June 30, 2008
ONE OUTCOME, TWO PATHS
The jig appears to be up. Many factors have brought us to this point, but it seems that there are two paths left. One or the other will out, eventually.
On the one hand, the Fed may raise interest rates, and thereby support the dollar, which in turn will put downward pressure on oil, which is priced mainly in greenbacks. The alternative path is keeping rates unchanged and so allowing the oil bull market to run skyward unencumbered by any monetary policy braking.
In time, the outcome will be the same: slower growth, perhaps recession, with the possibility of a deep, long recession. Shifting the odds in favor of something tamer, it seems to this observer, requires a proactive monetary policy in the form of hawkish behavior from here on out. Yes, that will incur economic pain. But economic pain is now inevitable. The only question is how it's administered?
If the Fed does nothing, and effectively allows the bear market in the buck to roll on, the threat of higher oil prices rises as well. In that case, an untethered increase in oil prices from this point will generate more demand destruction to push the U.S. economy, and perhaps the global economy, into recession. In time, that will pare oil prices to reflect the new, albeit temporarily adjusted supply/demand equation.
Alternatively, the Fed could engineer a similar outcome but with a higher possibility of imposing demand destruction gradually, with a kinder, gentler hand compared to the blowback from a runaway bull market in energy. There's no guarantee, but if Bernanke and company take the lead and steadily tighten monetary policy, and speak forthrightly to the markets about their intentions, there's a chance that the Fed can minimize the pain.
But let's be clear about what's possible, and what's not. To the extent the higher energy prices reflect higher demand and a growing struggle to find new supplies, monetary policy, enlightened or otherwise, can't change geologic reality. At the same time, some degree of higher energy prices are a function of the weak dollar. Exactly what degree is unknown. Whatever the degree, it's almost certainly a small influence on oil prices. Still, the Fed should use its influence, limited though it is.
Rest assured that if the Fed doesn't act, or doesn't act with sufficient speed or authority, the markets will eventually do the central bank's job. In that case, the damage may be greater than if the Fed acted pre-emptively and prudently.
June 27, 2008
RISKY WATERS AND OPPORTUNE WAVES
Yesterday's hefty selling in the stock market may have shocked the perma bulls, but it should come as no surprise to strategic-minded investors. The writing has been on the wall for some time now, economically and financially speaking, as your editor has been pointing out for the better part of the past year.
The challenge, as always, is keeping the long term in focus without getting distracted by the day-to-day tactical issues that emit conflicting signals. Rest assured, much of the financial industry is dedicated to analyzing the here and now, leaving the strategic view up for grabs. If the majority of investors aren't watching the broader trends, that's partly human nature; it's also a byproduct of the instant-gratification culture that's become part and parcel of the 21st century finance.
But big-picture trends wait for no man. Even so, let's no kid ourselves: identifying those trends amid the chaos of the daily noise is difficult and prone to error. That's one reason why we always favor broad diversification across all the major asset classes. Yet we're also inclined to tweak the weightings from time to time if the valuations enhance our conviction that the future is a bit less foggy in some respects than usual.
Most of the time, the clues are a blur and so we often lean toward a relatively passive asset allocation. But sometimes the financial gods give throw us a bone, as they seemed to be doing back in early 2007. Stock market volatility back in those halcyon days, we observed at the time, had fallen to unusually low levels. Since volatility can't drop to zero, along with an understanding of volatility history, suggested that the trend would soon reverse and so volatility would rise. In turn, the five-year bull market in equities was set for turbulence.
There were other signs of trouble as well, some of which we wrote about. Low yields, for example. Another clue: all the major asset classes had been in multi-year bull markets at the time, suggesting that something had to give.
The point is that a number of indicators were speaking volumes as 2007 rolled. The cycle was changing, and it was time to prepare for something other than bull markets in everything.
Granted, your editor has consciously decided to err on the side of caution since then, and so our various warnings over time have tended to be early. For the skilled trader, who's proficient at extracting profits (after taxes and fees) from the short-term twists and turns, our counsel has been of limited value and has probably come at a steep opportunity cost. But for the strategic-minded investor with limited, if any, tactical talent--i.e., yours truly--erring on the side of caution has worked well. Having slowly but consistently raised cash over the past 24 months, along with tweaking asset allocations here and there, we've managed to minimize the damage to our portfolio.
The goal is sidestep losses in bear markets and grab a fair share of the upside action in bull markets. Easier said than done, but our ability at pursuing that ideal has improved with time.
As always, the question is: Now what? In search of an answer, let's explore some context. That starts with speculating that yesterday's market action indicates that the crowd is showing signs of capitulation. Fear is nigh, with greed running for cover. We'd like to see more of that before making dramatic shifts in asset allocation.
Meantime, it's time to nibble at the opportunities. The S&P 500 remains in a downtrend, although some thought otherwise in the March-to-May bounce. But a review suggests otherwise, supported by yesterday's selling. The immediate question is whether U.S. stocks will dip below March's low, which is the trough for the current cycle. For the moment, we're within shouting distance of that trough, and breaching it on the downside would convince us to begin in earnest to redeploying fresh capital to equities, albeit slowly so as to diversify new investments over time and hedge the risk of even further declines.
In fact, other asset classes are looking increasingly attractive by virtue of their declines. High-yield bonds, for instance, have taken a beating recently. The iShares iBoxx $ High Yield ETF is near a new low for this cycle. As of yesterday's close, the ETF's annualized yield (using the last payout) is just over 8%. That's a roughly 400-basis-point spread over the 10-year Treasury. Middling, although another leg down for the ETF holds out the promise for truly attractive valuations.
The same can be said for REITs, which have also been pounded lately. The Vanguard REIT ETF (VNQ) closed yesterday at its lowest since March. Accordingly, its yield is up. Based on the last dividend payment, the annualized yield for this REIT ETF is 5.4%.
It stands to reason that lower prices equate with higher expected return. As a result, strategic-minded investors should be increasingly focused on asset classes when they're correcting. It's not rocket science, but it’s not easy, either. And there's always the danger of being too early. But that's the nature of risk, and the associated gains. If it was clear what was coming, there'd be no risk premium. But the prospect of a risk premium implies that loss is possible too.
So, yes, we're getting interested in certain asset classes. But we're staying humble, too. These are the times that try investors' souls. With a little common sense, it may also be a time for laying the groundwork for robust performance in the years ahead.
June 26, 2008
THE BREAKEVEN BLUES
The Federal Reserve yesterday talked about fighting inflation by raising rates, but so far it's only talk. But while the central bank chatters, inflation expectations continue creeping higher.
Consider the yield spread between the conventional 10-year Treasury and its inflation-indexed counterpart, a.k.a., the 10-year TIPS. The difference between the two yields is a widely followed market-based outlook on future inflation. By that standard, the market anticipates inflation at 2.5%, as of last night's closing yields. As you can see from our chart below, that's up modestly from last August's 2.2% outlook.
To be sure, the rise isn't dramatic. What's more, the inflation expectation of late is still middling compared with recent years. But it's the trend that worries us. Although no one knows the future, the fact that the market's inflation expectations are rising, albeit marginally so far, reminds that pricing pressures are bubbling and it's starting to have an effect on investor sentiment.
