brought a fresh reason anyway.
New housing starts continued tumbling last month, the Census Bureau advised this morning. Privately-owned housing starts fell 14% in December to levels last seen in 1991. Building permits crumbled again last month, too. Since permits are considered a measure of future activity, the ongoing slide here casts a pall over the outlook for housing.
"These figures confirm that the housing recession continues to deepen," Mike Larson, a real estate analyst for Weiss Research, told CNNMoney.com. "Slumping consumer confidence and tighter lending standards have already taken their toll on demand, and the broader economic slowdown we're starting to see unfold now threatens to make a bad situation worse."
Adding to the gloom is the fact that housing starts fell by more than the consensus predicted. According to Bloomberg News,
Starts were expected to decline to an annual pace of 1.145 million, based on a Bloomberg News survey of economists. But the actual number was far lower at 1.006 million.
The optimistic view on Wall Street is that a combination of rate cuts and fiscal stimulus via Congress will save the day. Perhaps, but even the Federal Reserve and the politicians in Washington can't wave a magic wand and make the bad news go away.
The market, it seems to us, wants to correct and needs to correct. After five years of nearly non-stop bull markets in almost everything, investors are again becoming acquainted with the laws of financial gravity. Yes, the market's already taken a hit since the highs of last fall and there's plenty of opinion that now says it's the time to buy the dip. The S&P 500 is down 13% from the peak. Is that all there is? We don't think so. The source of the selling in recent months has been economic weakness, and that's not about to stop next week or next month just because the Federal Reserve cuts rates and Congress votes to give taxpayers a $1,000 rebate. Those actions will mitigate the pain, but only a thorough correction will fully purge the financial system, and that purging may take longer than you think.
For our money, we're looking for signs of far deeper pessimism on Wall Street than currently describes the sentiment. The basic reason: we think there's more bad news coming, in which case more selling will follow.
Yes, we could be wrong, which is why we're nibbling ever so slightly at the dips in some asset classes. But time diversification seems reasonable for the moment and so our buying will be spread out over time, perhaps over the next few years. We don't know how long the dark clouds will hang over the economy, but we're confident the tough times will last through at least the second or third quarter, based on our reading of a number of economic statistics. It's taken years for the excesses to build up and so it's reasonable to think that it'll take, at the very least, a few quarters to unwind the problem.
Opportunities for buying on the cheap are coming, but we're not there yet. Patience and discipline are the priorities now for strategic-minded investors.
January 16, 2008
The Bernanke Fed caught a break this morning.
The December report on consumer prices shows that inflation returned to something approximating a manageable level. After November's eye-popping 0.8% surge in CPI, December's 0.3% looks like a gift, and a timely one. No, inflation hasn't evaporated as a clear and present danger, but pricing pressures retreated enough in December to give the central bank a green light to drop interest rates by 50 basis points at the end of the month, when the FOMC meets.
The market expects no less. As we write, the February '08 Fed funds contract is priced in anticipation of a 50-basis-point cut.
It's clear that the economy's slowing and may even be contracting. By that standard, slashing interest rates looks sensible. And thanks to this morning's CPI report, inflation doesn't appear to be an imminent threat, giving the Fed a clear path for firing up the printing presses at a higher rate in the hope that such action will head off a recession, or at least dull the economic pain.
But make no mistake: inflation's not dead, despite today's report. A closer look at price trends tells the story. As the chart below shows, CPI's still rising at an elevated rate when measured on a 12-month basis. Last's month's dip helps take the edge off, but inflation running at 4%-plus is a threat. The Fed can't afford to ignore the threat for too long. On the other hand, if the economic weakness lingers, it will be politically difficult, if not impossible to tighten in a presidential election year.
Another problem, and a potentially bigger one is the fact that core CPI (inflation less food and energy) continues rising. As our second chart illustrates, core CPI is on the march again, rising 2.4% last year. That's well above the Fed's comfort zone. This is the inflation rate that the central bank watches closely, and the fact that it's rising once more implies that there will be no easy choices this year for monetary policy.
