July 31, 2008
THE GOOD, THE BAD & THE UGLY
The big-picture economic news looks good, on the surface. But don't be fooled. It's not as robust as it looks.
Today's release of the "advance" number for second-quarter GDP shows that the economy rose by a real annualized 1.9% pace in the three months through June. That's up sharply from the 0.9% rate in Q1. Is it time to break out the champagne and declare the slowdown over? No, not even close. The correcting and cleansing process for the economy has only just begun.
Our reasoning starts with the observation that Q1's 1.9% jump, while better than the previous number, is mediocre, at best, in the context of the last several years. More importantly, a closer look at the catalysts for Q2's rise raises questions about the future.
A key contributor to the latest GDP rise comes from consumer spending, which rose 1.5% in Q2. That's up from 0.9% previously. Good news, right? Yes, although one has to wonder how much of this is related to the stimulus checks that have been mailed out since May. Stimulus payments are a one-time boost and so they won't be juicing the economy forever. When the charm wears off, consumers will be left to spend their own money. The question is: how optimistic will consumers be from here on out?
Meanwhile, take note that most of the rise in consumer spending in Q2 comes from increased purchases in nondurable goods while spending on cyclically sensitive durable goods dropped sharply. Not an encouraging sign. Indeed, the 3.0% decline in durable goods spending in the previous quarter follows the 4.3% drop in Q1. Back-to-back drops like this are rare for durable goods, and so the trend suggests more trouble on the consumer front.
Of course, one can look to exports as a bright spot once again. The 9.2% rise in exports in Q2 is a valuable offset to weakness elsewhere. But let's not forget that much of the export gain in the previous quarter comes by way of a weaker dollar, which imposes costs on the economy that aren't obvious in GDP reports. Indeed, there's a limit to how much economic gain any nation can enjoy through a weakening of its currency. Devaluation may offer short-term benefits, but the U.S. can't devalue its way to prosperity for very long.
Speaking of international trade, keep in mind that imports dropped sharply in Q2--down 6.6% for the quarter. That's one of the biggest declines in years. The fall boosts top-line GDP and so statistically speaking the lower level of imports is a technical plus for economic growth. But make no mistake: imports are down because the economy is weak. Falling imports help raise GDP, but no one should assume that the trend is healthy.
What worries us even more is today's weekly jobless claims update. Last week, new filings for unemployment benefits rose to 448,000, as our chart below shows. That's the highest in five years (if we ignore the one-time spike from Hurricane Katrina in 2005). Alas, this trend seems to be building a head of steam, and the implications for consumer spending aren't pretty.
Job destruction, in short, rolls on, or so it appears. We won't know the broader details until tomorrow, when the July employment report is released. Based on today's jobless claims numbers, however, we'll continue to keep the champagne on ice for a bit longer.
July 30, 2008
PONDERING "REAL" YIELDS
It's a simple calculation, although the implications may be huge.
Adjusting the 10-year Treasury yield by consumer price inflation tells us what we already know: money is loose, and by design. The Federal Reserve has been intentionally pumping liquidity into the economy to cure the various ills that hound the American business machine. But with the real (inflation adjusted) 10-year yield plumbing depths rarely seen, it's time to ask (again) what it all means.
As the chart above illustrates, the CPI-adjusted 10-year yield dropped to -0.8% in June. That's the lowest negative real yield for the benchmark Treasury since 1980. Using last night's closing 4.09% yield and June's 4.9% 12-month CPI change, we remain at roughly -0.8%.
What does it imply? That depends on your expectations. It could mean that we're giving inflation the fuel it needs to take deeper root in coming years. Or, it mean be just the ticket to temper the economic contraction that's set to get worse.
No one really knows which scenario is coming. Rather than attempt the impossible, let's review how we're calculating real Treasury yields to gain a bit of perspective of where we've been and where we may be going.
For the chart above, we begin with the monthly average for the constant maturity for the 10-year Treasury, as per the St. Louis Fed. We then adjust that monthly number by the comparable 12-month trailing change in CPI, as reported by the Bureau of Labor Statistics.
Yes, there are other ways to calculate real yields, including looking at the TIPS market, or using the personal consumption expenditures inflation rate. And while we can get somewhat different estimates of real yields by looking at various data series, the basic trend is the same: real yields are falling. Depending on the numbers crunched, the real yield may be in generational low territory, as it is in the calculation used in our chart above.
Perhaps, then, the primary question in the search for real yields is whether we should use headline or core inflation? Here's where number selection makes a huge difference in results. For example, if we adjust the 10-year yield by the 12-month change in core CPI, the real 10-year yield is 1.7% as of June. That's a bit low relative to recent history, although it's hardly abnormal. It's also a world above the -0.8% we get when using headline inflation.
The subject of whether headline or core inflation is a better measure of inflation is a contentious one these days, as we've discussed many times over the years, including here and here. The core vs. headline debate boils down to expectations, namely: if oil and energy prices (i.e., the prices excluded from headline inflation) are set for a secular rise, the value of using core inflation will mislead and misinform. On the other hand, if oil and food prices remain true to their history and continue to cycle up and down sans trend, core inflation will remain the better predictor of future inflation, as it has in the past.
But let's stay agnostic on the question for now and consider the headline-adjusted 10-year yield on its face. That leaves us to ponder the meaning of the extreme depths of real Treasury yields. For our money, we take this as a pivotal moment in the interest rate cycle. If real yields continue falling, we may be looking at a whole new ball game of liquidity injections, the likes of which haven't been seen since the 1970s. That suggests higher inflation.
Does that outlook mean, then, that the Fed will be compelled to tighten? An op-ed by Harvard economics professor Ken Rogoff, published in today's Financial Times, suggest as much: "Is it not now clear that the main macroeconomic challenges facing the world today are an excess demand for commodities and an excess supply of financial services?," he asks. "If so, then it is time to stop pump-priming aggregate demand while blocking consolidation and restructuring of the financial system."
Nonetheless, Fed funds futures traders don't smell a rate hike coming any time soon, as per current prices via CBOT. Perhaps by the end of the year the Fed will raise rates by a modest 25 basis points, the futures market suggests.