But before any one gets too comfortable with the numbers, keep in mind that the 2.5% market-based outlook for inflation is well below the consumer price index's current annual rise of 4.2%, as of May.
Such news may be worrisome to some observers, but the Fed is still expecting salvation to arrive soon and rescue the central bank from the dirty work of hiking rates. As the Fed announced in yesterday's FOMC statement, it "expects inflation to moderate later this year and next year."
The question is whether the markets will jump on that bandwagon? There's still time to debate both sides, but the clock is ticking and resolution, one way or the other, is coming. Much depends on food and energy prices, of course, which are the poster children for the inflation troubles of late. In short, tell us where energy and food prices are headed and we'll tell you how the inflation soap opera ends. Alas, the story still unfolds one day at a time. Meantime, this is no time to bet the house on one outcome or the other. Hedging one's bets seems more than reasonable these days.
June 25, 2008
THE MOTHER OF ALL CENTRAL BANKING CHALLENGES
The market expects no change in the current 2.0% Fed funds rate at this afternoon's FOMC announcement. Looking out over the second half of this year, however, the Fed funds futures market anticipates higher rates.
The December '08 contract is currently priced with a 50-basis point hike to 2.5% in mind. It's any one's guess if that forecast will hold, or if it's even worthy of pursuit. Meantime, the central bank continues to grapple with the twin risks of inflation and deflation, as Martin Wolf writes in today's Financial Times: "Two storms are buffeting the world economy: an inflationary commodity-price storm and a deflationary financial one."
It's not yet obvious that the Fed and other central banks are up to the job of collectively navigating the complex macroeconomic waters that define and threaten the global economy in 2008 and beyond. But resolving this challenge, or not, will determine much of what unfolds in the years ahead. The central banks, in short, have their work cut out for them. Hanging in the balance: trillions of dollars of investments, the outlook for the global economy and the livelihoods of the planet's workforce.
Alas, cracking this nut isn't going to be easy. For one thing, much of the experience in central banking is dealing with inflation fighting alone, occasionally interrupted by an outright bout of deflation, as during the Great Depression in the 1930s and Japan for much of the past 20 years. Battling both at once is a rare event, which is to say that the Fed's experience in dealing with such a beast is relatively thin.
Experienced or not, that's the predicament du jour. On the one hand, inflation is bubbling. Although absolute levels of prices generally are rising by historically modest standards, the fact that the trend has been up for some time sends a warning signal that central banks can't, or at least shouldn't ignore indefinitely.
The hope remains that the demand destruction will derail any inflationary spiral, leaving the economy in relatively good shape for the next upturn. That, at least, has been the Fed's strategy: lower interest rates sharply without fear that the cuts will spark lasting inflation, courtesy of the demand destruction.
It's a nice theory, and it may yet work out. But what if it doesn't? What if inflation doesn't recede and demand destruction continues apace? That's called stagflation, and it's a central banker's worst nightmare. And for good reason: there's precious little track record in the history of monetary policy for overcoming the problem. One exception of a sort was during the Volcker tenure in the early 1980s, when political considerations were cast asunder and an all-out effort to break inflation's back were embraced directly and forthrightly. Of course, winning the war over inflation came at a temporarily hefty price in terms of demand destruction, a fact that only reminds that central banks aren't really up to the task of fighting a two-front war.
But ready or not, the twin fronts are here. Further complicating matters is the necessity of fighting the war on a global basis. In a globalized economy, the benefits as well as the challenges are spawned by the U.S., Europe, Asia and Latin America together. As such, the proper policy responses ultimately must come in concert too. Indeed, now that globalization has taken root, the rules can't be temporarily suspended for central bankers.
That doesn't mean that all central banks should be doing the same thing at the same time. In fact, one could argue that an enlightened and effective policy of central bank coordination these days demands a mix of policy responses that are at once appropriate for the home country while positively supportive of the best interests for the global economy. So it goes in a world that has multiple currencies, multiple monetary policies, multiple economic trends, and multiple inflation rates.
But while the case for coordinated action is strong, it's not clear that it's imminent or that the central banks are up to the multi-dimensional task. This is not the challenge of yore, such as the Plaza Accord of the 1980s, when the objective was simply driving down the dollar vis a vis the Deutsche mark and yen. In many ways, that was a one dimensional task with clear objectives and an obvious path to success. Further complicating the task is the fact that some central banks are intent on pegging, in varying degrees, their currencies to the dollar. As a result, the U.S. is effectively setting monetary policy for some countries, and that policy is still quite dovish in a world that's calling for more hawks.
In any case, today's challenge is multi-faceted, with objectives including:
* lower inflation
* enhance growth prospects for the global economy
* reduce the trade imbalances between the U.S. and Asia
* soften the pain from the ongoing corrections in the real estate and financial markets but without promoting too much growth, which could ignite even higher commodity prices, which in turn could elevate inflation
* and all the while keep the dollar--the world's reserve currency--from crashing
Perhaps success on those fronts is possible only in a world with one global central bank overseeing one global currency. Alas, ours is a world with many central banks, which share conflicting agendas and a range of political pressures that don't always inspire an intelligent monetary policy. Like it or not, this is the world we live in, and the future begins now.
June 23, 2008
NO BORDERS FOR INFLATION-LINKED GOVERNMENT BONDS
Inflation is increasingly a global concern. Yes, the risk is still far below the levels that raged in the 1970s and early 1980s, but investors are starting to worry nonetheless. Certainly it's a sign of the times when the indomitable Ben Stein is wary.
One measure of the collective anxiety can be found in the rising demand for inflation-indexed government bonds. The Lehman Brothers U.S. Treasury TIPS index has risen 13.2% for the year through May 31, vs. 6.9% for U.S. bonds generally via the Lehman Aggregate.
Like so many trends in finance, going global is now part of the game, and inflation-linked government bonds are no exception. In ETF land, for example, one can choose between inflation-linked Treasuries (iShares Lehman TIPS Bond) and its foreign equivalent (SPDR DB International Government Inflation-Protected Bond).
In search of global perspective on the asset class, your correspondent recently chatted with Ralph Segreti, the London-based global inflation-linked product manager for Barclays, in the June issue of Wealth Manager. As we learned from our conversation, the world of inflation-linked government bonds is a growth industry. For more details, read on...
June 20, 2008
SPECULATING ON THE END GAME FOR THIS CYCLE
Interest rates are the hot topic once more. The pressing question: when will the Fed hike rates?
Inflation chatter has been in a bull market of late, and the bond market is again focused on the risks. The benchmark 10-year Treasury yield is roughly 4.2% as we write, up from March 17's 3.3%, which wasn't far above the generational low of 3.07% set back in June 2003.
The run in yields should surprise no one in a world where prices of commodities--food and energy in particular--have surged. But the fixed-income set, for all its current fears, hasn't been a reliable and steady barometer of pricing worries. That's not entirely odd, since bond prices (and their yields) are subject to two key drivers that are often in conflict, and the influence of one or the other waxes and wanes.
