May 30, 2008
THE REALITY OF ZERO
You can slice it, you can dice it. You can even massage it and look on the bright side. But you still can't get blood out of a stone or, it seems, inflation-adjusted increases in consumer spending.
Real personal consumption expenditures were flat in April, down from a slight 0.1% increase in March, the government reported today. Meanwhile, as our chart below shows, the longer-term trend isn't inspiring.
Looking at the three major components of consumer spending--durable goods, nondurable goods and services--doesn't inspire either. As the second chart below reminds, inflation-adjusted spending looks tired by several measures.
At least there's no mystery as to what ails Joe Sixpack's spending habits. Higher energy and food costs, a general if still modest rise in overall inflation, and housing and job stress are collectively taking their toll.
That leads to the question of whether the stress testing has legs? By this editor's reckoning, there's good news and bad news. The good news: the economic slump may not deteriorate into a full-blown recession. Yesterday's modest upgrade of Q1 GDP's growth is one clue. The bad news: the "recovery," when it comes, won't seem much like a recovery.
Why? We'll discuss this in more detail in future posts. For now, we'll simply say that the economic chickens are returning home and they're of a mind to roost.
May 29, 2008
BOND MARKET BLUES
Reports of rising inflation are everywhere, and the bond market is paying attention.
As evidence, we turn to Exhibit A--the 10-year Treasury yield, which closed above 4% for the first time since December 31, 2007. Rising yields are present in other maturities, too, including the 2-year Note, which yesterday settled at 2.62%, the highest since this past January.
It's not hard to guess what's behind the pop in yields: inflation fears, the bond market's worst enemy. Securities with fixed coupon payments are the first to suffer in a world of higher inflation.
As The Economist points out this week, inflation is bubbling around the world, particularly in the emerging market countries. What does that mean for U.S., Europe and the rest of the developed world? Food, energy and raw materials prices will "remain high," the magazine predicts: "In other words this is a permanent relative-price shock, not a temporary one. Yet this does not mean that commodity prices will keep rising at their current pace. Higher prices will encourage increased supply. And even if prices remain at today's levels, the 12-month rate of increase will decline, helping to ease global inflation."
Yet worries of higher inflation in the mature economies are still tempered by the widespread belief that the slowdown in the U.S., Europe and perhaps in some developing nations will take the edge off inflationary momentum. Perhaps, but the bond market seems inclined to price in a safety cushion for yields, just in case.
Staying cautious certainly has some appeal these days. In Europe, higher-than-expected growth in money supply is stoking fears that inflation is headed higher on the Continent. "With the underlying pace of monetary growth still strong, the latest data will do nothing to ease the ECB's inflation concerns," Capital Economics economists Jenifer McKeown and Ben May said via AFP.
As for the U.S., Dallas Federal Reserve President Richard Fisher counsels that the central bank should begin raising rates if inflation expectations take wing. "If inflationary developments and, more important, inflation expectations continue to worsen, I would expect a change of course in monetary policy to occur sooner rather than later, even in the face of an anemic'' economy, Fisher said yesterday, according to Bloomberg News.
By some accounts, inflation expectations in the U.S. are already worrisome. The folks at Guild Investment Management in Los Angeles, for example, opine in a commentary from Monday that the warning signs are flashing. Noting that a CNBC anchor was recently questioning the U.S. government's official inflation numbers, Monty Guild & Tony Danaher responded: "I don’t usually listen to financial TV, but it is important to note that when a medium like financial TV (which is slow to catch on to new trends) begins making fun of the government’s inflation reports…it means the public at large is waking up. They are waking up to the obvious fact that inflation is here and it is a lot higher than the government admits."
At the same time, the market's inflation expectations still look fairly tame. The spread between the nominal 10-year Treasury and its inflation-indexed counterpart has been in the mid-2% range for much of this year, and it remains there--2.45%--as of last night's close. The implication: the outlook for inflation is 2.45%.
Mr. Market reserves the right to change his view, of course. In fact, one could argue that such a change is underway as we speak.
May 27, 2008
COMMODITY BUBBLES & VALUATION: IMPERFECT TOGETHER
Commodities may or may not be in a bubble, which leaves strategic-minded investors grasping (and gasping) for context.
The media is flush these days with the "B" word, including today's Wall Street Journal, which advises: High Oil Prices Spur Thoughts About Bubbles, But This Might Be Misguided Meanwhile, earlier this month, Lehman Brothers energy analyst Edward Morse wrote in a report that commodities were, in fact, in a bubble and that it would burst by the end of the year, via Bloomberg News.
Many others preach the opposite, arguing that the run-up in commodities prices are a reflection of supply and demand trends rather than a speculative frenzy. True or not, the idea that speculators have gone wild is catching on and some in Congress are considering new laws aimed at curtailing commodity trading by institutional investors.
So, what's a prudent investor to do? There are no easy answers, although we can start with the facts. Fact number one: pricing commodities is inherently speculative. That's independent of whether commodities are in a bubble or not. In contrast, stocks, bonds and real estate (save for raw land) enjoy the attribute of generating measurable cash flows, which can be analyzed in the cause of putting a valuation on said assets. Commodities, by contrast, generate no income directly. Instead, one can only sell a barrel of oil or an ounce of gold to produce cash flow. The problem is that it's forever unclear how much cash the commodity will generate until the day of the transaction arrives.
