The Capital Spectator

Posted by jp at 11:51 AM | Comments (0)

November 24, 2008

THE GREAT EXPERIMENT

Have we seen this movie before? It certainly sounds familiar.

Once again, the government steps in to bail out a financial institution and Mr. Market takes kindly to the idea. Initially. But then reality sets in and the process starts anew. Perhaps it'll be a true sign of a bottom when the Feds engineer a bailout and the market tanks on the news.

But not yet. The latest installment of rescue centers on the once mighty Citigroup. Meanwhile, the stock market is soaring, as is Citi's stock, as of mid-morning, at least.

A giant among giants, this behemoth of financial behemoths surely fits the bill as too big to fail. If such a thing exists as a financial institution that must be saved at any cost, Citigroup looks like the poster boy for this idea.

Total assets for Citigroup were a bit more than $2 trillion in September. For those who like to keep score, that's roughly 14% of the annualized value of U.S. GDP for this year's third quarter.

The days of pulling another Lehman and letting a big bank fail are history. Better to bailout more rather than less and deal with the consequences later. The grand strategy here is that if the government bails out enough banks (and perhaps an auto company or two) while spitting out stimulus in various forms as far as the eye can see, the system will correct itself, or at least stop bleeding. At a time when deflationary risks are rising, this plan is considered prudent and timely by a growing swath of economists and voices from the peanut gallery, including yours truly. The risk of an even deeper implosion of prices and confidence must be avoided lest the vortex of deflation pull everything down the rat hole. Preventing deflation is the last battle in this horror film because once the big "D" takes hold, in sentiment and prices, the challenge becomes much, much tougher.

The problem is that no one's really quite sure if deflation with a big "D" is on our doorstep. Quite possibly it is, or so one could reason after witnessing consumer and wholesale prices fall last month on a scale unmatched since the government began keeping tabs on such things in the late-1940s. Waiting for definitive signs risks letting the monster out of the cage. Decisions, decisions. Nonetheless, there's a strong case for assuming deflation is coming. If we're wrong, we'll have more inflation on our hands than we otherwise would. But the world knows how to fight inflation, even if the political will is sometimes lacking. Attacking deflation, on the other, is another story.

Any way you slice it, there's bound to be more than a little disappointment and finger pointing in the months and years ahead. Indeed, no one should think that the necessary but risky strategy of preventing deflation is destined to end in triumph, or quick results. The stakes are high, in part because the government's moving quickly toward betting the house on a fiscal/monetary solution. On the opposing shore is the unwinding of excess, some of which has been decades in the making. When an immovable force meets government printing presses, the outcome isn't entirely clear.

All the more so if the world is looking for signs, one way or the other, by next Wednesday. It's difficult to gauge expectations as we run from one crisis to another. But this much is clear: the financial and economic problems will take time--years--to solve, and to the extent that the crowd thinks otherwise, the seeds of disenchantment have been planted.

The U.S. economy is sick, and getting sicker. Europe has the disease and Asia is at risk of contracting the same, albeit in a milder form. Looking back on the past five decades offers no clue for what may be coming. Growth has been a constant, according to GDP numbers from economist Angus Maddison, emeritus professor, University of Groningen (Netherlands). As the chart below shows, outright contraction is unknown in the postwar era.

Fifty years is a long time, virtually an eternity for mere mortals studying the past in search of clues about the future. It's all too easy to look at this track record and conclude that real declines in global GDP aren't possible, or are so unlikely as to be unworthy of considering. The IMF forecast, for one, still imagines more of the same with next year's estimate for real global GDP rising by a respectable if not impressive 2.4%.

Of course, the crowd used to think in persistent-growth terms for housing prices, and how they never fall on a year-over-year basis. Oh, sure, that happened in the Great Depression, but such episodes were dismissed as a thing from the past.

Perhaps it's time to consider the unthinkable. We've all received a crash course in just that over the last few months. But has the education so far been sufficient? Or do we still need to spend more time studying?

There are many dangers stalking the global economy, and at the top of the list is the assumption that the governments of the world can spend their way out of the slump on our collective doorstep. In the U.S. alone, the government now stands at the ready to spend $7 trillion--yes trillion with a "t"--to bring financial salvation to the system, according to Bloomberg News. That's the equivalent of three-and-a-half Citigroups, or half the U.S. economy. Scale no longer looks to be a stumbling block.

By spending enough money, governments are likely to keep inflation-adjusted global GDP floating somewhere above zero, if only slightly. That would still bring a fair amount of pain and repricing, but embedded in the expectation is the notion that a floor can be built under the crisis.

Perhaps, although at some point one might wonder if the cure will be worse than the disease. There are some awkward questions that will accompany the mother of all spending sprees now underway. First up: Is there some point at which additional government spending becomes counterproductive because a) it encourages future inflation on a scale that will be excessively burdensome; and/or b) the prospect of the government owning ever-larger chunks of the economy risks institutionalizing mediocrity or worse in the economy?

There are two great episodes of deflation in modern history, and each continues to raise questions about the associated lessons. Yes, spending is the only hope of sidestepping the beast, and if that means artificially engineered demand from the government, so be it. But it's not clear that the strategy leads to happy results all around. Meantime, there's more than one way to fight deflation.

That's not to say we shouldn't try to spend our way out of a deflationary trap. We should. We must. And we will. The risk is real this time, unlike the previous worries over deflation in 2001-2003. But the details of how we engage our anti-deflationary war may matter as much, if not more, as the decision to wage the war in the first place.

The dismal science has precious little experience with fighting deflation and so we must recognize that we may soon be caught up in an economic experiment on a scale that has little or no precedent. By all means, let's fight this war ferociously. But it also needs to be fought intelligently. What exactly do we mean by "intelligently"? We can't say for sure. No one can, and therein lies the greatest risk.

Posted by jp at 9:50 AM | Comments (2)

November 21, 2008

UNSAFE AT ANY YIELD?