The first might be called the run-for-safety factor. In times of financial and economic stress, Treasuries and other high-quality bonds are seen as a safe harbor. When investors are fearful, running for cover in government bonds is a popular strategy. But the urge to seek financial safety competes with the fear that the safety will come at the price of owning an inherently low-return investment that gets sideswiped by inflation.
No one expects to get rich holding Treasuries, although that limitation is enhanced by the assumption that one can't lose money in governments bonds. While that's true in nominal terms, it's not always so after subtracting inflation, i.e., calculating real returns.
Consider that the Lehman Bros. Government Intermediate index posts a 3.49% annualized total return for the five years through May 31, 2008, according to Morningstar. Slim to begin with, but it's far slimmer once you realize that inflation (measured by the Consumer Price Index) rose by an annualized 3.09% over that stretch.
The real return may very well be negative for Treasuries in coming years, depending on what inflation does. That leads to the question: Does the current 4.2% compensate for future inflation? The fact that inflation (a la the CPI) over the past year through May also happens to be higher by 4.2% surely raises some doubts about how to answer.
The good news is that the bond market seems to be on board with the idea that inflation may yet climb higher before the central banks of the world muster the backbone to fight the threat. In other words, sellers have the upper hand in the bond market these days, which is why yields are climbing. For strategic-minded investors with cash to invest, the prospect of purchasing Treasuries at higher yields brings hope to an otherwise gloomy market aura. Even so, this editor still prefers to see higher yields before making a serious commitment to Treasuries.
For what it's worth, our view is that fear is still rising in the capital markets and will reach a level that we haven't seen so far in the correction that's been unfolding since last summer. It seems to us that the many have held out hope that what has been happening over the past six months was just a minor bump in an otherwise intact bull market. As the evidence mounts to the contrary, investors are seeing the light and paring back risk exposures.
In the stock market, the S&P 500 is off roughly 14% from last October's all-time high, although compared with October 2006 the market's flat. As the markets fall, we're inclined to buy, although what would really whet our appetite for ratcheting up asset allocations in stocks and bonds would be a sign of capitulation in the markets. So far, we haven't seen that, although we expect that the white flag will go up later this year, or perhaps early in 2009.
The catalyst for this capitulation, we speculate, may be when the world's major central banks bite the bullet and begin raising interest rates in something approaching a concentrated action. But that's still a ways off. In the U.S., the political season is in high gear and the idea of raising rates may be a non-starter near or after the November elections.
In Asia, meanwhile, there are growing signs that rates need to rise, as a Financial Times story today reminds. Real short-term interest rates in a number of key Asian countries are negative, as they currently are in the U.S. That's fine for a few quarters, but it's a monetary profile that no self-respecting central bank can long tolerate. But for a number of reasons, rate hikes aren't imminent.
We're convinced, however, that after a few more months, the central banks will see the light and do the right thing. Commodity prices can't be allowed to rise unfettered. A bit of demand destruction is needed to reign in the bull market in oil and other raw materials, and it's up to the central banks to make the tough decisions on this front. No doubt, when that time comes later this year, or perhaps early next year, many investors will run scared when the news hits the streets. That will be the time to pick up asset classes on the cheap. Meantime, we're watching and waiting.
June 18, 2008
THINK GLOBALLY, ACT LOCALLY
We've said it before, and so have others. Now Martin Wolf says it, and far better than yours truly ever could. The U.S., along with the developed economies generally are importing inflation. It's time to act.
This is not solely a task for the Federal Reserve, writes Wolf in today's Financial Times. Monetary policy here, and abroad, needs to tighten, he advises. But there's precious little of that at the moment, and the risk is that global inflation, already bubbling, will take root and become a bigger threat down the road.
The warning signs have been flashing for some time, Wolf reminds, starting with the multi-year bull market in commodities. This is not the result of manipulation by traders; it's the reflection of a fundamental shift in the supply/demand equation in the global economy.
The "continuous rise in the relative price of commodities is a symptom of an inflationary process," Wolf writes. "Whenever excess demand hits, the goods whose prices rise first are ones with flexible prices, of which commodities are the prime example. Commodity prices then are a pressure gauge. If we look at what has been happening in recent years, the gauge is showing red."
The only question, then, is what to do? Ideally, China, India and the emerging markets generally will recognize that their Bretton Woods II strategy--keeping their currencies undervalued relative to the dollar--is contributing to the global imbalances that are fueling inflationary pressures. It's time to unwind, or at least downshift the strategy that has been so popular in the 21st century.
It's unclear if the developing world will make the hard decisions to nip inflationary momentum in the bud. Meantime, the U.S., Europe and the developed world is importing inflation, much of which is stoked by rising demand from the emerging economies. Complicating matters is the weakened state of economic affairs that the U.S. is now in. That's inspiring a looser monetary policy in America than current global conditions merit.
"Today, the hapless Federal Reserve is trying to re-expand demand in a post-bubble US economy," Wolf observes. "The principal impact of its monetary policy comes, however, via a weakening of the U.S. dollar and an expansion of those overheating economies linked to it. To simplify, Ben Bernanke is running the monetary policy of the People’s Bank of China."
To be sure, if the world's leading central banks acted prudently and started tightening, the global economy would suffer. But make no mistake: inflation is rising because demand has been rising, and to some extent the higher demand has been engineered by central banks in the developed world to stimulate strong domestic growth, which includes keeping the export machine humming. It's been a nice party, but it can't go on forever, at least not without repercussions in the form of higher inflation.
No, it's not too late to keep inflation risk under control, but the time is running short. What's more, this is a job for more than one central bank. But like any prudent economic decision, it'll come at a price. Pick your poison: lower inflation or lower growth. History reminds that it's always easier to let inflation run higher, largely because the pain increases slowly, over time, with no obvious victims, at least initially. That makes inflation politically easier to swallow. But there's no free lunch. Eventually, someone will pay, and it's always the man in the street.
It's a safe bet that supply and demand will reach equilibrium. It's the decisions in the interim that keep everyone guessing.
June 17, 2008
The economy has a familiar rhythm these days. Unfortunately, it's a dangerous rhythm.
Several economic reports hit the street today, and they ring familiar. It's been clear for some time that inflation is bubbling while the housing sector, among others, is still weakening. Today's economic updates reconfirms the trends.
New housing starts fell again last month, dropping to the lowest level since the early 1990s, the Census Bureau reports. Meanwhile, the forward-looking metric of new building permits issued slipped in May compared with the previous month, which means it continues to trawl depths last seen more than a decade ago.
There's also a fresh update on wholesale inflation, and the news is as unsurprising as it is humbling. Producer prices are now rising by 7.2% a year through May, the Bureau of Labor Statistics reports. Once again, the main culprits are higher food and energy costs. Stripping those items away reduces PPI to an annual pace of 3.0%, although that's the highest since the early 1990s too. The problem is that stripping out energy and food costs, whatever the merits for the dismal science, isn't possible for Joe Sixpack, who must pay the higher costs.