For the moment, the bond market seems inclined to give Bernanke and company the benefit of the doubt. Worries about inflation are virtually absent among the fixed income set, which is intent on buying. The yield on the 10-year Treasury keeps sinking, closing yesterday at 3.7%, the lowest since March 2004. Clearly, bond investors are focused on economic ills, sending a signal to the Fed that avoiding recession is the priority. The only question is whether inflation will play along in 2008.
January 15, 2008
BEHIND EVERY CLOUD…
The crowd was expecting a slight gain but instead found itself on the receiving end of a sharp tumble.
The consensus forecast called for a 0.1% rise in retail sales for December, according to TheStreet.com. The actual number was nowhere near that relatively sunny prediction. Retail sales crumbled by 0.4% last month, the Census Bureau reported this morning--the steepest decline since June.
The monthly change in retail sales is a volatile beast, of course, and so any one report doesn't tell you much. Indeed, November enjoyed a 1% surge, only to watch it crash and burn in December.
But there's more insight embedded in the rolling 12-month trend, and by that measure there's reason to worry. As our chart below shows, the trend is definitely not your friend of late. The strong growth that defined the 12-month change in retail sales in 2003-2006 has now been downsized to something less. Yes, there was a burst of buying last year, which gave hope to the idea that the downshift of 2006 was only temporary. But the downside momentum appears to be building.
The economic context suggests that the latest drop reflects a weary consumer. Fears that consumer spending would slow or even decline have been around for years but Joe Sixpack always managed to keep the ball rolling. Is this time different? Yes, it may be. Years of piling up debt may finally be coming back to haunt Joe. The fallout from the housing correction is one reason. Without the constant drumbeat of rising home equity to inspire consumer purchases, the prospect of buy now and pay later may have lost some of its luster.
Then there's the employment trend. Last month witnessed the weakest payroll report in four years. Meanwhile, unemployment jumped to 5.0%, the highest in over a year. Consumer spending is already under attack from the housing ills; the pressure will only build if the labor market remains weak.
Indeed, there's a name for all of this: recession. It may or may not arrive, but it's getting harder to ignore the warning signs. For some reason, the mere mention of the "R" word angers some pundits. Perhaps we're all supposed to politely look the other way. Or, maybe if we don't report on the obvious all the bad news will simply go away. But wishing away trouble doesn't have a good track record and there's zero chance it'll be effective in 2008.
In fact, business cycles are a normal part of all economies. There's even some good that may come. The prospect that Americans may start saving more, for instance, may be just what the dismal science ordered. No, the correction may not be pretty. But when the dust clears, a new era of growth will dawn.
January 11, 2008
BEN TO THE RESCUE
There's more than one way to run a central bank, which inevitably leads to the possibilities of success or failure. The trick is figuring out if one or the other's likely and if the expectation is already priced into bonds and other assets.
With that setup, we turn to the yesterday's announcement by the European Central Bank to hold rates steady and keep its benchmark borrowing rate at 4.0%. In the related press conference, ECB president Jean-Claude Trichet made it clear that rising inflation played a role in the decision.
For the casual observer, taking a tough stand on inflation may seem like an easy choice for a central bank, but investors shouldn't assume that the ECB's hawkish disposition is the default position.
Witness the Federal Reserve of late, which finds it far easier to cut than stand firm. In fact, Fed chief Bernanke yesterday signaled that even more rate cuts are coming. "In light of changes in the outlook for and the risks to growth, additional policy easing may well be necessary," he said in a speech in Washington. "We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks."
The fear is that recession, if not already here will soon arrive in the U.S. As an antidote, the central bank will slash the price of money in the coming weeks and months. Indeed, the February '08 Fed fund futures contract is priced in expectation of a 50-basis-point cut when the FOMC meets at the end of this month.
No one should be surprised that the Fed will continue cutting rates if the economy continues to falter. But investors should recognize that the medicine may not work well this time, if at all. A generation of minimizing if not sidestepping recessions by deft monetary policy has kept the economy humming with only brief and mild contractionary interruptions. This time, the Fed will try to keep the game going once more.