This year will be remembered for many things, most of them negative, brutish and just plain ugly. But 2008 will likely to go into the history books for other reasons, too, including a year that extended extraordinary gifts to strategic-minded investors. No less extraordinary will be the dearth of investors willing or able to accept the gifts from the financial gods.

So it goes in the money game. When prospective returns--long-run prospective returns--are thin, the crowd can't get enough. At the other extreme, when risk premia is soaring, Mr. Market finds few takers. All the more so when fears of depression are swirling about.

Consider the chart below, which is but one example of the astonishing repricing of risk now underway. The recent spread in junk bonds over Treasuries is currently at levels last seen, well, almost never, at least since the modern notion of high yield bonds as an asset class was minted in the 1980s. Today, the asset class can be had at a yield spread of nearly 1,700 basis points over a 10-year Treasury yield. For reasons that need no explanation, there are few takers, which is one factor for why the spread's so high. By comparison, in June 2007, the spread was compressed at one point to less than 260 basis points, a level that investors were happily accepting.

There are, of course, many reasons for shunning such rich spreads, just as there were many reasons for accepting the narrow spreads in June 2007. Indeed, juicy yields invariably come prepackaged with economic contraction and higher rates of defaults in the junk bond universe. They don't call 'em junk for nothing.

Are yields now sufficiently high to compensate for the higher level of defaults that are surely coming? No one really knows, although that doesn't stop anyone from considering the broader context. On that note, junk bond guru Martin Fridson of Fridson Investment Advisors in New York told Bloomberg News on Wednesday: "Either the [high-yield bond] market is right and expecting a default rate considerably higher than it was in the Great Depression, or we have such profound dislocations and selling pressures going on that it really is creating extraordinary fundamental value.''

Yes, the spread may go higher still, perhaps much higher. At some point it'll stop going up and it's a near certainty that almost no one will be buying at the apex. Indeed, few are buying now, and the buyers will surely dwindle further in the weeks and months ahead. That's not entirely illogical, since some of us like to get a decent sleep each night.

This much, however, is clear: Several years from now, when we all look back on 2008, many of us will promise to buy if junk spreads ever go that high again. The lesson being: great bargains only look compelling in a rear-view mirror, a.k.a, talk is cheap.

Posted by jp at 10:28 AM | Comments (1)

November 20, 2008

THE DECLINE AND FALL OF PRICING POWER

Deflation may or may not be coming, but the Treasury market's forecast is clear.

After yesterday's news of a sharp drop in consumer prices, which came on the heels of something similar in wholesale prices the day before, traders in government securities took the hint. Yesterday's closing yield of 3.391% for the benchmark 10-year Treasury isn't the lowest we've seen, but it's getting close.

Back in June 2003, the 10-year briefly dipped to the then-astounding low of just under 3.10%. At the time, some observers of the financial scene said the trough would stand for generations as a low-water mark. A reasonable call at the time, based on the available information. But the forecast has been abandoned in light of recent trends, and rightly so.

The economic news of late gives reason to think that the 2003 low may soon give way. In the current environment, any news of weakening demand promotes the expectation that prices generally will fade for the foreseeable future. The latest example comes in this morning's update on initial jobless claims, which jumped again last week, rising to 542,000, the highest since 1992. The message in this leading indicator is clear: the labor market will continue to shed jobs. Unfortunately, there's a surplus of similarly discouraging trends in everything from retail sales to manufacturing activity. Pricing power, as a result, becomes weaker by the day, and the shift is quickly finding traction in interest rates, as recent changes in the Treasury yield curve remind.

No wonder, then, that the inflation forecast coming out of the Treasury market has crashed. As of last night's close, the 10-year forecast for inflation was an annualized 0.4%, based on the yield spread between the nominal and inflation-indexed 10-year Treasury (see chart below). As recently as October 22, this inflation outlook was over 1% and just this past July it was above 2%.

The change in the state of economic and financial affairs in the past year or so--the past two months!--has been extraordinary, perhaps unprecedented in the modern age in terms of the pace and depth of the reversal. The magnitude of the change suggests that the recovery will be slow in coming and even then the rebound may be weak for an extended period. The smoking gun for this prediction comes via the generally high level of indebtedness among consumers. Leading the charge is the still-sinking real estate market, which continues to pressure household finances. The burden, already heavy, will be even more onerous if and when deflation arrives in earnest.

The main threat in all of this is that the financial pain becomes negatively self reinforcing. The elevated challenge of paying off debts convinces consumers to steer clear of the shopping malls, which in turn weighs heavily on economic growth, which contributes to job destruction, which pushes prices lower, which makes debt servicing tougher, and round and round we go.

How do we stop this toxic merry go round? As we've discussed, the monetary solution is spent. Effective Fed funds (a more realistic measure of actual banking transactions) is now at 0.37%, even though the more widely quoted Target Fed funds rate is 1.0%. With the central bank within shouting distance of zero, fiscal stimulus via Congress is the only game left. Accordingly, the economy's fate seems to rest ever more firmly in the hands of the politicians. That's less than encouraging for all the usual reasons that go with waiting and hoping for a Washington-based rescue. What's more, the U.S. is knee-deep in a government transition, which raises an additional layer of uncertainty over the usual political questions.

The silver lining is that the bargain prices for strategic-minded investors will be astonishing in the months (years?) to come--even beyond the already rich valuations on offer as we write. The question is whether anyone will have the stomach for partaking in the plush bargains that await.

Posted by jp at 9:57 AM | Comments (0)

November 19, 2008

DEFLATION WATCH: DAY 2

Yesterday it was producer prices; today it's consumer prices. The collective message is all the clearer: the risk of deflation is rising.

Consumer prices dropped 1% last month--a huge decline for a single month and the biggest on record, based on historical data on the Labor Department's web site going back to 1947.

Core inflation, which excludes food and energy, dipped by 0.1% in October, suggesting that the falling prices depicted in headline inflation is more than just a function of slumping commodity prices. And since the Fed focuses on core readings of inflation, last month's dip in core CPI reminds that the central bank is losing control of the pricing environment. Indeed, the last time core CPI dropped on a monthly seasonally adjusted basis was in July 1980, which proved to be a one-time event.