What are we to make of all this? For starters, there's momentum in the trends. That doesn't mean it can't all end tomorrow, of course, but that's unlikely. For what it's worth, this observer thinks that inflation will continue to creep higher and housing and other sectors of the economy will continue to weaken. Nothing dramatic, perhaps, but sudden salvation looks remote.
Perhaps a bit more stability in such metrics will come later this year, or perhaps early in 2009. But the emphasis will be on stability, not growth. That's the best-case scenario, by this editor's reckoning. Why? One reason is that the inflationary bubbling of late has only just started to work itself into the nooks and crannies of the broader economy.
Energy costs have been rising for some time now, and that's finally starting to look obvious in transportation costs. "Everything you purchase in the supermarket, the clothing we put on our backs, the wood that goes into a home – it's all transported there somehow," Kevin Smith, general manager of Dart Transit Co., an Eagan, Minn. trucking company, tells The Dallas Morning News. "So as the price of fuel goes up, everything is going to go up."
Consumers are feeling the financial pinch and will act accordingly, which is to say, reduce spending to compensate. That will continue to be a headwind for the general economy for some time. In fact, the spending downturn is already obvious in a number of statistics. The only questions: how long, how deep?
Adding to the woes is the view that the banking system is still hurting, and will continue to hurt for some time. Deleveraging balance sheets and raising cash is still very much a high priority for financial institutions around the world. As a result, loans are harder to come by, even with low interest rates in the U.S. In fact, those low rates are helping stoke inflationary momentum. And while it's not imminent, at some point the Fed will raise rates, which will introduce yet another complication into the recovery efforts.
It's anyone's guess when this cycle will be broken, or what mix of catalysts will align to trigger a break. The only point of confidence we have is that the recovery will take time and bring only modest improvement, at least initially. But even that thin reed is a ways off. The correction, in short, still reigns.
Meantime, one could argue that commodities are overextended and that bonds and equities don't look deeply discounted. All of which leaves us suspicious that it's time to lean heavily in any one or two strategies or asset classes. Rather, we prefer to take a relatively neutral approach across all the broad asset classes, with a touch higher cash levels than normal. In short, more of the same.
Strategic-minded investors must learn to pace themselves. The era of quick fixes is over.
June 16, 2008
OPTIMIZING THE SOCIAL INVESTING FRONTIER
Modern finance and socially responsible investing appear incompatible. One is quantitative and unemotional, focused on maximizing return for a given level of risk. The other is the epitome of subjectivity in the realm of money management. But marrying the concept of the "optimal" portfolio with investing strategies that also pursue a greater good above and beyond making a buck isn't beyond the pale.
Marrying the two seemingly mismatched strategies is Aperio Group LLC, which specializes in tax-efficient and socially responsible investing (SRI) indexing strategies. The nine-year-old firm excels in optimizing SRI portfolios a la Harry Markowitz's portfolio theory. But while Markowitz's original idea use expected return and volatility for calculating the optimal portfolio, Aperio revises the strategy by quantitifying each investor's SRI values in relation to a chosen target benchmark. The goal is building a portfolio that maximizes an investor's social preferences while minimizing tracking error against, say, the Russell 3000 or MSCI EAFE.
In the June issue of Wealth Manager, your editor profiled Aperio, which is based in Sausalito, CA. The firm claims to that its specialty strategies give investors more bang for their SRI buck. For the details, read on...
June 13, 2008
PRECEDENT TAKES A HOLIDAY
These are strange days in the global capital and commodity markets. The macroeconomic terrain isn't quite familiar either. No wonder, then, that central banking isn't quite itself either.
The weird aura is second to none in these United States, where the Federal Reserve is battling, among other things, a bout of the unfamiliar and unusual. Two recent commentaries by observers from the dismal science offer a sampling of how life in the central banking trenches is something other than par for the course of late.
"Recent Federal Reserve activities suggest that Chairman Ben Bernanke went from being in charge to losing control of the Federal Reserve in the span of a few days," wrote Michael Cosgrove (an economist who runs the Econoclast consultancy in Dallas and is a professor at the University of Dallas) in an op-ed this week in Investor's Business Daily. As a result, Cosgrove wonders if the longer-term direction of monetary policy is "up for grabs" after the election.
The fact that Fed Chairman Bernanke has broken with recent precedent and talked so openly and forthrightly about the dollar is one clue that's something's a bit amiss at the central bank, Cosgrove suggests. Another curious sign is the fact that there's a relatively high degree of public dissent among Fed members in 2008. That's raising an unusual amount of questions about whether the central bank has a sound monetary policy plan or is struggling with internal fighting.
"It looks like Bernanke, an academic, is attempting to run the Federal Reserve like an academic institution," wrote Cosgrove. But "Bernanke can't run the Fed like an academic institution. He needs to learn that quickly, or he will be leaving the Federal Reserve when his term is up in 2010. It may already be too late."
Meanwhile, there's the issue of the two open vacancies on the Fed's Board of Governors, which may soon turn into a third with the pending retirement of Frederic Mishkin in August. "The balance of power at the Federal Reserve appears to have shifted from Washington to the regional Federal Reserve banks," wrote Thomas Higgins, chief economist at Payden & Rygel Investment Management, in a note to clients yesterday.
Higgins advises that the regional Fed bank presidents are relatively hawkish on monetary policy compared with the balance of voting members of the FOMC. As a result, the vacancies on the board give the hawks more influence over monetary policy, as Payden & Rygel's graphic below illustrates.
Nonetheless, Higgins thinks rate hikes aren't imminent. Why? Quoting from his research note, he wrote:
1) The lower fed funds rate has yet to translate into lower borrowing costs for the average
2) The Fed would appear confused and damage its credibility with the financial markets if it
were to raise interest rates so soon after cutting them.
3) Higher interest rates would aggravate the pain in the housing market especially given the
large number of adjustable rate mortgages that are in the process of resetting to higher
Meantime, Cosgrove and others speculate that the vacancies are politically motivated. Senate Democrats are waiting for the election and the hope that a Democratic President will appoint Fed heads who are more dovish.
"So we could see sharply higher tax rates on capital and earned income along with movement to a less open trade policy — plus a shift toward appointing people with an easy money bent to help lessen the real debt burden of the U.S. government," Cosgrove predicted.
Perhaps. But at this point, there are more questions than anything else. There's a fair amount of risk with a Fed in some amount of disarray at such a critical juncture in the global economy. All of which reminds us of the ancient Chinese curse: May you live in interesting times. Certainly in the world of economics and finance these days there's no trouble meeting that standard.
June 12, 2008
THE PRICE OF INACTION
It's been all about prices lately, and it'll continue to be about prices for some time.
The update du jour on that front is import prices, which have surged higher by nearly 18% for the year through May, the Bureau of Labor Statistics reports. On a monthly basis, the trend looks a bit less threatening. Import prices rose by 2.3% last month, down a bit from April's 2.4%. The trend looks even better if we exclude prices of petroleum imports, which continue to climb into uncharted territory. Even so, non-petroleum import prices are up 6.6% for the year through May, reminding that the U.S. continues to import inflation.
