October 31, 2008
SAVING: IT'S THE NEW, NEW THING (AGAIN)
The smoking gun today is that while disposable personal income rose 0.2% in September, personal consumption spending dropped 0.3%. It's not the first time that income rose and spending slipped in the same month, although it's rare. Indeed, news of a spending decline generally is rare. Until now.
In the current climate, everyone will recognize that lower spending has legs, and that the trend will take a toll on an economy that relies so heavily on it for growth. Meanwhile, let's not assume that income will keep rising in the coming months and quarters, which is far from certain. Yes, a new fiscal stimulus is reportedly coming, but the inclination will be strong to bank another round of checks from the government. No wonder that some policymakers are talking of FDR-type infrastructure projects to bypass consumers in a bid to boost demand in the economy. As for Joe Sixpack's sentiment, much depends on how the labor market fares going forward, and for the moment that outlook isn't encouraging.
On the spending side, last month's drop is the biggest monthly decline in four years. What makes this news so discouraging is that it doesn't yet reflect the deteriorating consumer sentiment for October or the ongoing economic and financial pain that we think is coming for the remainder of this year into 2009. It's hard to imagine that spending reports in the coming months will somehow avoid further deterioration, and that news will weigh heavily on everything from the stock market to employment reports. More immediately, to state what now's surely obvious: the holiday retail season looks set to disappoint.
As we said yesterday, the age of consumption is over, at least as we've known it in recent years and for the foreseeable future. Spending is out, saving is in, and the revival has only just begun. Yes, Virginia, cycles are still alive and kicking.
October 30, 2008
THE DECLINE AND FALL OF CONSUMPTION
This morning's news that third-quarter GDP retreated by 0.3% should surprise no one. This slump is arguably one of most anticipated contractions in recent memory. In any case, the recession is here, although officially the label won't be applied until NBER gets around to reporting what's already obvious. But barring an extraordinary turn of events in Q4--an unlikely event if ever there was one--the recession is here, as we speculated it would be as early as this past March.
Granted, the government will update Q3 GDP two more times before a final print. But there's no reason to think that the revisions won't reveal even bigger pools of red ink.
As for what the Bureau of Economic Analysis reports today, the numbers on their face are humbling. The bad news is grounded in the overwhelmingly dominant piece of GDP: consumer spending, which accounts for roughly 70% of gross domestic product. The point now is plain: Joe Sixpack has finally cut back, and by more than a little. The great engine of the U.S. economy has shifted into reverse in a big way, as our chart below shows, with personal consumption expenditures dropping 3.1% in 2008's Q3 (on a seasonally and inflation-adjusted annualized basis, as per the norm). That's the steepest quarterly decline since 1980's Q2, although 1990's Q4 came close to reaching the latest drop.
There's just no way to sugarcoat this reversal of spending. It's steep and given the general economic and financial backdrop, along with the generally high indebtedness of Americans, it suggests more declines are coming. A generation or more of consuming at any price appears to be at an end, at least for the foreseeable future. Indeed, the chart below suggests the great boom in consumption has, for a time, ended. No, consumers aren't going away. But the extreme consumer age has ended, due for replacement initially by saving and then a more modest strategy for visits to the mall. It'll take time for the American economy to adjust. Ditto for the global economy. The sky-is-the-limit spending mandate of Joe is on hold till further notice. Retrenchment is never easy, but gravity has its way eventually.
Looking closer at consumer spending reveals that the greatest damage came in durable goods, which sunk by a huge 14.1% in Q3. Nondurable goods spending fared better, as you would expect, but only in relative terms. But let's be clear: the 6.4% drop in nondurable goods is troubling since these items include such staples as food, clothing and energy. The fact that nondurable expenditures dropped so precipitously reminds that the extreme negativity in consumer sentiment is taking a toll in the real world.
The other big slice of consumer expenditures--services--managed to eke out a gain in Q3, rising 0.6%. But this is a paltry outing for a sector that's thought to be the most immune to cyclical pain, since it includes such resilient spending sources as medical care and housing. All the more so if you consider that growth in services spending averages more than 2.0% for the last 10 quarters. By that standard, the Q3 reading sends a clear and humbling message of how the average American is thinking these days.
Exports, the great redeeming corner of the economy this year, is still growing, posting a 5.9% jump in Q3. But that's down sharply from Q2's 12.3% surge and is at the lower range of gains in recent years. It's debatable if export growth can hold up in the face of rising economic and financial anxiety in foreign markets. Meanwhile, the dollar has rebounded in the forex markets amid the global rush for the safety of Treasuries, thereby undercutting some of the fuel for exports growth.
No one should be surprised at the GDP numbers today. One could argue, as many do, that the current ills have been years, even decades in the making. But it's the future that matters, and today's GDP report is just another reminder that the economic blowback from the financial crises of the past year has only just begun.
October 29, 2008
A BRIEF REPRIEVE
A small ray of sunshine on the economic front greets us today in the update for durable goods orders. Alas, it's not the sign of a turning point. Not even close.
New order for durable goods rose 0.8% last month vs. August, the Census Bureau reports. But September's bump doesn't change the fact that new orders are down 4.7% from July's tally and 3.6% below the year-earlier level. Last month notwithstanding, the trend is still down.
If we strip out defense-related items, new orders fell 0.6% last month. No matter, since the market will be looking for positive signs and the top-line number for durable goods orders will satisfy the demand for something sweet. But the economic challenges have barely begun and investors should refrain from reading too much into any one number this early in the cycle.
The real pressure will come in consumer related numbers. It will take months for the full brunt of the financial hurricane of September and October to fully work into the consumer readings. A grim glimpse of things arrived in yesterday's update on consumer sentiment from the Conference Board, which advises that Joe Sixpack's as pessimistic as he's ever been since this index was first calculated in 1967. "Consumers are extremely pessimistic," observes Lynn Franco, director of the Conference Board's Consumer Research Center via AP. "This news does not bode well for retailers who are already bracing for what is shaping up to be a very challenging holiday season."
It's a virtual certainty that consumer-related economic reports will be discouraging in the months ahead, to say the least. The only questions: How much pain and how long will it last? In any case, brace yourself. The monsters are coming, and it won't end on Halloween.
October 28, 2008
WHAT, IF ANYTHING, CAN DIVIDEND YIELD TELL US?
It's been known for some time--decades, really--that relatively high dividend yields tend to precede relatively high returns in subsequent years. Graham and Dodd's Security Analysis suggests as much about the relationship between valuation and return. More rigorous studies of the valuation phenomenon (of which dividends are only one measure) arrived in the 1980s, when a number of new research efforts found a strong relationship between relatively undervalued equities and higher prospective return.
One review of the possibilities came in a 1984 Journal of Portfolio Management article: "Dividend yields are equity risk premiums," by Michael Rozeff. He explains that "the evidence dictates" that dividend yields can be used to time purchases. He warns against reading too much from specific dividend levels for establishing absolute buy and sell signals. He also counsels readers away from trying to profit from dividend-yield signals in the short term. Nonetheless, the basic premise, if not exactly original, reflects economic common sense, Rozeff argues:
My evidence indicates that returns increase continuously and monotonically as dividend yield in the prior year increases. My theory that the dividend yield is a measure of the ex ante risk premium explains why this is so. High returns tend to occur when the environment is perceived to be so risky that investors demand a high premium for holding stocks. Low returns tend to occur when the environment is perceived to hold such little risk that investors demand a low risk premium for holding stocks.
Subsequent studies lend support to the idea that valuation overall matters. For example, Robert Shiller, in Irrational Exuberance, argues in favor of return predictability based on valuation parameters. One example comes by way of a diagram in the book that plots price-earnings ratios against subsequent 10-year returns based on buying the S&P Composite Index (a proxy for U.S. stocks) at a given p/e ratio. The relationship, which draws on more than 100 years of market history through 1989, shows a "moderately strong" link between low p/e ratios and relatively high returns, and vice versa, according to Shiller.
Some simple tests seem to confirm the idea that long term investors should pay attention to valuation, as our chart below suggests. We've plotted dividend yields for the S&P 500 against the subsequent 5-year annualized total return for 1995 through 2003. The relationship is quite strong, at least in this sample period, posting a 0.95 R-squared. For example, the S&P's dividend yield was a relatively high 2.12% in February 2003 and the subsequent five-year annualized total return was 11.6%. By contrast, in May 1998 the yield was 1.48% and the subsequent return over the next five years was negative 3.8%.
A longer review of dividend yields and subsequent performance reveals a similar trend, i.e., future returns tend to be higher when current yields are lower. It's not absolute and it does always hold for each and every period. But generally, the evidence modestly suggests a recurring trend. This is hardly surprising. The notion that prospective returns are higher following a previous decline in price appeals to investor intuition, the empirical record and economic logic.