Meantime, there's still an abundance of uncertainty about what comes next. Given the volatility and surprises that have become the norm in so many corners of finance and economics, handicapping the future is getting tougher by the day. Nonetheless, it seems like we're about to enter a new phase in the global economic cycle. Alas, we don't have a good sense of what exactly this new phase will bring.
July 29, 2008
BUILDING BETTER BENCHMARKS
Redesigning indices that track securities and commodities markets opens new strategic doors. In theory, that is. Proving it in practice is something else. But if financial engineers can build better benchmarks, and index fund managers launch products tied to those indices, that raises the possibility of improving asset allocation by using the new index funds. But success, or failure, rests on whether indices can be enhanced. That struggle usually boils down to the question: Is there a better alternative to capitalization-weighted indices?
A growing list of index vendors answer in the affirmative. Indeed, the last few years have witnessed an explosion of new benchmarks, many claiming the title of "new and improved" in one sense or another. Alas, it's too soon to make definitive judgments one way or the other, but that doesn't mean we can't consider the strategic possibilities.
In the latest issue of Wealth Manager, your correspondent did just that. The question before the house: What, if anything, can new indices bring to the asset allocation table? For some thoughts on possible answers, read on…
July 28, 2008
MARKET CYLES, MYTHS AND "FREE" LUNCHES
There's been a lot of talk lately about market failure, although some of it, perhaps a lot of it has been misleading.
The basic argument goes like this: finance has been relatively unregulated over the past generation, in contrast to the 50 or so years following the Great Depression, when the first round of government oversight befell Wall Street. Lessening the regulatory strings that bound is at the heart of the current ills. The solution: ratchet up government regulation, just like in the old days, a decision that will inoculate the economy from similar bouts of trouble in the future.
Undoubtedly, some reordering of regulatory powers is in order. The fact that the government had to step in and bail out Bear Stearns, Freddie and Fannie and lesser names suggests that something's amiss. But let's be clear: rethinking regulation isn't the same as creating more regulation. And even the most-intelligent regulatory notions will come at a price.
New government regulations, no matter how well meaning or deftly conceived will spawn unintended consequences. History is clear on this point, as it's been proven time and time again. Market forces are always with us. Governments are inclined to suppress and re-engineer those forces to satisfy political demands. That's all well and good, and in a republic the crowd's demands, within reason, must be addressed. Still, the basic inspiration for action on this front is invariably one of manufacturing a free lunch of one sort or another. But there is no free lunch. Of course, that piece of information tends to be overlooked at the dawn of a new age of regulation.
Overlooked or not, re-engineering market forces here and now creates an effect there and then. The risk is that the byproduct of a new piece of regulation creates a new problem elsewhere. That opens the possibility of making matters worse on a macro level by intervening in the marketplace. That doesn't mean that the unintended consequences are obvious, or even recognized as painful. If the fallout of market intervention is spread out across the economy, over time, the fleeting appearance of a free lunch may arise. If a new tax grabs a few pennies more from everyone's wallet for a commodity or service, for instance, the apparent pain is minimal, perhaps even unnoticed. Meanwhile, the accumulated cash that's generated by the new tax can be redeployed for the common good. The result: the emergence of what looks like a free lunch.
Regulation is more subtle than taxes as a tool of market intervention. New rules of operation may impose additional costs of doing business, or they may equate with higher opportunity costs. Meanwhile, the efficacy of new regulations may not be obvious. A new financial structure that's designed to prevent corporate implosions a la Bear Stearns will, if effective, create the appearance of normality. In other words, regulation often seeks to prevent certain outcomes--bankruptcy, for instance--as opposed to creating events that might not otherwise happen, such as redistributing wealth. As such, regulation may be a covert force, impacting free markets in a way that's overlooked by the crowd.
The best case scenario is when regulation works quietly and produces a social good that's generally applauded as progress. But there are unintended consequences to consider, too. The fact that such consequences are "unintended" means that they're not obvious in advance. All the more so in an economy that's already regulated every which way. The prospect of identifying cause and effect has gone the way of the dodo as a practical matter in economic analysis.
Perhaps the mother of all unintended consequences is unfolding now, thanks to the grand plan in recent decades at engineering recessions out of existence. For 20 years or so, the so-called Great Moderation has been a success, or so it seemed. But a victory based on suppressing market forces is by definition a temporary victory, as we've discussed.
The idea that you can trim or eliminate economic contraction without materially affecting growth, or creating dangerous unintended consequences elsewhere in the economy is a popular myth. That's not to say that market forces should always and forever have the last word. But if we're wedded to the idea of some degree of government intervention to tame market forces, we must also recognize that the task will come at a price--eventually.
That leads us to assess the current dilemma, including the cries that unfettered market forces as the source of the financial and economic pain. First, we need to recognize that market forces, by their nature, are a volatile lot and in the short term there will be pain. Joseph Schumpeter, among others, made this clear long ago. In exchange for short term pain, however, is the prospect of long-term gain that, in the aggregate ends, produces a net plus for the economy overall. In the meantime, market forces will naturally and inevitably produce pain in one corner of the economy on an ongoing basis. Growth, after all, requires innovation, and innovation is by nature experimental, and experiments sometime stumble. Is that a sign of market failure? Absolutely not.
Let's also recognize that the broad efforts at promoting the Great Moderation have probably exacerbated the pain by promoting 20 years of borrowing and risk taking that might not otherwise have occurred if recessions weren't tamed. By pushing the payback into the future, the accumulated price tag has grown, and is now coming due, with interest.
No, we're not arguing that our economic policy should return to the 19th century, when booms and busts were dramatically more frequent and severe and government intervention was virtually unknown. The dismal science has learned much over the years and there's no reason to think that an intelligent management of the economy can yield benefits, or at least minimize the pain. But there's a limit to the benefits that can be extracted from market cycle management, and we may have reached those limits.
Conceptually, an intelligent economic policy will seek a) to maximize the growth that naturally flows from creative destruction; and b) minimize the pain. There are multiple points of equilibrium in that tradeoff, and deciding which point is preferable is a political decision, and an evolving one at that.
Economically speaking, the tradeoff is likely to yield relatively meager results in the next few years, if not the generation ahead. Why? Because the benefits of the past have been unusually big.