For comparison, domestic inflation is up by a relatively mild 3.9% for the 12 months through April, with an update for May scheduled for release tomorrow. It doesn't take a lot of math to figure out that the more this country imports, the stronger the pressure is for higher prices in everything from onions to oil.
Any way you slice it, prices generally are rising. The Federal Reserve's position to date has been more or less to hope that the slowing economy would take the edge off the pricing pressure. As we've long argued, that's an especially risky policy for this economic cycle. Much has changed in 2008 compared to recessions past, and so waiting for aid in the form of slowing or slumping demand may not do the trick this time around.
For starters, the central bank started cutting rates much earlier in this cycle compared to the past. Pre-emption has its merits, given the challenges swirling about, but it's not a free lunch. But that's history. The more immediate question: what to do now in terms of monetary policy?
Waiting and hoping looks increasingly dangerous if only because it's proven ineffective so far. For some time now, there's been talk that oil prices can't go any higher, that global demand for energy will slump, and that the inflationary pressures will soon subside and effectively do the central bank's job. In short, there's no need to raise interest rates because the inflation jump is a temporary glitch that would soon be corrected by macroeconomic forces.
For all we know, the correction may commence any minute. Then again, maybe relief isn't coming at all, in which case the U.S. economy becomes ever more vulnerable to inflation the longer the Fed sits on its hands. And as history teaches, once inflation takes root in the economy and the minds of consumers, the central bank's job is much, much tougher.
For the moment, the market expects no immediate changes in monetary policy, with gradual interest rate hikes coming later in the year. The November '08 Fed funds futures contract, for instance, is currently priced in anticipation of a 50-basis point hike to 2.5%.
No doubt the Fed is in a tough spot. This is an election year, and no one wants to be seen raising interest rates at a time when the voters are paying more for almost everything these days. Then again, there's a reason the Fed was set up as an independent institution that's relatively immune from the immediate passions of the political realm. Central banks weren't invented to make voters happy. In fact, one could say that an unpopular central bank may be a central bank that's doing its job, which in this editor's opinion is maintaining the integrity and value of the currency. After all, if the Fed falls short on that front, can it really be effective in any other sphere?
Granted, the surge in prices is driven by supply problems these days. Nonetheless, demand isn't irrelevant. Yes, higher prices are starting to do some of the work in terms of cutting demand. Americans are driving less these days, for instance, thanks to the rise in gasoline prices.
Perhaps it all boils down to this: will the Fed help in the business of demand destruction via rate hikes? So far, the answer has been a clear "no." Of course, we'd all like to avoid recession. But if that in fact is the only goal, one might ask: what's the price?
June 10, 2008
DIVING DEEP FOR VALUE
The idea that smaller companies can potentially generate bigger rewards is an old one, although it's forever new in creating hope.
In 1981, Rolf Banz formally introduced the concept of a small-cap risk premium into the academic literature. For the 43 years through 1974, small cap performance left large cap stocks in the dust, his study found.
The news probably wasn't surprising to financial economists. Modern portfolio theory, forged in the 1950s and 1960s, teaches that higher returns are a function of higher risk, and by that simplified reasoning the higher performance identified by Banz looks like compensation for higher risk.
In the years after Banz's paper, small cap research has became increasingly sophisticated, as well as controversial. As evidence, one need only review the debates that are still raging in the wake of the Fama and French research that identifies small-cap and value risk factors as fundamental drivers of equity returns generally.
Certainly there's plenty of risk in small cap stocks. On that, we can all agree. There's even more risk in the micro-cap equity realm, which includes the smallest of the small. Does the higher risk translate into even higher returns? Perhaps, although this world isn't for the financially squeamish. But if you can stand the heat, and you have an eye for value, there may be opportunity at the low end of the capitalization scale.
Exactly how much opportunity is debatable. In search of more context, Jon Heller recently created an index that tracks a basket of the "deep value" spectrum of micro-cap value stocks: the Cheap Stocks 21 Net/Net Index. It's far too early to make definitive judgments on such a short track record, but that doesn't stop us from looking.
If you're curious, pay a visit to Heller's blog, Cheap Stocks,where he comments on value investing far and wide. Yet for all his enthusiasm for poring over thinly traded microcaps in search of value, he's also mindful of the dangers. As he wrote last week, there's no shortage of hazards lurking in the murky waters of deep value microcap investing. That may be why the rewards can be so extraordinary. Nonetheless, the traps "are especially prevalent in the land of net/nets (companies trading below net current asset value) where we expend a great deal of research effort," Heller warns.
Heller, by the way, is an analyst by training. Holding both a CFA and an MBA, he's president of Newtown, Pa.-based KEJ Financial Advisors, LLC, his recently launched fee-only financial planning firm. Previously, he spent 17 years looking at the numbers for Bloomberg, L.P., in various positions, including overseeing the firm's equity research department for several years. He's also worked at SEI Investments. This reporter had the good fortune to witness Heller's impressive analytical skills up close, when our paths crossed at Bloomberg. For all his abilities at reading balance sheets, deciphering income statements, and otherwise looking for financial pearls among swine, he has also has a healthy respect for portfolio diversification and the power of multi-asset class portfolios. In short, Heller is that rare breed who knows how to navigate the micro and macro waters when it comes to investing strategies and financial analysis.
As such, we were intrigued when we learned that our old pal has been dabbling in an indexing project targeting micro caps that look undervalued. Relatively little is known about how this group acts as an asset class, if we can call it that. That makes Heller's forays, tentative and experimental though they are at this point, worthy of closer inspection. Inspired to learn more, we recently conducted an email interview with Heller on his new index. Here's an excerpt:
Q: What does your Cheap Stocks 21 Net/Net Index tell us about the world of micro-cap equities?
A: We’ll know more when we get a bit more history under our belt. But I believe what it will end up telling us is that Ben Graham’s technique of buying companies trading on the cheap, relative to their net current assets, still has merit. Perhaps, then, there’s value in “indexing” these small lost souls of the market that comprise our index.
Q: The implied assumption here is that the markets aren't efficient.
A: While the markets are pretty efficient in certain areas, such as large-cap stocks, they are far from perfectly efficient, I believe, in the micro cap space. While this may not provide much opportunity for institutional money, it may be beneficial for individual investors.
Q: How so?
A: The markets tend to throw the baby out with the bath water, and that’s probably truer within micro land.
Q: What's the design philosophy for your index?
A: It's constructed using companies that are so beaten down that they trade at less than their net current asset value. All else equal, if the assets have value, and the company is not insolvent--two big ifs in net/net land--the stock may be dirt cheap.
Q: What are the specific criteria for companies to get into your index?
A: There are several:
* A market cap that's below net current asset value, defined as: current assets less current liabilities, and then subtracting all the other long-term liabilities, including preferred stock and minority interest where applicable.
* A stock price above $1.00 per share.
* Companies that have an operating business, and so acquisition-oriented firms are excluded.
* A minimum average 100-day volume of at least 5,000 shares. And, yes, that's light as volumes go for the stock market generally, but it's fairly high in the wonderful world of net/nets.
* Index constituents are selected by market cap, meaning that the index is comprised of the “largest” companies that meet the above criteria.
