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March 28, 2008
THE CAKE IS BAKED
It's been tempting to think that maybe, just maybe, the U.S. could avoid recession. Perhaps some divine financial power might intervene and pull the economic coals out of the fire. But such hope, however remote in the first place, should now be packaged away in the file cabinet that holds all forlorn desires.
The recession, by our reading, is confirmed. That will come as old news to readers of these digital pages and anyone else who follows the economic news. Any number of warning signs have been flashing for months, some of which we've discussed. Economic models, by contrast, often dispense robust signals with lags. That's in part due to the fact that economic data is released with a lag. In addition, economic measurements that digest multiple data series are prone to false signals and a fair amount of volatility in the short term. The practical solution is to be patient and wait for a relatively high degree of confidence that the model's warning is more than statistical noise. As such, our own home-grown index has just issued what we think is a valid signal after we updated the last bit of selected February data (personal spending and income). Yes, we've suspected contraction all along, but now we're that much more confident.
Granted, absolute clarity in the dismal science is forever elusive--except in hindsight, when all the data's been revised and economists have scrubbed and rescrubbed the numbers so that the only remaining debate centers on what size font to use for writing the definitive history. That day is still a ways off. Meanwhile, back here in real-time economics, replete with all the usual caveats, the cake looks pretty much baked by this editor's reckoning. It's now time to move on and debate, among other things, how long the recession will last, how deep it will be and what it all means for strategic-minded portfolio design.
Our analysis draws on a number of factors, including our proprietary benchmark (CS Economic Index, or CSEI hereafter) of economic trends broadly defined. As our chart below shows, the downturn is now unmistakable by our metric. The slippage, having started in November and running through February, is four months old, which is exceptionally long and consistent according to our model in recent history. Alas, our system of measuring the broader economy is vulnerable to false signals from time to time and so we've waited until the arrival of four consecutive monthly downturns so as to avoid (hopefully) jumping to rash conclusions. Having reached that threshold, we're confident that the cycle has in fact turned. Again, that's old news in many respects, but in our mind it represents closure in the debate.
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There are a number of other clues corroborating the four-quarter slippage in CSEI but for now we'll simply note that ours is a view that uses a variety of indicators. Meantime, here's a brief description of the index's design.
CSEI is an equally weighted average of 13 indicators populated as follows: 7 leading indicators, 4 coincident indicators and 2 lagging indicators. Examples include the S&P 500, nonfarm payrolls and retail sales. In other words, it's weighted in favor of leading indicators because for this metric we're more interested in where we're headed as opposed to where we've been. Easier said than done, of course, but that's the thinking.
There's nothing magic about the index and certainly it's open to criticism on a number of levels, as is any one metric that seeks to condense something as complex and nuanced as the U.S. economy into a single data series. What's more, your editor is fully aware that countless economic consultancies armed with teams of experts attempt to divine macroeconomic trends and have come up short. Suffice to say, economic forecasting is fraught with truckloads of risk, and more than average in regards to yours truly.
Nonetheless, about a year ago we embarked on a project to build an index that would provide a general reading of the trend in U.S. economic activity. The choice of simplicity in design offers the benefit of transparency while the blending of indicators profiling varying aspects of economic activity holds a degree of promise for minimizing the noise that routinely infects any one data series. Nonetheless, there can be no guarantee that some other variable not included in the index will prove to be crucial. In fact, we're sure of it.
Despite the caveats, we keep studying the numbers, including today's update on personal income and spending, which are included in CSEI. Notably, personal income rose by a solid 0.5% in February, up from 0.3% in January. That's encouraging, although the more relevant metric for the economy outlook in the months ahead is how much of the income is being spent. By that standard, the trend offers more reason to think that economic contraction is real. Personal consumption expenditures (PCE) rose by a scant 0.1% last month, down from January's 0.4%. After adjusting for inflation, PCE was flat in February. Meanwhile, the general trend in real PCE, based on a 12-month rolling average, is unmistakably down, as our second chart below shows.
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Meanwhile, the Federal Reserve is moving heaven and earth in an effort to contain the pain of the cycle. The central bank will surely have some success, but it's not clear that this time around the success will live up to the high expectations set by previous recoveries. Indeed, for the moment, the recent liquidity injections have yet to stem the tide of slowdown. In addition, it gives us pause that the Fed has been early in the cycle in delivering its monetary medicine and still the patient remains wobbly. And at some point, the injections must end, perhaps earlier than expected depending on inflation's future path. If so, the recovery may disappoint. But we're getting ahead of ourselves. For now, it's all about monitoring the contraction.
Posted by jp at 10:58 AM | Comments (0)
March 26, 2008
RECONSIDERING "D" RISK
The Fed's current monetary policy looks reckless only for those who see inflation bubbling. The same monetary policy looks prudent, even prophetic for those who see deflation as the dominant risk.
Our bias, for what it's worth, leans toward inflation, as our posts over time suggest, such as this one. And we're not alone. That doesn't make us right, and to the extent that the crowd's on board with this idea gives us pause. Nonetheless, from what we can tell, inflation risk looks to be the bigger threat, although that view is contingent on a future of a fairly orderly downturn in the business cycle followed by a somewhat routine recovery in a timely manner.
As for the belief that the crowd's thinking inflation: one clue is found in the rush into inflation-linked Treasuries. The iShares Lehman TIPS, for example, posts a 12.9% total return for the year through last night's close, according to Morningstar.com. That's far above the 7.6% total return for nominal bonds overall during that span, as per the iShares Lehman Aggregate Bond. Another sign that inflation expectations have deep roots: the bull market in commodities prices. The iPath Dow Jones-AIG Commodity ETN, for instance, boasts a total return of more than 25% for the past year.
One can surmise that inflation fears have the market's attention, but it would be wrong to say that alternative views are absent or even misplaced. Indeed, some believe that deflation risk is relatively high and rising. Leading this charge is the deflation master-in-chief: Fed Chairman Ben Bernanke.
It certainly helps seeing Bernanke's aggressive easing strategy in a prudent light if deflation is a real danger in the foreseeable future. If so, dropping interest rates quickly and dramatically looks like a reasonable strategy for minimizing the potency of the approaching deflationary forces.
Then again, if inflation is the bigger threat, Bernanke's current game plan looks rash if not irresponsible.
Alas, no one knows what's coming and so we're all--central bankers included--reduced to guessing, a.k.a. forecasting, predicting, etc. Some guesses are better than others, perhaps because some guesses are better informed than others. Still, in real time it's hard to tell one from the other absent the passage of time.