Nonetheless, we must be careful about thinking the relationship offers easy and sure profits. Let's start by recognizing that the chart above tracks a sample period that, in absolute terms, may be abnormal. The overall relationship tends to hold over longer sweeps of history, but the actual numbers can vary quite a bit in the short term. In other words, a given dividend yield and subsequent return can be lower relative to the numbers above. Given that the 1995-2003 stretch was quite good for stocks, we should adjust expectations for less stellar periods.
Then again, the past year has been spectacularly bad for equities overall, which means that dividend yields are quite high by recent standards, as we discussed earlier this month. That implies that returns in the years ahead will be relatively higher.
Can we bank on that relationship? No, at least not to the extent that we bet the farm on the outcome. In fact, we should be skeptical. But we shouldn't ignore the evidence. Indeed, if we're partly optimistic that higher yields lead to higher returns, we'll avail ourselves of the opportunity, but only to the extent we have confidence in the idea. In other words, we'll adjust our strategic equity weighting down when yields turn thin, and raise the weighting when yields look appealing. If we're 50% confident that higher yields lead to higher return, that suggests that half of our strategic equity weight will be adjusted based on current valuations.
As far as mere mortals can read such tea leaves and profit from the signals, prospective returns five years-plus in the future certainly look better now compared with a year ago. No guarantees, but the odds appear to be modestly tilted in the favor of long-term equity investors relative to a year ago. That doesn't mean you can't lose lots of money by buying equities today. Nor is it clear how long it will take to reap higher returns. Patience is key here. We looked at 5 years in the chart above, but there's nothing magic about that period. In addition, prudence suggests we prepare to exploit the opportunities over time. Today's yields can go higher still. At some point the yields will stop rising, but we don't know when.
There is no contract from the financial gods that insures you'll turn a profit by buying stocks when yields have run upward. In fact, equity risk premia generally require faith. But to the extent that you have faith in the economy and its regenerative powers, the yield/return relationship looks modestly compelling, at least for those who are comfortable holding equity risk as a long-term proposition.
October 27, 2008
LOOKING AT ZERO
The current 1.5% Fed funds rate isn't long for this world. The Federal Reserve, perhaps in coordination once again with other central banks around the world, will cut interest rates, and soon.
That, at least, is the market's view. The November '08 Fed funds futures contract has all but priced in a 50-basis-point cut to 1%.
The announcement of a cut, whatever it is, will come as a shock to no one, given the events of late. Indeed, money supply has been rising at extraordinarily high rates in reaction to the extraordinarily dire state of affairs in finance and increasingly on the economic front. M1 money supply (the narrowest measure) surged more than 19% on a seasonally adjusted annualized basis for the three months through September 2008, the Fed reports. A year ago, M1 was up a mere 0.8% over the same time frame.
Such an aggressive creation of liquidity will be met with lower interest rates...again. But we're coming to the end of this road, and the dangers (psychological as well as economic) are growing. It's no longer beyond the pale to consider the possibility that the Fed will drop rates to zero, depending on how the turmoil unfolds in the coming weeks and months. What happens when Fed funds have sunk to nothing remains an open debate, but this future appears to be rushing toward us.
Moving monetary policy below the 1% rate is explored territory. In the 1950s, Fed funds briefly dipped below 1% and approached but never reached zero. What might happen this time if rates tested and bested those old lows is the stuff of speculation. A new era of monetary experiment, as Vincent Reinhart calls it, awaits. Outcome yet to be determined.
The U.S. isn't alone in facing the potential of venturing into this strange, untested realm of monetary policy. Britain, to name but one of the other candidates looking at zero, is also facing the possibility of virtually giving money away.
Beyond zero, what are the options? Fed Chairman Bernanke explored the issue in a speech back in November 2002, when he was a Fed governor. The bottom line: there are alternative means of creating additional liquidity when rates are at zero, he explained.
As to how effective those alternative levers are, well, stay tuned. Moving into uncharted territory is inherently full of surprises, and not necessarily for the good, and so it's unclear what we're looking at if Fed funds go materially below 1% for any length of time. In some respects, the central bank is the last, best hope for keeping an economic system from imploding when debt threatens to overwhelm. We're still a long way from deflation, but it's not too soon to start thinking about the consequences.
Debt, in short, is the basic issue. The question of how to deal with it is as complex as the threat is simple.
October 24, 2008
THE (RE)EDUCATION OF THE MASSES
Seeing the world as chaos, devoid of rules or logic when the capital and commodity markets go into a tailspin and the economic outlook is grim is a potent temptation. But it's a mistake to think that order has run off the rails.
The problem has been hubris—an excess of hubris. The comeuppance is now upon us, and the process of a return to modesty, humility and a healthy respect for risk in money management is in full swing. This comes as a great shock to many investors. But to say this is something new is to ignore history.
Financial calamity is always lurking. As Kindleberger put it, financial crisis is a "hardy perennial." Sometimes it's kept at bay for years, even decades, but eventually the beast returns. Painful as this recurring truth is for those who must live through it and watch hard-earned savings wither, there can be no other path.
Don't misunderstand. The pursuit of progress in economics and portfolio management must continue, and will continue. We're not doomed to sit on our hands and let the financial gods do what they will with us. We can and will advance the cause of intelligence on these fronts. Indeed, we've learned much over the past 100 years. Yet greed and fear are immune to knowledge and wisdom, much as the common cold is resistant to the miracle that is medical science.
But the system—the economy, the markets—impose their own discipline when self-restraint has given way, as it invariably does at some point. Imagine an alternative universe where companies and economies grow to the sky, risk is always rewarded. At some point in this fairy tale world everyone would be a day trader, working out of 80,000-square-foot homes and driving SUVs plush with surround-sound audio and widescreen TVs.
Such a world, as enticing as it may seem on a personal level, would--must eventually collapse of its own bloated excess. Someone has to run the farms, build the bridges and figure out how to build small, more efficient computer chips. Having plumbers and bus drivers, in short, comes in handy on a regular basis.
The discipline that takes leave at times is returned by force in the form of economic and financial turmoil. Stability is inherently unstable, Hyman Minsky famously warned. The inevitable instability isn't pretty, nor is it desirable per se, but ultimately it's necessary to keep us from turning into the financial equivalents of overweight blimps a la the animated movie WALL-E.
One might imagine that the pummeling of investors in the 2000-2002 collapse of the tech bubble would have reacquainted Wall Street and the world generally with the principles of humility and an appreciation of risk. For a time, the lesson was learned (relearned actually), but it was fleeting. This time, however, the lesson will be learned anew, and one day forgotten.
We're all guilty in some degree of ignoring the excess that preceded the correction that now bites us. We're all guilty in some degree of looking back at "history," as defined by 5 or 10 or even 30 years and concluding that risk never looks uglier than this, or that. We're all guilty in some degree of failing to look back over much longer periods of history, at the experiences of different countries, and considering how bad it can really get and what that implies for risk management. We're all guilty in some degree of assuming that a correction would be fairly brief and that it would create a buying opportunity by next Thursday, and that juicy rewards would flow within weeks, or months or certainly within a year. We're all guilty of assuming that the massive rise of debt, the non-stop spending by consumers, and the general embrace of the more-is-better paragon would be a costless affair.
Yes, some of us were warning of the dangers for some time. What's more, some have studied the past deeply in an effort to understand the full range of possibilities in the money game. GMO's Jeremy Grantham is one example. But such warnings generally fell on deaf ears. That's no great mystery. Optimism comes easily to the human mind. Meanwhile, preparing for the apocalypse--or just thinking about it--is always easy to postpone, like bringing out the garbage or cleaning up after the dog.
We've all been disabused of these and other short-sighted and historically shallow notions. Few of us have ever seen anything like what we're experiencing now. Few were expecting the risk blowback that now afflicts the planet. But the future is rushing toward us, and it's a future with a lot less finance in the economy. For some time now there has been too much finance in the world. It was naïve to think that the industry, and all its excess, could keep growing indefinitely. But that has stopped, and the process will continue reversing in a big way for a long time. The future will deliver few mutual funds, fewer ETFs, fewer hedge funds, fewer over-sized egos in money management, to name but a few examples.
It's all very painful, of course, partly because the biggest bull market of all was the explosion skyward in expectations. The hardest task is coming to terms with a future that looks radically different from the past. But rest assured, the pain too will be fleeting. When the last man has sold; when it looks like nothing could go possibly right again; when darkness appears infinite; that's when the rebound will commence in earnest. It'll arise quietly, mysteriously, and almost no one will see it in the beginning. But it will come. Meantime, we're all booked for a lengthy session in the Economics Re-education 101.