It's not clear that the negative signs in CPI this time are set for a quick fade. The perfect storm of recession, rising unemployment, a consumer population burdened with historically high levels of debt, the implosion of Wall Street, a housing crisis and a weakening global economy threaten to inject the poison of deflation into the U.S. economy.

It's true that the rapid price decline in commodities is the primary force behind the red ink in prices. That fact provides a bit of hope that deflation may yet be avoided. If falling prices is contained to raw materials, the trend could be dismissed as simply a correction in a formerly high-flying market. Indeed, at some point commodity prices will bottom and prices overall will stop falling. But with the other ills noted above, and the embedded deflationary risk they harbor, the extraordinary news of sharp price tumbles in wholesale and consumer prices can't be ignored just yet.

Another problem is that the Federal Reserve is nearly out of conventional monetary ammunition, and perhaps by more than is generally recognized. The widely quoted target Fed funds rate is at 1%, implying that another 100 basis points of cutting is still possible. But that rate overstates the case. The effective Fed funds rate, which is a better measure of actual transactions between banks and the central bank, is far lower at 0.37%. As such, lowering the 1% target Fed funds, which is likely, will be less of a rate cut than simply facing up to reality as it now stands in the credit market.

Fiscal stimulus engineered by Congress and the White House, along with nontraditional efforts at injecting liquidity by the Fed are the only levers left. For a number of reasons, including the limited experience of dealing with deflation in the modern era, it's unclear how effective those efforts would be for combating a general price decline.

The good news is that it's still possible to say that deflation hasn't arrived in earnest, at least not yet. On a year-over-year basis, CPI still rose 3.7% through last month. The deflationary warnings have only just arrived, and so we're in the early stages of deciding the broad trend for prices. Hopefully, October's price trends are exceptions, but we'll just have to wait for additional data to be sure. The problem is that if deflation is in fact a real and present danger, acting in a timely manner is essential. Once a deflationary mentality takes hold, there's almost no solution.

Pre-emptive action, in other words, offers the only path for sidestepping the disease. For that reason, erring on the side of stimulus--a lot more--looks like a reasonable course. The risk is that it triggers inflation, in which case it'll be time to reverse course. But at least the world knows how to fight inflation. Deflation, by contrast, is an entirely different monster.

Posted by jp at 10:01 AM | Comments (0)

November 18, 2008

D-DAY

One month a trend does not make, but today's update on wholesale prices invites the obvious speculation about what may be coming.

As for assessing the here and now, it's clear that the deflationary winds are blowing. Producer prices posted a jaw-dropping 2.8% tumble last month, the Labor Department reports. That's the deepest monthly decline for this series since the Great Depression, although that's just an educated guess since the Labor Department's PPI archive on its web site only has numbers going back to 1947. Since then, last month's drop is by far the biggest.

Monthly declines in the PPI series are hardly unprecedented, even if the magnitude of last month's drop is in a class of its own. But that's not the issue; rather, the economic context of the moment, coupled with a massive price decline in wholesale prices, suggests that an extended bout of deflation may be at hand. Tomorrow brings the October update for consumer prices, and the news is expected to be better, i.e., prices are expected to rise. We'll see.

Why all the anxiety about the potential onset of deflation? To be blunt, avoiding the Big D is always a priority for policymakers. Typically, the inflationary bias does the heavy lifting on that front, leaving governments to worry about other things. But sometimes the pricing landscape turns upside down. Is such a moment at hand? As always, the future's unclear, but it may be time to err on the side of caution about deflation's threat.

Although the prospect of falling prices has obvious appeal for consumers, economically speaking it's a virus that, if allowed to fester, creates any number of problems. The reason is that if deflation takes root, the normal incentive to buy and borrow takes a holiday, which elevates the odds for economic contraction. The fact that the U.S. is already in recession only makes the additional threat of deflation all the more troubling.

If prices are falling and everyone expects more of the same, the temptation increases for delaying purchases to cash in on future discounts. But the sentiment motivates more of the deflationary momentum, which inspires more deferred consumption. At some point, the trend turns into a deflationary spiral that feeds on itself, and at that point there's not much anyone can do to pull the economy out of a dire tailspin.

Borrowing and lending in a deflationary environment also suffer since debt servicing becomes increasingly burdensome. The normal inflationary scenario is borrowing in today's dollars and repaying tomorrow in less-valuable dollars. Under those conditions, there's a natural appeal for assuming loans. The opposite is true with deflation: the expectation of repayment with dearer dollars creates a disincentive for assuming debt. All the more so since purchases implies buying assets that are likely to decline in value, which is no one's idea of a savvy business plan. For obvious reasons, this scenario is a disaster for stimulating economic growth.

History is quite clear on those rare occasions when deflation strikes. The two great 20th century examples of deflationary environments—the Great Depression in the 1930s and Japan's experience for much of the past 18 years—need no explanation for why price declines of any duration must be avoided.

The good news for the moment is that there's still hope. In today's news on producer prices, the primary source of the price decline in October came from collapsing commodities, energy in particular. Core PPI, which strips out food and energy, actually rose last month by a rather robust 0.4%, matching September's gain. Deflation, in other words, hasn't affected all prices. Therein lies the basis for hope that deflation generally can still be avoided.

Nonetheless, today's PPI report sends a strong signal that the risk of deflation has jumped substantially. It's not yet fate, but it could be if policymakers don't act forcefully and in a timely manner. The risk is real, in contrast to the Fed's ill-advised deflation fears in 2001-2003. This time it's the real thing, and the clock may be ticking. Indeed, the recession has only just begun, and so it's not yet clear how deep and enduring demand destruction overall will be.

Tomorrow's consumer price update will offer further guidance on the state of the pricing environment. But given the general economic backdrop of fading demand, which feeds deflation's fires, today's wholesale price report must be taken a warning sign that the D threat is a real and present danger. If and when deflation has the economy by the throat, the virus becomes far more difficult, if not impossible to contain.