Also, the index doesn't discriminate by industry weighting and so some industries may have heavy weights while others may have minimal weights, if any.
Q: How many companies are in the index overall?
A: It’s The Cheap Stocks 21 Net Net Index, so you’d think that there would be 21, right? When I launched the index, there were 21. When Renovis (RNVS) was bought out, however, I made the decision not to replace that company in the index and therefore, in essence, keep that piece in cash.
Q: How is rebalancing handled for the index?
A: It's rebalanced annually. Companies no longer meeting the net/net criteria will remain in the index until annual rebalancing. Otherwise, the only cause for deleting a company prior to the scheduled rebalancing is due to bankruptcy, delisting or the firm's acquired by another company. We may also continue to track the original index over time, perhaps labeling them in vintages, to see how original net/nets perform several years out.
Q: How has the Cheap Stocks 21 Net/Net Index performed, and how does it compare to, say, the small-cap Russell 2000 and the Russell Microcap indices?
A: The results are very interesting and arguably encouraging, so far. But take that with a grain of salt since the inception date of my index is only February 12, 2008. In other words, we have less than four months under our belt and that's too short a period to make any real conclusions. That said, since inception (through 6/6/08) the Cheap Stocks 21 Net/Net Index is up 14.11%, while the Russell Microcap Index, the closest thing to a comparable benchmark, is up 0.74%. The Russell 2000 is up 5.41%, but I’m not sure how relevant that comparison is. In terms of performance of the index members, we’ve already had one company get into trouble (Handelman: HDLM) and another one was acquired (Renovis: RNVS). We’ve also had others, such as Finish Line (FINL), and Anadys Pharmaceuticals (ANDS) that have doubled or tripled in price.
Q: What's the rationale for targeting the stocks in your index? How would you expect their risk/reward profile to differ from other corners of the equity market?
A: When companies trade below their net current asset value, there are three potential reasons. The first is that the company is going under. The second is that the market just doesn't care. The third is some combination of the two.
Meanwhile, history has shown us—based on the few studies that have been done, plus our own research--that net/nets tend to outperform the markets. While it’s true that some individual net/nets are on the way to bankruptcy, a.k.a. cheap for a reason, others will recover. In that case, either business conditions improve, the company's acquired, or the market wakes up to the overlooked value in the firm. What’s difficult to do in some cases, however, is tell the difference between who will survive, and who won’t. As a result, taking an “index” approach and buying a whole portfolio of net/nets may prove to be a fruitful endeavor. Out of 20 companies, you may end up with a bankruptcy or two, a bunch of names that do nothing, and a handful of big winners. Without taking a broad portfolio approach of indexing, however, you may not have been able to single out the winners in the first place.
Q: What types of companies populate your index? For example, do they tend to come from the same industry? Are they usually profitable?
A: It depends on what's happening in the markets, but often you see tech, biotech and retailers, to name a few. A few are profitable, and these also tend to have a lot of cash and trade at very low prices relative to book. For instance, at inception, the average price-to-book ratio of the companies in the index was 0.58. Meanwhile, the companies in the index currently average $58 million in cash and short-term investments, while the average market cap is just $103 million. These are tiny companies that may be burning cash, but the good news is that they have plenty of it—cash, that is, relatively speaking—and with slow burn rates.
June 9, 2008
Perhaps it was just bad timing, or dumb luck. Or maybe the forex market really is testing the Fed chairman. Whatever the explanation, Ben Bernanke's decision last week to break with precedent and talk up the dollar looks ill-timed.
But what's done is done. As we discussed last week, the Fed chief last Tuesday and Wednesday decided to speak in relatively clear and transparent terms on the dollar and inflation. By the standards of former central bank heads, Bernanke's chatter was surprisingly transparent, especially as it relates to the dollar. Typically, talking about a strong dollar is left to the Treasury Secretary for public discussion. But last week was different, and Bernanke said in no uncertain terms that the Fed's "commitment to both price stability and maximum sustainable employment...will be key factors ensuring that the dollar remains a strong and stable currency."
Extraordinary as such comments are for a Fed chairman, the effort backfired, judging by last week's fall in the dollar. The U.S. Dollar Index fell by nearly 1% last week, with all of the decline coming on Thursday and Friday, i.e., the two days immediately following Bernanke's remarks on the dollar. Of course, it'd be naive to think that the greenback's stumble last week was purely a market referendum on Bernanke. There are many other global economic forces in play that conspired to trigger fresh selling in the dollar--higher oil prices and inflation worries, for example.
But let's be clear: if the dollar is allowed to decline for any length of time from here on out, the trend will take a toll on the Fed's influence. Yes, the central bank's primary weapon is the power to control the money supply, and by extension the price of money. But moral suasion is also a critical lever for the Fed. Simply put, what the Fed says is no less important than what the Fed does. In the cause of central banking, actions don't speak louder than words; rather, the two are on equal footing. A central bank that loses the respect of markets is a central bank that must wage its fight for sound money with one hand tied behind its back.
Ideally, a central bank will avoid backing itself into a corner in which it must wield the monetary weapon more forcefully to convince the markets that it won't waver in defense of its currency. The question now is whether the Fed is in this proverbial corner? If so, will it feel compelled to act by raising rates? It's too early to tell, although this week may be revealing, depending on what unfolds.
As it stands on Monday morning, it's clear that Bernanke and company have their work cut out for them. First and foremost is the task of convincing the markets that the Fed's words are more than just idle chatter of no consequence. Having set a new standard in Fed speak via his comments last week, Bernanke is now under pressure to prove that his public comments have significance in the world of foreign exchange.
Unfortunately, supplying proof won't be easy in a global economy swirling with change and risk. But it was Bernanke who chose to speak as he did last week, and so he's created a bigger challenge. Perhaps he should have delayed his comments until the dollar was more likely to stabilize. Then again, a coordinated policy of dollar support engineered by the major central banks may be imminent. Or, possibly the Fed will hike interest rates to reconquer the high ground. Meantime, there's always the possibility that a new era of dollar strength, or at least stability, is about to begin sans intervention from the institution that prints the currency.
In any case, it's clear that if the dollar continues slipping from here on out, without so much as a peep from the Fed, the trend won't do Bernanke and company any good. And the threat couldn't come at a worse time. Even under the best of circumstances, central banking in 2008 faces some of its toughest challenges in decades. Alas, these aren't the best of circumstances.
June 6, 2008
ANOTHER ROUGH JOBS REPORT
This week has witnessed some encouraging news on the economic front, but this morning's update on payrolls will mute any temptation for celebrating.
Indeed, the unemployment rate surged upward to 5.5% last month from 5.0% in April, the Bureau of Labor Statistics reports. The jobless rate is now at its highest since October 2004. And let's not forget that unemployment reports are the most politically sensitive economic number and that this is a political year. As a result, we expect the echo chamber to ring loud and clear over this report. Prepare yourself for a hefty dose of discouraging chatter about jobs and the economy this weekend and into next week.
Perhaps that's appropriate, considering that the economy continued to shed jobs in May, as our chart below shows. In every month of 2008 so far, nonfarm payrolls have shrunk.