What's coming will not be evidence of market failure. Rather, it's the cost of the "free lunch" we've all been enjoying over the past 20 years. So, yes, the bill has arrived and we're being asked to pay. But this time, management is only accepting cash.
July 22, 2008
A BRIEF INTERMISSION...
CS is indulging in a mid-summer holiday. What passes for normal on these digital pages will return on July 28. Meantime, be well, stay cool, and keep an eye out for the proverbial second shoe, which may already be in a descent near you.
July 21, 2008
THE POWER OF RISK (MANAGEMENT)
Risk and return are the twin sons of Mr. Market, but the equivalency ends there.
Return doesn't lend itself to forecasting, at least not in the short term. But when we look further out in time, there's a bit of transparency at times about what's coming. Meanwhile, risk's a bit more reliable generally when it comes to seeing the future, and that small opportunistic opening gives us a leg up on being completely and utterly subject to Mr. Market's whims.
Shrewdly blending the little intelligence we can gather from the market in terms of risk and return forecasts offers strategic-minded investors the last, best hope for success in portfolio management.
One example: if stocks generally offer a relatively high dividend yield compared with the past, numerous academic studies show that the odds are enhanced for earning higher-than-average returns over the subsequent three to five years and beyond. Mind you, there's no guarantee, but the higher the yield, the better the odds. But we can't rely on this prospect alone, which is why we can't apply this concept to one or two stocks. Instead, we greatly improve our odds of tapping higher-than-average returns by diversifying.
In other words, buying a broad portfolio of stocks at a relatively high dividend yield further increases our chances for beating the buy-and-hold long run performance. Combining the two risk management strategies--buying when yields are high and diversifying the bet--offers more confidence of earning above-average returns than either strategy does in isolation of the other.
We can further enhance our prospective risk-adjusted return by taking the advice above and applying it to multiple asset classes. Once again, we must do so intelligently, by leveraging what we know about risk and it's slightly better odds (compared to pure return forecasts) for extrapolating the past into the future. That is, correlations and volatility matter when considering how to intelligently blend multiple asset classes for above-average results.
If we look to bonds, we know a lot in terms of how they compare to stocks. We don't what the returns of each are going to be, at least not completely, but their relationship tends to be fairly stable over time. One, bonds tend exhibit relatively low standard deviations and correlations compared with equities. Again, that information by itself isn't much help, but it becomes quite useful when combined with what we know about stocks, as per our review above.
Let's say that we're committed to owning both stocks and bonds, based on the fact the two asset classes tend to provide complementary diversification benefits, i.e., one tends to zig when the other zags. The fact that bonds also exhibit low volatility compared with stocks sweetens the diversification deal. Knowing all this, if we also look to buy bonds when their yields are relatively high, we improve our odds of beating a buy-and-hold bond strategy in the long run.
We can take advantage of similar diversification and valuation opportunities by also considering commodities, REITs, currencies and cash as additional components for our portfolio. In fact, we may even find additional risk management value by breaking equities into several constituent parts, i.e., by region, industry or style. Ditto for the other asset classes.
So far, we've only been speaking of risk management in terms of betas, which is to say index funds. But perhaps we can further broaden our opportunities by considering alphas, such as market neutral funds, merger arb funds, managed futures funds, skilled stock pickers, etc.
In addition, if we consider all of our potential choices in the context of asset allocation--choosing portfolio weights for each by way of some economic logic--we may be able to add another layer of risk-management value to our strategic aims. And once the asset allocation is set, the prospect of a "rebalancing bonus" avails itself. Rebalancing in this sense is applying a tactical overlay to the strategic asset allocation in the management of the various asset class components through time. This is yet another risk management tool that can aid our strategic cause.
There are additional risk management applications to consider, but we'll leave it here for the moment. The basic point is that by focusing on risk management, strategic-minded investors can improve their investment results compared to buying and holding the global market portfolio.
Of course, a few caveats are in order. First, there are still no guarantees. It's possible, perhaps even likely that an intelligent investor can wield all of the above and still fall short of the long-run returns available from buying and holding the global market portfolio, which is available to everyone at a very low cost and that requires virtually no adjusting. Why? One reason is that as we blend risk management strategies, we build a more complicated portfolio, and so we must monitor and manage more variables. At some point, we face the hazard of taking on too much. It's tough to make five flawless investment decisions year in and year out; it's even tougher if there are ten annual choices, or 20 or 30. Also, more complicated portfolios incur more transaction costs, taxes, and other real-world frictions that work to our disadvantage. The more active our portfolio, the higher our results must be to overcome the drag. Expenses, in other words, add up and take a hefty toll over time.
Having said all this, let's return to our main point, which is that managing risk is the only game in town. Predicting returns directly, and in isolation of risk management, is a game for fools. Even so, we must proceed down the path of managing risk cautiously, prudently and only after we've done our homework. Each investor must decide how many risk management techniques to embrace. Some--such as diversification--are so basic and fundamental to our interests that we can't ignore them. But to the extent that we are considering adding new layers of risk management to our investment strategy, we should do so judiciously.
Risk, it seems, is our friend and foe. With a little common sense, and an understanding of history, we can keep it in the former camp. But that requires eternal vigilance. Success in risk management can unravel when our backs are turned. Perhaps that's one more reason to consider Mr. Market's global portfolio, which comes fully enabled with a self-sustaining risk management package, and at an attractive price.
July 17, 2008
WAS THAT A BOTTOM? SHOULD WE EVEN CARE?
Maybe, maybe not. We don't know and no one else does either. At least not today.
Nonetheless, it's tempting to say that Tuesday's intraday low of 1200.44 for the S&P 500 certainly looks like the trough--for the moment. Yesterday's bounce skyward already has some pundits speculating that a return of the good ole' days is imminent. And, of course, there's a few select bits of news to support that notion, including a sharp drop in oil prices, a confidence-boosting announcement for the battered financials by way of a dividend hike for Wells Fargo, and some better-than-expected news on business conditions for three stalwart names in the Dow Jones Industrials.
Of course, we could easily counter the upbeat reports with bearish ones. In fact, that's always true. There's never a shortage of reasons to worry, or to hope. Depending on your mood, you can find corroborating evidence to support the forecast preference du jour.