Indeed, the usual monetary levers no longer work in deflation because interest rates can't be negative even though prices can be. And so the limit imposed by what's known as the zero bound in monetary policy may be near. The Fed funds rate is already at 1%, meaning that the opportunities for lowering interest rates are constrained. To be sure, the Fed has alternative means of stimulating demand, although it's unclear how effective such efforts will be, in part because they're so infrequently used. Deflation, in short, is the exception and so there are few real world examples of fighting the beast.

Once again, let's remind that it's not yet clear that deflation is destiny for the U.S. economy, even if the risk has jumped sharply. Much depends on how fiscal and monetary policies unfold in the coming weeks and months. Ditto for the economy. It's possible that the deflationary risk will pass of its own accord, but for the moment that's a risk the country can't afford to take. Better to err on the side of too much stimulus rather than too little.

Yes, there's a risk that the excess stimulus won't be pulled back in once the deflation danger has passed. That too is a potential problem that can't be dismissed. But that's a battle for another day. Now is the time to prepare for an all-out war on preventing deflation.

Posted by jp at 10:27 AM | Comments (5)

November 17, 2008

FACING REALITY

The financial ills that began in August 2007 metastasized sometime over the past few months into an economic contraction. The exact moment is unknown, but there's no mistaking the trend now. The only question is whether the global economy overall will suffer a recession. The risk is rising by the day, largely because the developed world is already in a slump. If the emerging markets succumb too, the next few years will be quite difficult, perhaps more than is generally expected.

The IMF forecasts that the advanced economies will contract by 0.25% next year (see chart below). If so, the downturn would mark the first fall in the developed world's real GDP pace on an annual basis since World War II. The good news, or so the IMF advises, is that a rebound will commence sometime in late-2009 and that emerging markets will still expand by respectable if no longer spectacular rates.

In the meantime, the U.S. has already reported a dip in GDP for Q3 and more of the same looks likely. The sharp drop in October's retail sales, as reported on Friday, is the statistical poster child for expecting a string of negative numbers in the coming quarterly GDP updates here.

"Consumer confidence is beleaguered," Bill Martin, CEO of ShopperTrak, a Chicago-based retail analysis firm, tells The Christian Science Monitor. "There is no good news to look for anywhere. People are just squirreling away money."

That's an especially pernicious problem for U.S. economic activity, which is heavily reliant on consumer spending. The challenge is only compounded by the ongoing real estate correction, rising unemployment and similar ills now swirling throughout the globe. Can you say perfect storm?

Japan has now joined Germany among the developed world's recession club. It's only a matter of time before we have confirmation of the eurozone's slump.

If there's any hope for moderating the cycle's worst effects, it comes from so-called emerging markets, and that means that domestic demand in these nations will prove resiliant in the face of global headwinds otherwise. It's not clear that this outcome will survive reality, but that's the best-case scenario and for the moment many analysts subscribe to this view.

As we write, there's still statistical support for expecting China (to cite the obvious example) to beat the odds. And the good news is that it's still growing. Optimists say that the Middle Kingdom's GDP will continue rising even in the face of recession in the developed world. The current IMF forecast for China calls for growth just under 10% this year, falling to 8.5% in 2009. That's well below the sizzling 11.9% logged last year, although for China the moderating outlook has already triggered plans for a massive fiscal stimulus in an effort to keep the party going.

Overall, IMF expects emerging economies to grow 6.6% this year and by 5.1% in 2009. That's slightly lower than forecasts from only a month ago, and the current projections may be downgraded yet again. If so, that's a distressing prospect for the advanced economies. As emerging markets' fortunes fade, the pain will be that much greater for the developed world because of its weakened conditions elsewhere. The world economy has relied in no small measure on emerging nations in recent years. If and when that source of demand gives way, the already sober outlook for economic activity will take a further hit. The potential for a self-reinforcing negative feedback loop isn't easily dismissed. As such, watching events in China, India, Brazil and other developing nations has greater import than ever these days.

To be sure, governments around the world are hardly standing idle. Monetary and fiscal levers are being redirected in a new war on minimizing the cyclical pain that is now everywhere. Results are still unclear, although the effort promises to be massive in a collective sense. If the stimulus fails, it won't be for lack of trying.

Yet even if the coordinated plans of governments work as expected, there's no avoiding the economic pain that awaits. The correction is here, it's taking a toll and the best to hope for is that monetary and fiscal policies will lessen the bite. But for the foreseeable future, the world must live with diminished expectations. The macro context is everything at the moment, and it promises to dictate much of what happens for some time. Escaping the wrath of betas, if you will, will prove difficult for investors and everyone else.

Posted by jp at 9:40 AM | Comments (2)

November 13, 2008

MORE LABOR PAINS

This morning's update on initial jobless claims is both sobering and clear: the economy is contracting and the trend has legs.

There's no debate on this point now, nor is there much to be done in the short term to alter the fate that now awaits the U.S. The wave is crashing and the unwinding will have its way. Yes, government can and should soften the blow, particularly for the least fortunate. But in macroeconomic terms, there's no stopping the recessionary forces now unleashed.

Unfortunately, this process is still in its early stages and so the pain has only just begun. Indeed, for the first time in this cycle, last week's new filings for unemployment benefits--a forward-looking indicator--rose above 500,000, as the chart below shows. The nation's unemployment rate, as a result, is sure to rise further in the months to come.

For all the bearish news of the past year or so, much of it has been finance related. The fallout is now taking its toll on the broader economy, which is to say consumers, who collectively represent about 70% of GDP. If nothing else, everyone needs to recognize what awaits. The storm is here and will blow for some time.

The last time initial jobless claims moved above 500,000, the event was short-lived. The economy won't be so lucky this time around. After the tech bubble burst in 2000, the blowback on consumer spending was virtually nil. Indeed, Joe Sixpack kept spending, in part because the Fed dropped its benchmark interest rate to a mere 1%. The central bank has done so again, but low interest rates won't help this time. Even a 0% Fed funds rate, which can't be ruled out in the near future, won't do much to stimulate demand.