Yes, that's true for stocks, bonds and income-producing real estate as well. But the difference is that informed investors recognize that a bond's current yield, a property's income stream and a stock's dividends (or earnings) lend themselves to any number of analytics to effectively reverse engineer the "fair value" of the security or property by putting a present value on the future income. True, in the short term such analysis must be taken with a grain of salt, but over the long haul estimating the present value of prospective dividends, coupon payments, earnings and rent historically go a long way in dispensing intelligence on the matter of valuation.
Alas, commodities generate no income and so estimating fair value is unavoidably speculative. That by itself doesn't make commodities a "bad" investment, but it does remind that commodities stand alone from stocks, bonds and real estate. In fact, it's that difference (of which valuation is but one part) that makes commodities attractive in the first place.
That leads us to fact number two: because commodities can't be valued as an income-producing investment, it's unclear how to estimate the relative size of commodities vs. stocks, bonds and real estate for asset allocation purposes.
Calculating the market capitalization of stocks and bonds, and the equivalent of real estate, is fairly straightforward. That allows for informed guesses as to the passive asset allocation among those asset classes. Commodities, on the other hand, are a tricky bunch.
Commodities have no market capitalization, at least in terms of futures contracts. Long and short positions in futures always offset one another and so the market cap is always zero. That leads to a variety of tortured alternatives to figuring out the market cap equivalent of commodities so as to figure out how big the marketplace is relative to stocks, bonds and real estate. One approach is estimating global commodities total production. Another is looking at liquidity factors, open interest and other measurable variables tied to futures. Each comes with its own limitations and challenges.
For what it's worth, your editor uses what's known as total dollar value traded. This is basically the dollar value of futures contracts that change hands over a specified time frame. We'll leave it to another post to detail why. Suffice to say, it's one of many methodologies and it comes with its own peculiar share of pros and cons.
Where does that leave us? As you might expect, a passive global markets allocation gives a high weight to commodities these days, thanks to the rise in prices, which in turn has boosted the total dollar value traded of futures contracts. Mr. Market puts a much higher value on commodities in 2008, and by more than a few measures.
If you accepted the total dollar value traded numbers as is, commodities would have been valued at just under the total global market capitalization of equities at the end of last year, which implies a passive allocation of 50/50 between stocks and commodities. Clearly, that's far too aggressive for most investors, although so far the heavy weight in commodities has proven itself worthy.
Nobody knows if an aggressive weight to commodities will continue to generate high returns in a broadly diversified portfolio of the major asset classes. But this much is clear: a zero percent weighting is almost certainly extreme, and so too is a 50% weight relative to stocks. Somewhere in between is reasonable. Exactly where depends on the investor, i.e., her risk tolerance, investment goals, expectations, etc.
In short, a quantitative analysis only brings you so far in strategic portfolio design. At some point, there's nothing left to say other than: You're on your own. Caveat emptor!
May 22, 2008
GRILL THE ONE YOU'RE WITH
There are no easy answers to America's energy challenges, but if there's any hope of finding anything resembling a solution, it surely begins with an honest assessment and discussion of the facts. And therein lies the problem: coming to terms with reality.
It's a simple task, really, although in a business as politically charged as energy nothing is as easy as it seems. Yesterday's affair in the U.S. Senate offered no evidence to the contrary. Consider a few quotes from Wednesday's Judiciary Committee hearing that heard testimony from executives of the country's largest oil companies:
"Is there anybody here that has any concerns about what you are doing to this country, with the prices that you are charging and the profits that you are taking?"
--Sen. Dick Durbin
“Yet you rack up record profits, record profits, quarter after quarter after quarter, and apparently have no ethical compass about the price of gasoline.”
--Sen. Diane Feinstein
"Consumers are angry, and they have every right to be. You're making more money than ever. It doesn't seem fair, guys. It just doesn't seem fair."
--Sen Herb Kohl
There's also this intriguing colloquy yesterday between Sen. Patrick Leahy and two oil executives about their salaries. The Senator's point, as far as we can tell, is to alert the American public that high-level oil executives make a lot of money. That's not unusual, compared with many other industries. But oil, of course, is different.
And, this is a political year and politics is in high gear in Washington, perhaps more so than usual. The problem is that political grandstanding is as irrelevant as ever when it comes to intelligently discussing, much less solving America's energy problem.
It's all too easy to use publicly traded oil companies as scapegoats for the high price of oil and gasoline. But if this is a conspiracy, why aren't futures traders called to testify as well?
In fact, contradiction is everywhere when it comes to talking about energy in America. A few examples:
* On the one hand, some politicians are calling for lower gasoline prices. Meanwhile, others are complaining that America's "addiction" to foreign oil only seems to go up? News flash: the two are connected. Lower prices induce higher consumption, which necessarily leads to higher imports in a country with falling oil production.
* Despite calls for raising supply, attempts at bringing new energy capacity on line are often attacked. A recent example is Delaware's successful effort at blocking BP's plan for building a new liquefied natural gas plant. The Supreme Court decision on New Jersey v. Delaware on March 31, 2008 comes at a time when politicians are complaining that energy companies aren't doing enough to increase supply.
