September 30, 2008
SPECULATING ON THE FUTURE
Yesterday's huge tumble in the stock market has spread fear far and wide among investors, your editor included. But focusing on the here and now isn't the answer. This too shall pass, but not anytime soon.
What's a strategic-minded investor to do? Nothing at the moment. If you haven't been trimming back on risk in your portfolio, now's not the time to start. Easy to say, tough to do. But investing isn't easy and panic selling is never the answer. Yes, those are just words and it's slim comfort when you look at your investments and see only red. But keep in mind that people like Warren Buffett, and institutions like Citigroup and J.P. Morgan have been buying while everyone else is selling. Why? Because they're looking forward, several years down the road.
We'll go out on a limb here and predict that the global economy will survive, and in a year or two it'll be thriving once more. One reason is that there are multiple mechanisms in place to prevent collapse. No, the risk of a deep, systemic failure isn't zero. And, yes, an asteroid could hit the Earth next week. But for those with a medium/long time horizons, the key question you want to ask yourself: What will you think three years from now looking back?
For the 20 or so years your editor has been writing and investing for his personal account there's a recurring theme that gnaws: we didn't take advantage of the calamity. The mind tells us to run when there's danger, and ride with the crowd when skies are sunny. There's some logic to that, but left unchecked it leads to mediocrity or worse over time.
Remember, we're a lot close to the resolution of the mess that started more than a year ago. True, the factors that brought us to this point have been decades in the making, but the markets have been reacting only since mid-2007. Again, it's possible that the bear market will run for another year or two, but that seems unlikely. The central banks are now in open warfare in attacking the bears, throwing money every which way. Eventually, that money will find a home in the capital and commodity markets and prices will stabilize.
But not just yet. There's still too much uncertainty about how deep the financial damage is for banks. And there's the question of whether Congress will, or won't pass a bailout package. And then there's the bigger issue of how all this will affect the economy. A careful study of the numbers strongly suggests that we're looking at a recession for the coming quarters.
Nonetheless, markets are forward-looking animals. We're mildly optimistic that a bottom is near, although that's just pure speculation. But if you're sitting on large allocations of cash, it's time to seriously look at the opportunities. Strategic-minded investors should be prepared to make selective purchases of asset classes now and over the next year. If you're really risk-averse, you may want to wait a bit more.
There's no rush to buy today, this minute, of course. For all we know, the markets could go down much further from here. But this much is clear: the prospective returns of asset classes look dramatically better today than they did a year ago, or even six months ago. The catch is that the payoff probably won't show up for three to five years, maybe longer.
The global economy is now knee-deep in upchucking the excess it swallowed over the past 20 years. It's ugly, it's frightening, and it's necessary to purge the system of the financial and economic toxins. The recovery process will be long and slow. But it's just this kind of climate where opportunity reigns supreme.
In short, it's time to think strategically about buying. Slowly, cautiously and with an eye on making a series of purchases over, say, the next 24 months. Pace yourself, but by all means think about what you want to buy to round out your portfolio, and at what valuation.
There are no easy answers to winning the money game, mostly because emotion gets in the way. But letting what may be the biggest opportunity in a generation pass you by is hardly a winning notion.
If you find it hard to act, try this: make a small, symbolic purchase in an asset class you're underweight the next time prices dip sharply intraday. Why? To break the mindset of fear and inaction. The first purchase in times of crisis is the hardest. In fact, it's worthwhile to extend that thinking by making a commitment to add to your strategic portfolio once a quarter or two times a year from here on out.
It all boils down to whether you can look forward or not. There are better days ahead. Surely you'll want a stake in that future, if only modestly. As frightening as that may be now, the alternative if much worse, as everyone will realize a few years from now.
September 29, 2008
I DON'T LIKE MONDAYS
There's never a good time to release bad news about consumer spending and income, but it's even worse on the day that's likely to witness Congress vote in favor of the $700 billion bailout for the U.S. financial system.
Spending that mountain of cash to salve so much self-inflicted pain will inspire no one, least of all investors. Yes, it may provide a short-term bump in prices, maybe. And it may keep the apocalypse at bay, maybe. And the government may get the money back when it resells the assets down the road, maybe. But in the long run, it's not a productive use of capital. Mopping up spillage never is.
For every argument in its favor, it's easy to worry about the potential for negative blowback. Did we forget to mention that we're in uncharted territory here?
Adding to the woes about the limits of Washington's debt-financed restoration of financial order is news this morning that disposable personal income dropped 0.9% last month, the third in a row. No wonder, then, that personal consumption expenditures were unchanged in August from the previous month.
"With the labor market remaining very weak, slow to negative growth in disposable income will most likely plague the consumer for at least the next six months," Adam York, an economist at Wachovia Economics Group, told CNNMoney.com.
It's hard to see the outcome as anything other than recession. "It looks like we are poised to see a real-term decline in personal consumption and that will likely result in a negative GDP number in the third quarter," James O'Sullivan, economist at UBS Securities opined to Reuters.
As we write, the S&P 500 is off by nearly 4%. Meanwhile, the flight-to-safety instinct is very much humming today. Demand for the 10-year Treasury pushed its yield down sharply to around 3.65% in early afternoon trading, New York time, down from 3.83% at Friday's close.
The problem at the moment is the unknown. The haziness on the future—future earnings, future real estate prices, future this, future that—is weighing on just about everyone. It's going to take time—several weeks, at least—to get a halfway decent guesstimate of what the government's getting for its $700 billion. Add to that the question of how much patience the global markets have for yet another big borrowing binge by the U.S. And what will all this do to Joe Sixpack, and to corporate profitability, and real estate prices, and on and on.
No one really knows, and the depth of the ignorance and the magnitude of its implications have rarely been greater.
Yup, it's a Monday alright.
September 28, 2008
IT TAKES TWO TO TANGO...
As we prepare to enact the mother of all bailout packages, there are lots of questions about how it all happened. As The Big Picture's ever-perspicacious Barry Ritholtz reminds in Barron's, even Wall Street needed some help in blowing itself up. Alas, it's too late for salvation in 2008, but Ritholtz's brilliant analysis of what happened, and why, well, there's always the next time. Too bad that enlightenment in the money game is still cyclical. But we can still dream, can't we?
September 25, 2008
ANOTHER BAILOUT IS COMING, BUT THE ECONOMY'S STILL HURTING
Surveying the financial and economic landscape looks increasingly like an exercise in watching the perfect storm unfold. Today's sour updates on durable goods orders, new home sales weekly jobless claims only strengthen the sentiment.
Durable goods first: they're down. Big time. The government reports that seasonally adjusted new orders for durable goods slumped 4.5% in August, the biggest percentage drop since January. As the chart below reminds, the trend looks equally troubling in actual dollar value as well.
It doesn't help that on a rolling 12-month basis, new orders for durable goods have fallen for six months running. Ditto for the fact that the back-to-back losses of nearly 5% in July and August for the 12-month change in new orders is the deepest loss for two consecutive months in six years. Let's not mince words: the trend is definitely not our friend here.
It's arguably even worse in this morning's weekly update on new filings for jobless claims. As our second chart below painfully shows, the labor market continues to suffer. For the week through September 20, fresh claims for unemployment benefits jumped sharply to 493,000, the Labor Department reports. The last time initial claims were reaching so close to the 500,000 mark was September 2001.