October 23, 2008
INFLATION WORRIES FADE AS REAL YIELD RISES
It's no surprise to learn that inflation expectations have been pounded downward in the wake of the financial crisis, although the magnitude of the drop may still turn a few heads.
Consider the outlook for consumer prices embedded in the spread between the nominal and inflation-indexed Treasury, as per our chart below. Mr. Market is now anticipating that consumer prices will rise a mere 1% a year for the next decade, down from nearly 2.6% as recently as this past July.
The source of this massive and sudden change of heart needs no explanation other than to point to the events of the past two months. Meanwhile, amid all the turmoil and fading of inflation worries an investor can, as of last night's close, buy a 10-year inflation-indexed Treasury at a real yield of 2.59%, as our second chart below shows. That's shy of the October 14 close of 3.05%, although it's still high by recent standards. At one point during this past March, the 10-year TIPS yielded a scant 90 basis points.
The opportunity to lock in a real yield of 3%, or something close to it, shouldn't be dismissed lightly. Indeed, a nominal 10-year Treasury currently yields 3.65%, a mere 106 basis points over its TIPS counterpart.
Inflation, of course, is a dead issue at the moment, or so the crowd believes. No wonder, since there's a persuasive case for thinking that it'll probably be some time, perhaps several years, before pricing pressures return with any great force. Disinflation, or worse, is upon us, courtesy of the economic challenges that await.
All of which only goes to remind that the best deals in the investing game typically come joined at the hip with frightening headlines and gloomy expectations for the assets in question. Some things never change.
Prices, by contrast, are always in flux. The only task, then, is figuring out if the going rate is attractive, and that starts by comparing it with what the crowd was accepting in the past.
October 21, 2008
The biggest challenge in strategic-minded investing lies within. The high-yield bond market of late offers a telling example.
Trailing yields on junk bonds have soared recently, as our chart below shows. The risk premium on junk over 10-year Treasury Notes exploded skyward to close yesterday at nearly 15%. That's the highest since the early 1990s and, one could argue, it looks enticing.
The human mind, meanwhile, is a complicated organ. What looks like far better values today relative to, say, June 12, 2007 isn't necessarily obvious or compelling to homo economicus. We cite June 12 of last year because that was the trough for the junk/Treasury yield spread, as per Citigroup High Yield Index.
Not long after, we remained suspicious that the spread was sufficiently high to compensate for the risks ahead, as per our post in late summer 2007. As it turned out, we weren't wary enough, not by a long shot. We did, however, say that even though the risk premium had risen to a bit over 4% in August 2007, "we're not yet convinced that strategic opportunities are convincing in the highest-risk spectrum of assets." In fact, we should have told everyone to run for the hills and put everything in cash. Hindsight, as always, tells us exactly what we should have done.
As it turned out, the crowd had other ideas, which is to say bullish ideas. Indeed, the late summer of 2007 was a strong period for the junk bond market. The iShares iBoxx $ High Yield Corporate Bond ETF (HYG), for instance, had a run higher in August and September of that year, reaching an all-time high of $104.70 on September 25, 2007. The ETF closed yesterday at $71.40.
Having been crushed, the high-yield bond market now offers its highest trailing yield in a generation. We're guessing, but it seems as though there are few takers, if any. Yes, there's reason to shun junk bonds, starting with the high odds that a painful and lengthy recession awaits. If so, defaults on junk will rise. Understandably, that scares off the bulls. And for all we know, staying scared may be the only logical decision at this point. An economy that takes a beating will treat the lower-grade tier of securities harshly, even after the harsh treatment to date.
In fact, there are always convincing reasons to shun those asset classes when they've fallen on hard times. The process works in reverse too, as so there's always a bullish rationale for buying more even though the valuations look thin and the assets are priced for perfection.
High-yields bonds are but one example of this ebb and flow of greed and fear. Granted, junk offers one of the more extreme cases of boom turned bust. Yet all the asset classes suffer this back and forth, albeit in varying degrees.
No, we don't know if high-yield bonds are about to soar in price, run flat for many years, or dive deeper into the hole. All we know is what's passed and the prices currently offered by Mr. Market. By that standard, the prices look a lot better now than they did on June 12, 2007 for junk. What does that imply for the future? We can't say for sure, but we have our suspicions.
Keep in mind that we've made a number of comments this year that the junk spread looked relatively compelling, i.e., it had risen. We now know that we were early in making such comments. We may still be early, and in fact that seems probable. Rest assured we have limited, if any skill in short-term market timing, and it's debatable if we're any better on a long-term basis. As such, we favor diversifying by asset class and trying to exploit seemingly compelling valuations over time.
Junk bonds should never represent more than a tiny slice of a strategically diversified portfolio, in part because the market capitalization of such bonds relative to everything else is tiny. But there's a case for upping the allocation to this corner of fixed-income a touch these days, given the sharp rise in yield premium. Then again, there'll probably be an even stronger case for upping the allocation a month or a year from now. So it goes when mere mortals such as your editor attempt to divine the future by analyzing the present.
At some point the junk spread will top out, just as it bottomed out back in June 2007. We'll always miss the absolute tops and bottoms. But if you have a long-term view, you can't afford to miss a major turn in a cycle, and in fact you don't have to, at least not completely. But there's a catch: being wrong at times. Sometimes you have to be willing to lose a few battles to win the war.
October 20, 2008
CAN VOLATILITY HISTORY TEACH US ANYTHING?
There are no short cuts to easy profits, but sometimes Mr. Market throws us a bone (or two) in our quest for strategic insight. Two examples, though hardly the only ones, come by way of reviewing correlation and volatility histories. We surveyed correlations last week, and today we revisit volatility, as per our chart below, which graphs rolling three-year volatilities of monthly total returns back to September 1994.
The obvious trend is that there is one, or so it appears. Lulls in vol tend to be followed by surges, and then lulls, and round and round we go. It's all obvious in hindsight, of course, but dissecting where we are in real time and how long it will last (or not) is always more obscure.
Meanwhile, we're constantly fighting our own biases. That's partly because the mind likes to extrapolate recent activity far into the future. Back in the late-1990s, the calm in volatility readings was thought to be the dawn of a new era in smooth and high returns in stocks and other risky assets. Such thinking prevailed right up until the idea was beheaded in the crash of 2000-2002, a reversal of fortunes that was accompanied by a spike in vol.
Something similar unfolded during 2003-2007, when returns generally were strong and standard deviations were low. Once again, it was all too easy to believe that the trend would last. It didn't, leading to a collapse in returns and a swelling in vol.
It's always hazardous to speculate on when a current cycle will end and a new one will begin. Nonetheless, we can and should observe cycles for what they are: finite. The one that now has the world by the neck may appear set to roll on indefinitely, but that is an illusion. This too shall pass, although the timing, as always, is unclear.
We can, however, search for some perspective, and to some extent we can find it. Granted, it's thin and subject to revision on a moment's notice. As such, we must be wary, even when it seems as though we've stumbled upon something meaningful. With that caveat in mind, consider our second chart below, which can be read in context with the first graph above. Note that relative high performance tends to be accompanied with relatively low volatility. No, it's not a perfect match, but there's a general rhyme here, or so looks to our eyes. Similar trends pop up over longer histories as well.
In fact, we suggested as much back in early 2007, noting at the time that the lows in vol looked worrisome. One reason for our concern then was the history of blissful marriage of low vol and high returns ending with a spike in volatility and lower if not negative returns. Does it always unfold like that? No, but it's occured enough over the decades to keep us wary, and watching the trends.
Keep in mind that in both charts we've smoothed the data, i.e., the lines reflect trailing 3-year trends. As such, none of this is much help to the day trader and it's only of limited help, if any, to strategic-minded investors. Nonetheless, the graphs suggest that the current rise in volatility is still quite young, or so it appears next to the previous stumble in 2000-2002.
One could argue that volatility is still rising and returns are still falling. Indeed, trailing 3-year returns, although they've fallen sharply this year, are more or less flat. By comparison with the previous cycle, can we expect some red ink in trailing three-year returns and perhaps some higher volatility yet? Let's not rule it out. Even if vol has reached its highs this time around, it wouldn't be out of character for standard deviations to persist for a time.
Considering all this, one could reason that the correction still has a ways to go. Again, that's pure speculation and so it must be taken with a grain of salt. What's more, volatility and correlation offer only two perspectives, and by themselves they're of limited value, which is why we also review a number of other metrics, including dividend yields, economic conditions, and so on.