Alas, there's virtually no chance of calling bottoms or identifying tops, at least not in advance, or ex ante, as the academics say. The rear-view mirror, on the other hand, is always reliably lucid. No wonder, then, that looking backward tends to have an oversized influence on investor sentiment today. The problem is that the past, sans an informed and thoughtful historical perspective, is of little help to the strategic-minded investor.
Indeed, developing strategic perspective is an unnatural act for the human species. That's not to say that it can't be learned. But the path of least resistance is one of extrapolating from the very recent past as a basis for anticipating the very near future. That may work for traders and sail boat enthusiasts checking the weather at sea, but it's bound to lead you astray eventually when it comes to finance.
For those with an investment horizon of considerable length--five years or more--there's a better way, or certainly a way that's less prone to egregious error. The better path starts by admitting that the 14 oz. mass of tissue within our craniums isn't normally suited to thinking strategically. Tactical notions are more its style. Exhibit A is the rush of pleasure most of us get when we buy or sell when doing so with the crowd; or, the pain we suffer when we act alone.
Volumes have been written on how investors are at risk of becoming their own worst enemy when it comes to strategic thinking on matters of investing. We won't belabor the point here, other than to remind that the intersection of human psychology and money is a broad and rich field of study that's dispatched a sea of insights into how Mother Nature has left us high and dry for thinking prudently on matters financial. (For any one who's curious about behavioral finance, here's a solid overview of the literature.)
Reprogramming our heads for winning the investment game isn't easy, nor is it clear that there's a solution per se. More than 50 years of research in financial economics has taught us much about what works, and doesn't work in money management. But there are still no guarantees, and much of what we've learned has application only for long-term investing horizons. In many ways, we're as clueless about the short run as we've ever been, although that doesn't stop many from asserting otherwise.
As for the basic strategic lessons, it all boils down to:
1) Diversify broadly, across as many asset classes as you can reasonably and efficiently own; if you're not sure about how to weight and choose assets, Mr. Market's asset allocation will probably fare modestly well over time.
2) Minimize trading, reserving it for those times when your confidence about the future is relatively high. If you don't have much confidence about weighing the odds for what will happen down the road, then rebalance your portfolio every year or so, or perhaps more frequently when markets move dramatically. This advice, of course, requires a solid asset allocation benchmark as a basis for rebalancing. Not sure how to proceed? See item 1 above.
3) Keep expenses low, which is to say favor index funds as a general rule unless you have a deep conviction otherwise. But for most investors, passive investing will do quite nicely, even though it won't win the horse race.
4) Stay focused on the long run. Alternatively, if you don't have a long-run horizon, act accordingly with risk allocations.
If you're inclined to be active in your portfolio decisions, start by looking to take advantage of extreme moments on an individual asset class basis. That requires patience, since extreme moments, by definition, don't come along every other Tuesday. That said, if stocks are selling at high valuations, pare your exposure; if they're selling at relatively low valuations, raise the equity weight in your portfolio. (For some recent perspective on equity valuation, see our post from last week.) The same concept also applies to the other asset clases. In sum, be opportunistic, but neither chase performance or fall into a perma-bear state when prices slump for an extended period. And when you do rebalance, look to roll out the changes over the course of a cycle so that you don't bet the farm on thinking we've identified the bottom, or top, in real time.
Recognize, too, that almost everything we've learned about strategic-minded investing is less about boosting return than it is about lowering risk without paring much, if any return.
Finally, try not to get caught up in the tick-by-tick mentality of trading. We humans are highly vulnerable to what's happening now, this minute, this second. And we like to judge our success, or failure, based on what happened in the previous week. It doesn't help that we like to mingle with other investors at cocktail parities and compare notes. No, we're not suggesting that we all become monks and cancel our news subscriptions and real-time data services. But strategic success will require some compromise and concession, and that includes giving up some of the entertainment that comes by watching markets in real time.
A little common sense, in other words, is also necessary for strategic success. Perhaps there's some hope of investment victory after all.
July 16, 2008
PRICE TROUBLES ONCE MORE, BUT STILL HOPING FOR A BREAK
Today's update on consumer prices for June is one more bit of bad news on inflation. But maybe, just maybe, the inflationary momentum is about to break for a while.
Before we dive into what may, or may not happen, let's review the latest numbers. Consumer prices surged by 1.1% last month, the Bureau of Labor Statistics reports. That's the highest monthly gain since 1981. On an annual basis, CPI rose by 4.9% through last month--the highest since 1991.
There's no doubt what's behind the price hikes: energy prices jumped 6.6% last month, the government reports. The surge in energy costs spilled over into transportation, which climbed 3.8% last month. Food isn't lying low either, although its 0.8% advance in June looks modest by comparison with energy and transportation.
Once again, if you take out food and energy prices, the resulting core-CPI is up a modest 0.3% last month and for the past year has climbed just 2.4%, which is middling based on the last three years.
The Fed, of course, likes to focus on core inflation, in part because a number of economic studies have shown that it's a better predictor of top-line inflation. That's certainly been true in the past, although there's a danger that the old relationships are breaking down, as we've discussed many times over the years, including here and here.
It doesn't take a Ph.D. to recognize that a slump in oil prices would go a long way toward salvaging the belief in core inflation as the better yardstick for setting monetary policy. As luck would have it, crude prices dropped sharply yesterday. The August '08 contract in New York shed more than 4% yesterday. Even so, we'll need a lot more down days to take the edge off inflation. Crude, after all, is still lurking at almost $140 a barrel as we write.
Still, the prospect of demand destruction for energy, along with a lot of other goods and services can't be dismissed at this point. The economies of both the U.S. and Europe look set for more weakness in the balance of this year and probably well into 2009. The underlying factors driving the weakness are by now familiar, including a liquidity crisis in the financial sector, a real estate correction, rising unemployment, and soaring commodity prices. All of which promises to nip demand in the bud in the coming months and quarters.
Recession, in short, is still very much a threat. In addition, the prospect of slow/no growth economy after the technical end of the recession remains a distinct possibility. As such, one can imagine that oil prices will correct, or at least stop rising once the market fully factors in the economic outlook. In turn, an oil price correction would go a long way toward keeping inflation in check from here on out.