The system must be purged of the excess and it will be purged, and this time the man on the street agrees. There's no other way to reach equilibrium for asset prices and supply and demand in the economy generally. Policy makers, in turn, must focus on how best to deploy future stimulus efforts so as to maximize the benefits. That's not going to be easy, for several reasons.

The biggest challenge is the magnitude of the correction/recession. For the past generation-plus, economic corrections have been mild and infrequent, and so there's been limited attention cast on dealing with deeper, longer recessions. That's changing, of course, as current events are pushing policymakers to undertake a crash course in pain management.

That leads to the second problem, which is figuring out what to do without throwing money down the drain. Some issues are clear cut, like extending jobless benefits. We don't need a Congressional hearing to understand the reasoning for this action. It's a different story when it comes to the more innovative plans afoot, starting with the $700 billion bailout package enacted last month that gives the U.S. Treasury authority to, well, spend a lot of money in an effort to prop up the financial system and by extension the economy. Alas, there's no consensus on the most efficient and effective way to spend the money, as yesterday's volte-face announcement by Treasury Secretary Paulson suggests.

Are we making it up as we go along? Yes, at least to a certain extent. Like FDR in the 1930s, the U.S. government in the 21st century is engaged in a massive experiment in macroeconomic policy intervention. Some of the efforts will work, some won't. Ultimately, we'll learn a lot when this is over, but the education will come at a price.

Brace yourself.

Posted by jp at 9:49 AM | Comments (1)

November 12, 2008

DON'T EVEN THINK ABOUT IT

Ours is a world hopelessly addicted to looking at the past. The recent past in particular. That's how the mind of homo economicus is wired and only with hefty doses of discipline can we alter the psychological fate that otherwise awaits the crowd. And so we all look over the past 2 months or so and come to hard and fast conclusions about where we're headed.

That includes the temptation to announce: We dodged a bullet. Yes, there's still a lot of pain out there, and more is probably coming. But the risk of all-out catastrophe seems to have passed, leaving us with something approaching a more routine, albeit still serious downcycle in the U.S. and probably the global economy.

The stock market suggests as much. For the time being, at least, the days of 800-point rallies and declines in the Dow Industrials have been replaced with relatively mundane losses and gains. The tone is still decidedly bearish, but it's a bear that growls without frightening the children.

In this somewhat calmer version of delevering and correction, the tolerance for minting money is still quite high. The former nurtures the latter. Understandably so, given the intense drama of the last few months. Despite the lessons of history, almost no one is worried that governments the world over are now engaged in what promises to be the mother of all liquidity injections. Again, no big surprise, considering recent (as opposed to long-term) history.

The crowd would be howling if central banks and governments were still stingy in doling out monetary and fiscal stimulus. But nothing of the kind is even remotely true now. To invoke the metaphor that gave one central banker so much grief a few years back, the helicopters are dropping money these days...big time. For the moment, the biggest problem is making sure a bag of money doesn't fall on your head. Looking to the future and imagining something different is as popular as doing your taxes. Both are easily delayed as tasks for another day.

Eventually, and perhaps sooner than the crowd expects, this nonchalance regarding the creation of liquidity mountains will give way to something less indulgent. Like everything else in economics, timing is unknown. But the day when the markets worry in earnest about the mopping up exercise is coming, which is to say intermediate and long rates will rise and inflation's loathsome traits make a return engagement on the lips of traders, bankers and cabbies alike.

Not now, though. Not even close. Banish the thought. Spending is in for governments. Even before the crisis of 2008, spending was set to rise in these United States to unprecedented absolute and relative levels. The future is the same, only more so now.

Meanwhile, we're ever mindful of our tendency to extrapolate the recent past into infinity. That can lead us astray, although it's virtually impossible to shake the habit. It's easier to imagine otherwise. Life would surely be easier if trends lived up to their image and evolved slowly, quietly, surprising no one. In that case, using the past as a guide would be massively more productive in crafting notions about the morrow. Alas, reality is often the exact opposite for macro paradigms.

Remember $145 oil? Now it's under $60. Remember worries about high inflation? Now we're grappling with the threat of deflation. Six months sometimes makes all the different. Stuff happens, things change, the future looks different.

That's not always the case, or so it appears in the short term. The reason is that most of the time the world operates fairly smoothly, which makes colossal change look impossible. Markets change modestly most days; the future looks different only on the margins. And that's when our brains lead us astray.

With that in mind, this editor harbors the intensely unpopular belief that inflation will soon return as one of the biggest economic challenges for the planet. But not today, and probably not next year or even well beyond that. We're undoubtedly early on this call, and probably by several years. The current and future fiscal and monetary stimuli from around the world are being absorbed in the price vacuum of disinflation and perhaps deflation. Few can imagine anything else. Maybe that's prudent. We don't know. But we're also wondering where all the money will eventually go, and what effect it'll have on pricing generally?

Such questions are moot if there's a deep and lasting recession, a.k.a., depression. That suggests a solution to our dilemma: decide if a depression is coming, or just a garden-variety recession. Once we know that, we can determine if we should worry about future inflation or not. Easy, right?

Posted by jp at 10:22 AM | Comments (0)

November 10, 2008

THE WONDERFUL (AND SOMETIMES CONFUSING) WORLD OF DIVIDEND YIELDS

You read about such things in books; you gaze at the historical charts; but rarely do you live through such events in real time. Such is the nature of extremes in economic and financial cycles.

Reviewing history with the safety and objectivity of distance, it's easy to pledge grand schemes for taking advantage of the great buying opportunities the next time they come around. But talk is cheap. Who among us would have the courage, the fortitude, the discipline, the temerity to buy stock in, say, 1932? Or 1974? Looking back, the timing was right, although that is obvious only with hindsight. Nonetheless, some mustered the discipline to buy in those and other dire moments. Yet such intrepid actions were--and always will be--the exception.

So it goes in times of crisis, which also describes the current predicament. It is the height of irony and frustration that the financial gods only extend great bargains when the broader financial and economic context looks darkest. Analyzing that recurring state of affairs is easy; acting on it is atypical, to say the least.