Summarizing our research, only of which a portion appears on these pages, we expect that the correction will roll on, although we're generalizing broadly in terms of asset classes. Some look better than others at this point, and that informs our asset allocation. But to the extent we're making general observations, volatility is just one reason. The economic outlook weighs heavily on our thinking, too. And for the moment, it's unclear just how much blowback is coming to Main Street.
October 17, 2008
RESIDENTIAL HOUSING'S RED INK ROLLS ON
By now the routine is familiar--and increasingly painful. The government updates the state of the housing market and a bevy of negative numbers fly by. Today's news on this front is, alas, more of the same, reminding that the primary source of the current economic and financial ills is still correcting and therefore throwing off bearish shock waves in all directions.
New housing starts dropped 6.3% in September from the previous month, the Census Bureau reports. That's a lesser decline than August's 8% drop, although as our chart below reminds that's cold comfort given the persistent declines that have been battering this sector almost nonstop since early 2006.
It's no better for new housing permits issued, and that casts a pall on the future. As our second graph below shows, this forward-looking measure remains under enormous strain too, virtually assuring that housing construction and related activity will continue to shrink for the foreseeable future. The 8.3% drop last month in new permits is steep and only slightly below August's 8.5% tumble, suggesting that the negative momentum has still got its foot on the industry's neck.
The best we can hope for at the moment is that a bottom in the housing market is near. Forget about a rebound--that's probably a year or two off at the earliest. At this point a material slowdown if not an end to the bleeding is housing is priority one. It's unclear what policies will bring that about other than to let the excess in the housing market unwind naturally. Suffice to say, government intervention with an eye on moderating the pain will be ongoing on several fronts, but getting some traction relief remains a trial-and-error effort still.
Injecting more liquidity into the system is, of course, at the center of the best laid plans. And that includes lowering interest rates further. That's looking like a done deal...again. The November '08 Fed funds futures contract is currently priced in anticipation for at least a 25-basis-point cut in rates and quite possibly a 50-basis-point cut, which would bring Fed funds down to 1%.
Helpful, perhaps, but the aid is increasingly marginal. But helping on the margins is all that's left. Maybe the collective actions of marginal changes can bring about a floor to the housing market. Another productive development comes from the energy markets, where dramatic price declines are now doing their part to give consumers yet another source of relief. The November '08 contract for crude oil in New York is currently about $70, or half the level as recently as this past July.
It's anyone's guess when all the various fiscal and financial stimuli, from government bailouts to falling prices on Main Street, will bring some stability to the housing market. No doubt more action is coming if the patient doesn't soon show signs of at least stabilizing. It's likely the brighter days will sneak up on us when we least expect it, i.e., at the point of maximum pessimism.
Meantime, negative momentum still rules, and given the size of the previous housing bubble it's probably a safe bet that the unwinding still has a ways to go.
October 16, 2008
RAMBLING ON ABOUT INFLATION AND STRATEGIC VISION
As expected, inflation is now retreating in the face of financial turmoil and economic contraction.
Consumer prices were flat last month, following a 0.1% decline in August, the Labor Department reports. Of the eight major components of the consumer price index, three posted declines (housing, apparel and transportation prices) last month. Among those that posted increases, food and beverage prices led the way with a 0.6% rise. Core CPI (which excludes food and energy prices) rose 0.1%.
The data doesn't yet confirm that inflation has faded from the economic landscape, but that future's coming. CPI's 12-month change dropped to 4.9% last month, down from 5.4% in August. It's likely that the annual pace of consumer inflation will show further drops in the months to come, courtesy of the slowing economy that's probably headed for contraction if it isn't already shrinking.
Looking for lower inflation is hardly a dangerous forecast these days. Commodity prices have continued falling in October, with crude oil prices falling under $75 a barrel yesterday in New York futures trading for the first time in more than a year. A number of other key commodities are under selling pressure as well.
The big unwinding of the last five years is underway and it'll roll on for a bit. It's an across-the-board correction and it's driven by fundamentals and fear. The U-turn doesn't surprise us since there was a bull market in virtually everything for several years running. If one trend's possible, so is the other. Cycles are as old as civilization, although it's the degree of the rotation that's so shocking this time, although the shock is directly related to our capacity for focusing primarily on the recent past and thinking that's true perspective.
For strategic-minded investors, the reversal of fortunes offers opportunity--eventually. For those who missed the commodity bull run, for instance, the chance to climb on board at greatly reduced prices now and perhaps in the coming months and quarters reveals itself once more. Emotion, however, will argue against the idea, as always. The crowd-pleasing elixir of going with the flow will prevent many from partaking in contrarianism until the all-safe sign has been flashing in earnest for a few years.
No doubt there's a strong case for remaining cautious on all the asset classes save cash these days. Nothing wrong with that. Being a little late to jumping on the eventual rebound bus is no great tragedy. The same can be said for being a bit early. It'd be nice to call bottoms exactly, but that's not an option for mere mortals.
Keep in mind that it's easy to delay one's opportunistic buying until the next wave of selling, and repeating the decision again and again. Bear and bull markets promote self-reinforcing behavior and so one must be careful of letting inertia in one's decision making become a habit that no longer reflects strategic thinking.
Far better, then, to have a plan--a long-term strategic plan. Making a commitment to X number of asset classes with an eye on making multiple purchases over time, based on where absolute and relative value are highest, is a good start. Almost anything is better than sitting dazed and confused for months, which can turn into years if you're not careful. Inaction has a tendency to turn into a long-term strategy if you're not paying attention. That and 50 cents gets you a cup of coffee, although free advice is sometimes good advice.
There are no easy answers in managing risk portfolios. The threat of loss is always lurking, although the magnitude of the threat is forever in flux, in part because prices aren't static either. That's good news, even if it's not obvious when you're reviewing your 401(k) statement of late.
October 15, 2008
THE BIG FADE ON SPENDING ROLLS ON
This morning's retail sales report will surprise no one who's been watching the economy this year, but the trend is still disturbing.
Estimated monthly sales for retail and food services on a seasonally adjusted basis slumped 1.2% last month, the biggest monthly percentage decline in more than three years, the U.S. Census Bureau reports. On a 12-month basis, retail sales are 1% below the year-ago figures. As our chart below reminds, the trend looks ugly, and it's virtually certain that there's more of the same and worse on tap for the coming months.
Considering the U.S. economy's high dependence on consumer spending (roughly 70% of GDP comes from personal consumption expenditures), today's retail numbers speak loud and clear that the recession is here, and it probably has been for some weeks or month, and that the general economic downturn will deepen for the remainder of the year and quite possibly continue through early next year. Your editor was at a press conference with money managers in New York yesterday and one especially pessimistic chap talked of quarterly GDP falling by an annualized 5% at some point in this year's second half. We're not sure the pain will get that bad, but one can't rule out much these days in light of all the negative surprises in recent weeks.
The bright side of all this, if we can call it that, is that inflation for the moment is in hibernation. Again, no surprise there, at least not since last month, and for some the epiphany came a lot earlier. Yours truly, however, was a bit late to the party. But better late than never. We've been worrying about inflation for some time, and we're still convinced that eventually this beast will return as a threat of some distinction, given all the liquidity that's been pumped into the global economy. But the magnitude of the economic and financial ills recently convinced us to reconsider the threat in the short term and we said as much a month ago.
Today's wholesale price report for September only lends more support to this view. Producer prices last month fell 0.4%, following a 0.9% drop in August, the Labor Department advises. Core PPI is still bubbling, posting a 0.4% rise in September, although we expect that too will moderate if not turn negative in the months to come.
A whiff of disinflation that could turn into a mild if temporary deflation is in the air. So it goes with all the economic and financial unwinding these days.
Unfortunately, the bad news for Main Street economics has only just begun. It's unclear where exactly we're headed and how much damage the economy will suffer. It's still far too early to venture a guess other than to expect a hefty storm. No, it's not the end of the world, but the Great Moderation, like so many other rosy assumptions that took root over the past generation, is set for a major revaluation. Recessions of some magnitude, in sum, only appeared to be a thing of the past.
October 14, 2008
MR. MARKET & ECONOMIC CYCLES: IMPERFECT TOGETHER
Single-day rallies of 900 points or more in the Dow Jones Industrials tend to get our attention, in part because they're the unicorn of market action: Often imagined but never seen. Well, we saw a unicorn yesterday.
In fact, we've seen a lot of things lately that just a few months ago were the stuff of dreams--or nightmares. No wonder, then, that this reporter is at risk of losing perspective amid all the chaos. But let's try to sober up and reassess where we're at in the economic cycle. Maybe, just maybe, we can cut through the extreme volatility and venture a guess as to what's coming. It's a long shot, but let's go through the motions anyway.