No wonder, then, taking a neutral view of investment strategy has its merits, along with a fair amount of finance theory on its side. In this case, neutrally oriented investors will build a portfolio of all the major asset classes in their appropriate market-valued weight and leave asset allocation among those groups to Mr. Market from here on out. Meanwhile, this risk portfolio's relative weight to a risk-free fund--T-bills, for instance--should be adjusted to account for the investor's general preferences for risk. The total package is at once neutral on the outlook for risk and designed with the investor's particulars notions of risk in mind. Come inflation, deflation or whatever, this is the default portfolio for all seasons for an investor who has no particular view on the future.
Perhaps it's no wonder that few investors subscribe this strategically neutral view of the world. Ill-advised or not, that's the way the world works. We bring this all up only to put the strategic outlook in perspective and remind that unless you're a neutrally inclined investor, you're making a bet. Some will lose, some will win. So it goes. Bets vary by degree, of course, and some of us are making larger or lesser bets than others and so we'll all be rewarded (or pinched) accordingly.
With that in mind, the inflation/deflation question looks like one of the bigger issues weighing on future results for investment strategy. Simply put, the stakes are high in deciding if Bernanke's right or wrong.
The Fed is again focused on deflation risk for the second time in this decade. The first time--2001-2003--Bernanke was the point man under the Greenspan regime. It's fitting that Bernanke is a student of deflation in economic history, and it may explain why he's so focused on the risk. In any case, it turns out that the Fed was wrong about deflation the first time around, and the error came with costs. There's a case to be made that real estate boom that's now deflating was a direct consequence of the easy money policies associated with the deflation fight of 2001-2003. In defense of the Fed, one could say that the U.S. was far from alone in promoting easy money policies, in which case one might surmise that the Fed's deflation focus was driven by global economics rather than local events. (In fact, some argue that the deflation risk was quite real a few years back and the only reason that it didn't bite is because the Fed acted pre-emptively.)
Today, the Fed is leading us into another battle against deflation, real or perceived. The problem is that assessing deflation's true risk potential requires knowing how bad the current correction will (or won't) be. There's little doubt that if the economic downturn now underway is deeper and longer lasting than the crowd expects, the deflation threat is higher than is generally realized.
The bottom line: deciding if deflation is or isn't a threat depends on your expectations for the cyclical downturn now underway. All the usual risks apply, of course, and so it's every strategic-minded investor for himself. Meanwhile, perspective helps improve the odds of making intelligent decisions, or at least decisions that are less erroneous than others. Maybe.
On that note, we recommend a recently published commentary that parses deflation's risks in some detail. Brian McAuley, portfolio manager at Sitka Pacific Capital Management, does a nice job of summarizing where we are now, we're we've been and what it implies for the future. Although he writes as someone apparently worried about deflation, everyone should give his paper a read if only to gauge how the view from the other side of the aisle, so to speak, sees the future. Here are two excerpts from McAuley's essay:
--With all that has been going on the in the markets with the continued housing decline and the credit market problems, the Fed has over the past two months made their intentions quite clear. As they're fully aware, this is a very risky time for the U.S. economy – and not just because average housing prices are down close to 10% year-over-year. They understand that our current circumstances are similar to past instances in economic history where a major economy faced significant deflationary risks.
--Given our debt burden, the Fed understands very well the deflationary risk if prices fall too far for too long. Not only is there is a risk of debt service overwhelming current aggregate demand, there is also the risk that the psychology of consumers and businesses would begin to change from an inflationary attitude of “buy now and pay later” to a deflationary “save now and buy later.” In an economy in which 2/3 of GDP depends on “buy now,” the Fed will do everything in its power to prevent this from happening.
Posted by jp at 10:20 AM | Comments (1)
March 24, 2008
DEFAULTING THROUGH HISTORY
Risk comes in two basic flavors in the realm of finance: the expected and the unexpected. There's no obvious fix for the latter, other than remembering that a black swan can fly into your financial life without warning. That implies some basic preparation, like keeping a stash of cash. Expected risks, in theory, may be easier to grapple with. Single-security risk, for instance, is easily minimized with diversification. But other expected risks can be more problematic, as we're reminded in a new paper that surveys financial crises over the centuries. Indeed, a recurring risk can be a tricky adversary if its reappearance schedule unfurls in s-l-o-w motion, in which case it's easy to dismiss/ignore the threat potential as nonexistent.
"Major default episodes are typically spaced some years (or decades) apart, creating an illusion that 'this time is different' among policymakers and investors," advises "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises," a working paper by professors Carmen Reinhart (University of Maryland) and Ken Rogoff (Harvard).
The central message: the relative macroeconomic calm of the past generation isn't necessarily written in stone. It's easy to think otherwise, of course. So it goes for cycles that unfold over long stretches. Lulling otherwise prudent investors into a false sense of security is as old as markets, and so it should surprise no one that many look to the recent past and extrapolate that as fact for the future.
Readers of these digital pages know that your editor has a warm spot for studying cycles and looking for the historical perspective, such as our post back in 2006 that considered a research paper looking at the history of 20th century economic booms. Perspective is a valuable thing, or so we believe. But it can be akin to watching grass grow if you're wondering what to do now, this minute. No, historical perspective won't help much for day trading, but maybe, just maybe, the long view promotes a healthy respect for risk. And that respect may one day save your financial life.
Risk management is, alas, a thankless task and widely dismissed as an unhealthy obsession with the pessimistic side of life. The same could be said of fire insurance. Indeed, the ideal outcome is that one's efforts in risk management were all for naught. Unfortunately, such wisdom is only available as hindsight, suggesting to reasonable minds that the only solution is to engage in risk management techniques that may never prove their worth.
With that in mind, consider three charts from the Reinhart and Rogoff paper. The first, reproduced below, shows the historical incidence of default/restructuring episodes in government debt on a global basis since 1800. The obvious feature of the chart is the cyclical pattern, albeit one that unfolds slowly to a degree that may render it virtually imperceptible in real time to the unaided eye. Indeed, the last big surge in defaults and restructurings in sovereign debt came during the emerging market debt crises of the 1980s and 1990s.
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Source: "This Time is Different: A Panoramic View of Eight Centuries of
Financial Crises," by Reinhart and Rogoff
That may be ancient history to some, but studying the recurring nature of such episodes reveals several related trends worthy of deeper analysis, Reinhart and Rogoff report. "Our extensive new dataset also confirms the prevailing
view among economists that global economic factors, including commodity prices and
center country interest rates, play a major role in precipitating sovereign debt crises," they write. Given the recent surge in commodity prices, the observation may be particularly timely.
The authors also point out that there's been far too little attention to how much domestic debt (as opposed to foreign debt that's owned by offshore investors) influences the general trend in defaults and restructurings. As the paper explains,
The forgotten history of domestic debt has important lessons for the present.... most investment banks, not to mention official bodies such as the International Monetary Fund and the World Bank, have argued that even though total public debt remains quite high today (early 2008) in many emerging markets, the risk of default on external debt has dropped dramatically, especially as the share of external debt has fallen. This conclusion seems to be built on the faulty premise that countries will treat domestic debt as junior, bullying domestics into accepting lower repayments or simply domestic to external debt in overall public debt is cold comfort to external debt holders. Default probabilities probably depend much more on the overall level of debt.