The trouble is that the economy's not in trouble because interest rates have been too high. Quite the opposite has been true: the price of money's been too cheap for too long and the excesses that flowed from that state of monetary affairs are correcting. The idea that the Fed can keep consumers spending at a sufficient rate to keep GDP from sinking seems a bit far-fetched. Then again, don't underestimate the power of the central bank. We may yet see a fresh season of zero-percent-financing deals and commentary that fuses helicopters with monetary policy.
It's any one's guess is Joe Sixpack can be convinced to keep spending as if the economy's booming. No doubt the Fed will try. But it's tougher this time and Congress may have to lend a fiscal hand too. A fresh round of tax cuts, any one?
Even if all this works to keep the U.S. out of a deep recession, the cost is likely to be steep in terms of future inflation. Somewhere, somehow, some day, the bill must be paid. The warning signs are certainly clear: a falling dollar; rising prices for gold, oil and other commodities; and consumer prices that are moving higher as well, to name a few. Of course, this is an election year and short-term gain will be sacrificed on the altar of long-term pain. It's an ancient tradition, and it's not about to stop here.
January 9, 2008
MR. MARKET'S GLOBAL EQUITY ALLOCATIONS
The U.S. stock market capitalization, as a share of the global equity market, has fallen to its lowest level since 1995, according to numbers from S&P/Citigroup Global Equity Indices.
As this year dawned, U.S. stocks claimed a 40.6% slice of the global equity pie, down from 43.9% the year before. As recently January 1, 2002, the U.S. share was as high as 57% of global equity cap. Since then, the U.S. slice has slipped each and every year, bringing us to the current 40.6%, which is more or less tied as the lowest with 1995, based on looking at January 1 numbers over the years.
On a relative basis, if the U.S. is down, other markets must be up. The most conspicuous rise comes in the emerging markets, which posted a 10.5% share of the global equity capitalization as this year opened, up sharply from 7.5% a year ago and triple the level in 2002.
Looking more closely on a regional basis around the world, Europe actually eked out a marginal gain while Japan slipped. Asia Pacific ex-Japan moved higher, rising to 6.4% of global equity cap, up from 5.3% a year ago. Latin America continues to rise as well, starting this year at 2.4% vs. 1.6% on January 1, 2007.
What insights should strategic-minded investors draw from these numbers? For starters, it provides a rough estimate of how to allocate a global equity portfolio if you had no particular view on which regions looked more, or less attractive than others.
Alternatively, for those who think they know better than Mr. Market, the numbers provide a rough benchmark for deciding what constitutes over- and underweighting on global equity basis. For those who are so inclined, the numbers may suggest that overweighting the U.S. is starting to make sense while underweighting emerging markets has some merit.
Perhaps, perhaps not. Mr. Market never reveals his plans ahead of time. The past, at least, is as clear as ever.
January 4, 2008
HERE IT COMES
There's no mistaking the trend now. The economy's slowing dramatically and the risk of recession is quite real, as this morning's dreary employment report for December strongly suggests.
Nonfarm payrolls rose a thin 18,000 last month, the Labor Department reported today. As our chart below shows, that's the slowest pace for job creation in over four years. Adding to the labor market's woes is the news that the unemployment rate for December jumped to 5.0%, up from 4.7% previous. The jobless rate is now at its highest since November 2005.
One jobs report may or may not reflect the future, but it's tougher to overlook the broader trend over time. The economy's been creating fewer and fewer jobs for two years now and we expect it to go negative. Yes, there are various reasons for that, and in any given month the trend changes. But there's no mistaking the slowdown now. When the largest economy on the planet has had a tougher time creating jobs for two years or so, one should take notice.
Even the services sector, the great source of strength for the economy over the past generation, is now showing signs of strain in minting new jobs. Consider that last month, the economy generated 93,000 new services jobs, down sharply from November's 160,000 gain. Meanwhile, the losses in construction and manufacturing jobs are accelerating and last month the tumbles there nearly overwhelmed the frugal gains in services sector.