But let's not get too giddy. Rising commodities prices generally, and oil in particular, are based on a fundamental shift in the supply/demand equation in the global economy. To restate the obvious: demand has risen sharply in recent years while supply growth has lagged. Perhaps we'll enjoy a break from the trend and see energy prices fall in the wake of economic slowdown or worse. Maybe. It all depends on how much of a global slowdown we're looking at, and how much influence the U.S. has over oil prices these days. The latter subject is open to debate, thanks to the rise of China, India, etc. and the relative maturing of the U.S. economic growth outlook compared with emerging markets.
In any case, it wouldn't surprise us to see oil prices drop sharply from current levels. Volatility and commodities, after all, are old friends, regardless of economic conditions. Longer term, however, it's unlikely that oil prices are due for a sustained fall. Noise may dominate the short term, but supply and demand dictate price trends over time. That means that while inflation pressures may ebb for a time, the respite will only be temporary, assuming it comes at all.
July 15, 2008
THE ROCK AND NOW THE ROLL
Blood is definitely running in the streets these days. The troubles at Fannie Mae and Freddie Mac and the run on IndyMac Bank are only the latest examples of the various ills afflicting the markets and the economy. Discouraging as all this is, the ongoing challenge of upward inflation momentum won't help.
Today's update on wholesale inflation for June suggests that inflation may get worse before it gets better. The annual pace of producer prices was an astonishing 9.1% through last month--the highest since 1981. And there's no salvation in focusing on core wholesale prices, which rose by 3.1% for the year as of June--the highest since 1991.
No matter how you slice it, wholesale inflation has taken wing. We can only guess what tomorrow's report on consumer inflation will show, but it would come as no surprise to see higher numbers on that front as well.
The Fed is still more concerned with disinflation/deflation arising from the liquidity crisis in the finance and real estate sectors, thus the 2.0% Fed funds rate. Perhaps that's prudent, perhaps not. Either way, it doesn't change the fact that the cyclical slowdown has yet to tame the pricing pressures, as the Fed has continually said it would.
Adding to the inflationary woes is the bubbling of prices in overseas markets, starting with China. That's doubly troubling because in China's reaction to fighting rising inflation is less than encouraging. As the Wall Street Journal today reports, "China Falters on Inflation Fight."
Some of the problems are related to the dollar, which continues to weaken. Indeed, the buck hit a new record low against the euro today. China long ago hitched its currency to the greenback, which means that U.S. monetary policy is exported to China. Breaking free of the relationship, which effectively gives China a looser monetary policy than its domestic economy warrants, is proving difficult, in part because to do so threatens to materially slow the Chinese economy. Having grown used to 10% economic growth, China's in no mood to tighten their belts, especially right before the high-profile summer Olympic games. But as the U.S. learned in the 1970s, printing money as a tool for boosting economic growth is, at best, a short-term fix, and one with a hefty price tag once the party's over.
Meantime, oil and many other commodities are priced globally in dollars. No wonder, then, that as the dollar falls, commodity prices rise. Or is it vice versa?
In any case, all eyes will be on Fed Chairman Ben Bernanke in his testimony to Congress today and tomorrow. It's not clear that he can say anything to wipe away the worries, although there's the possibility that he could make things worse if he's not careful with his chatter.
As such, strategic-minded investors should stand ready to start nibbling at asset classes, particularly if they spike down in the coming days and weeks. U.S. stocks, junk bonds and REITs have been particularly hard hit of late. Meanwhile, we're not inclined to chase commodities at these levels, although fully selling out previously established positions isn't recommended either. Nonetheless, if you've owned commodities for some time, it's a good time to start thinking about rebalancing from winners to losers on an asset class level. No, we're not sure that bottoms in stocks, junk and REITs are imminent, but if you have a long-term horizon you could do a lot worse by starting to buy, albeit cautiously and with an eye on time diversifying purchases over the coming months and perhaps even years.
More generally, a fully diversified global portfolio across all the major asset classes is still the only game in town. The good news is that some portions of the global asset allocation pie look more attractive on a long-term basis than others. That's always true, but it's been quite a while since the differences have been so stark. In short, this is no time to be blinded by the volatility. Opportunities like this don't come along every day. Even so, no one said this is going to be easy. Tapping risk premia takes a lot more discipline than it used to. Inflation, it seems, really is everywhere in 2008.
July 11, 2008
Another monthly report on import prices, and another monthly record high. If that sounds familiar, you're right. In fact, we can almost set our watch by the reliability of the trend these days.
No wonder, then, that we've become a broken record on the subject. Our only defense is that our recurring message is a reflection of the consistent rise in import prices, which we've written about regularly in the recent past, including here and here and here.
As we've discussed over the years, there are many hazards of letting prices rise with nary a monetary peep. The hazards continue to increase now that import prices are advancing at more than 20% a year, as of last month. As far as we can tell, that's the fastest pace on record, based on the data available on the Bureau of Labor Statistics' website, as the BLS chart below shows.
The rationale for doing nothing is that a recession/deflation risk coexists with the inflation danger, as the Bank for International Settlements noted in its recently published annual report:
This combination of rising inflation pressures and financial disturbances
slowing demand growth is open to a spectrum of interpretations. On the one
hand, if slower growth were thought just sufficient to hold global inflation in
check, albeit with a lag, this could be viewed positively. On the other hand, the
eventual global slowdown could prove to be much greater and longer-lasting
than would be required to keep inflation under control. Over time, this could
potentially even lead to deflation, which would evidently be less welcome.
Unfortunately, when one considers the possible interactions between a
weakening real economy, high household debt levels and a severely
stressed financial system, such an outcome, even if unlikely, cannot be ruled
With conflicting signals swirling about, these are not easy times for central banks. Dealing with one or the other is within policy powers of the Fed (assuming the discipline to carry out the relevant monetary prescription). Tackling both simultaneously, however, is more of gray area, with limited precedent of success for encouraging optimism with the current battle.
That leaves us to question whether it's time to hedge one's bets a bit by at least tightening slightly. For the moment, the Fed is having none of that and instead seems intent on betting exclusively on the recession/deflation risk, in effect hoping that the inflation hazard will fade away in due course.