The punch line is that the overall level debt is quite high, as the second chart from the paper below reminds.
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Source: "This Time is Different: A Panoramic View of Eight Centuries of
Financial Crises," by Reinhart and Rogoff
Meanwhile, default and inflation share a troubling history, as the third chart from the paper illustrates (see below). The historical record shows a "striking correlation between the share of countries in default on debt at one point and the number of countries experiencing high inflation (which we define to be inflation over 20 percent per annum)," Reinhart and Rogoff write. Given the recent news of rising inflation in economies around the world, this last point is, at the very least, a timely reminder to keep history's lessons in mind.
click to enlarge
Source: "This Time is Different: A Panoramic View of Eight Centuries of
Financial Crises," by Reinhart and Rogoff
The paper's central lesson is that investors as well as policy makers shouldn't ignore the historical default/restructuring cycle in government debt. Alas, that bias seems to be the path of least resistance, we're told. The idea that "it's different time" is forever new. Nonetheless, accepting without reservation the notion that the world and human behavior has changed still carries all the usual caveats in finance and probably always will.
Posted by jp at 10:06 AM | Comments (3)
March 21, 2008
CAUTIOUS OPTIMISM & NAGGING PESSIMISM
It's probably too early to call a bottom in global equity markets, but the thought is tempting after looking at the past week and discovering that we're still standing. Survival is always a confidence builder.
Still, this is no time to be a roaring bull, although some degree of optimism may be just the ticket.We're oriented toward a contrary approach to portfolio strategy generally speaking, but that's tempered by a healthy respect for risk and reward. And there's still a lot of risk lurking in the global economy, and a fair amount of that continues bubbling within the U.S. In short, we still think the remainder of 2008 will be a challenging year on a number of fronts. That leads us to favor oppotunistic nibbling in asset classes where the margin of safety is relatively higher than, say, a year ago.
That said, it's tempting to think that the point of maximum stress for the capital markets has come and gone this week. The Bear Stearns implosion a few days back promises to be the poster child for the current correction, much as Long Term Capital Management and Enron were for past purges.
Of course, there's no way to say for sure if even greater hazards await. A number of economists we chat with regularly say that there's still a risk that the current troubles in the U.S. could linger longer and cut deeper than the crowd expects. We're told that the hangover from a generational accumulation of debt on the consumer level is one potential trouble spot for the years ahead.
More immediately, the liquidity crunch in the financial sector is another issue, although some cautious pundits are now saying that the worst on this front may have passed. Meanwhile, the sharp drop in commodities this week, much of it coming yesterday, is encouraging some to see the glass as half full rather than half empty. One example of the emergence in the past few days of cautious optimism--if we can call it that--in some corners is evident in a Bloomberg News story today titled "Commodities Drop, Rally in Dollar, Stocks Vindicate Bernanke." "Bernanke took care of the commodity bubble,'' says Ron Goodis, the retail trading director at Equidex Brokerage Group, in the article. "Commodities are coming back to earth. The stock market looks OK, and Bernanke is starting to look a little better.''
Another quote in the Bloomberg story: "Clearly they've gotten some stability,'' opines Keith Hembre, chief economist at FAF Advisors "You have to stand back and say, for the time being, it looks to be a pretty successful combination of moves that have worked.''
We're not willing to go that far, at least not yet. Nonetheless, no one should discount the possibility that equities could stage a rally in the coming days and weeks. And even if the bear continues to roar later this year, there's reason to think that maybe, perhaps, the second half of 2008 will deliver relative stability.
Barclays Capital pitched the idea of recovery, albeit cautiously at a press briefing yesterday in New York. This writer sat in on the presentation and heard the argument that the Fed will do whatever it takes to insure that the current liquidity ills among banks don't get any worse. So said Larry Kantor, head of research for Barclays Capital in the U.S. Although he recognized on Thursday that "we're in the middle of a financial crisis," he suggested that there's reason to think that the crisis won't deteriorate further and that in the near future the pressures may start to ease considerably.
Kantor reminded that the value of assets in the eye of the current storm reflect both the underlying intrinsic worth and liquidity, and it's been the absence of the latter that's weighing on the financial sector. If the Fed can remove this weight, it'll go a long way in lowering prospective risk, Kantor explained. What's more, he said the odds of the Fed succeeding look pretty good now that the Bear Stearns debacle has passed without (as yet) a secondary effect. Certainly the outlook looks better now compared to Monday morning, when the Bear Stearns news hit. And so Kantor said that the odds of another Bear Stearns collapse are much lower now by his reckoning.
Meanwhile, Kantor notes that the stimulus checks that will soon be sent out by the U.S. Treasury to taxpayers will help juice the economy, if only slightly, later this year. He adds that corporate balance sheets are in good shape and employment rolls are far from being bloated so the odds of big layoffs may be lower than usual relative to past cyclical downturns.
Maybe, maybe not. Only time can say for sure. Meantime, the case for limited buying on any future dips in equities looks reasonably compelling. With that in mind, here's a broad look at how the global equity markets have fared so far this year. Every major region is deep in red ink, although the pain is more acute in some areas. The emerging markets in Asia have been especially pummeled, as our chart below shows. As of last night's close, emerging Asia is down 20% in dollar terms so far in 2008, according to S&P/Citigroup Indices. On the other end of the spectrum is Latin America, which posts a relatively modest decline of roughly 6% in total return terms.
Finally, let's recognize that a recovery will eventually arrive. But when it does, and perhaps well before the upturn is obvious on Main Street, interest rates are likely to rise, perhaps quickly and sharply. Why? Inflation.
As we discussed last week, pricing pressure is bubbling. Falling commodity prices may take the edge off the trend, but it's not clear that inflation risk is about to evaporate. If there's a modest recovery later this year or in early 2009, the Fed will be under enormous pressure to hike rates. So, yes, there's reason to look past the current ills and consider the broader cycle, but let's not go crazy. There's no easy escape this time from the macroeconomic box that currently hems in the capital markets.
Posted by jp at 9:51 AM | Comments (0)
March 20, 2008
THE TOP 10 INVESTING IDEAS
We couldn't have said it better. In today's Wall Street Journal, Brett Arends does a stellar job of summarizing the core ideas behind investment success from a strategic perspective. Although we quibble with one (can you guess which one?) and would prefer to see another point added (hint: we're a fan of betas), this list is otherwise a keeper. Here's an edited listing of the main ideas, which shine in the aggregate (no cherry picking, please). Meanwhile, we recommend reading the full article.