* Politicians charge that oil company profits are too high, at least as defined in absolute terms. But in relative terms, the profits are more or less middling. As CNNMoney.com recently pointed out, citing data from Thomson Baseline, the average net profit margin for the S&P Energy sector is 9.7%, slightly higher than the 8.5% for publicly traded companies generally, as per the S&P 500. For comparison, Microsoft's profit margins are a dizzying 28%, according to Yahoo Finance.
Nonetheless, everyone focuses on the absolute profit levels for oil companies, and certainly the dollar amounts are staggering. But the scale is necessary. Finding, pumping and shipping oil is a business that demands massive up-front investments that may--or may not pay off in the years, perhaps decades ahead. Meantime, there's lots of expense. Drilling for oil 10,000 feet under the ocean simply doesn't allow for small-scale operations. Yet this fact is conveniently overlooked. Criticizing the scale of oil company operations, and then asking the same companies to deliver more supply, is nothing if not contradictory. If you want the latter, you need the former.
There are many more examples we could cite that remind us that intelligent discussions about energy can't be assumed as the natural course of affairs. Granted, oil companies aren't saints and so we assume that all the usual imperfections that infect human activity in other industries, and government, apply in the energy patch.
Meantime, the fact remains that the supply and demand equation has changed for energy, thus the rise in prices. The idea that it's a conspiracy is ludicrous. Otherwise, one has to assume that the oil companies engineered the collapse in oil prices in the 1980s, and again in the late 1990s. If they were really in control of price, why allow such extremes on the downside? The answer, of course, is that supply and demand are running the show. Not entirely, not absolutely, and not for each and every minute of the day. But generally, price trends are a function of supply and demand. Yes, the supply is manipulated in some parts of the world, but that tends to occur beyond these United States. But we digress.
When it comes to talking about oil companies, particularly Big Oil--publicly traded Big Oil, that is--reason seems to take a holiday, at least by the standards of discussion that usually hold for chatting about, say, cement manufacturing. Or even coal. When, an inquiring mind might wonder, will there be hearings on "excess profits" earned by coal companies? Don't hold your breath.
In fact, while we're dreaming up ideas for Senate hearings, here's a thought: let's talk more about boosting energy efficiency, which conceptually represents a synthetic equivalent of finding a new Saudi Arabia. Yes, some of that goes on, but it's a lot more fun to bash the usual suspects.
Indeed, the debate in Washington is hot and heavy when it comes to passing new taxes on oil companies to penalize their "high" profits of late. Perhaps that's warranted. But no one should expect that it will solve Joe Sixpack's problem of paying more at the pump. In fact, if Joe owns shares in the oil companies, either directly or through mutual funds, imposing punitive taxes on oil companies may end up hurting the man on the street.
No matter, since oil habits die hard. Some of the thinking about Big Oil is a legacy of decades past, when the Seven Sisters prevailed.. But the old days are gone. The publicly traded oil companies' power today pales by historical comparison. Yes, that's another inconvenient truth, but so be it.
The new Seven Sisters, as the Financial Times dubbed them last year, are: Saudi Aramco, Russia’s Gazprom, CNPC of China, NIOC of Iran, Venezuela’s PDVSA, Brazil’s Petrobras and Petronas of Malaysia. Notably, all of the new seven are government-owned companies. Collectively, they hold one third of the world's oil and gas production and more than one-third of the world's oil and gas reserves, FT advises. In the grand scheme of today's energy markets, the publicly traded oil companies are bit players by comparison with the new Seven Sisters.
Yes, the old Seven Sisters have lost much of their clout when it comes to the price of crude. On the other hand, they're much easier to drag into Senate hearings than the new power brokers.
May 21, 2008
It's not just about food and energy, and that makes it all the more worrisome.
Core wholesale prices, which is to say ignoring food and energy prices, are now running at their highest annual pace since the early 1990s, as our chart below shows. Through April 2008, core producer prices rose by 3.0% for the year, the highest since December 1991.
And yet the Labor Department yesterday reported that producer prices overall advanced by a relatively mild 0.2% in April, down considerably from March's soaring 1.1% rise. On first glance, that looks encouraging. So, what's the problem?
The short answer is that inflation at the wholesale level is spreading into the broader economy. Indeed, although top-line wholesale prices rose just 0.2% last month, core wholesale prices jumped at twice that pace, or 0.4%.
This should come as no surprise to those who've been following wholesale prices in recent months. Back in February, your editor noted that the trend in core PPI looked threatening, and the threat has only grown since then.
In contrast to February, the wider world seems to be taking notice. "The trend in core PPI inflation remains uncomfortably high," Zach Pandi, an economist for Lehman Bros., wrote, according to MarketWatch.com. "This release is likely to keep inflation concern relatively high" at the Fed.
Meanwhile, "We can see a steady spreading of wholesale price increases into the more general economy," Joel Naroff, chief economist at Naroff Economic Advisors, tells AP.
Still, there's hope that the slowing economy will dampen the inflationary pressures. Naroff and quite a few others are in this camp. Perhaps, although one might wonder when the dampening will begin. The economy has slowed considerably on a number of fronts in recent quarters, and yet the inflationary pressures still look threatening.