There's simply no way to spin the reality that the economy is on the defensive. The pain isn't necessarily deep or wide, at least not yet. But there's no denying the trend.
Still, it's been tempting at times this week to think otherwise. Yesterday's news that retail sales for May exceeded analysts' expectations was taken by some as a sign that the worst is behind us. Another potential bright spot was the drop in jobless claims for last week, which surprised economists and inspired some to declare that the economy was finally on the mend.
But the danger of reading too much into any one number is quite high at a moment such as this, when the economic cycle is in transition, which tends to produce more than the usual array of conflicting data. That's what makes the continuous decline in payrolls so forceful. The fact that the trend is now five months old, with no break, suggests that this trend, alas, has legs. A fundamental shift in the economy is underway, and it's not clear that cheap money alone will set the ship right.
But that's rank speculation. As for the fact: the decline in jobs last month was led by the goods-producing sector, which shed 57,000 positions in May. Meanwhile, the services industry, which provides the lion's share of employment in the U.S., barely grew last month. What's more, subsectors of services are now shrinking, including retail trade.
Once again, the lesson for strategic-minded investors is one of patience. The hope that all that ails the economy will quickly pass is, in this editor's opinion, still premature. Although there's been a correction in several of the major asset classes over the past six months or so, there's still a sense that the bulls never quite threw in the towel, which suggests that bigger bargains may be coming in terms of valuations once the all the dirty economic and financial laundry is recognized and accepted by Wall Street and its minions.
June 5, 2008
TALK IS CHEAP, BUT IT'S NOT WORTHLESS
The Federal Reserve Chairman is chatting up the dollar these days. On two separate occasions this week, Ben Bernanke made some extraordinary comments about inflation and the greenback. Extraordinary, that is, for a sitting Fed chairman.
Typically, the tired remarks about a strong dollar being in the best interests of the U.S. are dispatched by the Treasury Secretary—a view that's summarily dismissed by forex traders largely because it's been made so often over the years that it's lost any real meaning. But when the Fed chairman speaks of the buck with a bullish view, well, that's something else entirely. Unsurprisingly, the foreign exchange market is paying attention.
On Tuesday, June 3, Bernanke talked directly about inflation and the dollar, a rare and therefore refreshing event in the history of Fed head chatter over the past 20 years. "In collaboration with our colleagues at the Treasury, we continue to carefully monitor developments in foreign exchange markets," Bernanke advised. He later went on to say that, over time, "the Federal Reserve's commitment to both price stability and maximum sustainable employment and the underlying strengths of the U.S. economy--including flexible markets and robust innovation and productivity--will be key factors ensuring that the dollar remains a strong and stable currency."
But let's not kid ourselves. Bernanke's comments were hardly an economic epiphany. If the chief economist of a large Wall Street bank had uttered the points above, the audience would have nodded in agreement and moved on. But when the chief of the world's most important central bank makes these kind of statements, it's news, in part because such clarity from the Fed chief on these matters is usually MIA.
The clarity was repeated the next day, when Ben spoke at Harvard, his alma mater. "If people expect an increase in inflation to be temporary and do not build it into their longer-term plans for setting wages and prices," he explained, "then the inflation created by a shock to oil prices will tend to fade relatively quickly." He continued,
Some indicators of longer-term inflation expectations have risen in recent months, which is a significant concern for the Federal Reserve. We will need to monitor that situation closely. However, changes in long-term inflation expectations have been measured in tenths of a percentage point this time around rather than in whole percentage points, as appeared to be the case in the mid-1970s. Importantly, we see little indication today of the beginnings of a 1970s-style wage-price spiral, in which wages and prices chased each other ever upward.
It's no coincidence that the dollar has been rising this week. Some of this can be attributed to Bernanke's commentary, which basically boils down to advising the markets that the Fed is alert to the dollar's weakness of late and the modest rise in inflation. The implied message: the central bank will do what's necessary when, and if, it feels compelled to act in the defense of the greenback.
In fact, there's more than jawboning behind the dollar's rise, namely: rising expectations that the Fed's rate cuts are over for this cycle, as we discussed back in late April. Since then, the market for Fed funds futures has decided that the Fed's 25-basis-point cut to 2.0% Fed funds on April 30 will stand as the low point for the foreseeable future.
It's that change in expectations that's largely responsible for driving the dollar higher. The Bernanke comments are helping, of course, but it's the view that rate cuts are now history that has swayed the forex market. But here's where it gets tricky.
If rate cuts are over, it's because the outlook for the economy is improving, or at least no longer deteriorating. Alternatively, the Fed expects inflationary momentum to continue bubbling. Or perhaps both apply. In any case, the notion of further rate cuts is now a minority view. It's not clear that the Fed's going to start raising interest rates any time soon, although Bernanke's hand may be forced if the dollar resumes its fall. Indeed, a threat is only as good as the willingness to carry out the action, which in this case amounts to raising rates. Is that possible? Is it likely?
Words, in short, can be potent tools in the forex market, but only in the short run. Over time, traders respect only actions. It would do the Fed's credibility no good if the dollar takes up its old habit of recent years and plumbs new lows. In that case, the central bank would be forced to raise rates to avoid losing face, or otherwise wave the white flag and effectively admit that its verbal forays into talking up the buck were a failure. Quite frankly, the Fed can't afford that kind of a credibility loss at this stage and so logic suggests it won't happen.
Then again, it's possible that a coordinated intervention by the world's central banks could prop up the dollar without a change in rates directly. But that too comes with risks in the current environment, starting with the fact that the markets might see it as a desperate act.
But for the moment, Bernanke and company have scored a tactical victory. As we write, this dollar is inching higher again today. It would come as no surprise to see the dollar rally in coming days, or perhaps even weeks. But it's still too early to know if a fundamental turnaround is brewing. Eventually, the economic trends define outcomes. In the short run, however, anything's possible.
June 4, 2008
PORTFOLIO THEORY: THE UNNATURAL ALTERNATIVE
The genius of Markowitz's portfolio theory, unveiled to the world in a 1952 research paper, shines as bright in the 21st century as it did 50 years previous. But it's debatable if the associated logic and allure of the basic concept is widely understood or practiced in 2008.
Granted, Markowitz himself has partially renounced some of the technical aspects of the original paper. Namely, the idea that one should "optimize" a portfolio solely by analyzing expected returns vis a vis expected volatility (standard deviation) is considered by many to be overly simplistic and in need of revision. In fact, there's been much progress in bringing more nuance and sophistication to portfolio theory over the past 50 years. There are as many ways to implement a Markowitz-inspired view of portfolio theory as there are stars in the heavens. Yet there's still value left in the conventional proposition of Markowitz's portfolio theory, aided and abetted by the capital asset pricing model and the efficient market hypothesis.
In other words, strategic-minded investors could do a lot worse than owning the global capital markets portfolio weighted by the relative market cap weights (and the equivalent for commodities). Such a portfolio has proven to be quite competitive on a risk-adjusted basis with other portfolios, as we've discussed from time to time, including here.