1. Invest during a panic.
2. Don't speculate.
3. Don't make too many bets.
4. Be very wary of any boom.
5. Don't put too much weight on expert financial analysis.
6. You don't need to pick individual stocks.
7. Invest in stages.
8. Only invest for the long-term.
9. Consider picking a really good active fund manager to make your bets for you.
10. Finally, if you're simply too afraid of taking any risks at all -- try thinking about what inflation is going to do to you if you sit in cash on the sidelines.
Posted by jp at 6:12 AM | Comments (0)
March 19, 2008
DISSENT IN THE RANKS
As dissension in central banking goes, yesterday's discord was fairly tepid but significant nonetheless.
The Fed's whopping 75-basis-point cut on Tuesday, which lowered the Fed fund rate to 2.25%, was approved by eight and questioned by two. Richard Fisher and Charles Plosser raised doubts about the wisdom of FOMC majority's analysis by voting against the rate cut. Quoting yesterday's FOMC press release, we're told that the two holdouts on easing "preferred less aggressive action at this meeting."
Voting FOMC members who voice opposition to the Fed's will, in fact, has become routine of late. Since the central bank starting cutting rates last year, there have been dissents each and every time. In the last five FOMC meetings, four of the dissents were in favor of either no cut or a lesser cut. (The fifth dissent was actually in favor of an even bigger cut).
That compares with the previous run of unison in FOMC voting. By the standards of recent history, the rise of dissension in the ranks suggests that it's less than obvious that slashing interest rates is a no-brainer in the minds of those who steer the world's most important central bank.
Fisher, president of the Dallas Fed when he's not casting votes in the FOMC, has now voted nay twice this year. Reviewing his public comments in recent months leaves no doubt that he's more worried about inflation rather than slow economic growth and Wall Street credit ills.
Speaking in London a few weeks back, Fisher laid out his bias in no uncertain terms when it comes to choosing the central bank's priorities at this point in the cycle. "Containing inflation is the purpose of the ship I crew for," he asserted via DallasNews.com. "And if a temporary economic slowdown is what we must endure while we achieve that purpose, then it is, in my opinion, a burden we must bear, however politically inconvenient."
No one questions that inflation is higher these days, although there's still lots of debate about where inflation's headed. So it goes in trying to see the future by looking at the past. That said, the leading force for seeing the glass half full rather than half empty is the institution that oversees the integrity of the currency.
Officially, the Federal Reserve expects that inflationary pressures will soon ebb. "Inflation has been elevated, and some indicators of inflation expectations have risen," yesterday's FOMC advised. But the release goes on to dismiss the idea that the trend deserves to derail the policy of printing more money, at least for the time being: "The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization."
It's no great challenge to find supporters of the Fed's easing. Robert DiClemente, chief United States economist at Citigroup, for example, wonders how much inflation risk lies ahead. "I’d like to know how you’re going to get inflation in an environment with suffocating financial restraint and pervasive slowing in demand," he tells The New York Times today.
To which we respond, be careful what you ask for. Yes, there's the possibility that the combination of a credit crunch and weakening economy will conspire to lessen demand generally, which in turn may drive prices lower. Meantime, the statistical evidence leans to the contrary in consumer and wholesale prices.
Still, as yesterday's massive rally in the stock market suggests, there's a natural focus on how the liquidity injections will eventually counter the credit problems and economic downshifting. The prospect of another Fed-led recovery keeps optimism alive and no one should dismiss the powers of the central bank to engineer growth. The Fed wants a recovery, and will do everything in its power to engineer one. And the economy has yet to really fall into the cyclical ditch, despite what we read in the newspapers. Yes, there are problems, and those problems could create a chain reaction of trouble. But so far, as downturns go, this one is still pretty mild, judging by historical standards. No matter, the Fed has already come out with monetary guns ablazin'. Maybe Bernanke should just drop Fed funds another 225 basis points and be done with it.
Last we checked, however, there's still no free lunch, in macroeconomic spheres or anywhere else. The conflicting forces of recession and inflation are now engaged, and one or the other may soon give way, which will unleash the next stage of the cycle. The clash is evident in the fact that while the stock market soared yesterday, the bond market became a touch more skeptical about the Fed's strategy. The yield on the 10-year Treasury jumped yesterday by nearly 14 basis points. Perhaps it's significant that the 10-year yield has now twice made a recent low in the 3.30% range and twice bounced higher immediately after, as this chart reminds. At least one corner of the capital markets reserves judgment on inflation's course.
Indeed, strategic-minded investors may also want to consider what awaits if the Fed's successful in sparking stronger growth in the economy. Might Bernanke and company feel compelled to take away the proverbial monetary punch bowl later this year or early in 2009 if the apocalypse is averted? If so, what are the implications for stocks, bonds and all the major asset classes?
Posted by jp at 10:08 AM | Comments (0)
March 17, 2008
PERSPECTIVE IS STILL THE MOST VALUABLE COMMODITY
The Bear Stearns fire sale over the weekend is just the latest example of how cycles impart pain as well as pleasure. Pain for all those shareholders who shunned diversification and pleasure (of a kind) for JPMorgan Chase, which has bought Bear Stearns for the equivalent of $2 a share, a 93% discount to Bear's closing price on Friday and a universe below last year's roughly $160 peak set last summer.
The financial industry up until about six months ago could do no wrong. For five years, financial stocks were flying, convincing many that the trend was enduring. For years, the finance sector comprised the largest weight among the 10 sectors in the S&P 500 and analysts spared no expense in making arguments for why the trend reflected a new world order that would stand the test of time.
But, oh, how the mighty have fallen. Financials' market cap now represents about 16% of the S&P 500 overall, down from 21% a year ago.
It all began to change last summer. The details are complicated, but the basic explanation is that the death of cycles has been greatly exaggerated. Ignoring this basic truth has brought trouble if not ruin to many, and for longer than some care to recognize. Prudent investing is as much about planning for cyclical peaks and troughs as it is about riding the wave of bull markets between the two points of extremes when the only risk appears to be falling behind in relative performance.
But the danger of letting emotion replace analysis and perspective is a two-way street. If it was all too easy to ignore the buildup of risk in the markets during 2002-2007, now it's tempting to focus exclusively on the potential for loss. In fact, there is always a mix of risk and reward embedded in the world's major asset classes. The reality is that the mix is in continual flux. Some assets always offer better terms than others. In fact, it's the strategic and tactical blending of these assets (with an eye on valuation and respect for rebalancing and diversification) that wins over multiple cycles. The price of entry, however, is that one can't embrace such notions at the 11th hour and expect to come out smelling like a rose. It's only through a number of cycles that the wisdom of strategic thinking bears fruit.