It's any one's guess what comes next, but today's numbers are likely to cast a long shadow over investor sentiment until something dramatic arrives to persuade the crowd to think otherwise. In short, volatility is likely to remain in a bull market.
For strategic-minded investors who've been increasingly wary, and raised portfolio allocations to cash, all of this provides the potential for continued opportunity to pick up asset classes on the cheap in the coming weeks and months (and years?). No, it won't be easy, but successful investing never is as a long-term proposition. Nonetheless, those with a long-term view must stay vigilant and ignore the noise.
Just keep repeating the mantra that when it comes to asset classes, lower prices equate with higher expected returns. Realizing those higher returns won't necessarily come quickly or be an easy decision. But the combination of opportunity and patience will pay off eventually.
None of which is news to students of history. As Nathan Rothschild long ago counseled, buy when blood is running in the streets. Easy to say, tough to do. In fact, it's just the flip side of selling in roaring bull markets. If you believe in one, you should embrace the other.
January 3, 2008
DON'T STOP THINKING ABOUT TOMORROW
Homo economicus likes to imagine himself as a clever being. And in some respects, he's right. But when it comes to investing, even the most intelligent minds in the universe can be hornswoggled. Mr. Market, someone once told us, is a tricky nemesis.
With a new year standing before us, and an old one behind, this is the traditional moment to reassess, review and make a guess at what's coming next. That includes deciding how to tweak the portfolio, if at all. The challenge, for our money, is now and forever at the center of success, or failure. Strategy, in other words, trumps all, even though the outcome may not be obvious for years or even decades. Nonetheless, the choices we make today, tomorrow, next year and beyond for building a portfolio--overweighting this, underweighting that--ultimately dictate results, for good or ill.
On that subject we're routinely impressed by how difficult it is to reengineer betas to suit our investment needs and claim victory. Indeed, a popular if not universal goal is reducing risk while maintaining return. No easy trick, although it's tempting to think that any one can do it. The proliferation of ETFs, to take an obvious example, provides a broad and ever-expanding palette of betas to play with. Surely an intelligent strategist can choose a mix of betas, from stocks to bonds to commodities and beyond, and craft a winning portfolio that delivers superior risk-adjusted returns.
While such a goal isn't impossible, it's devilishly difficult to achieve for the long run. Ironically, most investors probably have no clue just how difficult the task. Why? Because one can only recognize the depth of the challenge by routinely analyzing a living, breathing portfolio over the course of time. Daily analysis is ideal, although weekly or even monthly data will suffice over long periods. In any case, unless you're crunching the numbers regularly, and comparing your results to a benchmark, it's easy to overlook just how elusive successful investment strategy can be.
Consider that for most investors with a long-term horizon, equities are the primary risk factor. Looking out 10 or more years, it's a reasonable assumption that equity risk will deliver superior returns compared to bonds, cash and perhaps even commodities and real estate. The risk of underweighting equities over time, therefore, can be thought of as the primary risk.
But ours is an age of clever strategists armed with access to inexpensive betas, in both conventional and alternative forms. As such, there's a strong temptation to craft a portfolio that will is expected to enhance what can otherwise be had by mindlessly buying the major asset classes in something approximating their market weights on a global basis.
No, we're not saying that it's always best to buy and hold the market-weight portfolio, although as a long-term proposition you'll probably do pretty well with that mix. For those who aspire to more, we recommend at least keeping in mind that playing with asset allocation far beyond Mr. Market's recommendations invites additional risk in the form of trailing what you could otherwise obtain quite easily. On the other hand, if you're not going to choose an asset allocation that's materially different than the global market portfolio, what's the point? Modest deviations won't do much to alter the risk-reward profile of the market, although such tweaks may raise the risk of underperformance.
But don't take our word for it; run the numbers on your own portfolio and see for yourself. As a simple example, calculate the total value of your investment portfolio at the end of each week and compare its performance to, say, the S&P 500, or a balanced mix of 60% stocks/40% bonds. Even better, create a custom benchmark of global stocks (50% S&P and 50% EAFE) that adds up to 60%, with the remaining 40% in Lehman Aggregate Bond Index. You might add in commodities and foreign bonds to the benchmark too in their proper market weight to build a relevant benchmark of what's available. Over time, you'll discover if you're adding or destroying value, relative to what you can earn on a globally weighted index fund comprised of ETFs.