The latest news on new home sales is also disappointing--again. The annual rate of sales of new one-family homes tumbled a hefty 11.5% last month from July, far more than economists were expecting. The 460,000 new houses sold in August is the lowest annualized pace in 17 years.
The message here is one we've been warning of for some time: the economic signals are weak, and they're getting weaker. Initial jobless claims are particularly troubling because they're a forward-looking metric. Joe Sixpack asks for unemployment benefits today, which invariably means he'll be cutting back on spending tomorrow. And since 70% or so of U.S. GDP comes from consumer spending, it doesn't take an I.Q. of 200 to figure out where we're headed.
On top of all this is, of course, the implosion on Wall Street. Our duly elected representatives in Congress are working diligently on crafting legislative salvation as we write, a.k.a., putting together the mother of all bailout packages. We, for one, expect more government money is coming soon, and one could imagine some degree of relief will follow.
But let's not forget the trend on this front: Washington, through its various institutions, steps in with liquidity in one form or another. The initial reaction in the markets is positive, but investors quickly get cold feet and return to selling. Maybe it's different this time, but that's not yet clear. Nor is it obvious that the economy is set to recover, or even tread water.
The final capitulation in the investment realm may still be ahead of us, at which point even greater bargains in asset classes will arise. For what it's worth, we believe tthat to reach that point of maximum opportunity will require a broader, deeper and more comprehensive sentiment adjustment from even currently low levels. We're more than halfway there, or so we guess. Save for a catastrophic collapse, next year will be loaded with bargains. But we've not quite arrived at the station.
But remember that calling bottoms and tops in markets or economic cycles is inherently risky. So, yes, we could be wrong, which is why holding 100% cash is probably a bad idea--ditto for fully loading up on risk, for that matter. In fact, absolute extremes are almost never a good idea, unless the valuation levels are so extreme as to warrant taking a jump. More generally, as Tobin long ago advised, one needs to separate the risk portfolio from the cash portfolio and think intelligently about blending the two halves.
When it comes to designing and managing a risk portfolio, our strategic beliefs remain unchanged. As for cash, well, that needs no explanation.
The great question, as always: what is the appropriate ratio for weighting risk to cash? The answer depends on the individual (or institution), of course, although as a general observation we're not yet convinced that the cash weight should be minimal. But that's just a guess—an enlightened one, we'd like to believe. Or, if you prefer, a strategic outlook. But let's emphasize the word "guess" for now, since that's ultimately at the bottom line of every forecast, be it economic or financial. In the interest of full disclosure, it's refreshing to admit it every now and again.
September 24, 2008
THE ALLURE (AND RISK) OF SILVER LININGS
Financial crises, bank implosions and chaos generally don't often inspire. But every debacle has a silver lining. One of those linings shows up these days in higher interest rate spreads. Investors willing to wade into the riskier realms of debt are being paid for their troubles, or so one could argue.
As our chart below shows, you get more for your money these days when buying high-yield bonds and Baa-rated corporates, the lowest tier of investment grade debt.
High-yield bonds (as per Citigroup High Yield Index) offered an 875-basis-point yield premium over a 10-year Treasury Note as of Monday's close. Meanwhile, the yield on Baa bonds (represented by Moody's Seasoned Baa Corporate Bond Index) closed at 378 basis points over the 10-year the same day. As the graph above relates, those are the highest risk premia in roughly six years.
But are they high enough? Do they fully compensate for the turbulence ahead? Since we don't really know what degree or type of hazards await, we must remain agnostic when it comes to proclaiming definitive answers. Common sense, however, suggests that there's still trouble afoot, and so one can't be fully confident that the elevated risk premia noted above will suffice. But they might.
The potential for capital losses that exceed the received yield is an ever-present risk, and perhaps more so than usual in the early days of autumn in these United States. At the same time, it's getting harder to ignore the rising spreads. It may be too early to make hefty bets about the future, but it's not too early to begin dipping one's investment toes into the riskier ranks of bonds. That's especially true for those with an existing multi-asset class portfolio, a long-term perspective and an underweight position in lower-grade fixed-income allocations.
There are no guarantees with investing, but you can count on variations in risk premia. Ignoring the variations is imprudent, but so is diving in head first at the first uptick in yields. Finding a middle ground is the goal, and arguably that middle terrain begins with a toe in the water now.
Yes, spreads may be higher down the road. Or not. We don't know, and neither does any one else. You can bet the farm one way or the other. Alternatively, you could make modest buys on occasion, when the odds seem at least moderately favorable. Might these be one of those times?
September 23, 2008
WHAT YOU DON'T KNOW CAN HURT YOU
The dollar was crushed yesterday. The U.S. Dollar Index dropped more than 2%, reversing whatever gains were left from the now-evaporated summer rally.
The verdict, it would seem, is in. The forex market isn't amused by the prospect of adding $700 billion-plus to the already bloated U.S. budget deficit. Jay Bryson, global economist at Wachovia Securities, summed it up neatly in a note to clients yesterday, explaining that "this weekend’s announcement that the U.S. government will buy up to $700 billion worth of bad debt from financial institutions is a short-term negative for the dollar. In order for investors to absorb the increased issuance of U.S. Treasury securities the returns on those securities will need to rise."
Bryson adds that there are two ways for bond returns to rise from a foreign investor's perspective. Yields can rise, which is to say that prices will drop. That seems plausible, given that $700 billion in new debt equates to roughly 15% of existing Treasury debt outstanding. The second way is a depreciation of the dollar.
Yesterday, we got both. The buck was slammed and the benchmark 10-year Treasury Note rose to 3.83%, the highest close in more than a month.
Why does this matter? Because foreigners will be ponying up a fair chunk of the $700 billion loan to fund the new bailout plan. As such, monitoring what foreigners think is more than a passing news story these days. One might wonder what might compel foreign central banks and offshore investors to further expand their already large holdings of Treasuries.
But all is not lost for dollar bulls. Some of the fall yesterday was a reflection that there are still lots of unknowns about when Congress will greenlight the money, and what the terms will be. As those gray areas lift, and if the market takes a shine to the details, the greenback may rebound.
Nonetheless, forex risk has jumped sharply in recent days. The U.S. was already tending a hefty batch of red ink before the events of the past few weeks. The federal government was in the hole for $162 billion for fiscal year 2007, according to the Congressional Budget Office. The good news: that's smallest pile of debt since FY2002's $158 billion. It's also the smallest share of U.S. GDP since FY2002 as well.
The challenge isn't looking backward, however. It's the future. A variety of storms look set to bedevil the U.S., and a $700 billion bill that dropped out of the sky is only the beginning. The CBO's baseline budget projections already called for a doubling of the budget deficit to $325 billion by 2011, as published on September 9. But a lot can happen in a few days, and back-of-the-envelope analysis suggests that given the latest bailout news we can boost the $325 billion deficit to $1 trillion, give or take. Oh, and by the way, that surge in debt is imminent, or so it appears.
Granted, your editor is no authority in the Byzantine ways of budget projections and so one might imagine that the green eyeshade boys will figure out a way to deliver a kinder, gentler statistical report going forward. One can take inspiration, if that's the right word, from the existing distinction for on-budget and off-budget appropriations, and related accounting tricks. In any case, the actual budgets and the degree they represent spending in excess of assets is always an adventure, and the future promises to bring no less.