It's a nice theory, and it may ultimately prove accurate. But heaven help the man in the street if the Fed's wrong. So far, one can argue that the bet has been a net loser for Joe Sixpack, courtesy of the bull market in oil. Crude's priced in dollars and to the extent that dollar-based inflation is a problem, oil prices will rise in sympathy. True, supply/demand factors are also pushing up oil prices, but a portion of that rise is surely linked to the weak dollar. And with the Fed's current monetary stance, combined with
It's anyone's guess if Bernanke & Co. will win this game of chicken. So far, there's not yet much sign of success in the numbers, least of all in import prices. Even if you take out petroleum, which is the primary source of the imported inflation, import prices are still climbing by more than 7% a year. That's better than 20%, but it's still not encouraging, all the more so when you consider that higher oil imports are this country's destiny for some time to come.
By comparison, the 10-year Treasury yield is a mere 3.81%, as of last night's close, and Fed funds remain at 2%.
For the moment, we're left to wonder (and hope) that next week's update on consumer prices will bring better news on the inflation front. Meantime, it promises to be a long weekend.
July 10, 2008
WATCH THOSE YIELDS
Equity markets are down, which means that dividend yields are up.
It's a fundamental relationship, and one that endures. No wonder, then, that a growing body of academic research (and a healthy dose of common sense) counsels that the relationship produces valuable clues for strategic-minded investors. In short, raise equity weights when yields are relatively high, and trim that exposure when yields are relatively low. Ideally, such shifts are done gradually, over time, to manage the risk that no one really knows if current yields will remain the apex, or trough, for the cycle.
There are other factors to consider in managing portfolios of course. For the moment, however, we'll focus on dividend yields, which are up these days, as our chart below shows. Indeed, some corners of the world's equities markets are sporting rather attractive yields, relative to recent history.
Europe leads the way among the globe's major regions, posting a 4.35% yield (based on the trailing 12 months) as of June 30, 2008. (All data is via S&P/Citigroup Global Equity Indices.) How high is 4.35%? It's the highest in at least 13 years. After factoring in the selling so far this month, the current trailing yield is almost certainly a bit higher today.
By comparison, the U.S. trailing yield is quite a bit lower at 2.0%, although relatively speaking that's close to a new high based on data since 1995. And if we consider the continued selling this month, we may already at a new high in yields in the U.S. market generally.
Meanwhile, developed markets in Asia are at a new post-1995 yield high, as is the developed-world equity market ex-U.S.
It's a different story in emerging market stocks. As our second chart below reveals, yields are still middling relative to the their history since 1995, ranging from 1.38% for Latin America up to 2.65% emerging Asian markets, as of June 30. Of course, one might argue that the allure of the emerging world is the growth potential rather than its yield capabilities, and so dividends aren't all that important here. Perhaps, although for the moment there's not much growth in share prices anywhere and so dividends are a lone bright spot.
In the long run, dividends do matter, at least for a broadly diversified portfolio. No one should buy, or sell stocks solely because of dividends, of course, or any other single metric. But neither should strategic-minded investors ignore the income stream produced by stocks. Indeed, when equity yields move to extremes, the associated signals about prospective returns are more reliable. History, at least, tells us so.
The eternal question, of course, is whether we can accurately identify extreme levels in real time. Inevitably, that's a speculative task and prone to error. Nonetheless, it's clear that in some markets we're quite a bit closer to the extreme than we have been in quite a while. As a result, the odds have improved for buying now in anticipation of receiving relatively higher total returns over the next five years-plus compared with buying six months ago.
That doesn't mean that yields won't be even higher down the road, or that buying today insures a profit as of, say, July 10, 2013. The future is always unclear, and that introduces risk. But at least we have some clues about what's coming, a message that boils down to the basic lesson that Ben Graham taught us all those years ago: valuation matters.
July 9, 2008
THE MEANING OF VOLATILITY
Yesterday we profiled correlations; today, we update volatility.
In preview, vol is up, which is to say that it's no longer down, as it was for several years previous. The bear market in volatility ended in late 2006/early 2007, as our chart below reminds. As it happened, the windup in vol's decline preceded the start of the bear market in equities. If you're thinking that volatility's nadir was a clue of things to come, you're right. In fact, we considered no less in the recent past, including this post from January 2007, when we advised, after a long spell of falling standard deviations: "Higher volatility is probably coming, one day, and history reminds that sometimes higher volatility is forged by falling prices."
But that was then. What of the future? As always, we can only guess. Fortunately, we can also learn from history. No, not everything is revealed by looking backward, and certainly not with full clarity about what's coming. Still, Mr. Market leaves a few crumbs of insight about the morrow.
On that front, volatility at the moment has little to tell that we don't already know. Yes, standard deviations in the major asset classes are rising, as we suspected they would after reaching unsustainable lows in late 2006/early 2007. Based on the above chart, one may expect that vol still has a ways to go, which suggests that the selling isn't about to dry up just yet.
The broader point is that standard deviations, like much else in finance and business, are subject to cycles. Alas, the exact nature and timing of the cycles are fully transparent only in hindsight. But don't despair: vol cycles aren't completely obscure in real time either. What's more, the primary value of this metric--other than considering the historical context for building informed portfolios--is taking the hint when standard deviations are at extremes, high or low.
Yes, there'll always be a debate about whether the current levels are at extremes, or not. But that's where history comes in handy, if only to provide some guidelines. We can start from the premise that vol won't fall to zero. Stepping out a bit on the speculative path from there we can say that a precipitous drop in vol--particularly if it's been several years in the making--will run out of momentum. When it does, the shift in trend is a warning signal that higher volatility may be coming, which almost surely means falling prices.
Generally, falling vol is a byproduct of rising prices; meanwhile, rising vol comes by way of falling prices. This knowledge/assumption, combined with an understanding of the mechanics and implications of correlations and valuation (dividend yields, p/e ratios, etc.) adds up to a powerful tool kit for coming up with an informed guess about what's coming and building diversified portfolios that have some chance of meeting expectations, or at least not disappointing too extensively.
Why go to all this trouble? One reason is that prices are almost impossible to forecast directly, at least in the short term, which we define as something less than two years. Volatility, correlations, and other non-return measures are a bit more amenable to analytical predictions, which open the door to price predictions by reverse engineering through the other metrics.