All of this comes to mind as we look at trailing dividend yields. The chart below graphically captures the drama in global equity markets of late, October's close in particular. The trend needs no explanation. The question is whether the latest data points are compelling? And if not, why not?

We've discussed dividend yields before and so readers are encouraged to review the debate, including this post, and its predecessor here. No, trailing dividends aren't a magic solution for easy profits, largely because only the past is revealed with full clarity. As such, dividend yields have been known to mislead us at times--sometimes it's a trap. But not always. Trying to distinguish one from the other is what's known as risk analysis. And risk is always lurking, including these ever-popular worries:

* Are dividend cuts coming, thereby diminishing the allure of the trailing yields?
* Is inflation headed higher, which makes real dividend yields less attractive than they appear to be in nominal terms?
* Will capital losses overwhelm dividends going forward?

And on and on we go. There's always a reason to question an apparent gift. One might wonder why such worries are on everyone's lips in a bear market but tend to be missing in action in a roaring bull market, but we'll leave that for another day.

Meantime, it's clear that we should always be suspicious of any one market metric in the absence of broader financial and economic context. Perspective comes in handy--always. But generally speaking, we like dividends, which is to say we enjoy receiving payments from our equity investments, and the more, the better.

Alas, we have no control over the absolute amount of dividends dispensed by our equity allocation. But we're not completely at the mercy of Mr. Market. We do, still, have executive authority over the timing and the amount of equity investments, and that ain't hay. It's a power that's fraught with risk, of course, but beggars can't be choosy.

If we think of dividend payouts as coming at a price--a variable price through time--it should come as no shock to learn that we're disposed to pay as little as possible for access to a stream of dividends. Presumably, no one on the planet disagrees with the concept overall. The details, in real time, are something else, and so explaining why it's so hard to take advantage of yield opportunities is infinitely more complicated.

Posted by jp at 9:59 AM | Comments (0)

November 7, 2008

10 MONTHS OF JOB DESTRUCTION

Each new economic update is painful these days, and today's release of the October employment report is no exception.

The U.S. economy lost 240,000 jobs last month, the Labor Department reports. That's not as steep as September's 284,000 tumble, but there's no mistaking the trend. The economy is in recession and the labor market is now Exhibit A for that view, in no uncertain terms.

No wonder, then, that the jobless rate jumped to 6.5% in October, up from 6.1% in the previous month. The unemployment rate, as a result, is now at its highest since 1994.

Unfortunately, it looks like the negative momentum has a ways to go. Even the mighty services industry is now routinely stumbling. For the second month running, services employment dropped sharply, falling more than 9% last month, which comes after a 17% decline in September. The significance of this slump can't be underestimated, given that services jobs represent about 85% of total nonfarm payrolls.

Weighing heavily on services is the retail business, which is now knee-deep in contraction. So-called same-store sales in the retail industry plunged 0.9% last month, reportedly the steepest monthly drop in almost 40 years.

As bad as all the economic and financial news is of late, what's most disturbing is the worry that the contraction for the general economy has only just begun. It may seem like we've been living with economic pain for years, but in fact the downcycle so far is measured in months, broadly speaking. If the downturn is longer than usual, which looks increasingly likely, the challenges in the months and perhaps years ahead will be bigger than we've been accustomed to in the past 20 years. One reason: the U.S. is entering a downturn with nearly all of its conventional monetary policy ammunition used up.

Indeed, America enters the recession with the Fed funds rate at 1% currently, down sharply from 5.25% barely more than a year ago. High interest rates didn't trigger the recession this time around and so low interest rates won't pull us out of one.

The excess that built up across the economy over a generation is unwinding, and the correction will be as painful as the boom was pleasurable. The government will pull out all the stops to ease the pain, as it should, but this time out there's no sidestepping the purge.

It's been easy to think, until recently, that the Fed could keep the growth cycle going indefinitely, as it seemed to do in recent history. After the tech bubble burst in 2000-2002, the central bank rapidly slashed interest rates in a bid to keep consumer spending from falling. The strategy worked--big time. But the obvious lesson about what was possible was misleading--big time. One could argue that a similar consumption-at-any-cost strategy has been the stock in trade for the past 20 years. But the liquidity injections have lost their power to elevate consumer sentiment.

In the long run, the economy will be stronger once the cleansing process is complete, but in the short run the pain will be considerable. The prospect of Fed funds at or near zero grows by the day. As a temporary matter, that's fine. As the risk of deflation rises, central banks should act accordingly. The Bank of England's huge 150-basis-point cut in rates yesterday is a sign of the times.

But no one should think there's an easy way out via monetary policy. Even the prospect of an increasingly aggressive round of fiscal stimulus from Washington will, at best, dull the pain.

For those with a long-term view, the good news is that the opportunities will be huge--of once-in-a-lifetime proportions. Yet history suggests that only a few of us will have the discipline to partake of the prospective gains, once the time is right. Why? By the time the recovery begins in earnest, most of us will be far too numb from the months (years?) of bad news to contest the idea that bears rule the world.

As such, emotions run amuck remain the greatest threat to long-term investing success. Same as it ever was.

Posted by jp at 9:39 AM | Comments (0)

November 5, 2008

OUT OF THE ELECTION AND INTO THE FRYING PAN

Barack Obama has won the presidency, and we wish him well—for his sake, the country's sake and for the world's. America, in addition to being (still) a crucial factor for global economic growth, remains a beacon of hope and inspiration for liberty. All of that is on the defensive when the U.S. stumbles, as it clearly has in recent years on a number of fronts, including the economy.

The interregnum is traditionally a period of relatively calm political transition, reflection and celebration. But the honeymoon for President-elect Obama is effectively over before it's even begun. Two wars, a hornet's nest of other foreign-relations issues and the onset of what promises to be a painful and perhaps lengthy economic contraction insure that yesterday's history-making election will soon give way to the immense challenges that await. Make no mistake: the challenges are of a breadth and depth that are rarely waiting on the doorstep of new presidents. No doubt he'll be tested like few before him.