No wonder, then, that Fed funds futures are signaling that the central bank is probably done with cutting interest rates. Contracts with expirations in the months ahead are in agreement that the current 2.0% Fed funds will hold in upcoming FOMC meetings, the next one scheduled for June 24/25.
Depending on how the inflation reports in the weeks and months ahead look, there's even rumblings that the Fed may have to start raising rates a bit, as futures contracts expiring in early 2009 suggest.
The great question in all of this is how will Mr. Market price assets without the tailwind of new injections of liquidity waiting in the wings? If yesterday's action in the stock market is an indication, it may still be too early to take off your seat belts and walk around the cabin.
May 19, 2008
Studying history promises no short cut to easy profits, but it does provide some intriguing perspective at times. The last six months or so is one of those times. We're speaking here of the real or inflation-adjusted rate on the 10-year Treasury yield. By our somewhat subjective calculation (more about that below), this real yield has gone negative in recent months, which is to say that owning a 10-year Treasury bond leaves owners with less than nothing after deducting inflation.
The negative real yield in the 10 year isn't unprecedented, although as the chart above reminds it's a fairly rare occurrence. Back in 2005, the real yield went negative in September, but that was a one-time flirtation with life below zero. The last sustained dive into negative territory came during a two-year stretch in 1978-1980. Of course, that was a time when inflation was taking a toll on fixed-rate investments and the country was grappling with high energy prices. (Sound familiar?)
There are three paths to negative real yields. The first is higher inflation. The second, falling yields. Three, a combination of the previous two. We seem to have arrived at the current state of negative yields via the combo deal.
Deciding what it all means remains speculative, but here's what we do know. The 10-year yield went negative last November for the first time since 2005; the yield then rose to zero in December 2005 and has since slipped back into negative territory ever since. As of last month, the 10-year yield is a slightly negative 0.22%.
Of course, there's more than one way to calculate real yields. For good or ill, our methodology here is taking the constant monthly 10-year Treasury yield (as per the St. Louis Fed's database) and adjusting it by the 12-month change in consumer prices, as per the CPI index. The result is the graph above. For example, the constant 10-year Treasury yield was 3.68% in April 2008, according to St. Louis Fed. Meanwhile, the 12-month change in CPI through April 2008 was 3.9%. Thus, the slightly negative 10-year yield (3.68 less 3.90 = -0.22).
What does that mean? For starters, one might think twice before locking in a negative interest rate for the next 10 years. True, there aren't a lot of good alternatives at the moment, but that's a story for another day. Unless you're expecting deflation, negative yields are about as appealing as open flames at a gasoline station.
Then again, based on the past 54 years, negative real yields don't last long, which suggests a case for waiting for better valuations. The 1978-80 bout was the longest stretch of negativity, at 26 months, albeit interrupted by one month of slightly positive yields. The longest uninterrupted run was 24 months in 1973-1975.
You'll note that in both of those periods inflation was a problem and there was more than a trivial amount of pain in the capital markets and economy. By contrast, today's struggle with inflation is a mild affair and the capital markets and the economy are only slightly bruised by comparison with 1973-1975 and 1978-1980. That's no guarantee that deeper ills await, but for the moment 2008 is faring surprisingly well given the record high prices in oil and gasoline.
For what it's worth, this writer expects something between the apocalypse and nirvana as the path of least resistance. Of course, that's always the default forecast, and now's no time to look for extremes, which is our way of saying that we're as clueless as anyone about what's coming. As such, we're optimistically cautious, or cautiously optimistic, if you prefer. Then again, that outlook is conditioned on expecting that the global markets portfolio will fare reasonably well in the years ahead. Yes, there are a number of risks still looming, which suggests to your editor that broad diversification across equities, bonds, REITs and commodities is still the best game in town.
No doubt some will do materially better with their portfolios. What worries us is that many will do materially worse.
May 16, 2008
HOPING IT'S OVER
At long last, some good news from a pair of front-line economic reports.
Housing starts and new housing permits popped higher last month, the Census Bureau advises. After more than two years of nearly nonstop declines, robust increases in April in these two critical housing surveys lend fresh reason to think that the housing crisis, if not over, may at least be stabilizing.
Certainly the numbers look good for April, relative to the past. Housing starts jumped more than 8% last month, the strongest since last October. Meanwhile, new permits issued for building houses advanced nearly 5% last month--the highest since December 2006. In both cases, the actual numbers exceeded the consensus forecast by a healthy margin, according to Briefing.com.
April's rebound in these numbers is all the more encouraging since both data series are considered leading indicators. Economists consider housing starts and new housing permits a sign of what may be coming rather than what's passed.
Adding to the statistical cheer is yesterday's better-than-expected update on inflation for April, the Bureau of Labor Statistics reports.
But there's still plenty to worry about. The notion that the economy may be at or near a bottom is one thing. Expecting a strong rebound is something else. Indeed, yesterday's report showing a sharp loss for industrial production last month reminds that not all the news for April is encouraging.
Meanwhile, as inspiring as today's housing starts and permits numbers are, putting them in context with recent history is still a sobering task. As our first chart below shows, the fact that housing starts popped higher in April doesn't seem to alter the broader trend, at least not yet. It'll take many more months of higher housing starts to convince your editor that the winds have fundamentally changed.
The same cautious outlook also applies for permits. As our second chart below reminds, it's far too early to claim that long decline is housing permits is over.