Does it work? Sometimes, although one can't be sure until the future arrives. In short, there's still a fair amount of risk embedded in even the most enlightened investment strategies. No surprise, since the presence of risk implies that there's also a risk premium lurking about.
Yes, Virginia, there's an order in all the chaos, and so some of Mr. Market's patterns may be visible to the naked eye. Sometimes.
July 8, 2008
Diversification isn't everything, but it's a lot. And sometimes, it's everything.
It doesn't take much analysis to recognize that asset allocation's value has risen sharply this year. More precisely, the right asset allocation has generally made the difference between losing a lot of money and either losing a little or even turning a profit this year. Even a passive asset allocation across the major asset classes has generated potent benefits. Indeed, the year-to-date performance numbers for the major asset classes midway in 2008 are wide ranging, as we noted last week.
That's in sharp contrast to the horse race as it looked mid-year in 2007, when almost everything was running higher. No wonder that halfway through 2007 there was chatter that asset allocation was washed up as a strategic tool. Who needs to own everything when robust returns are falling out of trees?
So it goes in the cyclical mindset of investing analysis for the crowd, which too often succumbs to belief that the recent past informs the future. Yes, wisdom on Wall Street tends to wax and wane over time, but on these digital pages diversification's value endures, as our update on correlations remind.
But let's be clear: diversification is anything but static. It prevails over time, but in the short run its offerings vary, as our chart below reminds. (For easy reading, click to launch a larger view of the chart.)
Let's start by noting that as equity markets have corrected this year, correlations between the U.S. stock market (Russell 3000) and foreign markets have trended higher. (Correlations range from 1.0, or perfect positive correlation, to -1.0, perfect negative correlation. Generally, mixing assets with less than perfect correlation improves expected risk-adjusted performance.) The same can be said of U.S. stocks and REITs. That's par for the course in bear markets, where like-minded products tend to dive together. Of course, there are always a few surprises along the way. The fact that the correlations between REITs and equities is so high of late can be chalked up as bad luck born of the fact that bull markets in real estate and stocks seemed to have peaked together this time around.
Meantime, look at the brown, purple and blue lines in the bottom right-hand corner of the chart. Note that all have been falling for the past year or so relative to the Russell 3000. (For simplicity, all correlations in the chart are calculated relative to the Russell 3000.) Unsurprisingly, all three of these lines (representing commodities, U.S. bonds and foreign-government bonds denominated in foreign currencies) have historically provided valuable diversification benefits relative to stocks when the diversification is needed most. By the standards of the first half of this year, those benefits are once again alive and kicking.
Nonetheless, correlations fluctuate over time, sometimes dramatically. The fluctuations occasionally offer clues about what's coming. Such was the case in 2006 and early 2007, when correlations generally were rising. But just when it seemed that diversification's value was fading, the worth of broad ownership was only beginning to shine.
For those who stayed committed to holding a diversified portfolio across the major asset classes, the payoff has been sweet. But we have no doubt that when the bear market is over, and bull markets in equities bloom anew, diversification and asset allocation will once again fall victim to criticism and neglect. Perhaps that's why diversification remains so valuable over time, i.e., many if not most investors ignore its benefits at critical junctures, effectively leaving large arbitrage opportunities across asset classes on the table for strategic-minded investors.
If everyone woke up to strategic diversification's value, the benefits would undoubtedly diminish. Even so, that would inspire a fresh wave of skepticism and create new asset allocation opportunities as investors bailed out of the idea. Hope, in short, never fades for strategic-minded investors.
July 7, 2008
A SLIPPERY RISK PREMIUM
Oil is a commodity, but it's also something more, and therein lies the complication. And risk and opportunity.
The dual status of oil as raw material and proxy for global macroeconomic risk dates to at least the 1973-74 oil crisis, when OPEC waged an economic war against the West with crude as its primary weapon in support of the Arab attack on Israel. Although oil was used previously as a strategic weapon, the events of 1973-74 elevated the commodity's profile on the global stage on that front to unprecedented heights. Since then, oil's price has reflected the forces of both supply and demand, and global risk perceptions.
Supply and demand are almost always the dominant pricing factor. Global risk's influence on price, by comparison, waxes and wanes. In the late-1990s, the risk premium in oil was relatively low; today, it's quite high.
No one can say for sure how much risk impacts price for oil on any given day. But it's clear that crude is not just another commodity. Yes, gold too is influenced by global risk, but gold has no strategic economic use. Jewelry and industrial demand are pricing factors for the precious metal, but those applications are hardly critical in the global economy. In any case, most of the gold mined in history sits in vaults and safe-deposit boxes and so no one worries about a shortage. The only question is price, which is largely driven by sentiment and the vague memories that the metal was once used as legal tender. We don't discount gold's value as indicator of danger in the world economy, but in terms of practical applications it's virtually irrelevant next to oil.
Oil's dual role is no secret, of course, and much ink has been spilled over the years on the subject. Yet it seems that some analysts don't fully grasp the implications. There's no shortage of research focused on oil's economic status in isolation of the political risk, a narrow view that leads some to wonder why the commodity's price remains so high. Cries of "the fundamentals don't support the price" are common. A number of observers of the energy scene have gone so far as to charge that speculators are to blame for the bull market in oil, insinuating that buying the commodity's futures contracts, either directly or through publicly traded funds such as commodity ETFs, is somehow illegitimate if it's not tied directly to refinery activity.
In fact, such claims overlook the fact that going long oil offers a hedge on global risk. At the moment, there's no shortage of risk fears. Perhaps at the top of the list are reports of Iran's recent threats to block the Strait of Hormuz--through which 40% of the world's oil moves--if and when it's attacked.
More generally, there's an ongoing apprehension about oil and its potential to destabilize political and economic plans. "We do have to do something about the energy problem," Secretary of State Condoleezza Rice told the Senate Foreign Relations Committee in 2006, via Spero News. "I can tell you that nothing has really taken me aback more, as Secretary of State, than the way that the politics of energy is… ‘warping' diplomacy around the world. It has given extraordinary power to some states that are using that power in not very good ways for the international system—states that would otherwise have very little power."