Then again, it's never too late to face reality. After all, the remainder of your life's investment results starts now. Job one is recognizing that breaking the fundamental principles that govern success and failure courts disaster--eventually. Within the time period between the outer bounds of any given cycle, the illusion that something has changed is a powerful force. But it's a force for capital destruction. Perhaps what's so fascinating and frightening about these illusions is that there's overwhelming evidence in history that they're recurring and that naive investors are disabused of thinking otherwise once the cycle turns.
And yet there's always a fresh crop of believers all too willing to think it really is different this time. But while the crowd's wisdom itself may be cyclical rather than cumulative on Wall Street, there's no reason that any one investor has to embrace the lemmings-into-water mindset. Financial fate is largely determined by every investor's decisions, or lack thereof.
Easy to say, hard to achieve with favorable results, of course. It was easy to think that tech stocks were the equivalent of low-risk perfection in 1999. It was easy to see real estate as a sure thing in 2005. It was also easy to think that the world was coming to an end in 1974 and 2002.
There's quite a bit of financial truth in Santayana's dictum that "Those who cannot remember the past are condemned to repeat it." If finance was medicine or engineering or paper manufacturing, the lessons of history would lead to enlightenment and progress. But because money is money, and greed and fear are a perennial toxin that ravages common sense, all too many otherwise intelligent beings will keep making the same basic mistakes, again and again.
Sad but true, although this durable truism also creates opportunity for those who heed the lessons of the past and take a longer-term view of cycles. And if our suspicions of late prove accurate, the current turmoil will bring opportunities of substantial magnitude. That assumes, of course, one's able and willing to take advantage of the prevailing opportunities as they unfold in the coming weeks, months and, yes, perhaps even years.
Posted by jp at 10:05 AM | Comments (0)
March 14, 2008
A QUESTION ABOUT TODAY'S CPI REPORT
Is something amiss in the energy statistics in today's CPI update?
The question comes to mind after reading the press release for the report on consumer prices in February. In particular, the CPI's "special" energy index posts a 0.5% decline for last month, which presumably is a contributing factor for why CPI inflation overall is reported as unchanged for February. Given all the chatter about inflation risk of late, the news that the CPI change last month was zero is surprising, at least to this reporter. Even more surprising is the reported decline in energy prices as per the CPI numbers, a drop that contrasts with the sharp increases in spot prices in February 2008 for four primary energy commodities, according to Barchart:
crude oil: + 11.0%
gasoline: +7.5%
natural gas: +12.5%
heating oil: +12.3%
The first step in trying to explain the gap is that the spot price changes are nominal fluctuations whereas the CPI energy index decline is "seasonally adjusted." But adjusting for seasonality is, at best, only a partial solution since CPI's "unadjusted" energy index also fell in February, albeit by a relatively modest -0.1%.
Unsatisified, we called the Bureau of Labor Statistics in search of deeper statistical contentment. The resulting explanation can be traced to several reasons, we were told by one dismal scientist on staff. He suggested the possibility for a slight--he emphasized slight--bias in the timing of data collection. He also noted the seasonality factor in the data. Take gasoline, which makes up about 60% of the CPI energy index. The unadjusted one-month price change for gasoline as per the CPI report is -0.6% as opposed to a seasonally adjusted -2.0%. "So there's some seasonal factor that's pulling it down as well," he said.
Meanwhile, to repeat: spot gasoline prices rose 7.5% last month via Barchart. To which we respond with a formal, hmmm.
Our economist at the Bureau reminded that no one should confuse nominal pricing with seasonally adjusted pricing. "That's a little bit of the explanation." Nonetheless, he admitted, "I was a little surprised at the gasoline data myself."
The economist said too that while gasoline represents about 60% of the CPI energy index, the remaining 40% weight in the energy index is natural gas and electricity. Natural gas prices were up in Feburary, but for the moment your editor doesn't have access to electricity prices and so there's the possibility that this may be the missing piece of this puzzle. Perhaps, although for the moment we don't know. Contentment will just have to wait.
Posted by jp at 4:17 PM | Comments (0)
RESPITE OR REVERSAL?
Today's update on consumer price inflation brings good news for the trend in February, and not a moment too soon. CPI was unchanged last month, the Bureau of Labor Statistics reports. That's a sharp deceleration from recent months.
"On a seasonally adjusted basis, the CPI-U was virtually unchanged in
February, following a 0.4 percent rise in January," according to the Bureau's press release. "Each of the three groups--food, energy, and all items less food and energy--contributed to the deceleration."
Now begins the debate over whether the welcome news marks the end of the recent surge in pricing pressures that have been bubbling for the past year or so. It's tempting to think that the inflation scare has passed and that it was all just normal CPI volatility within a range. Anything's possible, of course, but we're skeptical that it's safe to ignore inflation risk from here on out. Still, one can't fully discount the possibility that the pricing fires are cooling, if only temporarily. As always, only time will tell, leaving earthlings with the thankless task of speculating with incomplete information.
Ideally, our speculations are rooted at least partly in a sound reading of the data and a respect for market history. Even so, that leaves plenty of room for error, which is why our default position is always staying diversified, in varying degrees over time, in the primary asset classes.
To the extent that inflation factors into our strategic asset allocation, we remain suspicious that the danger has passed. Our skepticism begins with the old saw that one month a trend does not make. In any one period, the possibility for statistical noise is high--and that's true for any data series. One can partially minimize the noise by looking at longer measures of change over time. By that standard, it's hard to ignore CPI's annual rate of change that, even with February's flatlining, is still running above 4%. Although that's down slightly from the recent past, a 4%-plus inflation pace is hardly benign.
Notably, it's the general trend that offends. As our chart below reminds, the sharp rise in the annual change of CPI of late is at the core of our worries. Plotting the linear trend (as per the chart's black line) reminds that pricing pressures have been on the rise for some time. Inflation in absolute measures still remains modest by historical standards, but we should remember that small brush fires can turn into something more if left unattended.
But if headline CPI offers compelling evidence to stay wary on inflation's upside potential, the trend is more favorable if we restrict our analysis to core CPI, which excludes food and energy prices. Why would we do that? For starters, that's the Fed's preferred measure of inflation and, to be fair, the preference enjoys some historical rationale. The case for using core inflation as a benchmark for monetary policy boils down to the fact that in the past, core has been a superior predictor of future inflation than headline. That's because food and energy prices were more volatile than the other components and so by looking at core one saw a clear, less statistically noisy inflation trend. In other words, prices bounced around a lot but over, say, five years they didn't usually change much. The proof is that in the past, core and headline inflation have generally converged over time.
The conceit is that food and energy prices will continue to be volatile but more or less trendless. If so, core may continue to offer a better gauge of expected inflation trends than headline. But if food and energy are now in the early stages of a secular bull market, the case for favoring core breaks down.
That said, core CPI's trend looks relatively encouraging these days compared to headline. The linear trend for the 12-month rolling percentage change in core (as per the second chart below) is essentially flat for the past 10 years vs. the upward sloping trend for headline over the same time period. And while the latest 12-month core CPI rate of 2.3% as of February is still a bit hot for the Fed, the good news is that it's trending down.