But for those who worry about the dollar, and what it means for the U.S. economy in 2009, one could soothe nerves by considering the economic weakness that's bubbling in Europe, which of course houses the primary alternative to the little pieces of paper the U.S. Treasury signs off on. Indeed, the biggest economy in euroland is struggling, Reuters reports: "An end to the export boom that has long underpinned German prosperity leaves the country's economy, despite its relatively sound fundamentals, facing the prospect of several quarters of low or negative growth."
The U.S. has its own economic issues, starting with the outlook for consumer spending. It's unclear how Joe Sixpack will react to all the news on Wall Street of late, but it doesn't take much to imagine that consumer spending in the months going forward will be a tad weak.
If so, what might we expect for corporate profits? Or, to pose the question another and not-entirely unrelated way: How much will financial sector ills weigh on earnings generally for U.S. stocks? Only a handful of companies have reported Q3 numbers so far, and by that thin sampling there's mostly red ink. But for the yet-to-report majority, the bulk of the pain will come in financials, of course. Zacks projects that earnings will slump 11% in this year's Q3 for financials in the S&P 500. Other than a slight drop in earnings for consumer discretionary stocks, the remaining eight S&P sectors are all expected to report gains for the July-through-September period, leaving a 6.6% overall gain for S&P earnings.
"The S&P 500 as a whole is trading for 15.0x and 12.0x, 2008 and 2009 earnings, respectively," Dirk Van Dijk of Zacks wrote yesterday. "Based on a blend of 33% 2008 earnings and 67% 2009 earnings, that translates to a 7.71% earnings yield, which looks extremely cheap relative to a 3.80% ten year T-note. Even against the A-rated corporate bond yield of 6.30% it looks attractive."
In short, there's a case for continued nibbling at stocks, particularly for those investors with a long-term time horizon (five years plus) and U.S. equity allocations that are significantly underweight. But make no mistake: the unknowns are many, and their potential for surprising Mr. Market--both negatively and positively--are high by normal standards.
Still, sentiment is hurting and there are not a lot of investors who aren't already shell shocked. That doesn't mean that there's a bottom lurking around the corner. But for those who can wait a few years, the massive risk that seems to inhabit everything may not be so massive as it appears if we adjust by looking forward.
But in times like these, one can't ignore the unknowns. Ours is a moment of extreme stress, and for good reason. The frustration of investing is that it's always one part science, one part art. The weighting, however, is far from fixed and equal at any given moment. Let's simply say that there's a lot more artists running around in portfolio management these days.
September 22, 2008
WALL STREET, R.I.P. NOW WHAT?
The financial industry has been transformed to a degree that few thought possible only a few weeks before. But this is all a sideshow to the real story of change as it relates to the economy and deciding how Main Street will fare in the months and years ahead.
Still, it's hard not to gawk at the spectacle that is Wall Street. First observation: Wall Street as it existed just a few weeks ago is gone. The news that Morgan Stanley and Goldman Sachs--the last two large, independent investment banks standing--will transform their businesses into bank holding companies, a decision that completes the decimation of the old investment banking model. The boys had a good run. Unfortunately, they blew up the industry and now all that's left is a bunch of humbled Citigroup wannabes.
That's not so bad, if only because Citigroup, sprawling and unwieldy as it is, didn't self-destruct. Neither did J.P. Morgan or Bank of America. One reason: those three, as bank holding companies, operate under a tighter, more constricting regulatory framework, and so by law they were forced to operate more conservatively compared to the likes of Bear Stearns and Lehman Brothers. No problem: some of our favorite institutions are plain old banks and the world will probably survive just fine now that they've inherited the throne.
But let's not get too giddy. Keep in mind that there are still a lot of little Lehmans and Bear Stearns in the world, otherwise known as hedge funds. Collectively, this gang runs a lot of money, much of it leveraged, and some of it--perhaps most of it--is managed unintelligently. We don't really know, of course, but given what's transpired in recent weeks we're inclined to wonder.
Overall, there are still a lot of financial bodies buried in the rubble, and quite a bit more that are ailing. It's unclear how much price-cutting will be necessary in the various assets held by banks, hedge funds and other institutions. Unknown or not, the unwinding rolls on. And there are still lots of dicey securities sitting on balance sheets the world over. Meanwhile, reassessing their value, and the resulting impact on companies and economies, is still in its infancy.
It's tempting to think that now that Wall Street as we knew is effectively gone we can all breath a sigh of relief. Indeed, the U.S. government, we read, seems likely to buy up a fair chunk of the toxic securities that caused so much pain. Assuming the bailout plan arrives, the government-sponsored buying will help drain some of the poison from the system.
Even under the best-case scenario of a quick government action that's focused on purchasing what no one else wants, there's plenty of heavy lifting to be done on the economy generally. And deciding how the macro picture unfolds is where it gets really tricky.
Predictably, there are some who see lots of trouble ahead for the economy. The headwinds start with a chastened consumer and rolls on with a weakened outlook for growth in corporate earnings.
For most investors, there are four major groups of asset classes with which to build investment portfolios: equities, bonds, REITs and commodities. The question before the house: How will the new world order impact the prospective returns for these big four?
Let's start with equities. It seems likely that raising earnings and profits will be tougher going forward as a general proposition. Some industries and sectors will fare better, or worse than others, as always. But overall, it's hard to see equity returns on a global basis besting their best pace from the recent past.
Yes, equity prices are substantially lower today than they were a year or two before. If this was a normal cyclical downturn, the outlook would be brighter for stocks at this point. But this is not a normal cyclical downturn and so it's hard to get excited by prospective equity returns until prices and valuations fall further. At the end of last month, global equities posted a 2.88% dividend yield, according to S&P/Citigroup Global Equity Indices. No doubt that's higher now, thanks to falling prices in September, But even at 3%, we're not yet convinced this is the time to overweight equities generally, although opportunistic nibbling is encouraged.
True, some regions of the world offer better value. That starts with stocks beyond the U.S. The S&P/Citigroup Global ex-U.S. Index reported a trailing dividend yield of 3.48% at the end of August, substantially above the U.S. number.
Nonetheless, higher dividend yields look set to be offset by lower earnings for the time being. Short of additional markdowns in prices for stocks--which we expect--the outlook for earnings growth is still sufficiently modest to warrant a cautious outlook on equity allocations generally. As prices go down from here, however, allocations should go up.
As for bonds, interest rates at the moment are too low to get excited about loading up on bonds. Although few are talking about it yet, the government bailouts will produce inflationary winds through the U.S. economy. This risk isn't imminent, and it probably won't be an issue for months, perhaps even a year or two. The deleveraging and unwinding of risk comes first. But eventually, bonds will suffer as interest rates rise and so long-term fixed-income weights should reflect this future. The 10-year Treasury yield closed Friday at 3.78%. Thanks, but no thanks. If it's safety you want, we'll lean to the short end of the curve. A 1-year Treasury yield, for instance, was 2.05% on Friday: more than half of the 10-year's yield at 1/10 of the maturity.
REITs, meanwhile, will attract attention for their relatively high yields. Globally, REIT yields were a hefty 5.8% at the end of last month, according to S&P/Citigroup. That's a modestly alluring margin of safety, although it's offset by the headwinds that commercial real estate faces in the new world order. Nonetheless, long-term investors will do well to focus on adding to broad-based REIT positions at those moments when Mr. Market is selling the asset class.
Finally, there are commodities. A good buy? Maybe, although until we get a better sense of timing and outlook for the global economy it's premature to load up on the asset class, even when it stumbles. Nonetheless, taking advantage of price corrections is tempting, particularly for those with zero or low relative exposure to commodities in their portfolios.