Some have compared Obama's start with the opening of the Lincoln and FDR presidencies. That's a bit much. Comparisons to the arrivals of Nixon, Carter and Reagan are closer to the mark. Any way you slice it, Obama will have his hands full, and the odds are high that he'll have to make tough and unpopular decisions for the next few years.

The stakes are indeed high—higher than at any time in recent memory for a new government. The fact that the incoming president's resume is a bit light doesn't inspire. And so we must wait, somewhat anxiously, to see his decisions on a host of subjects. One topic that he can't afford to fumble is promoting growth, which is really the only solution to what ails America domestically speaking.

On the bright side, he's shown himself to be thoughtful, calm and—above all--intelligent. With the circus of politicking over, one might reason that that the sober realities of governing will push the new president to make informed choices that keep America firmly in the club of growth. Let's hope that his natural abilities and intellect carry the day in that regard. The alternative these days is too frightening to even consider.

Whatever path Obama takes, the economy will certainly be a high priority, and not necessarily for favorable reasons. Trouble continues to percolate, even if the stock market yesterday this chose to focus elsewhere. Ignored or not, the widely followed ISM factory index dropped to a 26-year low, we learned on Monday. The sharply bearish trend in manufacturing was confirmed a day later with the hefty fall in the Fed's industrial production index for September.

Today brings word that the labor market continued to fall in October. Nonfarm private employment slumped 157,000 last month on a seasonally adjusted basis, according to ADP National Employment Report. On Friday we'll see the government's tally for October jobs, although everyone expects the update will once again post another negative number of some significance. Par for the course in 2008, a year that, so far, has shed jobs in each and every month.

Disturbing as the general economic trend is, it comes as no surprise. Our proprietary economic index has been warning of trouble for some time now, as we've discussed all year, including our official recession call back in March. Our only mistake was not making the call earlier or being sufficiently bearish.

There's no mistaking the trend now. The last of the optimists has gone silent with the hope that recession, somehow, could be avoided. It can't. As our chart below illustrates, economic contraction has begun, and the writing's been on the wall for some time now, as per the precipitous fall in our leading index of economic indicators for the U.S.

Unfortunately, we're still in the early stages of what threatens to be a prolonged correction. What's more, the "rebound" may be modest by historical standards, thereby exacerbating the pain that accompanies a generational unwinding of economic and financial excess. It doesn't help that the usual prescriptions—i.e., cheap money—won't work this time, as they have so often in the past. Even dropping interest rates to zero, which may be coming, won't do much to stimulate demand broadly speaking. Fiscal stimulus, as a result, may be the last, best hope to keep the economic slump from turning into something worse.

The government, in short, will be spending gads more money in the coming months (and years?), over and above the already extraordinary amounts spent this year. Fortunately, there's minimal risk of inflation at the moment, although that window of spending/borrowing opportunity won't be open forever. One only need invoke the words Medicare, Medicaid and Social Security to remind that Washington, as we wrote a while back, is on the hook for massive amounts of new spending in the years ahead—money that it doesn't have. We can--and will--borrow it, of course, assuming enough foreigners remain will to lend us what domestic investors won't, or can't.

Add to this mix a newly minted president-elect, fresh with hope and ambition, including his promise to lower taxes for most taxpayers below the rates that prevailed during the Reagan administration. There are also plans for expansion of America's healthcare system, and on and on.

Keep a close eye on the honeymoon that's now in progress. If you blink, you might miss it.

Posted by jp at 9:58 AM | Comments (1)

November 4, 2008

DIVIDEND YIELDS, PART II

Last month, we looked at the relationship between dividend yield and the subsequent 5-year return for the U.S. stock market. The motivation: searching for a liaison that binds relatively high yields with relatively high returns. If it holds, then low yields lead to low/negative returns.

In our short sample of history, the relationship held up rather well. For the period January 1995 through February 2003, higher yields were linked with higher returns over the next five years. Indeed, running a regression analysis on the data produced a persuasive 0.95 R-squared. (A quick digression: R-squared ranges from 0 to 100. A reading of 100 means that the variance of one factor fully explains the movement of the other. A reading of 0 tells us that there's no relationship between two variables. In short, the higher the R-squared, the greater the influence of one factor on the other.)

We also warned in that post that the strong relationship documented in 1995-2003 wasn't absolute. We cautioned readers to "be careful about thinking the relationship offers easy and sure profits." It doesn't. Bottom line, we counseled last month to remain "skeptical" whenever someone shows you a relationship that purports to bring easy profits. No such animal exists, even if the evidence suggests otherwise in the short run.

Our essay inspired others to run a deeper analysis of dividend yield and stock returns. The Aleph Blog, for instance, correctly points out that over a longer sweep of history, the 0.95 R-squared we quoted falls dramatically. Using data from Professor Robert Shiller, Aleph reports that the R-squared for dividend yield and subsequent stock market returns is a mere 0.07 for 1871 to 2003. Crunching Shiller's numbers on our own, we come up with a similar reading.

Does that mean that looking at the market's dividend yield is worthless? No, not at all. Although a simple analysis of one holistic view of 100-plus years of stock market history seems to tell us otherwise, there's a compelling reason to look at dividend yields as one of several metrics for judging prospective return for equities generally. No, we shouldn't drive blindly down this road, or think we've stumbled upon a short-term trading strategy. But with eyes wide open, we should consider the possibilities of using dividend yield as one of several metrics for judging long-term return opportunities.

To explain why, let's begin by pointing out that there are no absolutes in investing. If it were otherwise, we'd all be rich with minimal effort. Economics, in that case, would cease to exist as we know it. In fact, risk is always and forever present in the money game, which is to say that we don't know if (or when) an investment strategy will pay off. That's the nature of risk, and so we must proceed cautiously, gathering whatever clues history sends our way in an effort to manage risk as intelligently as possible.

That said, let's recognize that a number of studies over the years have found a relationship between dividend yield and return, i.e., higher yield sometimes leads to higher returns. Again, it's not an absolute relationship, but it's sufficiently robust to compel us to monitor the trend and, at times, act on it when the odds appear in our favor.