The great debate in real time is whether food and energy prices will continue to trend higher. Alas, this question can only be answered over a period of years. Even if energy prices stayed flat or dropped sharply in the coming months it wouldn't necessarily offer definitive evidence that core was still a robust predictor of future headline inflation. Similarly, it's not clear that higher energy and food prices in the next six months would kill core's value as an inflation predictor.
This much, at least, is clear. Looking at the past five years shows that core has been a poor predictor of headline inflation as we write today relative. The reason, food and energy prices have trended up for longer than many economists thought probable and so core CPI wasn't a good measure of expectations on headline. Will that continue for the long term? Once we know the answer to that, we'll know the deeper meaning to February's CPI report.
In the here and now, there are only guesstimates, and our guesstimate is that food and energy prices will trend higher in the years ahead. But that's just a guess. Yes, it's one we believe can be supported by the economic and financial trends of recent history. But we may be wrong, which keeps us from betting the farm on higher inflation. Nonetheless, we favor some prudent hedging of our asset allocation strategy. Mere mortals don't really have any other compelling alternatives.
Posted by jp at 10:34 AM | Comments (1)
March 13, 2008
TWO MORE CLUES
There are at least two more reasons to worry and wonder about the future, judging by today's data updates. Import prices and retail sales provide fresh incentives to stay cautious.
Let's start with import prices, which are now rising by 13.6% a year as of last month, the U.S. Bureau of Labor Statistics reports. That's sky high by recent standards, as our chart below shows. Energy imports are, of course, driving the trend, although non-petroleum import prices are also rising at a robust pace of 4.5% over the past year. By comparison, U.S. consumer prices rose by 4.3% for the year through January. Any way you slice it, the United States is importing inflation, adding momentum to the domestic inflationary fires already smoldering.
Meanwhile, retail sales took a hit last month, according to the U.S. Census Bureau, falling 0.6% in February. That's the steepest monthly decline since last June. More worrisome is the longer-term trend. As our second chart below illustrates, year-over-year retail sales continue slipping, as they have been for the past two years.
From a price stability perspective, lowering interest rates looks irresponsible at this point. With inflationary pressures bubbling, printing more money will only add fuel to the trend. Indeed, the dollar continues to weaken, which is helping pump up import prices. If the Fed continues to cut interest rates, the buck may plumb even lower depths. The U.S. Dollar Index is already at all-time lows, and no one should discount the possibility that more selling awaits.
But what's irresponsible from the perspective of monetary policy may look necessary from another vantage. The Fed is under growing political pressure to inject more liquidity into the economy and slow the slowdown. It remains to be seen how effective the central bank's tools are for the task at hand. Meanwhile, the market expects lower rates: the May '08 Fed funds futures contract is priced in anticipation of a 100-basis-point drop in Fed funds.
Commodities and foreign bonds denominated in currencies other than the dollar will probably fare well in this climate, although the strong gains in those asset classes don't encourage us to favor huge overweights in those areas. In fact, paring back weights in foreign bonds and commodities looks more prudent as prices in those areas runs higher. Meanwhile, stocks and domestic U.S. bonds still look vulnerable and the TIPS market has already enjoyed a strong run over the past year.
Strategic investors may reason that the best action is standing back and letting the process unwind. Corrections eventually burn themselves out, the only question is when. By your editor's reckoning, it still seems early. The system hasn't been sufficiently purged. Meanwhile, the Fed must at some point hike interest rates to soak up the liquidity it's throwing around to stave off recession and ease the credit crunch. It's unclear when those hikes will come, but when they do the markets will have a yet another challenge to digest.
In short, this story has a ways to go. Meantime, defense is still the priority du jour.
Posted by jp at 10:25 AM | Comments (0)
March 12, 2008
THE TROUBLE WITH BUSINESS CYCLES
Yesterday's powerful rise in the stock market offers an easy target for rationalizing that the five-month-old correction in equities is over. Perhaps, but your editor is suspicious.
Yes, there's no getting around the fact that yesterday's 3.7% jump in the S&P 500 is one of the better daily gains on record. But the human mind is too easily influenced by the most recent events while minimizing older trends. For our money, the older trends are still in force, which is to say that all the obvious threats to a sunny outlook for stock prices still apply: Higher energy prices, continuing fallout from real estate, the accumulating evidence of an economic slowdown or worse, and so on. All of these items, and more, threaten to weigh on the stock market in the weeks and months ahead. One more Fed decision intent on liquefying the otherwise gummed-up credit market doesn't materially change much for this writer's intermediate term outlook.
Yes, the Fed's accumulating actions will eventually be a contributing factor that turns the strategic sentiment to positive. But the idea that this moment arrived yesterday afternoon looks slightly premature.
That's only a guess, of course, and so the new bull market may be underway as we write. The S&P 500 was off roughly 15% as of yesterday's intraday low from the all-time high set last October. That's hardly trivial. But considering the context of the last several months, one can reason that the selling is driven by the fundamental deterioration in general economic conditions. If so, the central question is whether those deteriorating conditions have ended or are about to end in the near future? On both counts, our forecast is "no."
Again, we have no way of knowing for sure and so one shouldn't fully discount the possibility that the stock market's headed for higher ground. In fact, there's an inherent danger in assuming that economic cycles and stock market cycles align in real time. In fact, they very definitely do not. That's an important caveat to keep in mind in the months ahead. The risk of being early or late is forever present in timing the bottom, which convinces us to diversify strategic and tactical bets over time as a tool for grabbing the opportunities that corrections inevitably offer while keeping risk at bay.
If the past is any guide, the stock market will be looking for signs that the economic pain is over. The market, as a result, may repeat its former glories by anticipating the recovery well ahead of the statistical evidence that the recovery is written in stone. In other words, waiting for clear and compelling evidence that economic growth is accelerating risks missing a sharp rise in the stock market that anticipates the rebound.
Or not. Sometimes the market divines the rebound in advance, sometimes not. Much depends on the context. Timing is important, of course, but no one should assume there's an iron law that makes investing in real time obvious based on drawing lessons from the past. That's unsurprising since every business cycle begins, unfolds and ends for a variety of reasons that have limited, if any, relationship over time.
Consider the past two recessions, as defined by the National Bureau of Economic Research. The 1990-1991 recession and the 2000-2001 recession were identical in length--eight months. But the timing ideal was different in each for winning the investment race.
For each downturn, we looked at four different timing decisions using the Russell 3000 as a proxy for the U.S. stock market and the monthly start and end dates for the recessions, as per NBER:
* The EARLY strategy: buying the Russell 3000 three months before the onset of recession.
* The START strategy: buying the Russell 3000 at the end of the month for which the recession starts.