Cash, finally, is still an attractive holding since it represents opportunity to exploit the continued turbulence that we think is coming. Granted, the new turbulence will be of a lower-grade than the headline-shocking experience of late. But the troubles ahead will be a slow burn, unfolding relatively quietly over time, and inspiring little in the way of massive new government handouts as solutions.
Having lived through the biggest financial calamity since the Great Depression, investors must now grapple with the economic consequences. No, we're probably not going to fall into a depression nor is the likely recession going to be especially deep. But the path back to growth could be a long, hard trek. Recovery will take longer than many think. Indeed, the addict has only just come to the conclusion that he has a problem. Several years of group therapy are coming, and it's only just begun.
September 19, 2008
A BULL MARKET IN GOVERNMENT INTERVENTION
First it was Bear Stearns. Then the government bailed out Fannie Mae and Freddie Mac. Before the ink was dry on that deal, Uncle Sam loaned $85 billion to insurance giant AIG in exchange for an 80% stake in the company. Along the way, the Fed has been throwing money every which way, depending on the day.
But wait: there's more. In the last 24 hours, a new round of government bailout efforts are underway. Yesterday, Congressional, Federal Reserve and Treasury officials were talking of launching a massive government fund to buy up the toxic securities from investment banks and other institutions. Meanwhile, the SEC announced a ban on short selling on nearly 800 financial stocks. And the Treasury is now insuring money market funds to shore up sentiment in the wake of news that the Reserve Fund—a money market portfolio—broke the buck this week, i.e., its net asset value fell below $1. The drop stoked fears that even cash equivalents might not be safe.
The government, in other words, is throwing everything but the kitchen sink at the bear market. There's some logic to this, of course. Preventing bank runs and the like is just common sense. But how much is too much? Or too little? Alas, intervention is an art, not a science. Financial turmoil of the degree we've seen this week is rare, and so there's not a lot of precedent. The early 1930s are an obvious era for study, but the relevance is limited, since two or three things have changed the days of FDR and "brother can you spare a dime."
Meanwhile, asset prices want to fall, and interest rates want to rise (i.e., those rates that involve private parties that can't print their own money). But the government is doing everything in its power to keep Mr. Market from having his way. This is reasonable, up to a point, although it's a safe bet that it'll take time before we know where reason ended and moral hazard began.
One can be forgiven for wondering if the latest batch of fixes will fare any better than the previous ones. Since the Bear Stearns bailout earlier this year, each new "solution" was initially greeted with cheers in the stock market only to be followed by more selling. Will the new efforts hit pay dirt?
Maybe. But it's debatable if government intervention, massive though it is in cumulative terms these past months, can engineer a bullish aura of any duration.
For the moment, however, hope springs eternal. Out of the gate this morning, stocks surged skyward. But after the warm glow of yet another government intervention cools, how much bullish enthusiasm will remain? As troubling as the toxic securities problem is, it's still a symptom of deeper problems, starting with the correcting real estate market. Meanwhile, there's the issue of consumer spending, which was already faltering before the latest ills went ballistic. It's hard to imagine that Joe Sixpack will take inspiration from all the news and run out and buy a new wide-screen TV.
The government can keep bailing out firms, buying up securities no one else wants, and guaranteeing money market funds. But the cycle will have its way eventually, in part because sentiment and psychology can't be denied.
It's worth repeating the reality that prices want to fall and interest rates want to rise. It's not clear that the government can change that reality. And while the government theoretically has access to unlimited amounts money to throw at problems, in practice there's a limit if only because the dollar is regularly valued vis a vis other currencies and gold. At some point, cranking up the printing presses to bail out Acme Finance is self-defeating because the marginal gains of injecting liquidity are more than offset by a slump in the purchasing power of the buck.
Of course, we're talking of medium- and long-term worries, and for the moment all the concern is about what happens in two hours. But at some point the fires will stop burning, the smoke will clear and the crowd will look out six months or a year and reassess prices and interest rates. This much is clear: fundamentals will regain their place as the dominant force in pricing. Exactly when that happens is unclear. Meantime, it's all noise.
Remember, too, that financial crises are nothing new, nor are interventions of one sort or another. In the panic of 1907, for instance, J.P. Morgan--the man--orchestrated a private-sector-based bailout. In one sense, we're not in uncharted territory in 2008. The future, on the other hand, is always unknown.
The details of the full government-sponsored bailouts will determine much of what happens in the markets and the economy in coming years. The challenge is that we don't yet know the details, and the future, well, is still the future. But make no mistake: the price tag will be big, very big. But that's tomorrow's worry.
September 18, 2008
A DESPERATE STRUGGLE FOR PERSPECTIVE...AGAIN
Perspective may be the only true value left when fear runs amuck.
There's a blizzard of reports swirling about and it's easy to get confused. One need only review the headlines for a few minutes to feel dizzy. But while the red ink flows like rivers in a hurricane, the first step in assessing what's happening is stepping back and looking at the big picture. With that in mind, here's a whirlwind tour of where we stand as of last night:
First, demand for safety has surged--to extraordinary levels. One need only look at the collapsed yield on 3-month Treasury bills for evidence. It's a rare event when money managers willingly accept a guarantee of no return, perhaps even a slight loss in exchange for assurance that principal will be returned. Welcome to the new age.
The annualized yield on the popular benchmark of a "risk-free" asset closed at 0.03% last night, a sea change from just three days earlier, when the security closed at a 1.49% yield. Reportedly, some investors yesterday at one point were gladly buying 3-month T-bills at negative nominal yields! The rush to safety was so strong that the hope of turning a profit could wait for another day (or year?). The same motivation drove up the price of gold by one of the biggest single-day gains ever for the precious metal. The rise had nothing to do with inflation worries, which are effectively dead for the moment. Rather, it's all about finding a port that's sure to weather the financial storm blowing through global markets. A few thousand years of encouraging history in the metal's ability to preserve wealth aren't easily ignored these days.
Where does that leave the major asset classes? Battered and bruised, to be sure. With the exception of commodities and bonds--short-term investment grade bonds--there was red ink everywhere yesterday. There's no shortage of minus signs so far this month either. All the major asset classes are down in September through last night, with the exception of U.S. investment grade bonds as per the Lehman Aggregate Bond Index. As a result, our CS Global Market Portfolio Index (GMP) has slumped 8.5% so far this month, based on our preliminary estimates. That's better than the S&P 500's 9.9% drop this month through yesterday, although it's cold comfort given what's going on in the world. (We'll analyze GMP and the implications for portfolio strategy in more detail in the coming days and weeks. As a preview, this isn't entirely unexpected although it's clearly painful.)
The biggest fear is now fear itself. Perhaps that's rational, perhaps not. Lending has dried up, cash is king and everyone's wondering where the next shoe will drop. That's hardly a surprise, but strategic-minded investors must keep the big picture in perspective.
For several years we counseled that long-term investors should have been increasingly cautious as bull markets bloomed in everything. By the time the correction finally hit a year or so ago, prudent investors should have held above-average levels of cash. For those who've followed that advice, they're halfway home. But now comes the real work, i.e., redeploying the cash.
Given the current climate, talking about buying is about as popular as sticking needles in your eye. We've been counseling nibbling in the recent past, and with the benefit of hindsight that looks like bad advice. If only we knew what was coming in more detail, and when, we'd have advised 100% cash. Alas, we don't have any greater insight into the future today than we did last year, or yesterday for that matter. We've been sufficiently suspicious, however, to recommend no more than modest forays into seemingly bargain priced asset classes. A year later, we now know that was premature.