We begin by speculating that all the government's efforts at stabilizing the financial industry don't really change the underlying economic conditions that brought us to this point. The government's intervention was about stopping the bleeding and shoring up the system to avoid implosion. Perhaps it's time to label that effort successful, although no one quite knows just yet. As for the real economy, the question mark is much bigger. Indeed, the financial crisis over the past year has only recently been making a mark on Main Street, and it's our guess that the trend has quite a few more months to run, at the least.
We're talking here of real estate bubbles and the associated fallout. It didn't start overnight, nor will it end suddenly. No, we still can't see the future any better today than yesterday or last year. Regardless, we're not convinced that the cycle gods are done playing with mortals.
We could cite any number of economic numbers to support our still-cautious outlook, but we'll start by looking at our proprietary measure of economic activity--CS Economic Index. As our chart below shows, momentum still looks biased to the downside, as it has been for some time. This is hardly news. Your editor has been pointing this out for some time now, along with many others observers of the economic scene. For quite a while, we were premature in calling for a material weakening of the general economy, as in this post from last March. So it goes in forecasting generally: you're either early or late. A few lucky souls enjoy perfect timing, of course, but repeat performances by the same people are rare, and rest assured that yours truly isn't likely to ever join that celebrated club.
As for the economy, the above chart strongly suggests that there's more weakness coming. Economic weakness tends to beget more of the same. Until it stops. Even then, recovery may be preceded by lengthy stretches of treading water. Distinguishing one from the other is as much art as science, of course, and on that note it's every forecaster for himself.
As for our index, let's decipher its design. The black line is our CS Economic Index, an equally weighted measure of 17 leading, lagging and coincident indicators covering such diverse corners of the economy as housing, the labor market, the stock market, consumer spending, and so on. Roughly 47% of the index is weighted in leading indicators, i.e., those metrics that are thought to be forward-looking gauges of economic activity. Building permits, for instance, are considered a leading indicator because they reflect intentions about future construction plans. The remaining metrics are coincident indicators (29.5%) and lagging measures (23.5%). No, it's not a magic measure, and to some extent its naive and it may even be misleading. Alas, we can only make that determination in hindsight. For now, we're reasonably sure it captures the basic ebb and flow of the economic trend, and it's still telling us that more weakness is coming.
The fact that our index of leading components are falling even faster strengthens our view that we're still looking at a rough patch for the wider economy. Yes, our economic metrics are only updated through the end of August and we won't have all of the numbers for the September reading until early in November. But the more-recent numbers we do have aren't providing much reason to expect that a turnaround in our broad economic index is imminent. A few examples: initial jobless claims are still running hot, nonfarm payrolls are still shrinking, and various measures related to consumer spending look weak.
The stock market, as always, is looking ahead, which contrasts with the big-picture economic reports, which are invariably backward looking. Bridging the gap in that statistical chasm is the terrain of speculators. Of course, huge rallies come and go within the broader context of secular bear markets, and so one should be cautious about equating one with the other in real time. Tactical opportunity, in other words, is always waiting in the wings. But so is risk.
Nonetheless, we think it's premature for investors to buy equities on the assumption that the economic troubles are now passed. Traders have their own reality, of course, and it may differ at times from strategic investors. As one of the latter, we're still of a mind to nibble on weakness while keeping enough cash on hand to take advantage of future issues. No, we can't guarantee that last week was the bottom. It may very well prove to be the trough. But we don't know, and there's sufficient evidence to support our view, or so we argue. As such, we still favor cautious rebalancing and redeployment of capital, with the assumption that this part of the cycle will take time to unfold in economic terms.
October 13, 2008
The extreme in finance and economics is by definition rare, and that makes it valuable for study.
The crisis of late is no exception. It's one thing to analyze markets when everything is running smoothly, but sunny days don't offer much, if any insight about what to expect during hurricanes.
On the matter of diversification benefits, or lack thereof, one might wonder how the volatility and selling have impacted correlations among the major asset classes. With that in mind, we ran the numbers for trailing 36-month correlations through September 30, 2008, which delivers the chart below.
As usual, correlations are a mixed bag, at least as we calculate them. (Our definition of correlations here is based on the trailing 36 months of monthly total returns. In all cases above, the correlations are in relation to U.S. stocks, as defined by the Russell 3000. The assumption is that investors are looking for opportunities to diversify their equity holdings, which tends to be the dominant risk asset.)
Unsurprisingly, stocks the world over have moved in tighter lockstep recently. In financial panics, all equities look the same, which is to say that investors want now, today, this minute. No wonder, then, that correlations have gone up from already high levels between U.S. stocks (Russell 3000) and stocks in mature foreign markets (MSCI EAFE) and emerging markets (MSCI EM).
The Russell 3000/EAFE correlation as of last month rose to 0.85, the highest in nearly three years. The Russell 3000/EM correlation also climbed, touching 0.73 in September, the highest since December 2006. (1.0 indicates perfect positive correlation, 0.0 is no correlation, and -1.0 is perfect negative correlation.)
The biggest change in terms of posting sharply higher correlations with U.S. stocks comes from high-yield bonds. Just 2-1/2 years ago, the correlation between the Russell 3000 and the iBoxx Liquid High Yield Index was a mere 0.34, meaning that the junk bonds over the previous three years at that point had been exhibiting a large degree of independence from U.S. stocks in terms of monthly performance. But as the chart above illustrates, that independence has faded quite a bit, with the correlation between the two asset classes jumping to 0.85 for the 36 months through last month. That's virtually identical to the correlation between U.S. and foreign developed market stocks. The reason? Investors have been dumping junk bonds just as vigorously as stocks.
REITs, by contrast, have been going the opposite way. Correlations between U.S. stocks and REITs have been falling recently. The underlying cause: REITs have managed to lose significantly less money than domestic equities in recent months. Last month, for example, the Russell 3000 shed 9.4% while Dow Jones Wilshire REIT index lost a modest 0.4%.
Meanwhile, domestic and foreign bonds, along with commodities, are moving more in line with U.S. stocks of late, courtesy of the non-discriminating urge to sell anything and everything in recent months. Even so, these three asset classes still post low and negative correlations with domestic equities, suggesting that the traditionally potent diversification power of bonds and commodities is still largely intact if somewhat bruised.
Keep in mind that correlations are always in flux. Even so, correlations are a bit more predictable than returns. It's a safe bet that that correlations between Russell 3000 and MSCI EAFE will remain in the upper range of the chart above, for instance. Bonds, by contrast, are likely to remain in the lower portion. Therein lies the basis for thinking about portfolio design.
Remember, too, that there are many ways to measure correlation in terms of trailing history. We use 36-month rolling correlations on these pages, in part to maintain consistency. The argument for looking at longer periods--5 years, 10 years or even longer--is a good one, since it cuts out much of the short-term noise and so it provides a more robust sample of what the "true" correlations are. In fact, we do just that, and much more, in our proprietary research. Then again, 10-year correlations are a slow-moving animal and so recent history has little impact. In order to see how the tide is shifting, then, we look at shorter term measures, too.
Overall, whenever two asset classes post correlations below 1.0, there's a benefit to holding both, although the benefit may be relatively slim in pure correlation terms alone. History suggests that we also consider the fundamental nature of asset classes as they relate to one another. Selling (buying) one simply because it's posting a higher (lower) correlation in recent months compared to another holding is probably short-sighted.
Indeed, there are many reasons why we can choose to hold an asset class, or avoid it. Current dividends, interest rates, expectations about earnings and performance, along with an investor's risk tolerance are relevant variables too. But correlations are worth watching, if only to stay abreast of extreme moments, which may signal a change in trend is coming. When commodities were posting sharply higher correlations with stocks (relative to the past) back in 2006, for instance, that was a sign of a potential shift in the market relationships, as we suggested at the time.
To be sure, commodities are still valuable for diversifying equity risk. In fact, all the major asset classes always deserve serious consideration when building strategic portfolios, at least initially. Meanwhile, as the chart above reminds, the value of diversification waxes and wanes over time.
October 10, 2008
FEAR IS NOT A STRATEGY
It all looks so easy on paper, but in real time, using real money, making strategic investment choices is hard. Especially during a banking crisis that threatens the broader global economy.
Each January, we offer an historical chart of how the major asset classes fared on a calendar year basis, starting with the recently ended year and going back several years. Here's what we published this past January--see table at end of post. Looking at this history leaves the impression that one can easily sidestep danger and favor the winners over time. In fact, looking at the past and managing portfolios in real time are equivalent only in the sense that both are focused on investing. But one and only one is immensely difficult, and the reason has as much to do with managing emotions as it does with informed financial analysis.