Of course, if you've been beaten, slapped and cursed for a couple of years, the smallest bit of good news looks like divine intervention on your behalf. But it's worth pointing out that some of the smartest dismal scientists have been burned in calling an end to the real estate crisis. Recall that Alan Greenspan, the celebrated former Fed chief, said in November 2006 that "the worst is behind us" for the real estate crisis, as we reported at the time.
Yes, the housing crisis will one day pass. In fact, it may be in the process of bottoming as we write. But no one knows for sure, and the fact that the optimists have been burned a few times thinking otherwise suggests that it's still not time to bet the ranch on the idea that the housing crisis is over.
That caveat aside, there's reason for hope. We're certainly a lot closer to the end of this problem than we were when Greenspan made his ill-timed forecast back in November 2006. But no one should expect that housing will soon return to a roaring bull market. Having lost so much money in speculating on homes, with much of the cleanup still before us, the masses aren't likely to rush back in anytime soon, if ever. Licking the financial wounds will take time, even if macro signals suggest otherwise.
May 14, 2008
RETHINKING MODERN PORTFOLIO THEORY
The investment universe is filled with surprises, and perhaps the biggest shocker of all is the idea that the value strategies of Ben Graham and his disciples are in general agreement with modern portfolio theory (MPT).
Granted, it sounds absurd. MPT, after all, is the suite of financial theories that spawned index funds and the view that market prices are the best estimate of intrinsic value. Meanwhile, Graham's value strategy asserts the opposite, advising that savvy investors on the hunt for bargains can do a better job of calculating fundamental value, a strategy that boosts the odds of generating market-beating returns.
MPT and value investing, it would seem, are natural adversaries. That was true, but the two ideas have become similar thanks to the evolution of MPT. But while the academic interpretation of MPT has changed, the popular perception remains stuck in the 1960s and 1970s, when two of its major components--the efficient market hypothesis (EMH) and indexing--first arrived on the financial scene. Recognized or not, there's been a slow but steady accumulation of empirical research since the 1980s that's altered financial economists' view of capital markets. As a result, there's a new MPT in town and it's a lot closer in spirit to a Graham-inspired view of investing.
Ok, but why should investors care? Because if the classic strategies of active and passive investing are more closely aligned around value investing principles, the union lends more authority to value strategies generally. Indeed, if two formerly competing notions of money management--each commanding huge amounts of money under management--are now in basic agreement, it probably reflects a fundamental truth about how the capital markets function and how investors should build and manage portfolios.
The story of how these two ideas have become relatively complementary and why this meeting of the theoretical minds is relevant for investors starts in 1934, with the publication of Graham and Dodd's Security Analysis. The book (currently in its fifth edition) is widely hailed as the value investor's bible by teaching that market prices can and do deviate from a security's intrinsic value and that investors should exploit the mismatch whenever a bargain can be had. Buying securities at prices that offer a margin of safety improves the odds of capturing relatively higher expected returns, the book counsels. This is the definition of investing, Graham preached and anything else is speculation.
Meanwhile, MPT's founding research was published in the 1950s and 1960s. The early interpretation was based on a strict view of what's known as the random walk hypothesis, which argues that price changes are randomly distributed a la a standard bell curve. The practical lesson is that price changes are independent: yesterday's changes are unrelated to today's, which will be unrelated to tomorrow's. Securities prices are unpredictable if they follow a random walk. If so, investors are better off buying and holding index funds.
Unpredictability was the dominant view of MPT in the 1960s and 1970s, a view popularized by Burton Malkiel's best-selling 1973 book A Random Walk Down Wall Street. Three years later, Vanguard launched the first index mutual fund. The business of passive investing has been exploding with assets ever since.
But if there was a rush to embrace a random walk-view of MPT, it was premature. Even at the dawn of MPT, some academics warned that prices don't follow a random walk. Notably, Benoit Mandelbrot's 1963 Journal of Business paper—"The Variation of Certain Speculative Prices"—showed that securities prices didn't follow a random walk, which left open the possibility that prices may be at least partly predictable.
Nonetheless, the early readings of MPT conveniently overlooked such observations. But the truth has a way of emerging eventually. Indeed, a new generation of researchers took a fresh look at the random walk in the 1980s and 1990s and the accumulating tide of studies began to turn the academic tide. Even Eugene Fama, one of the founding fathers of the efficient market hypothesis, recanted, at least partially. In 1991, writing in the Journal of Finance, he recognized that the evidence was mounting that the "predictable component" of equity returns rises to "as much as 40% of the variance of 2- to 10-year returns."
If the empirical research was strong enough in 1991 to convince Fama, the academic smoking guns are more compelling (and numerous) in 2008. In fact, looking back over the past quarter-century of published research leads to what is now widely considered as strong evidence that the stock market's expected return is at least partly predictable over multi-year horizons. To be sure, studying prices alone still doesn't offer much insight into what's coming in the short term. But other observable variables, which were initially ignored by academics in the 1960s and 1970s, tell a different story.