The fact that the global markets portfolio, spanning the world's equity, bond, REIT and commodities markets, can be constructed efficiently and at low cost via ETFs and index mutual funds constitutes real progress in finance, at least by this editor's reckoning. Why, then, is there so little discussion and analysis of the subject and related opportunities?
Consider, for instance, that of the dozens of ETF-related events this reporter has attended over the last few years the subject of the global markets portfolio rarely comes up. Oh, sure, diversification receives plenty of lip service, but the dialogue is usually pretty thin on the finer points of building and managing a globally diversified portfolio. The preference is almost always one of focusing on the components, i.e., U.S. equities, emerging market equities, commodities, bonds, etc. In fact, there's ample evidence that the world is even more obsessed with discussing and debating pieces of asset classes, such as value vs. growth stocks, industry analysis, and so on. The big picture--the truly big picture--by comparison is habitually an afterthought, if that.
There's also a strong affinity for reviewing the technical aspects of ETFs: expense ratios, bid-ask spreads, tax efficiency of ETFs, and so on. Those are all important issues and so they deserve attention and analysis, but it still doesn't explain the lack of focus on the global markets portfolio.
Perhaps the oversight can be chalked up to self-serving behavior in some corners of finance. The idea that any schlub can now hold a portfolio approximating the global capital and commodities markets, and at a reasonable cost, is nothing short of a financial revolution. And we don't use the word revolution lightly.
Indeed, John and Jane Doe can own the global capital markets portfolio at an expense ratio of under 50 basis points. What's more, if they accept modern portfolio theory in strict form, John and Jane can build this portfolio by weighting the various asset classes by their market cap or equivalent weights. In that case, the overall portfolio is "efficient" and so requires no rebalancing going forward, which is to say that no further trading costs are involved. And if the portfolio is built with ETFs, the taxable distributions will be surprisingly low in any given year.
Of course, one could decide that there are reasons for building a portfolio that differs from the asset allocation as per Mr. Market. Ditto for rebalancing, for which there's a rainbow of strategic options that offer varying degrees of inspiration that managing the portfolio is preferable.
Even so, the case for owning everything is no less compelling. As such, the core debate should focus on: 1) how to initially weight the portfolio across the asset classes; and 2) how to manage the allocations, if at all, across time. Suffice to say, there's enough work tied to each of those topics to keep even the most ambitious strategist busy on a regular basis.
But let's not kid ourselves: the world doesn't work this way. As one example, there's a certain street that's famous in finance that's not particularly interested in promoting the idea of the global markets portfolio. Why? Perhaps it has something to do with the fact that such a radical idea offers precious little opportunity for remuneration compared with the bountiful cash flows generated from business as usual.
It also doesn't help the case for the global markets portfolio that analyzing the components with an eye on their interaction with the overall portfolio is tougher than it appears. There's probably not a lot of investors thinking hard about how the purchase of, say, a U.S. equity fund will change the risk-reward outlook for of an existing portfolio. It's far easier to ponder the prospective returns and risk of U.S. equities in isolation of a larger portfolio.
Clearly, building and managing a global markets portfolio--i.e., thinking and acting strategically--doesn't come naturally to homo economicus. That's no surprise, since formal portfolio theory only arrived 50 years ago, despite the fact that the notion of diversifying wealth goes back to at least the 2,000 year-old Talmud.
So, yes, portfolio theory is quite old, which renders it dull and uninspiring in the eyes of many. Of course, that's true only if you avoid studying the finer points of the global markets portfolio.
June 2, 2008
THE ALLURE (AND RISK) OF EMERGING MARKETS
There's a whole lot of stress-testing going on these days in the capital markets. And one of the striking lessons is that emerging markets have proven to be far more durable than many investors, including yours truly, thought possible. Yes, the durability could evaporate tomorrow for all we know. But for the moment, it's hard not to be impressed by the resiliency of equities in the developing world.
Consider the table below, which compares the major asset classes and ranks performance by May 2008 total returns. Once again, emerging markets were the clear winner, rising by more than 3% last month. Other than commodities, emerging markets equities are comfortably in the lead for the past year through May 31, 2008 as well.
Yes, there have been some tough spots along the way, as there inevitably are for all the major asset classes. This year's January and March were especially hard on equities in emerging markets, which suffered dramatic declines in those months. Nonetheless, it's hard to overlook the fact that despite all the turmoil in the global economy--from wars to price shocks in energy and food to various political and weather-related disturbance--this slice of the world's stocks has held up remarkably well.
Let's take a look at the longer term for some historical perspective. The iShares MSCI Emerging Markets (EEM) posts a 33% annualized total return for the five years through May 31, 2008. By comparison U.S. stocks are up by an annualized 10.3% over that span, as per iShares Russell 3000 Index (IWV). Foreign equities in the developed world, mainly Europe and Japan, look a bit better than the U.S., with a 18.9% annualized total return via the iShares MSCI EAFE Index (EFA), although that still pales next the emerging markets.
On one level, there's nothing particularly surprising about emerging markets superior performance. Indeed, these markets are higher-risk economies and so the higher return is compensation for bearing that risk. One measure of risk, although hardly the only one, is price volatility, and by that metric MSCI Emerging Markets Index is nearly twice as volatile (based on trailing 3-year annualized standard deviations) as either MSCI EAFE or Russell 3000 indices, which represent foreign-developed equities and U.S. equities, respectively.
The bottom line: emerging markets have soared through thick and thin in recent years. There have been mini corrections, but so far this asset class has yet to suffer a major setback. That alone makes your editor nervous. Parties, after all, don't go on forever, and higher risk eventually lives up to its reputation on the downside.
Yes, there are strong arguments for why emerging markets should prosper in the years ahead. We don't dismiss those arguments and, in fact, we're a believer in the idea that the developing world will continue to shine as a long-term proposition.
But everything has limits, including the idea that emerging markets are immune to the various economic, financial and political viruses that stalk the globe. Note that the trailing dividend yield for emerging markets (as per the S&P/Citigroup Emerging Markets index) at the end of April 2008 was a relatively spare 1.9%, down from more than 3% as recently as July 2005. No doubt the yield is even lower as of Friday's close, after emerging markets' robust rise in May.
What's a strategic-minded investor to do? Cut back on emerging markets. Not completely, although if you've been riding this wave for several years, your portfolio's allocation to emerging markets is surely overweight by more than a little, relative to Mr. Market's allocation. As of last Friday, the float-adjusted capitalization of the world's emerging markets represented just under 11% of global equity market capitalization, according to numbers from S&P/Citigroup indices--more than double from the start of 2004.
Yes, strong growth in emerging markets in recent years warrants a rising share of the global market capitalization for this realm. As such, there are many reasons why strategic-minded investors might want to put more than 11% of their portfolio into emerging markets stocks. In fact, asset allocation is inevitably a customized decision that's specific for each investor's particular situation. Nonetheless, by this editor's reckoning (and imperfect expectations of the future), we're of a mind to venture no higher than a market weight, if not a below-market weight allocation in emerging markets. The reasoning starts with respecting the financial laws of gravity.