We cited one study in our post from last month. We could cite many others, including one from Professor Burton Malkiel, who reviews the evidence for using valuation to forecast performance. One test: comparing dividend yields for the U.S. stock market (measured by the S&P 500) for each quarter from 1926 through 2001 relative to subsequent 10-year total returns. The result, he writes, "shows that investors have earned a higher rate of return from the stock market when they purchased a market basket of equities with an initial dividend yield that was relatively high and [earned] relatively low future rates of return when stocks were purchased at low dividend yields." Similar results are found using price-earnings (p/e) ratios: buying the stock market when p/e ratios are relatively low leads to higher returns in the next 10 years, and lower returns when stocks are purchased at relatively high p/es.

Valuation, it seems, matters. Not always, but enough of the time to make the subject a worthwhile area of study. But dividend yields are also quite nuanced when we look over long periods of time and so we must be careful of reading too much into one massive overview that attempts to summarize decades of market data in search of one enduring rule of thumb. Consider again the low R-squared for dividend yield and subsequent return for the 1871-2003 period. True enough, but when we look more closely we find that the R-squared waxes and wanes through time.

Consider our chart below, which tracks a rolling 10-year R-squared for current dividend yield and subsequent 5-year return for 1881 through 2003. Note the recurring cycles. During some periods, the R-squared is quite high; sometimes it's quite low. The implication: using dividend yield as a window for estimating future returns is more valuable at certain times, but not always.

In a perfect world, the R-squared would remain at 1.0. In that case, dividend yield would be a perfect forecasting tool for returns, in which case everyone would always have perfect foresight about prospective equity performance. But we live in an imperfect world and so dividend yield is less than perfect, just like every other metric and strategy in the investment game. If we wait for the perfect methodology for managing money, we'll wait in vain.

Nonetheless, we must recognize the limitations of our analysis and act accordingly. For instance, dividend yield's limits as a forecasting tool compels us to look at other metrics, such as p/e ratio and earnings yield. We should also monitor interest rates for additional context. Ditto for knowing where we are in the economic cycle. Putting dividend yield in financial and economic context, in other words, gives us more information for deciding if the yields we're looking at in real time are relevant at the moment, or not.

Indeed, if we only consider those points in time when dividend yield is relatively high (based on, say, the previous 20 years), this metric fares better as a tool for estimating future equity returns. The same is true if we look at yield when it's relatively low. Extremes are, by definition, rare, and so by this standard dividend yield will be used infrequently. Using it each and every month, by contrast, and thereby ignoring the larger context, will likely lead to mediocre results.

Don't misunderstand: it's not easy. There are no turnkey software packages that spit out the right answer on a regular basis. It's always hazardous to make decisions in real time. But strategic-minded investors ignore dividends at great risk. Over time, dividends (including their reinvestment) have proven to be a crucial part of total return in the U.S. market. One quick example: for the 20 years through 2005, $1 invested in the S&P 500 grew to $1.45 in price-only terms. The same dollar grew to $9.54 if we include dividends and their reinvested return. (The source for this data is How to Select Investment Managers & Evaluate Performance, p. 115.)

Dividend yields can tell us a lot. It's not a crystal ball, and if we're not careful it can even lead us astray. But that shouldn't keep us from studying dividend yields. As valuation metrics go, this one's too important to ignore.

Posted by jp at 10:39 AM | Comments (0)

November 3, 2008

OCTOBER--THE DEEPEST CUT YET

If October 2008 wasn't the worst month on record for the capital and commodity markets, we'd hate to find out what is.

Indeed, September was an awful month, but October was a disaster. September's across-the-board losses for all the major asset classes suffered a repeat performance in October, only more so. The declines last month were in all cases bigger than September's, in some cases a lot bigger.

REITs suffered the biggest blow in October, falling a shocking 32%. But no other asset class was spared, including U.S. stocks, which tumbled nearly 18%, as per the Russell 3000. It was, to summarize the obvious, the worst month in memory, perhaps the worst in modern times. If you want to see what hell looks like in the investment game, October 2008 looks set to stand as a benchmark of the abyss for generations to come.

No wonder, then, that our measure of the global market portfolio index slumped 15.7% last month--the fifth straight month of losses, and the biggest one yet.

Diversification, to put it simply, did not work in October--the second month running that the global markets repriced risk downward via a broad wave of selling. The lesson is that the pool you're swimming in will dictate how--or if--you swim. One can't extract blood from a stone, or positive returns from risk of any kind in a financial calamity. Clearly, the pool has been battered by gale force winds for two months running and the effect has taken a hefty toll on the various components. When risk begins to pay off, the waters will turn calm, but for now investors are knee-deep in the act of wound licking. Perhaps one can be thankful at having any assets left to mourn over.

As for the global markets index, the best we can say is that compared with the defaults, bankruptcies and the complete evaporation of assets in some corners of finance, the red ink afflicting GMPI looks mild. But by any reasonable measure of absolute standards, there's no way to downplay the fact that risk of any type has inflicted sharp losses on investors. Other than cash, there's been no place to hide. When a generational storm of unwinding and correction hits, the usual rules take a holiday.

Will this sorry state of affairs continue for a third month running? No one knows, although it's hard to imagine that everything keeps tumbling. The extraordinary liquidity-injecting efforts of governments around the world--with yet more coming--is starting to show signs of success in at least stabilizing markets. Or so it appears. Outright panic seems to have, temporarily at least, ceased. That's progress in this environment: stop the massive bleeding. The panic has been replaced with a sober wariness about the future, including the recognition that repairing the financial system and managing the economic contraction will take time and money. Perhaps that keeps asset prices from another month of sharp losses, perhaps not.

Meantime, we've all received a lesson in humility, starting with the now-painfully clear lesson that risk can inflict much, much more pain on investors than many thought possible. So it goes after living through a generation of relatively easy and smooth gains.

Posted by jp at 9:38 AM | Comments (0)