So it goes in trying to maximize return and minimize risk over a business cycle, or two or three. No one rings a bell at the bottom or the top. The next best thing is to manage a multi-asset class portfolio dynamically, favoring those corners where value and prospective returns are highest while shunning those at the opposite extreme. And, as per Tobin, one needs to think how much cash to hold in relation to the risk portfolio. Some call it asset allocation for short.
Rebalancing along the way is essential and in order to be effective it must be ongoing. In the short term it's almost doomed to look ugly at times, but hopefully less ugly than picking one or two asset classes. The payoff will only come over the long run, perhaps as early as 5 years or so although 10-years-plus is probably a more realistic time horizon.
In the short run, there's always a more alluring alternative. If we knew which one would stand up to the test of time, that'd be the way to go. But we don't, and so the next-best strategy is the only game in town.
For the moment, cash is king; in early 2007, cash was trash. Round and round we go.
But we digress. For those with a larger weighting in cash than is strategically prudent, you're only halfway home. Sitting in cash, or going overboard by shunning risk will eventually take a heavy toll, especially after subtracting future inflation, which we expect will be hefty as we look backwards sometime in 2018 or so. No one's all that worried about the mounting liabilities on the government's books today, nor should they be. It's all about injecting liquidity. But those chickens will one day come home to roost.
That leaves us with the decision of when and where to nibble. No doubt we'll have to continue nibbling far into the future, assuming we're not willing to redeploy everything on a given day.
Risk management is still essential, but it's also frightening. But this too shall past. The only question: are you of a mind to take advantage of the future? If so, how? The answer, it seems to this editor, is the same as always: slowly, methodically and carefully. In short, the strategy's the same, and so are the expectations. It's only the prices that have changed. In the long run, that's the good news, even if it seems otherwise in the here and now.
September 17, 2008
THE HOUSING SLUMP ROLLS ON
A bit of good news on the real estate front would be ideal right about now. Alas, today's update on the housing market is disappointing once again.
Housing starts for August posted another hefty decline, the Census Bureau reports. The 6.2% drop in annualized starts last month vs. July isn't the biggest decline on record, but it's still hefty. More troubling is the fact that the declines just keep coming, as our chart below shows. Starts are now at a 17-1/2-year low.
Investors have been looking for a bottom in starts, and the bounce in June gave hope to some, including this editor, who thought maybe, just maybe, the carnage was behind us. But the optimism was premature--again. Today's numbers reconfirm the bearish tone in housing.
Ditto for the number of new housing permits issued, which continued slumping last month as well, as our second chart below reveals. As with starts, the June bounce in new permits is now ancient history and the downward spiral rolls on. Privately-owned housing starts in August dropped more than 6% from July to a seasonally adjusted annual rate of 895,000 last month, the government advises. That's more than 33% below the year-earlier figure.
The permits report is the more disturbing of the two data series since it's a leading indicator. It's message remains the same: the odds for a rebound in housing still look a ways off.
Indeed, home foreclosures are still mounting, and to the extent that the housing market looks for stability in the financial sector, well, one only need read the headlines in the last few days to realize that there's still plenty to worry about on that front.
It ain't over till it's over, as Mr. Berra famously said, and this slump still isn't over.
September 16, 2008
INFLATION IS SO YESTERDAY...FOR NOW
The great sucking sound on Wall Street has few redeeming features with the possible exception that it'll cleanse the economy of long-running financial excess and dampen, if not kill the former inflation for a time.
Today's update on consumer prices for August offers a preview of things to come. The CPI dropped a seasonally adjusted 0.1% last month, the Bureau of Labor Statistics reported today. That's a sea change from the surges of 1.1% in June and 0.8% in July. The last monthly decline was -0.4% in September 2006.
That still leaves CPI higher by 5.4% in August from 12 months previous, but the annual pace of CPI is likely to fall further in the months ahead. The reason, of course, is that demand generally is retreating. From commodities to large-screen TVs to the three-bedroom ranch in the suburbs, the marginal growth in buying overall has evaporated.
One need only read the newspapers in the past 24 hours to understand why. Deflation, in short, is the big risk at the moment. It may or may not pass quickly, but that's the primary hazard hanging over the economy as we write. Rest assured that the Federal Reserve will continue to inject liquidity into the system as insurance to keep the blowback from Wall Street from infecting Main Street. In fact, the Fed yesterday "added $70 billion in reserves to the banking system yesterday, the most since the September 2001 terrorist attacks," according to Bloomberg News. The helicopters are in the air and Captain Ben is releasing the proverbial bags of money.
We have no problem with the central bank going to extraordinary lengths to keep the system from seizing. That's the only challenge today. The question is whether, and when the bank will commence a mopping up effort at the appropriate time down the road. Keep in mind that the government is accumulating lots of new debt as a result of the financial troubles. The recent bailout of Fannie Mae and Freddie Mac, for instance, will increase government's red ink by a tidy $300 billion, estimates economist Nouriel Roubini in an interview via Advisor Perspectives. And it's not clear how much more the government will have to spend before the crisis is over. Meanwhile, the ongoing expenses of modern government continue to roll on, i.e., the expanding price tags for Medicare, Social Security, the Iraq War, and on and on.
The path of least resistance is still printing more money. For now, however, no one really cares, given the turmoil of the moment. And rightly so. Focusing on whether AIG will be liquidated, for instance, is the priority, as today's FOMC meeting will surely reflect. The long-term isn't dead, but it's taken a back seat to the events of the moment.
Nonetheless, for those who can still look out a year or more, inflation is still an issue, although the future of pricing pressure depends on what unfolds in the coming weeks and months. How bad will the economy be hurt? How steep will job losses be? How will foreign economies be affected? And on and on.
Monetary policy is fated to attack the virus du jour, which is a function of falling demand and the associated illness of deflation, either real or perceived. No wonder, then, that the stampede into Treasuries went up a few notches yesterday. And for good reason, since there are real and present deflation dangers afoot. The D risk may soon pass, and it may evade us entirely, but for the time being no one really knows and so the Fed will and must act on the side of assuming a rising D risk.
The Faustian bargain of central banking is on full display. Trading long-term price stability for short-term comfort is always lurking, although it's rarely on such a stark display as it is now. The good news is that enlightened policy can navigate the two quite well by satisfying the immediate needs of liquidity without throwing away price stability over time. The bad news: human error hasn't been banished.
September 15, 2008
NIRVANA FOR NIBBLING
If it keep on raining, the levee's gonna break.
Some of these people gonna strip you of all they can take.
--Bob Dylan, "The Levee's Gonna Break"
There's a rumor going around that Wall Street's troubles, which have become every investor's troubles, reach back only a year or so. In fact, the genesis of the mess goes back much further. It's true, of course, that most investors have only been paying attention for the last year or so, thus the rumor.
The unwinding of the great bull market is now unwinding faster, and with devastating consequences. But for those who claim that they didn't see it coming, it's obvious that they weren't paying attention in the 21st century. Excess has been building for some time, and the trend must reverse, as all trends eventually do.
There are many lessons one can draw from the downfall that is now in full swing, but the most important one is the same one that every crisis imparts and that too many investors ignore until it's too late: risk management is the only salvation over a full business cycle.