Analyzing such factors as dividend yields, price-earnings ratios, book values and other fundamental metrics provides insight about future returns. One finance professor, writing in 1999, labeled academia's volte-face on the subject of return predictability as one of the "new facts" in finance. "Now we recognize that stock and bond returns have a substantial predictable component at long horizons," observed John Cochrane, a finance professor at the University of Chicago, in Economic Perspectives, published by the Chicago Federal Reserve. The old view of MPT is gone, he declared.
Card-carrying members of the Graham school of investing can rightfully say, "We told you so." Although academics are latecomers to the party, the fact that they've arrived only adds more credibility to what Graham taught: valuation matters. Indeed, Security Analysis instructs readers to analyze the balance sheet, study earnings trends, compare dividend yields to interest rates and so on for deciding if Mr. Market's prices are compelling or not. In fact, that sounds a lot like a 21st century reading of MPT.
In the May issue of Wealth Manager, your editor mused over how much has changed when it comes to portfolio strategy. At the same time, some aspects are eternal, including risk. Although there's more predictability in markets than previously recognized, the transparency is only partial. That's one reason why there's a risk premium in equities. It's also a reminder that you can still lose money in stocks, even if the markets are somewhat predictable. For more, read on...
May 13, 2008
RETAIL SALES & IMPORT PRICES
Retail sales last month slipped a bit, the Census Bureau reports. But much of the decline came from the auto and related industries. Given the soft economic backdrop of late, it's no wonder that consumers are reluctant to buy cars, which for most folks are the largest purchase after a house. Otherwise, this was a surprisingly good report, given the dominance of plus signs elsewhere in the column of monthly changes among the broad categories of retail sales. Excluding motor vehicles and parts, retail sales overall rose 0.5% last month.
Joe Sixpack seems to be holding up quite nicely in the face of recessionary fear, or so this data series is telling us. So, what's the problem? For some thoughts on that, we turn to import prices, which surged by 1.8% last month, the Bureau of Labor Statistics reports. Sure, that's lower than the nosebleed 2.9% for March. But no one should be celebrating. The United States is importing inflation, and the problem may get worse.
On a rolling 12-month basis, import prices are rising by 15.4% through April, which is the highest since at least 1990 (the monthly data doesn't extend further back). The point here is that the prices of imports are skyrocketing. The weak dollar is a key reason. As the buck sinks in value relative to foreign currencies, the result is higher prices for Americans. The hope is that the dollar will stabilize or (gasp!) rise a bit. But for the moment, that's just a hope. There's been some recovery in the U.S. Dollar Index this month, although it's not yet clear if that represents a sustainable reversal or just noise.
Meanwhile, it's true that a fair share of the bubbling in import prices can be blamed on petroleum prices. But even after excluding oil and gasoline from the mix, import prices are still rising by a lofty 6.2% on an annual basis, as of last month, as our chart below shows, which is well above the 4.0% annual pace of consumer prices, as of March.
If this keeps up, Joe Sixpack will be more than just pinched—he'll be run over with a bus, or two. Indeed, imports overall are significant slice of the U.S. economy. Last year, U.S. imports totaled $2.3 trillion, or about 16% of GDP.
Imports as an economic enterprise are too big to ignore. The same goes for import prices. The only question: When will the consumer start paying more attention?
May 12, 2008
WHAT'S UP (AND DOWN) WITH EXPORTS?
Exports account for about 13% of the U.S. economy these days. That's a small piece of the GDP pie, but it's an important piece, thanks to the strong growth in exports.
Exports have been one of the rare consistently bright spots in the U.S. economy. For each and every quarter since Q4 2005, exports have grown at a higher pace--quite often a significantly higher pace than overall GDP, according to the U.S. Bureau of Economic Analysis. In this year's Q1, for instance, exports jumped by 5.5%--a world above the meager 0.6% rise in overall GDP (both are quoted in seasonally adjusted real annual rates).
In fact, the strong performance in exports in Q1 is typical of the trend for the last several years. Exports, in short, have become a critical factor in keeping the recessionary forces at bay. Exports climbed 5.2% through this year's Q1 over the year-ago quarter. Overall GDP is up only 2.5% over the same period (seasonally adjusted real annual rates).
The weakening dollar has been a potent source of the bull market in U.S. exports. As the buck has fallen, so too have the prices of U.S. goods and services as denominated in foreign currencies. No wonder, then, that exports have taken flight.
That brings us to the latest trade report for March, released on Friday. Suddenly, the winds have shifted. It's unclear if it's a temporary shift or if it portends a new trend. In any case, as our chart below shows, exports in March posted an unusually sharp decline, far out of line with recent history.
Total exports tumbled by nearly $2.6 billion, or 1.7%, in March. What's more, the decline was sustained in five of the six major export categories. Only exports of foods, feeds and beverages posted a gain, which is probably due to the severe food shortages that now plague some areas of the world. Otherwise, the trend in March exports was down. Autos and consumer goods took the brunt of the fall.
What should we make of the reversal of fortunes in exports? More importantly, what does the March report imply for GDP in the quarters ahead? Clearly, the March trade news reminds us that the exports machine may not shine indefinitely. If the dollar stabilizes or rises, export growth may level out or fall. Meanwhile, if foreigners' appetite for U.S. goods and services flat lines or falls, either because of slowing economies abroad or other factors, then export growth will moderate.