There are many ways to manage the various pieces of the global market portfolio. We can exclude certain pieces, load up in others or own everything, either in a passive market-value-based mix or by way of an alternative methodology, i.e., active management. But no matter how we manage our portfolios, we must make decisions, all the more so at extreme points in the cycle. At the very least, rebalancing the mix, according to some preplanned strategy, is critical. The exception is building a passively weighted portfolio that self adjusts, thereby remaining weighted as per Mr. Market's portfolio and effectively putting the rebalancing on auto pilot. But even there, we must decide how much cash to hold, if any, in relation to owning the passively managed global portfolio and how that cash/risk portfolio mix should change over time.
The point is that decisions must be made at times. Invariably, some of those decisions will be wrong. But doing nothing solely because of fear, when reasoned analysis suggests action, is a mistake. A strategic mistake, and perhaps one that will forever haunt us.
Indeed, the only thing worse than watching one's portfolio get crushed is doing nothing during or afterwards, once prices have dropped sharply. No, we don't know where the bottom is, or when it will arrive. Our leap of faith is that a rebound will one day come. Could be on Monday, or several years from now. We simply don't know, but we can't risk assuming it's never coming or that it's so far off in the future that there's nothing left to do but sit idly for years.
Rather, we're confident that the only hope of earning modest if not spectacular returns in the years ahead requires some degree of availing one's portfolio of lower rather than higher prices. Ultimately, successful investing boils down to buy low, sell high. Simple to say, hard to do, but we must intelligently strive toward that ideal.
Again, easier said than done. The natural order of the financial universe, for the average investor, is to buy high and sell low or buy high/low and sell high/low. It's easy to lose money, in short. Any one can do it. Making money is harder, all the more once you factor in commissions, fees, taxes, etc. The net result--the real net result--looks uglier than most people realize. In the grand scheme of investing, the deck is staked against most of us. That doesn't mean we're doomed to lose lots of money, although that happens more often than a casual observer might suspect. Yet mediocrity is too often fate, and that's assuming some degree of diversification, i.e., owning mutual funds, ETFs, etc.
If we can summarize what we've learned about strategic investing over the past 50 years, it might roll out like this: keep fees and expenses low, diversify broadly within each asset class; own a mix of asset classes; develop a sound long-term investment strategy and stick too it, but leave room for nuance. By nuance we mean: pare back exposure to risk after a long run of good times or when valuations go to extreme so that assets are priced for perfection. The flip side of that nuance is ratchet up exposure to risk in a measured, time-diversified process when prices fall.
The alternative of sitting idle and missing the opportunity to lock in relatively higher prospective returns certainly looks unappealing. Nonetheless, in the current environment one can argue for waiting before buying. That's certainly reasonable today, next week, next month, perhaps even next year. But there's a fine line between making a tactical decision to avoid new purchases and suffering from fear and doing nothing for long periods as a result.
So, yes, we can all reasonably decide that now is still not a good time to buy. But if not now, when? Each investor's answer will differ, as per the interpretation of events and valuations. But do you have a plan? Is there a price point or valuation point when new investments are warranted? Have you thought about the answer thoroughly? Have you talked it over with an advisor or informed investor, if only to get some feedback? Will you spread out your new investments over time, which is eminently reasonably in times of high uncertainty? Or will you sit there and find an excuse not to buy today--or ever?
We're all vulnerable to doing nothing in times like these. That provides some emotional satisfaction, but the satisfaction has a limited shelf life. Investing is always uncertain. Always. But sometimes the odds look a bit better for prospective returns. That creates opportunity. If that sounds like bad advice at this moment, perhaps that's a sign that the prospective opportunity is higher than normal.
QUOTE OF THE DAY (OR YEAR)...
If not the decade, depending on how all this plays out. In any case, Carl Weinberg, chief economist at High Frequency Economics, cuts through the fog and goes right to the heart of the challenge, in a quote from today's New York Times:
“The core problem is that the smart people are realizing that the banking system is broken. Nobody knows who is holding the tainted assets, how much they have and how it affects their balance sheets. So nobody is willing to believe that anybody else isn’t insolvent, until it’s proven otherwise.”
And until there's some reasonable degree of certainty as to where the bodies are buried--and not buried--the pain will go on. Here's one naive idea for a step in the right direction: All banks and financial institutions publish a list of their holdings on their web sites so everything body can see who holds what. Yes, for some institutions this is going to be a complicated list. Accountants, bloggers and everyone else can then start weighing in. Some of the holdings are already widely known, of course, particuarly among publicly traded institutions. But there's still a fair amount of mystery out there, and mystery is exactly what we don't need at this point. More transparency--complete transparency is needed. Urgently needed. Granted, that's just step one in a thousand mile journey, and it's no silver bullet. But it would help. And it won't cost $700 billion either.
October 9, 2008
FEAR AND VALUE: TOGETHER AGAIN
The classic conundrum in strategic investing is that relative bargains in the stock market tend to arrive when buyers go on strike. There's no mystery as to underlying cause, as current events remind.
Consider our chart below, which shows month-end trailing equity dividend yields for the major regions of the developed economies. The trend of late is clear: yields are rising, dramatically so in recent months. European yields lead the pack at 4.93% at last month's close, based on S&P Global Equity Indices. The U.S., Asia Pacific and the developed world-ex-US are also posting substantially higher dividend yields compared to recent years. For reasons that need no explanation, however, investors are reluctant to avail themselves of these higher yields. For comparison, the yield on the benchmark 10-year Treasury Note closed out September 2008 at 3.85%.
Perhaps avoiding equities (broadly defined) with relatively high yields is prudent at the moment, perhaps not. Yield, after all, is but one component of total return for equities. The other key variables are capital gains and changes in valuation. All three are ultimately speculative in ex ante terms. But if today's higher yields are unappealing, one might ask why the relatively skimpy yields of 2003-2007 deterred almost no one from owning equities? Was it that the outlook for capital gains were so bright that yields did not matter? If so, were expectations for capital gains reasonable or something less? Tackling such questions is as much a job for a psychologist as it is for a financial analyst. In any case, we're better at asking questions than providing definitive answers, in part because we see the past so clearly and are forever fuzzy about what's coming.
Rest assured that the true answers reduce down to the age-old explanation of fear and greed. The duo is always at work, of course, although at times one or the other dominates to the extent that the other is overlooked, dismissed if not left for dead. Until, that is, the cycle changes. The process, we're sure, will endure, along with weather patterns and sunspots.
In short, dividend yields and other fundamental measures will remain in a constant state of flux, which implies (but doesn't guarantee) that prospective returns vary through time as well.
That's meaningless information if you're looking to turn a quick buck over the next month or even year. But what about investors with time horizons of five years or more? The possibilities--maybe, perhaps--aren't quite as dire as the headlines suggest.
October 8, 2008
RATE CUTS WILL HELP, BUT ONLY MARGINALLY
The Federal Reserve and other central banks around the world cut interest rates this morning for reasons that are obvious to everyone. Normally, we'd criticize the cut, given the sea of liquidity already flowing from the world's central banks. But these are not normal times, nor is it clear when normality, or something approximating it will return.
One indication of the abnormality is the rapidly fading threat of inflation, at least for the short term. With the credit crisis becoming materially worse over the past month, the idea of generally higher prices is on holiday until further notice. Disinflation if not deflation is the bigger risk for the time being, which gives the Fed and its counterparts around the world more room to drop rates. (The Fed's cut was 50 basis points, which brings the Fed funds target down to 1.5%.) But while the evaporation of inflation risk provides some monetary breathing room, it's also a sign of trouble in the global economy. There are several ways to mute inflationary pressures, but what we're experiencing now is the worst of all possible ways to achieve that otherwise sound goal.
The immediate question is how much help will a rate cut bring to the frozen credit markets? The pressing goal is convincing financial institutions to lend. Today's rate cut will help, as will the various efforts announced by the Fed in recent weeks. But the prospect of a quick turnaround in lending is dim, at least for the moment. Confidence has been shaken in the belief that loans will be repaid in a timely manner, if at all. Repairing that battered sentiment will take time, and a 1/2-point rate cut, while helpful and warranted, is only a small part of the solution.
A critical issue is that it's still not clear how the ongoing fallout in real estate will unfold. A big part of the problem is that an uncomfortably high share of residential mortgages are underwater—equity below the mortgage balance. The Wall Street Journal today reports that 16% of U.S. homeowners are underwater, based on data from Economy.com.
If you owe $300,000 on a house that's worth $250,000, that's going to influence most if not all of your financial decisions until the situation is resolved. It doesn't help that the home value will probably fall further in the coming months if not years. The mortgage balance, alas, remains unchanged. That means cutting back on non-essential shopping, which reverberates in an economy that's heavily dependent on consumer spending.