The bankruptcy of Lehman Brothers, the sale of Merrill Lynch and the precarious and perhaps fatal finances of AIG are nothing new in the grand scheme of economics and finance. Businesses have been collapsing and investors have been losing money since the ancients invented the money game. What's changed in relatively recent history is our understanding of how we should play the game, as we've discussed many times, such as here.
Risk management, in short, is the first and last rule in money management. Easy to say, tough to do, but always and forever essential. Unfortunately, learning this lesson is very, very difficult, if not impossible at times--especially for those at the highest levels of the financial industry.
Risk management has been ignored, or at least manipulated and distorted by too many finance heads, and the price tag is now in full view. Identifying the motivation and rationalization for going off the deep end with inane behavior in managing assets is ultimately an exercise in reviewing the flaws of the human mind as it relates to greed and fear.
The policymakers will soon declare X and Y as the evil sources of the problems, and new legislation will no doubt follow to prevent a repeat crisis. Make no mistake: there's much that can and should be done. It's now clear, for instance, that letting large investment banks go to extremes in betting on mortgage-related derivatives is an idea right up there with drinking while driving and taking a bath in an electrical storm.
The only bright spot in all of this relates to the investor with a long run time horizon who has cash to buy securities on the cheap. When we say buy, we're talking, as always, of broad asset classes. Long-term prospective returns are rising. That's a function of falling prices. Of course, that doesn't mean that prospective returns won't rise more, which is to say that falling prices may keep on falling.
The question is how many investors will have the discipline to take advantage of the pain? Our guess is probably the same number of investors who were skeptical about the longevity of the previous bull market in everything.
Rest assured that while the details of the current calamity are unique, this is an age-old process that will one day end. The U.S. economy and indeed the world economy aren't going to collapse, although they'll come out of this a bit lighter in terms of financial institutions and some oother select assets.
Indeed, the center of asset destruction is finance and related industries, which expanded too far based on what could be sustained economically. It's all about trimming the excess, and as our post from last Thursday reminds, the trimming of finance's sails has been unfolding rapidly of late. But just as the excess in finance went higher and lasted longer than reasonable minds expected, the correction in finance will do the same in reverse. Patience, and cash, will come in handy in the months and years ahead.
Today, this week promises to be a watershed in that ongoing correction, perhaps in ways that nobody currently can fathom. But it's all natural and necessary. The only question is how and if strategic-minded investors will benefit. The prudent answer is to continue nibbling at the asset classes that are battered, i.e., equities. Broad-based equity indices, such as the Russell 3000 and MSCI EAFE are hurting, and they'll probably bleed more in the coming weeks and months. No, we don't know where the bottom is, nor does anyone else, but we know it'll arrive eventually. Prudence suggests buying before and after the trough. We'd prefer to buy at the absolute bottom, but we've yet to receive an email alerting us to that glorious moment and so we proceed to plan B.
But there will be clues, albeit vague and obscure but clues nonetheless. Just when the outlook looks darkest, the value is probably at its highest. As such, now may be the time to nibble here, nibble there, if only marginally so. Keep enough cash on hand to nibble again in six months, 12 months, 24 months. But by all means nibble. For those with a long-term view, there's really no other game in town.
September 12, 2008
How many times must this lesson be learned? Apparently there's no limit when it comes to naïve and overconfident investors, which is to say that the need for tutoring is vast and unending. Sad and frustrating, but still true.
Two examples from today's papers remind once more that diversification is too often ignored, assuming it's recognized at all. Chalk it up to greed and fear, and perhaps ignorance of sound investment strategy. Good financial planning advice is widely available, but that doesn't stop self-destructive behavior in finance, even in the center of the financial universe.
In today's New York Times, for instance, a story about the fallout from the collapsing Lehman Brothers—a 157-year-old Wall Street investment bank—quotes a "rank and file employee" of the stressed company as it relates to the person's investments. This former Lehman worker, who left the firm earlier this year, "lamented that he had put enough faith in the firm to retain shares — a decision he is paying for. 'My children’s education fund is wiped out,' said this person."
One might imagine that working on Wall Street would provide some exposure to the lessons of sound portfolio strategy that have been honed over the last 50 years, but one can never assume when it comes to money.
Another sad item comes today via The Wall Street Journal, which relates the tale of a man who apparently invested all or at least most of his sons' college money in Freddie Mac shares last week. The government has since taken over the battered mortgage institution and the shares have dropped sharply, leaving the investor's college fund virtually wiped out.
The lesson, of course, is that diversification is your only friend. That truism is only rarely on display, such as the two instances above demonstrate. But please don't confuse frequency of value with general necessity. Most of the time diversification, along with fire insurance and a sturdy roof, are taken for granted. That leads some to fall into the trap of thinking, especially after a long stretch of good fortune, that neither are relevant after all.
Similarly dim views are known to harass diversification, which usually pales in comparison to betting the ranch on a more narrowly focused investment notion. A few lucky or skillful investors can turn those odds in their favor and break the rules and cash in on easy profits. For the rest of us, a prudent approach to portfolio strategy is still the only game in town, even though it appears otherwise 98% of the time. Risk management, to be precise, is too important to ignore, as we've discussed many times over the years, including here and here.
Even so, the value of risk management is rarely obvious, save for extraordinary moments in the cycle--like now. The prudence of risk management is unrelated to how often it's useful. It's primarily a strategy minimizing the odds of insolvency. Sometimes winning on that front just once makes all the difference. Indeed, for most of us, we won't have a second chance to accumulate a lifetime of savings. 'Nuff said.
September 11, 2008
The U.S. stock market has been battered, twisted and otherwise assaulted over the past year or so. From the outside, the point requires no elaboration for those with equity positions of one type or another. But what has the havoc wrought on the internal sector allocations?
In search of some perspective, we crunched the numbers to see what's changed over the past two years in large- and small-cap sectors for domestic stocks. Let's start with the large-cap realm, as defined by the S&P 500 (all data comes from StandardandPoors.com).
As the above chart shows, information technology now occupies the top position in the S&P 500 as of yesterday, posting at 16% share of total market cap. Although that's up only slightly from its share of two years previous, the rise was enough to dispatch the former leader—financials—to the number two slot.
Given the carnage in financial shares of late, it's surprising that the sector retains as much share as it does. In any case, the relative change from two years ago is dramatic, as the gap between the red and black bars for financials reminds.
Meanwhile, the energy and consumer staples sectors have earned sharp gains in grabbing a larger relative share of S&P 500's market cap. No surprise there, given the bull market in energy and the recent bias toward businesses that supply staples, i.e., goods that Joe Sixpack can't do without. By comparison, companies selling non-essential goods and services, a.k.a., the consumer discretionary sector, has lost relative ground over the past 24 months.
How does all this compare with changes in small-cap sectors? One obvious difference is that industrials dominate market cap for the S&P 600, as our second chart below shows. But as in the large-cap arena, financials are also in second place in the S&P 600. But in a twist, small-cap financials have gained relative ground in terms of market cap share, in sharp contrast to the stumble in their large-cap brethren.
Another difference in the small-cap sector mix is that energy firms have lost relative ground in the S&P 600. The 8.3% share of market cap for small caps two years ago has shrunk to 7.0% as of yesterday.
As for trends running in parallel for both large- and small caps: materials and telecom services in both realms are still at the bottom of the pile in terms of market cap shares. For these sectors, not much has changed in terms of overall weight in the broad indices.
Overall, the correction in stocks generally has redistributed sector market caps to a less extreme mix in large caps, due mostly to the haircut in financials. In small caps, on the other hand, concentration in industrials and financials has gone up a notch over the past two years.