The problem is that if and when exports stop offering an economic salve to an otherwise weakening U.S. economy, what will take its place? Consumer spending may not be up to the task this year, as we discussed recently. That leaves the corporate sector to pick up the slack. The good news is that corporate America is in remarkably good shape, considering the macroeconomic backdrop. Corporate profits as a percentage of GDP were still running at an exceptionally high 11% at the end of last year, according to the Bureau of Economic Analysis. In normal times, that might lend hope to the idea that corporations will invest capital and hire employees. But these aren't normal times. Certainly these are different times. Meantime, reading the trade reports is once again a high priority.
May 9, 2008
Does money matter? The answer depends on who's talking. Suffice to say, however, Milton Friedman's dictum that inflation is always and everywhere a monetary phenomenon is now debatable in the academic community as well as in the board rooms of central banks around the world.
Consensus on the strategic answer for managing inflation appears to be fading. Michael Sesit at Bloomberg News has a nice essay today on some of the stress points that harass the subject of inflation theory these days.
In the academic world, there's a relatively fresh dispute brewing about money's role. On the one side are some who say that money supply is no longer relevant, or at least much less relevant in the battle for containing inflation. "Nowadays monetary aggregates play little role in monetary policy deliberations at most central banks," observes Michael Woodford, a professor at Columbia, in a paper that's forthcoming in the Journal of Money, Credit and Banking. "I have examined a number of leading arguments for assigning an important role to tracking the growth of monetary aggregates when making decisions about monetary policy," he writes in "How Important is Money in the Conduct of Monetary Policy?" He goes on to report,
I find that none of them provides a convincing argument for adopting a
money growth target, or even for assigning money the "prominent role" that the
ECB does, at least in its official rhetoric. Of course, this is hardly a proof that no
such reason will ever be discovered. But when one examines the reasons that have
been primarily responsible for the appeal of the idea of money growth as a simple
diagnostic for monetary policy, one finds that they will not support the weight that
they are asked to bear.
This attack on money supply has spawned rebuttals of varying degrees, including a recent batch of opining from economists at the St. Louis Fed. For example, the title of Edward Nelson's recent essay says it all: "Why Money Growth Determines Inflation in the Long Run: Answering the Woodford Critique." Meanwhile, another St. Louis Fed paper ("Monetary Policy: Why Money Matters and Interest Rates Don’t") argues, "Suggestions that the Fed can control prices without controlling the nominal stock of money (or final payment) are simply wrong."
No one will take comfort from such debates, or that central banks around the world see the future in increasingly divergent terms. The Federal Reserve continues its preference for cutting rates and seeing the inflation risk as relatively tame. That's in contrast to the European Central Bank and others, including the Reserve Bank of Australia, which anticipates higher inflation. Some of the variance in outlooks is due to local conditions, although cynics might say that local political pressures, or the relative lack thereof, are part of the explanation too.
It's too soon to say that globalization has advanced to the point that the world economy is united and requires one monetary policy for all. Monetary policies, for good or ill, still vary widely and so to the extent that Friedman's edict is accurate there will be and should be different inflation rates in different countries. Nonetheless, with the higher level of financial and economic integration, inflation exporting and importing is also easier than before. No central bank is an island in the 21st century.
In a sign of the times, the capacity for the migration of pricing pressures across political borders is stirring tension around the world, particularly in Asia. Increasingly, critics are pointing to the easy money policies in the U.S. as the source of the trouble. A Singapore-based media outlet argues that the "U.S. must stop using food for fuel."
The optimists say that inflation will soon abate, in part because of the slowdown in the global economy. Perhaps. Meantime, monetary policy is in transition as policy makers grapple with a new era that enjoys precious little precedent. The outcome, in short, is still up for grabs and less than transparent. Hanging in the balance is inflation, and it's impact on expectations.
May 7, 2008
TALKING ABOUT OIL
Where's the price of oil headed? Higher, says Matt Simmons, CEO of Simmons & Co. International, a Houston energy-focused investment bank. Of course, Simmons has been saying that for years. In fact, his bullish view on crude predates the great energy bull market of the 21st century.
The surge in oil's price doesn't surprise Simmons because the fundamentals of supply and demand have been sending a clear signal about the future since the late-1990s, he says. For example, the discovery of large oil fields on a global basis has trailed off over the years, his research advises. Meanwhile, global demand keeps rising. And with China, India and other developing economies looking for more oil than ever before, the prospect of keeping supply and demand balanced looks more challenging by the day.
Your editor recently caught up with Simmons for an interview in the May issue of Wealth Manager. True to form, he sees oil prices headed higher still. At the end of the Q&A, we asked if he thought $200 a barrel is a possibility. His answer: "Sure, but I don’t know when. Meanwhile, I keep telling people that $100 for a barrel of oil is cheap. And they ask, 'How can you say that?' Well, it’s 15 cents a cup. Do you know of anything else we can buy for 15 cents a cup?"
For the rest of the conversation, read on...
May 6, 2008
Dividend yields don't tell you everything, but they tell you a lot. Sometimes.
A fair number of studies over the years find that the correlation between yield and subsequent return over the next five years and beyond is strong enough to convince fair-minded investors to watch those yields for clues about what's coming. In other words, higher yields have a tendency to lead to higher returns, while lower yields imply lower returns.