For some, the decision to simply walk away from their house weighs heavily. In that case, banks are saddled with more non-performing loans. Many homeowners will try and muddle through, although that gets harder if the labor market continues to deteriorate, which seems likely in the months ahead.
Ultimately, the solution to the housing crisis is lower prices and refinancing mortgages. But with credit markets frozen, securing new loans is tough. Clearly, all of this is going to bring a fair amount of financial pain on homeowners over and above what they've already endured. The government will undoubtedly step in various capacities to alleviate the financial suffering. Even so, the unwinding of the housing bubble isn't over. We're guessing that we'll be well into 2009 at the earliest before signs of a bottom appear. Even then, the prospect of rebound in housing is several years away at least.
The Federal Reserve and the government can and will do much to help ease the distress, starting with efforts to keep the financial system from imploding completely. For what it's worth, we're confident that the government will succeed in keeping the financial apocalypse at bay. But repairing sentiment in the private sector is a different challenge, and one that will take time and the realization that prices of houses and other assets must fall to reflect the new supply/demand equation.
So, yes, today's rate cuts will help, but only in terms of keeping the financial sickness from becoming worse. In fact, as we'll be discussing semi-regularly going forward, the broader economic implications of the financial crisis have only started to hit Main Street.
October 7, 2008
WHAT HAVE WE LEARNED?
The rolling crisis that has become the daily routine of late has no obvious and immediate solution, but at least we can be clear about how we arrived in this thankless position. And maybe, just maybe, we can learn a thing or two about policymaking for the years ahead. It won't be easy, but progress never is, especially in the dismal science.
Facing up to reality offers no silver bullet answers, but ignorance will only aggravate our troubles in the future. With that, let's acknowledge that the current mess is the consequence of years, perhaps decades of mistakes and short-sighted policies. The list is long, and the details complex. Volumes will be written about how policy makers stumbled. For now, we'll revisit one issue that this observer believes has been central, though hardly alone in the buildup to the problems that afflict us.
Arguably one of the bigger missteps flows from the idea that the economy can be reengineered and manipulated so that recessions are a thing of the past. For quite a while it's been tempting to think that the Federal Reserve and its counterparts around the world figured out how to smooth out the rough bumps in the business cycle. Viewed through the perspective of history, the Great Moderation looked like the answer to every central banker's prayers. The goal certainly was a populist winner: recessions that were less frequent, less painful and perhaps even a vestige of a bygone era. For a while, the impossible seemed possible. A look over the history of business cycles certainly gives that impression via fewer, less painful downturns. That appeared to be the new world order, and the assumption was that the retooled cycle rules could go on forever. The tech bubble burst early of 2000-2002 was a warning shot, but most chose to ignore it, in part because for all the pain of that episode, consumer spending never really suffered, thanks to Greenspan's Fed.
But the kinder, gentler cycle was a myth. Rather than dispensing economic pain to the dustbin of history, it was only pushed into the future. The Federal Reserve has spared no expense over the past generation in pre-empting the first sign of trouble by cutting interest rates and creating liquidity first, and asking questions later. Never mind that the policy promoted debt and greater risk taking. It seemed to work, with no apparent price tag.
Politically, this has been popular, as of course it would be. There is no constituency for recession; there is no lobbying group calling for the cleansing action that comes from corrections. But while no one wants economic pain, inevitably it comes. Preventing the beast from emerging, or moving heaven and earth to moderate it, eventually creates bigger trouble down the line.
The reason is partly tied to the fact that humans make mistakes. As a result, money is lost, companies close and people lose their jobs. That can't be legislated out of existence any more than gravity can be banished from the Earth. Fortunately, loss is the exception, which is why the world economy tends to grow over time. The net change in GDP is positive in the U.S., and for the planet generally in the long run. That's a direct function of the innovation and productivity that arises from Mother Earth's workforce. But for all of that, we're not perfect. Not every investment is profitable; not every company endures. Capital destruction isn't pretty, but it's familiar and it's inevitable. Luckily, it's relatively rare. But rare isn't nonexistent.
As such, neither is financial pain. Shareholders lose their investment, perhaps all of it; workers lose their jobs; etc. That's a problem if your investment was defined exclusively in shares of a failed company. Of course, diversification easily solves that problem. As for unemployed workers, well, that's more complicated, but there are two main issues to consider. One, jobless benefits in the short term help smooth over the rough edges of cycles. Two, promoting and nurturing innovation and productivity in the economy improves the odds that eventually the unemployed will find new opportunities. That's not a dream; it's reality, which is why the blacksmithing industry is gone and software engineering is prospering.
Nonetheless, there's a fine line between promoting economic growth and preventing recessions. Yes, we want lots of the former, but going too far in search of the latter may at some point create more problems than it solves. The rubber band only stretches so far, much as we'd like to think otherwise.
To be fair, it's not obvious where healthy central banking stops and ill-advised cycle engineering begins. But there is a tipping point, and simply recognizing its existence is the first step on a thousand-mile economic journey. And for all our criticism of the Fed, it should be recognized that central banking in this country, and in many countries around the world, has improved considerably over time. But what we don't know about intelligent central banking and how it interacts with business cycles still exceeds our collective wisdom. Progress arrives, but it's painful. As recently as the 1970s, remember, the economic chieftains of the Fed believed that economic growth flows directly from printing money. Learning that lesson wasn't easy, but it was necessary.
What, then, are the lessons in the here and now about the limits of trying to preempt, forestall and otherwise sidestep the natural course of business cycles? No, we don't have definitive answers or detailed policy prescriptions, nor does any one else, at least not yet. Trial and error is still the only game in town, and that's a tough way to gain insight. We can do some of it, much of it on paper, but some of the answers will only come from the field.
Meantime, this much is clear: the previous 20 years of sparing no effort to avert cyclical pain, with no thought as to the outcome, has a price. We'd all like to think that the tactical plan of injecting morphine into the economy to keep everyone feeling happy incurs no pain. But that's a fantasy. Moral hazard eventually has real world consequences. Inhibiting macro corrections in the short run isn't a long-term solution, at least in terms of pursuing the goal without recognizing its limitations.
The hope that consumer spending would always grow, via debt or other means; the desire to see home prices continually rise; the expectation that stock prices will never suffer prolonged corrections; etc., etc., etc., has come to an end. But the game couldn't roll on indefinitely. Perhaps our biggest problem was simply thinking otherwise.
The great challenge for the years ahead is finding a reasonable balance between promoting growth and prosperity while allowing a prudent degree of excess trimming. This is a political question as much as it is an economic one. But answer it we must, and that starts with recognizing what's gone wrong.
In some ways, we've come full circle since the creation of the Fed. Recall that in the early 1930s, the policymaking bias was standing back and letting the market heal itself. (Actually, the Fed negatively intervened in the early '30s with monetary tightening, but that's another story). By contrast, in the last 20-plus years, the Fed has been aggressively intervening in an effort to manage the business cycle in an effort to keep everyone happy now and forever. Is there a third way?
No, we're not saying that recessions should be left to run their course. We've learned too much over the last 80 years to go back to that. But we must also recognize the other extreme, and its subtle but ultimately painful consequences that pop up eventually.
As we ponder the question how to proceed, there's no doubt that the business cycle is having its way with us now, reminding that the we weren't as clever as we thought we were. The good news: the long-averted cleansing will one day give way to a stronger, more robust cycle of growth. But first we have to survive the correction.
October 6, 2008
PLENTY OF BLAME TO GO AROUND
The finger pointing has only just begun, and there's lots of targets to point at. Analzying what went wrong on Wall Street is clearly in everyone's best interest if only to prevent trouble in the future. But the greatest danger is looking for scapegoats and missing the forest for the trees.
Let's first recognize that a fair amount of the pain in the financial industry was self-inflicted. There simply wasn't enough attention paid to risk management. Yes, there was a surplus of quantitative modeling, but at the end of the day too many relied on the math geeks, many of whom didn't provide much value when it came to estimating the potential pitfalls of leverage, buying and holding mortgages of questionable risk, and diving headfirst into derivatives. Alas, the temptation to leave the analysis there is strong. It's also a mistake, and probably dangerous if it influences the inevitable wave of policy changes that are coming.
Whatever degree of blame lies with Wall Street (and its considerable amount), it's clear that the financial industry had a helping hand in shooting itself. The government was no bit player in stoking the flames of the current financial crisis, which is first and foremost a real estate crisis. Yesterday's New York Times detailed the extent of misguided efforts in Washington to promote financial institutions to make loans to people who couldn't afford mortgages. Three key paragraphs summarize the article's message:
Fannie, a government-sponsored company, had long helped Americans get cheaper home loans by serving as a powerful middleman, buying mortgages from lenders and banks and then holding or reselling them to Wall Street investors. This allowed banks to make even more loans — expanding the pool of homeowners and permitting Fannie to ring up handsome profits along the way.