September 10, 2008
There's a bear market in prices, but the bull is alive and kicking when measured in risk premia, albeit in varying degrees, depending on the asset class.
Consider two examples in our chart below, which illustrates the history of yield premia for high yield bonds and equity REITs relative to the 10-year Treasury yield. Clearly, Mr. Market is offering a bigger cushion of safety in these asset classes relative to recent history. The question is whether the cushions will suffice for what's coming? To be sure, higher yield premia are no short cut to easy profits, but neither are they chopped liver.
For junk bonds, the premium over the 10-year is the highest in five years. At the end of August, the Citigroup High Yield Index posted a trailing yield of 779 basis points over the constant 10-year Treasury yield, as per numbers from the St. Louis Fed. That's the richest spread for the index since early 2003.
The spread premium on equity REIT yields, although higher relative to recent history, is less compelling. At 115 basis points over the 10-year yield, the NAREIT trailing yield has risen from negative territory, but it still pales in comparison to the 300-basis-points plus of 2003.
What does it all mean? The case for buying junk and REITs looks more enticing today than it did in 2006 or 2007. That doesn't mean you can't lose money in either asset class going forward, but it does suggest that the prospective returns vary and that's largely driven by shifting valuations.
For investors with broadly diversified portfolios across the major asset classes and a long-term focus of five years or more, the above charts suggest that it's time to start nibbling at high yields bonds via broadly diversified portfolios targeting the asset class. The same could be said for REITs, although the case is less compelling.
Putting cash to work these days is unnerving, of course, as yesterday's steep decline in the stock market reminds. But blood is running and that suggests that prospective returns are higher. No guarantees, of course. Even prudent-minded investment strategies can look ugly in the short run, and perhaps for even longer stretches than logic suggests. That said, opportunity abounds, at least for those who have risk capital at the ready and the stomach for the roller coaster that almost certainly awaits in the near term.
September 8, 2008
STILL SEARCHING FOR VALUE
It's one of the most fundamental and enduring relationships in finance. As fear and risk rise, the valuations become more enticing. When all hope is gone, and the last bull throws in the towel, the prospective returns are probably at their highest.
Simple enough, right? The lesson: buy at maximum pessimism or when blood runs in the street, to quote the infamous Rothschild axiom. Sound advice, and perhaps the only true piece of wisdom for dealing with the capital markets. Alas, it's devilishly difficult to pull off. One reason: no one knows where the bottom is except with the benefit of hindsight.
Another reason: investors tend to be human, and humans tend to trip over that emotion thing every now and again.
So it goes. Pessimism rises, and the more it rises the more likely higher expected returns will be ignored. Of course, there's always a reason to ignore the seemingly higher odds of richer prospective performance, and much of that has to do with negative signs on recent trailing returns. It's tempting to think that because recent history has thrown us a pair of concrete shoes, it'll continue to do so for the foreseeable future. The effect works in reverse, of course: positive returns are expected to continue after a long string of gains in the recent past.
An antidote to giving recent performance too much weight in your strategic decision making comes by way of relative valuation. That includes trailing dividend yields among the major regions of the world. As per our chart below, dividend yields are up in the developed world's capital markets, as per data from S&P/Citigroup Global Equity Indices through the end of last month. Europe in particular offers comparatively rich yields.
The U.S., by contrast, looks a lot less compelling on a dividend-yield basis. That doesn't mean that domestic stocks won't outperform European equities. But if we limit ourselves to what we know, the numbers speak for themselves.
Of course, investing isn't so easy as picking the highest yielding regions, much less the highest-yield stock. Yes, it's a critical factor, but risk premiums are opportunities, not guarantees.
Indeed, valuation metrics can be tricky, particularly in bear markets. The U.S. is a case in point. Although the stock market has fallen sharply in America since last October, that hasn't led to a more compelling valuation across the board of the various metrics. As our second chart below shows, the U.S. is alone among the major regions of the developed world's equity markets in posting sharply higher p/e ratios.
What's going on? Earnings are falling faster than prices in the U.S., the New York Times reports: "In the first quarter this year, earnings of the S.& P. 500 sank 17.5 percent, according to Thomson Financial. But the index, excluding dividends, itself declined 9.9 percent. And in the second quarter, corporate profits declined by an estimated 22 percent while stock prices fell by a much more modest 3.2 percent."
Some analysts argue that p/e isn't a great metric to use for calling bear-market bottoms and so its surge of late isn't all that relevant. In fact, one research paper that passed our desk today claims that the high p/e in the U.S. is a buy signal. Perhaps, although based on the above chart, the double whammy of falling prices and even faster falling earnings in the U.S. doesn't appear to be harassing other markets, or so the falling p/e ratios elsewhere suggest. Meanwhile, consider that the U.S. stock market's trailing dividend yield is the lowest in the developed world.
That leaves the outlook for stronger earnings growth as the last best hope for U.S. stock market on a relative basis. And based on history, there's a case for thinking the U.S. growth machine will outdistance the competitors among the mature economies. Of course, now we're in the realm of speculation, and so all the usual caveats apply.
Yes, a hefty allocation to U.S. equities still looks prudent on a long-term basis, particularly if you compare the prospect for American stocks today vs. last October. But given the above analysis, we're not yet convinced that this is the time to bet the farm on U.S. stocks.
September 5, 2008
LABOR PAINS, PART DEUX
The labor market continues bleeding, as today's update on the nation's payrolls for August reminds.
Compared with past recessions--and, yes, we're in one--the current ills look mild, as our chart below suggests. What worries us is that the pain, however modest, may roll on for longer than usual.
Is a "mild" recession that lasts longer than usual better, or less painful, than a deeper contraction that ends quickly? Only time will tell, although our suspicion is that in the grand scheme of economics, deeper and quicker is probably the better choice, although that depends heavily on how deep deep is.
In any case, no one has a choice and we're all fated to play the recession cards we're dealt. What's more, there's plenty of pain in the employment numbers these days, comparisons to the past notwithstanding. For the eighth month running, nonfarm payrolls contracted. Adding to the pain is the rise in the unemployment rate last month to 6.1%, the highest since 2003.
True, August's loss of 84,000 jobs in the economy was fairly middling, although that's cold comfort for those who are out of work. But in the search for a silver lining in today's employment news on a macro level, that's as good as it gets for the moment.
The question, then, is how long does the job destruction roll on? To repeat our standard mantra, no one knows. But there are clues, and currently they're not encouraging. As we pointed out yesterday, initial claims for new unemployment benefits look inclined to rise. The implication: future employment reports will stay negative for the foreseeable future.
One result is that the Fed is likely to shy away from an interest rate hike any time soon. But even that traditionally bullish news has lost its power to inspire. Meanwhile, there's still the question of whether inflation is set to fade. If not, we're in for even greater challenges.
In short, there are still many risks bubbling in the economic and financial spheres. Defense is still the only game in town.
September 4, 2008
If there's reason for optimism about the state of the U.S. economy, you won't find it in today's update on jobless claims.
As our first chart shows, the bias toward the upside continues with new filings for unemployment benefits. Certainly the modest dip in new claims last month appears to be fading. Last week, new filings rose to 444,000, up from 429,000. That's still below the recent high of 457,000 set on August 2, but the upward momentum doesn't look like it's about to fade any time soon.