No, it's not absolute. Nothing ever is in finance. That caveat aside, favoring markets, and points in time when yields are relatively higher has a tendency to improve the odds of capturing higher total returns in the years ahead. In fact, this is an old idea, captured in Ben Graham's famous counsel that the market is a voting machine in the short run and a weighing machine in the long run. By that he meant that speculators rule now, tomorrow, next week and even next year when it comes to setting prices. But over longer periods, certainly five years or more, valuation dictates price. And dividend yield has proven to be an especially robust signal of expected returns.
With that in mind, we present two charts, each telling different stories. The first chart below graphs the dividend yield history for the world's developed markets. Although the absolute levels vary, the trend of late has been consistent across regions: yields are up. That's a function of the fact that prices have fallen relative to levels of a year ago.
In contrast, emerging market equity yields generally have continued slipping, which is due to the fact that stock markets in the developing world have trended higher even as corrections roiled the developed world.
Looking at market prospects solely on the basis of dividend yields suggests owning only developed world stocks and shunning emerging market equities. But if we consider growth opportunities, the emerging markets don't look too shabby after all. In fact, they look quite a bit better than the outlook for the developed world. All of which implies that an exposure to emerging markets is warranted, even if yields are uninspiring.
Perhaps the key question is whether this is a good time to overweight emerging markets? Dividend yields suggest the answer is no, or at least that this is no time for overweighting these stocks. The case for caution is strengthened when you consider that emerging market stocks have been spared a correction, at least relative to the developed markets.
Then again, much depends on one's time horizon. Traders will no doubt dismiss the counsel to stay wary on emerging markets. But for long-term investors, the case for caution may carry more influence.
To invoke Graham's metaphor, it's time to ask if you're planning on voting or weighing.
May 2, 2008
WILL MAY LOOK LIKE APRIL?
It's hardly great news, but the fact that job destruction was a bit less destructive last month will inspire the optimists that the recovery has begun.
Nonfarm payrolls shrunk by a relatively modest 20,000 last month, or roughly a quarter of the monthly losses that have been posted in each of the previous three months of this year. The April reprieve, if we can call it that, certainly made a graphical impression. As our chart below shows, last month's softening in job losses ended a five-month stretch of decelerating conditions for minting new employment opportunities. By that we mean that for the first time since last October, the trend last month didn't worsen compared to the previous month. And while we're pointing out reasons to be cheerful, let's note that the jobless rate ticked down to 5.0% in April, slightly better than the 5.1% for March.
But let's not get carried away, at least not yet. Let's not forget that goods-producing employment is still getting hammered even as the broader employment picture offers reason for hope. Meantime, Wall Street is eager to see light at the end of this tunnel, as yesterday's stock market surge suggests. Yet another rate cut by the Fed earlier in the week helped get the bulls' hearts racing, as did an improvement in the dollar in forex markets. And as we noted yesterday, April generally was a good month for most asset classes.
So, what's the problem? As always, there's no shortage of things to worry about. But no one should underestimate the stock market's capacity for climbing this year's wall of worry. Mr. Market is always looking forward while many of us are overly focused on the past. Such is the limitations of being stuck with wetware as the primary tool in the business of asset management.
In any case, the fact that the S&P 500 is still well below its all-time high of last October suggests a case for adding a bit of risk exposure to portfolios that have shed equity weighting in the correction of recent months. By that standard, it's still possible to see yourself as a contrarian if you're buying stocks today vs. last October.
In your editor's humble and perhaps flawed opinion, however, it's still not time to load up portfolios with a super size dosage of risk. For starters, the rebound of April may be noise. Consider the S&P 500, which suffered five straight months of total return losses through March. Such a string of red ink almost never happens in the broad stock market. The fact that equities posted an extraordinary line of consecutive losses suggested that April would surely witness some degree of gain.
Meanwhile, there's the issue of interest rates. The Fed has slashed the price of money to 2.0% in Fed funds from 5.25% last September. Is this the end? The chatter suggests it is, barring some new calamity that's currently off the radar screen. When and if the economy stabilizes, or starts to show the capacity for sustainable growth again, the central bank will have to start hiking rates, or so one would assume. Is the market factoring in that outlook?
Not yet. Rather, the crowd is looking at the short-term effects of stimulus. That includes the fact that the Treasury begins sending out the stimulus checks this month. The possibility of juicing consumer spending, and therefore the economy may be better than even for the next few quarters.
The question is whether all the stimulus will take root and right the ship to the extent that a new upcycle is set in motion? For what it's worth, we're betting on the idea that the recovery will take longer to bubble than the leading edge of optimists assume. Embedded in our expectation is the worry that the stimulus effect will fade by this year's Q4 and digesting the excess will reveal itself anew in the economic stats. All of which adds up to the possibility of flat lining into early next year on a macroeconomic perspective. As to how the stock market prices that possibility is anyone's guess. Traders may have the wind at their backs in such a scenario, but strategic-minded investors can still afford to be patient and selective.
Then again, that's just a guess. No one knows what's coming and so we're all left to apply reason and logic in a space that's notoriously immune to such efforts. So it goes.
Nonetheless, we'll be looking closely at the data that rolls in for May for signs, anecdotal or otherwise, that April's rebound was something more than just an uptick in a deeper downturn. Meantime, we're still digesting April's numbers.