For most of us the lesson will probably be that second-guessing Mr. Market incurs an opportunity cost. The reason boils down to the fact that Mr. Market doesn't bite his nails when prices sink, nor does he celebrate when prices soar. Emotion, in short, gets in the way of even the most disciplined investors. Some of us will be able to beat the odds and improve risk-adjusted returns relative to the true world portfolio; most will fail.
Perhaps, then, the most important investment decision is deciding if you've got what it takes to compete in the arena on a long term basis. History is quite clear on the stakes: if you're wrong on this all-important issue, you'll pay a price, and perhaps a heavy one, albeit 10 or 20 years from now. Like cancer and inflation, such a risk will be almost invisible in the short term. On a day-to-day basis, it's easy to assume that all's well and that your decisions are top rate. But taxes, commissions, and the accumulation of minor mistakes take their toll as the years roll on. Alas, only a relative few of us are up to the task of successfully evading what is otherwise fate for the investment masses. What's more, many if not most of those who pay an opportunity cost may not even know that they've underperformed. Ignorance may be bliss, but it still has a price.
January 2, 2008
A YEAR OF LIVING DANGEROUSLY
Last year will be remembered for many things, but calm investment waters won't be one of them.
One reason is that 2007 witnessed the widest range of performances among the major asset classes since 2000. On top was emerging market stocks, which soared by 36.5% in 2007. At the opposite extreme were REITs, posting a loss of 17.6%--the first down year for the asset class since 1999.
The spread from best to worst last year was a hefty 54 percentage points--the widest since 2000, proving once again that there's always plenty of opportunity (and risk) inhabiting the investment landscape in terms of the broad asset classes.
The fact that REITs finally succumbed to the laws of gravity after seven straight calendar years of gains may or may not signal what's coming in 2008. But if you compare the steep slide in REITs last year against the five-year bull market in emerging market equities that's still ongoing, one can see the outline of a rebalancing opportunity.
Then again, it's probably too early to make hasty, dramatic decisions for portfolio strategy. REITs, after all, defied gravity for seven years. The hope that they're now poised to rally after just one down year may be asking too much. Nonetheless, as a long-term proposition, taking a bit away from emerging markets and redeploying it to REITs looks eminently reasonably, at least at the strategic margins.
Still, your editor expects that additional bargains among the asset classes will surface as 2008 unfolds and volatility continues to rise. The crowd isn't sure if deeper economic troubles are coming, and so the odds for surprises look pretty good.
Meanwhile, we can't help but notice a few intriguing trends that present themselves at the dawn of a new year. That includes the fact that commodities are also boasting five consecutive years of gains. Ditto for domestic stocks and equities in developed nations around the world. Who's willing to bet that all three will make it six in a row?
Alas, the recurring problem of recent years remains intact, namely: What looks attractive? Other than REITs, nothing was clobbered last year, and so there's plenty of debate as to which asset classes, if any, are poised for greatness in 2008.
That said, we're keeping our eyes on high yield bonds at the moment, in part because the asset class's yield premium over the benchmark 10-year Treasury is close to 500 basis points, the highest since 2003. Granted, that spread may not suffice if the economy goes into a recession this year, and junk defaults shoot up.
Perhaps the biggest challenge this year will be the declining yield in cash. Investors are no longer "paid to wait," and so the pressure's on to invest somewhere. As 2007 faded into the history books, our proxy for cash--the 3-month Treasury bill--offered a yield of just 3.36%, down sharply from 5.02% a year earlier.
Nonetheless, 2008 looks set to deliver opportunity for the savvy investor who's prepared to ignore the crowd. No, it won't be easy, nor will gratification come quickly. Indeed, winning the money game in the long run usually requires decisions with limited mass appeal in the short run. How many investors are willing and able to endure such discomfort? Relatively few, if history's a guide. Therein lies opportunity.
With that in mind, bring on 2008!