Some of oil's status as more than just another commodity resonates on the global stage in ways that aren't always obvious. Take China's growing appetite for energy to support its economic growth. The Middle Kingdom's search for reliable sources of oil have pushed Beijing to invest far and wide, sometimes bringing economic resources and money to nations that the U.S. considers something less than a strategic ally. Oil, in short, creates a broad array of tensions in the world.
The challenge for strategic-minded investors is separating the risk-premium in oil's price from the pure economic factors. This is inherently a speculative task and so no one can be confident that they understand how much of oil's price is affected by risk considerations vs. supply and demand analytics. Nonetheless, the biggest risk is underestimating, or ignoring the potential for an oil risk premium--which can and does fluctuate widely over time.
In fact, the risk premium itself is the source of a significant amount of risk. Because its driver is sentiment, it can rise or fall dramatically, sometimes overnight. Or, it may adjust slowly over time, almost imperceptibly, catching economic-focused oil analysts by surprise.
In a perfect world, someone would model the oil risk premium and create an ETF to track its synthetic value. Alas, risk isn't always so open to quantitative analysis and hedging. No wonder, then, that speculation and guesswork are rife when it comes to pricing oil, a necessity that leads to mistaken estimates at times, if not routinely. But as hazardous as this terrain is, the landscape is even more so if you ignore the oil risk premium and its capacity for laying waste to the best laid plans of mice and men.
July 4, 2008
232 YEARS AND COUNTING...
Happy Independence Day to all our readers. Here's our favorite excerpt from the seminal document:
We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness. — That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed, — That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it, and to institute new Government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their Safety and Happiness. Prudence, indeed, will dictate that Governments long established should not be changed for light and transient causes; and accordingly all experience hath shewn that mankind are more disposed to suffer, while evils are sufferable than to right themselves by abolishing the forms to which they are accustomed. But when a long train of abuses and usurpations, pursuing invariably the same Object evinces a design to reduce them under absolute Despotism, it is their right, it is their duty, to throw off such Government, and to provide new Guards for their future security.
July 3, 2008
STIMULUS OR BUST
The stimulus checks may be propping up consumer spending, at least temporarily, but the job market is still weakening.
Initial jobless claims jumped to 404,000 mark last week, up from 388,000 the week previous the Labor Department reports. That's only the second time the 400,000 mark has been passed on the upside in many a moon, the previous instance coming this past March 29 when claims reached 406,000.
As our chart below shows, the trend is clear: new filings for unemployment benefits continue running higher. It's not clear that the stimulus checks will deliver salvation. There are many negatives weighing on the economy, from rising energy prices to the unwinding of various debt burdens, and those ills aren't about to evaporate next week because consumers are receiving checks in the mail for $600 to $1,200.
Reading the writing on the economic wall, Washington is now talking about a second stimulus package.The political inclination to act is understandable, but at some point the correction will have its way. Trying to keep the growth cycle alive indefinitely isn't plausible, nor is it possible--or even healthy. Yes, the past 20 years suggests otherwise, but the pain has simply been pushed forward.
Strong growth ultimately arises from ashes of recessions--a harsh but ultimately accurate fact. Artificially keeping the growth alive in order to avoid recessions risks nipping future growth in the bud. Again, politics calls for no less, but in the end it's not obvious that letting the political mindset run the show is the best long-term strategy for the man in the street. That won't stop Washington from moving heaven and earth to try and re-engineer a more comforting outlook, although the patient may not respond as expected this time.
July 1, 2008
A MONTH OF SEEING RED
Blood was definitely running in the streets last month.
As our table below reminds, red is now the dominant color in performance tallies. But black hasn't been completely banished. For those who owned commodities, inflation-indexed Treasuries or cash, June wasn't a complete loss.
Commodities, of course, were the big winner last month. The Dow Jones-AIG Commodity Index surged more than 9% in June and is now up 27% so far this year, based on the exchange traded note proxy cited in our numbers above. Clearly, if you didn't have commodities exposure in your portfolio, your portfolio suffered.
Although it's tempting to chase the hot performance in commodities, strategic-minded investors should be wary at this point. The DJ-AIG Commodity index, like all commodities benchmarks, has been rallying for years. The last calendar year loss for DJ-AIG Commodity was 2001. If the index manages a gain by the end of 2008, that will mark the seventh straight year of calendar year gains.
No, we're not willing to say when the commodities boom will end. For all we know, it'll go on for another seven years. Then again, it could end tomorrow. As a general rule, however, the longer any asset class rallies, the more cautious we become on estimating expected returns. At the same time, the longer asset classes endure selling, the more optimistic we become.
That said, we never doubt the value of diversification across all the major asset classes. On that note, we're adding a new monthly update to our usual scorecard of asset class returns. As you can see in the table above, there's a new line at the bottom for the Capital Spectator Global Market Index. This benchmark, compiled and updated by your editor, owns all the major asset classes in their respective market-based weights. We'll be writing more about the CS Global Market Index in future posts; meantime, here's a brief overview, as per our recent post.
Returning to the issue of June's performance, it's clear that the CS Global Market Portfolio Index was only slightly bruised in last month's selling. Posting a relatively mild loss of 1.8%, our global market index has held up quite well. It's encouraging to see that for the past year it's up 3.7%.
In fact, the value of owning everything in its market-based weight is that over the long term the mix has proven itself a worthy competitor to those who attempt to outguess Mr. Market. Or so history tells us. No guarantees for the future, of course, although there are fundamental reasons for thinking that more of the same is available for patient investors. One reason is that a market-weighted portfolio of everything requires no rebalancing. That, in turn, keeps trading costs, and associated taxes at zero, excepting, of course, for any distributions from the various funds. Meanwhile, building a real-world portfolio based on all the major asset classes via ETFs, ETNs and index mutual funds carries a low fee in terms of dollar-weighted expense ratios--something on the order of 50 basis points.
To be sure, owning everything isn't a short-cut to easy riches. Nor can any one say for sure that it'll always and forever beat the majority of actively managed portfolios. As we learned last month, even a global market portfolio can lose money at times. But to the extent that diversification is a good thing, the world's equities, bonds, REITs and commodities are available for a relative song. For most investors with a long-term perspective, partaking of the full offering of the world's markets is a compelling strategy.