* The DURING strategy: buying the Russell 3000 three months after the onset of recession.
* The AFTER strategy: buying the Russell 3000 at the end of the month in which the recession ended.
In all four cases, we computed returns as of 12 months after the official end of the recession. The results:
In the 1990-91 recession, the DURING strategy was the clear winner, delivering a 45% cumulative gain. The worst-performer was the AFTER strategy, posting a cumulative rise of 13%.
The tables turned in the 2000-01 recession, which witnessed the AFTER strategy in first place, albeit a meager one with only a 4% cumulative rise. Meanwhile, the EARLY strategy was a loser in absolute and relative terms, imposing a cumulative loss of 26%.
In fact, our research shows that as we analyze business cycles further back in history, the random results among the four strategies listed above remain intact. The lesson is that every business cycle is different as are rules for timing the cycles with an eye on maximizing the potential for gain. No surprise, really, as this is just one more way of reminding that the future's always unclear.
That leads us back to our belief in gradualism in adjusting a multi-asset class portfolio to take advantage of prevailing conditions. As asset classes become more, or less, attractive over time, strategic-minded investors should make tactical shifts accordingly. But just as we're loathe to bet the house on any one asset class, we're equally suspicious of making just one tactical adjustment in asset class weights at any one point in the cycle. The reasoning boils down to our view that, We're all risk managers now.
Posted by jp at 10:57 AM | Comments (0)
March 10, 2008
ANY BARGAINS YET?
Markets correct, valuations become more attractive and expected returns rise. It's no short cut to quick riches, but paying attention to valuation offers strategic-minded investors the opportunity to improve risk-adjusted returns compared to simply buying and holding.
Savvy investors have long preached no less. Graham and Dodd's Security Analysis is the bible for analyzing securities in search of market prices trading at less than intrinsic value. The academic literature has increasingly come around to this perspective over the past 20 years as well. Buying low and selling high, in short, boasts support from both practitioners and academics. What works for individual securities looks no less appealing for broader measures of equities and asset classes too.
The devil, of course, is in the details. While it's easy to argue that buying low and selling high is the only way to fly, there's the perennial problem of timing. The mere arrival of higher-than-average dividend yields, or lower-than-average p/e ratios is hardly the investment equivalent of blasting the all-clear signal. Stocks can get cheaper for longer than a sunny optimist assumes. That doesn't mean we should ignore valuation; rather, we must understand the potential risks as well as rewards that come with shopping for value.
With that in mind, we present a brief history of trailing dividend yields for equity markets in the developed world as of last month's close. As the chart below shows, valuations look relatively more attractive today compared with the past two years. Europe is particularly alluring compared with the U.S., according to S&P/Citigroup Global Equity Indices.
click to enlarge
Meanwhile, our second graph below shows that forecasts of p/e ratios for the fiscal year ahead also compare favorably these days relative to the recent past. Europe is also out on front on this metric: its forward p/e dropped to 11.4 as of February's close--the lowest since at least the mid-1990s. (Asia Pacific developed p/e ratios were left out of the second chart because of the absurdly high valuations of a few years back due to Japan. As a result, a graphic comparison between Asia Pacific developed and other regions is difficult. In any case, recent trends in Asia Pacific developed forward p/es reflect falling ratios elsewhere in the world. At the end of last month, Asia Pacific developed's forward p/e was 14.2, down from the mid- to high-teens of the past 24 months and currently just slightly above the U.S. forward p/e of 13.9.)
click to enlarge
What does it all mean? For starters, equities are becoming relatively more attractive. Of course, they may get even more attractive, which is to say the correction may roll on. We don't know for sure, and neither does any one else. As such, caveat emptor. That said, rest assured that what was overpriced is, for the moment, moving towards being fairly priced and, perhaps, that will lead to inexpensive pricing. The process is underway as we speak, although where it stops, nobody knows.
Posted by jp at 10:23 AM | Comments (0)
March 7, 2008
STRATEGIC THINKING IN A SHORT-TERM WORLD
There's more than a week to go before the Fed's next scheduled FOMC meeting on March 18, but judging by the February employment report released this morning the odds of another rate cut look virtually assured.
Payroll employment slumped by 63,000 last month, the Labor Department reported today. That's the second monthly decline and the steepest in nearly five years. Perhaps the economy's capacity for minting new jobs is set to rebound, but it doesn't look that way. As our chart below suggests, cyclical downturns have been known to run for a while, suggesting that at this moment it's premature to think that the economy has now purged itself of excess.
Yes, the previous downturn was extraordinary in some ways and so perhaps the recent past isn't necessarily prologue this time around. The hope is that the current slump will be short and mild, but as always there's no guarantee. In fact, there are more than a few reasons to think that we may be in store for something more than a brief rough patch. For example, mortgage foreclosures jumped to an all-time high at last year's close, the Mortgage Bankers Association reported yesterday. Meanwhile, home equity dropped under 50% for the first time since World War II in last year's fourth quarter, according to the Federal Reserve.
Making a case that the economy's under stress is, in short, rather easy these days. The data certainly suggest as much, and so it's no wonder that the market's expecting another cut in Fed funds rate. The May '08 Fed funds futures contract, for instance, is priced for a 2.0% Fed funds rate--100 basis points below the current level.
The stock market is obviously sensitive to the news of late, as is the bond market. Predictably, each is going their separate ways. The S&P 500's total return this year through yesterday's close is in the red by -10.8%, according to Morningstar.com. The Intermediate U.S. Government Bond Index, by comparison, is higher by 4.4%. The flight to safety is very much in force, and so valuations and long-term return expectations are being ignored in the stampede. These dual trends won't last forever, but there's still plenty of fuel to keep the game going...for now.
Par for the course in corrections. They eventually die when the sellers are exhausted and the Fed has done all it can reasonably do to resuscitate the patient. By our reckoning, we're still shy of the halfway point in this process, although that's only a guess and one that probably suffers from a wide margin of error.
Perhaps the bigger danger is that as the correction process continues, investors will find themselves drawing the wrong conclusion from the recent trend. The bias was on full display when everything was running higher, and now it threatens to work in reverse when several major asset classes are tumbling, notably, stocks and REITs. Alas, we can't predict the bottom, but we know that lower prices equate with higher expected returns. For those with a five-year time horizon or longer, the rebalancing opportunities are getting better by the day. In fact, 2008 is shaping up to offer the best prospects for strategic-minded investors since 2002.
As always, Mr. Market gives nothing away. Yes, expected returns for some asset classes are rising. But at what cost? Surely the free lunch doesn't exist. Indeed it doesn't. Rather, the price tag is living with a hefty dose of anxiety for the foreseeable future. Buying when virtually everybody else is selling is about as comfortable as walking on nails. But that's the price for improving the odds that your portfolio's risk-adjusted performance doesn't suffer mediocrity in the long run. As our second chart below reminds, return series are volatile, even over rolling 3-year periods, which is what we illustrate below.