But by the time Mr. [Daniel H.] Mudd became Fannie’s chief executive in 2004, his company was under siege. Competitors were snatching lucrative parts of its business. Congress was demanding that Mr. Mudd help steer more loans to low-income borrowers. Lenders were threatening to sell directly to Wall Street unless Fannie bought a bigger chunk of their riskiest loans.
So Mr. Mudd made a fateful choice. Disregarding warnings from his managers that lenders were making too many loans that would never be repaid, he steered Fannie into more treacherous corners of the mortgage market, according to executives.
In addition, it's this editor's belief that the Federal Reserve in 2003 and 2004 kept interest rates too low, which helped spark the extraordinary real estate bubble. Yes, there were other factors involved, and so it's unclear if higher rates would have prevented or modified the property bubble. But it's now clear, at least to this editor, that the Fed was part of the problem. Indeed, a cursory look at leading economic indicators in 2003--including building permits and housing starts--strongly suggested that economic activity was on the mend and so higher rates were necessary. In fact, the Fed did begin raising rates in June 2004, but not only was the decision late, the rate hikes were a long series of tiny 25-basis-point increases. In short, too little, too late, as we and others were already suggesting in March 2005, for instance.
Again, our message here is not to shift blame from Wall Street to Washington. There's enough blame (and increasingly pain) to go around. What's more, the problems that afflict the economy--problems that are likely to get worse before they get better--took years if not decades to fester and involved a myriad of players. Cleaning up the mess will take time, and lots of money. So it goes.
But let's try to fully and objectively assess what brought us to this point, if only so that we can emerge from the crisis at some point with insight and an understanding of what went wrong. The only thing worse than enduring a major financial crisis is suffering through one and not learning anything once the storm passes.
October 3, 2008
THE DIE IS CAST
This morning's employment report for September is the worst yet for this cycle, and we'll probably see even deeper pain in the months to come. But for now, the last shred of hope that maybe, perhaps, somehow the U.S. could avoid recession has been definitively dashed, once and for all in today's jobs update.
Nonfarm payrolls slumped by 159,000 last month, the biggest monthly loss for the labor market in five years and the ninth straight month of red ink for job destruction, the government reports. That's a sharp drop down from the relatively moderate losses we've seen previously, as our chart below shows. Although unemployment was unchanged at 6.1%, the steady jobless rate for September should fool no one. The message from the labor market is clear: the one-year-old financial crisis is now taking a bigger toll on the broader economy, and the pain is still gathering steam and cutting deeper.
The mounting troubles for the economy have been bubbling for some time, of course, as CS has chronicled throughout this year. Back in March, we laid out the case for why a recession was virtually certain. Unfortunately, the corroborating evidence has continued to pile up since then. Earlier this week, for instance, we learned that car sales and factory orders suffered hefty declines last month, adding more signs that there's still plenty of trouble ahead.
The unwinding is upon is, and there's not much that the Federal Reserve can do now to ease the pain. Cutting interest rates at this point won't help much beyond the margins, although some are calling for cut in Fed funds to 1% from the current 2% and there's a sense that the cut could come before the FOMC is scheduled to meet on October 28 and 29.
"Cutting short rates as close to zero as possible," writes Ian Shepherdson of High Frequency Economics in a note to clients today, "is a key ingredient of the policy mix required to prevent a pre-depression economy becoming a real depression economy."
But let's be clear: this process will roll on until it's had its way. The government can help some by, say, extending unemployment benefits and buying up those securities from financial institutions that no one else wants. There's some additional insurance in dropping interest rates too. But no one wants to lend, and consumers are cutting back on non-essential purchases and so borrowing at any price looks unappealing for most folks. That defensive posture's not likely to change anytime soon, and therein lies a key part of the challenges that await.
One of the few bright spots in all of this is the continuing fall in oil prices. The NYMEX November '08 contract for crude, for instance, is currently in the low-$90 range, which is near the lows for the past 12 months. Lower energy costs will help ease the financial pain weighing on Joe Sixpack. But even continued price declines in gasoline, heating oil, etc.—assuming that's coming—won't be enough to turn around the pain bubbling elsewhere in the economy.
Ultimately what's needed to change the economic tone is an upturn in sentiment among consumers, investors and businesses. That will come, but not until deep into 2009 at the earliest. And that's the optimistic outlook.
For now, the die is cast. It's unclear how deep and how long the economic correction will be. October promises to be a critical month in providing clues about how this downturn plays out in the coming quarters (years?).
For now, however, it's going to be a long weekend, no doubt the first of many. It's time, dear readers, to pace yourself and keep an eye out for opportunity in the capital and commodity markets. But patience is essential, along with a cool head.
October 2, 2008
The monthly numbers for all the asset classes suffered red ink in September (save for cash), as our table from yesterday details. Fortunately, that's a rare episode.
For the 10 asset classes listed in that table, the last time the representative indices all posted monthly losses was October 2005. Overall, there have been three times in the last 10 years when losses infected all the major asset classes in one month: 9/08, 10/05, and 4/04. That translates to 2.5% failure rate, if we can call it that. It's low, but it's higher than zero, and so we can't be blind to the possibility.
What's different this time is that the crisis that came to a head in September 2008 makes the problems of the recent past look shallow by comparison. Indeed, the current troubles are deeper and threaten the economy. The main lesson today is that no asset class is immune from financial and economic crises. Nor is there any reason to think that all the major asset classes can't suffer losses simultaneously.
The good news is that an across-the-board fall in the 10 major asset classes is abnormal. But it does happen, and a bit more often such events nearly happen.
Clearly, strategic-minded investors should be prepared for such times, at least emotionally. But looking over longer periods further lessens the incidence of everything tumbling. Once you begin looking at 12-month trailing returns and longer, the frequency of all the major asset classes suffering negative performance drops significantly. For the past decade, for instance, there are no cases of all 10 asset classes posting losses. That's not to say that it can't or won't happen, but it's less likely to the longer the time period. Therein lies the benefit of broad diversification over time. But on a monthly basis, and certainly for weekly or daily periods, anything's possible.
But let's think about the longer periods. Why should we see more stability in a multi-asset-class portfolio over, say, 1-year periods vs. monthly returns? The fundamental reason is that over time, the risks that loom over commodities vs. bonds vs. REITs vs. equities are different. That may not matter in any one month, particularly when all hell breaks loose, as during last month. But the prospect of everything dropping month after month after month is virtually nil. That's not to say it can't or won't happen. Personally, though, we don't worry about that possibility. If all the world's major asset classes post red ink for 12 months straight, the apocalypse is surely upon us and most of us will be preoccupied with such things as finding a loaf of bread and clean drinking water.
Assuming the world survives (which is one our little biases), we're confident that our Global Market Portfolio Index will be higher a year from now, or at the very least unchanged from current levels. No, we can't promise that forecast, nor any other of our guesstimates. But investing always involves a leap of faith on some level, and that's the essence of our strategic assumption. Meanwhile, keep in mind that when we speak of multi-asset classes, we're talking of its value over the long haul, at least three years out. As for any one month, or even a string of them, the noise risk is ominpresent, and sometimes the noise can be deafening.
October 1, 2008
SEPTEMBER: THE CRUELEST MONTH BY FAR
Thank goodness September's gone. Although it's passed into history, the legacy will long linger, in our minds and wallets.
Indeed, September 2008 was ugly. Really ugly. There was no place to hide other than cash. It was just one of those months and it didn't really matter what you did or what you owned save for T-bills or the closest equivalent. Even our CS Global Market Portfolio Index (GMPI) was crushed last month, dropping a nerve-rattling 9.4% in September. As our table below shows, our index of the global market portfolio is down steeply for year-to-date and 12-month readings too.
That's an extraordinary loss for GMPI, all the more so since the previous three months have witnessed hefty losses, although not nearly as deep as September's tumble. But it's not entirely surprising. Faith has faded in large swaths of the U.S. economy and investing strategies generally this past month, and GMPI wasn't immune to the virus.
We'll be analyzing why GMPI stumbled so horribly last month in the coming days, provide some historical perspective, and what it means for broad asset-class based strategies generally. For now, we'll let the red ink above speak for itself.
One housekeeping note: the performance numbers for the individual asset classes above are based on indices rather than ETFs and mutual funds, which was the norm previously. That will be the standard going forward, in part because GMPI is based on indices rather than securities products and so the adjustment provides a more apples-to-apples comparison between the components and the global portfolio.