Another clue about the state of the job market comes by way of continuing claims for unemployment benefits. This pool of the previously unemployed is much larger than the new arrivals, and the ranks of those who've been collecting checks from the government for some time continues to swell, as our second chart below illustrates. Today's update on continuing claims reveals that 3.435 million were drawing unemployment benefits for more than a week in the week ending August 23.
Keep in mind that the stress in the labor market didn't drop out of the blue. Looking at the initial claims chart above suggests that the early signs of trouble go back a year or more. At first, the gentle rise of new claims was subtle, and therefore widely dismissed. In recent months, the trend became too obvious to ignore, and by this editor's reckoning the rise will roll on in the coming weeks and perhaps months.
"The labor market will continue to worsen,'' Dana Saporta, an economist at Dresdner Kleinwort in New York, told Bloomberg News ahead of this morning's jobless claims report. "I look at claims and see much higher readings than just a few months ago, and I see that as consistent with the rising unemployment rate.''
Today's numbers don't offer reason to think otherwise. In turn, the soft labor market will likely keep the Fed from raising interest rates. That raises the question of whether, or if, inflation will cool. But we're getting ahead of ourselves. The update on consumer prices doesn't come until September 16.
September 3, 2008
THE INVESTMENT BENCHMARK FOR THE MASSES
Every investor needs a benchmark. Picking a relevant one is a challenge, in part because the menu is crowded. The good news is that there's a great starting place for everyone: the yield on the 10-year inflation-indexed Treasury Note, a.k.a., the 10-year TIPS.
As guaranteed payouts on Mother Earth go, this one's about as solid as they come. Not only can you sleep easy knowing that your principal will be returned, the payout in the years ahead will be immune from inflation. Yes, one can argue that the underlying inflation yardstick--the consumer price index--is flawed, but we'll leave that glitch aside for the moment.
Accepting the 10-year TIPS at face value gives us a robust benchmark for comparing and contrasting our investment strategies. It is, in short, the true risk-free benchmark for investors considering the rainbow of risks in the world to embrace or avoid. Yes, we could quibble and cite the 5-year or 20-year TIPS. But we'll split the difference and use the 10-year span, in part because much of bond investing revolves around decade-long maturities as benchmarks.
As of last night, a 10-year TIPS yields 1.69%. The question before the house: can you beat it? That is, will your investment strategy generate more than a 1.69% return--after inflation--when you crunch the numbers on September 3, 2018?
No doubt some, and quite probably many investors will answer in the affirmative. But the task ahead is tougher than it appears. Why? Several reasons, starting with the fact that buying and holding a 10-year TIPS is a strategy with no moving parts. As such, there's no chance for error in executing the strategy and grabbing the yield as stated. But as history suggests, a fair share of investors who try to excel at the money game will end up being stumbling, perhaps dramatically.
Nonetheless, many will claim that besting the 10-year TIPS yield presents a minimal challenge. Perhaps, although beating this benchmark may not be the cakewalk it appears to be. Consider the outlook five years ago. The 10-year TIPS yield was 2.43% at the close of trading on September 2, 2003. Did that yield represent a muscular yardstick? It was easy to think not. Indeed, a conventional 10-year Treasury yield at the time was 4.61%, or nearly twice the TIPS yield. Keep in mind that the inflation outlook at the time was fairly modest. CPI was up just 2.2% for the year through August 2003, and expectations for anything materially higher were a rarity.
But five years later, the conventional 10-year's yield-inferred return doesn't look encouraging. CPI's rise over the past five years through July 2008 has averaged 3.65% a year. Deducting that inflation rate from the 10-year's 4.61% yield of five years ago leaves a real yield of just under 1% these days. In short, the 2.43% real yield of TIPS now looks far more enticing than many thought back in 2003.
Clearly, one's inflation expectations are critical for weighing the investment options of the moment. The exception is when choosing TIPS. Inflation may soar into the stratosphere, or tumble into deflation, but when you buy an inflation-indexed Treasury you lock in the current real yield. Come hell or high water, you'll receive that real yield.
That leaves the question of whether the 1.69% real yield that currently profiles the 10-year TIPS will suffice? It certainly looks low relative to recent history. Perhaps that inspires you to think that equities, commodities, REITs or other investments will fare better over the next 10 years. Or, maybe a diversified portfolio of several asset classes is the prudent choice, a strategy your editor tends to favor for the long run.
In truth, no one knows the answer. But our analysis must start somewhere, and the 10-year TIPS is arguably the first step for assessing what's available for everyone, no questions asked. In a world of risks, unknown and known, the first investment decision is uncomplicated: should we accept or reject the government's 10-year real yield? Question two, by contrast, is infinitely more complex.
September 2, 2008
August was another tough month for diversified portfolios. For the third month running, the Capital Spectator Global Market Portfolio Index lost ground in August, declining 3.3%.
For the major asset classes generally, last month was a mixed bag, as our table below shows. REITs were the leader, posting a 2.4% advance. U.S. stocks weren't far behind, earning 1.7% for the month. The big loser in August: commodities, shedding 7.4%, a steep loss, which is all the more painful after July's 12% decline. Foreign equities and bonds were also hard hit last month. Overall, August wasn't pretty for broadly defined market-valuation-based portfolios.
Strategic-minded investors might wonder if owning a portfolio that's diversified across the world's major asset classes, and weighting the components by their respective market-valued share, remains an intelligent decision. Year-to-date, our Global Market Portfolio Index (GMPI) has shed 8.6%. That's slightly better than U.S. stock performance, which posts a 10.1% loss through the end of August. Nonetheless, one might expect a broadly diversified multi-asset class portfolio to fare better. What's going on?
In a word, correction. In fact, the reversal of GMPI's fortunes this year comes as no shock to this editor. In fact, we're surprised it didn't come earlier. To see why, consider the longer term perspective. For the five years through last month, GMPI posted a 10% annualized total return vs. 7.6% for U.S. stocks (as per the Russell 3000). In addition, GMPI's robust outperformance has come with roughly one-quarter less volatility compared with Russell 3000.
The fact that GMPI has delivered superior risk-adjusted performance relative to U.S. stocks was anticipated. But the fact that the outperformance has been so extreme in recent years was unexpected. As our graph below illustrates, owning the global market portfolio, passively allocated, has paid off handsomely. A little too handsomely, in our humble opinion. Beating the U.S. stock market by such a wide margin, although possible in the short run, can't be sustained. Market equilibrium wins out eventually, which is why it's tough to beat the major markets as a general rule.
Yes, GMPI is likely to deliver a small long-term performance premium, as well as a lower risk profile over time. But the edge is almost surely destined to be modest, as opposed to spectacular, as was the history in recent years until 2008. Thus the pullback in GMPI to more humble comparisons with U.S. stocks.
As such, we make the following predictions: First, GMPI is likely to fare relatively poor against stocks or bonds in the coming months, perhaps into 2009. Five years from now, on the other hand, we expect GMPI to handily beat either asset class on a risk-adjusted basis, and perhaps even on an absolute returns basis. In fact, we continue to forecast that GMPI will do well against most investment strategies over time. No guarantees, of course, but market history and common sense suggest no less. Alpha's hard to sustain as a general proposition.
In short, the future looks more or less like the past when viewed through the prism of the global market portfolio--at least to your editor's somewhat jaded eyes. As always, it's easy to think otherwise by focusing on recent history. That was true when GMPI was blowing away the U.S. stock market from the vantage of a year ago; true by current standards. But for strategic-minded investors, the short run is still mostly noise.