Yes, it's obvious what we should have done in the past. No doubt we'll make mistakes in real time about second-guessing the future. But a large chunk of the prediction risk can be mitigated by owning all the major asset classes and adjusting the weights when the valuations, volatilities and other metrics signal that it's a prudent time to act. Additional risk reduction can be had by time diversification. Rather than trying to pick a single point of maximum expected return (i.e., market bottoms), investors are better off deploying new capital over a time period that's reasonably close to the bottom. In short, plan on being a bit early and a bit late relative to the absolute bottom when attempting to exploit volatility. Why? It's a tool that improves the odds of capturing the lion's share of the opportunity.
Uncomfortable? Absolutely, but far better when you consider the alternative. Trading short-term comfort for superior odds of long-term success still looks like a winning bet. Even so, no one said it'd be easy.
Posted by jp at 10:14 AM | Comments (0)
March 6, 2008
TALKING ABOUT RISK
It's said that investors learn more from their mistakes than their successes. If so, most of us are a lot wiser today compared with a year ago. If so, much of the progress in controlling cognitive bias relates to understanding risk. Such insight doesn't come easy, nor does it insure success in the future although we're confident that ignorance of risk eventually leads to failure.
With that in mind, consider a recently published essay by Malcolm Knight, general manager of the Bank for International Settlements. In a speech late last month, given at the Ninth Annual Risk Management Convention and Exhibition of the Global Association of Risk Professionals, he discussed what he sees as the major surprises and non-surprises that have defined much of market activity since roughly mid-2007. Perspective is no short cut to profits, but a healthy dose of historical context may save us from grief later on.
An excerpt from Malcom Knight's Feb. 26, 2008 lecture on risk:
Some of these problems could have been foreseen, and indeed some observers had expressed strong warnings well before the turmoil. Which developments should not have come as a surprise? And what has been genuinely surprising? Let me highlight three non-surprises and three surprises.
The first non-surprise was the sharp repricing of risk that began in the middle of last year. The signs of an underpricing of risk had not been hard to discern beforehand. A month before the turmoil, we issued our BIS Annual Report for 2007 and repeated our grave concerns about the build-up of financial imbalances and their potential disorderly unwinding. Admittedly, it was impossible to predict the timing of the repricing. But the likelihood that it would occur was not. Indeed, in one respect the fact that it did occur is actually welcome: had the underpricing continued, the eventual adjustment would have been worse.
The second non-surprise should have been the simultaneous evaporation of market liquidity and funding liquidity. Reflecting the increasing marketisation of finance, the system had become critically dependent on liquidity – the oil that greases the wheels of the financial machine, but is the first to disappear when confidence is shaken. Rising uncertainties in the valuations of complex products, and in the location of risks in the system, exacerbated this process.
The third non-surprise should have been that banks did not prove immune to the turmoil in credit markets. A key feature of the new financial landscape is precisely the tighter association between banks and other financial market participants. Markets now rely on both “traditional” financial firms and “new” types of financial firms for the supply of securities, market-making services and backup liquidity lines. Financial firms increasingly rely on markets for generating new activities and profits and, above all, for managing their own risks. The shift from the originate-and-hold banking model to the originate-and-distribute financial business model that has accelerated in recent years is just one of the most conspicuous aspects of this growing interaction.
What about the genuine surprises? The first major surprise was the sheer intensity and speed with which the turmoil hit the banks. Not even during the banking problems of the early 1990s or those in the 1980s associated with the Mexican crisis were the dislocations in the interbank market so severe. It seems that everyone – market participants and policymakers alike – had seriously underestimated the impact of potential tensions in financial markets on the involuntary reintermediation pressures that would affect banks. The geographical reach of these pressures, well beyond the US markets where the subprime crisis originated, had also been underestimated.
The second surprise was the major role played by special purpose vehicles – what some observers have aptly characterised as the “shadow banking system”. Conduits and SIVs had grown very rapidly in recent years, but were hardly on the radar screen of authorities and observers. And yet, this sector was thinly capitalised and carried out covert liquidity transformation on a large scale. As a result all of us, I think, greatly underestimated the potential liquidity demands that could fall back on the banks, or the degree of leverage embedded in the global financial system.
The third surprise was the apparent inadequacy of financial institutions’ capital cushions. The reported high degree of capitalisation of the banking system before the turmoil was a source of pride and comfort to market participants and policymakers alike. And yet, the major efforts that are now being made by banks to strengthen their capital bases suggest that capital cushions are considered too small in the face of currently perceived risks. This is just the latest reminder of how easy it is to overestimate the size of buffers in booming, exuberant times. And it is precisely the non-linearities inherent in the financial system, such as in the case of the option-like payoff patterns I mentioned earlier, that underlie this all too familiar error of judgment. Examples are not hard to find: debt contracts increasingly vulnerable to frothy housing prices; CDOs with strong in-built leverage; high leverage in conduits and SIVs involved in liquidity transformation; monoline insurers sailing too close to the wind. All of these strategies yield steady earning streams in good times, but possibly at the expense of raising tail risks. The widespread use of securitisation seems to have facilitated this process further, by appearing to disperse risks across the system and hence encouraging risk-taking.
Posted by jp at 9:45 AM | Comments (0)
March 4, 2008
TAKING A CLOSER LOOK AT FOREX AS ASSET CLASS
Forex is hot, your editor observes in the March issue of Wealth Manager, and for all the obvious reasons, starting with the fact that the formerly mighty dollar has come under the attack of the bears these past few years. No wonder, then, that a rising number of investment strategists in the U.S. see currencies generally as a separate and distinct asset class. It all looks good on paper, but does treating forex as one more choice in asset allocation plans stand up to reason in practice? Exploring the question is the subject du jour, and you can find a full serving here….
Posted by jp at 9:17 AM | Comments (1)
March 3, 2008
THE RED & BLACK OF FEBRUARY
The power of diversifying across asset classes has rarely been more convincing than it was last month. Perhaps even more notable is the fact that the winners and losers of late are beginning to reflect the longer term trend.
Consider the table below, which ranks February's total return among the major asset classes. Commodities were the top peformer, surging more than 12% last month. In fact, raw materials were in the lead for the past 12 months. At the bottom of the rankings: REITs, the big loser for February and for the past year too.
No one knows when the correction will end, but it's worth reminding that the division between bull and bear markets across asset classes is nearly evenly divided. Recognizing that momentum doesn't last forever (because it inevitably gives way to the value factor, and then vice versa) has us thinking about the next big shift in strategic portfolio design and how we might take advantage.
For now, momentum has the upper hand, which is to say the winners keep winning and the losers keep losing. For now....
Posted by jp at 8:48 AM | Comments (0)