December 31, 2008
HAPPY NEW YEAR!
The Capital Specator is taking short holiday break to ring in 2009. We'll be returning on Friday, January 2 to review 2008 and consider risk and opportunity for the newly minted year ahead. It's a dirty job, given the current economic climate, but we'll forge ahead regardless. Perspective is always valuable, even more so in times of crisis.
Meanwhile, to all all readers, thanks for your support. Here's wishing everyone a healthy and prosperous 2009. Cheers!
--James Picerno, editor
December 30, 2008
TALKING WITH STAN RICHELSON, TODAY'S GUEST ON THE INSIDE VIEW PODCAST
Bonds are usually the only asset class that Stan Richelson owns in the client portfolios that he manages at his wealth management firm, Scarsdale Investment Group in Blue Bell, Pa. But not all fixed-income securities are created equal, of course, as he explains in his recent book Bonds: The Unbeaten Path to Secure Investment Growth.
Selectivity is all the more important in today's turbulent times—even with bonds, Richelson advises in today's edition of The Inside View podcast. Despite enormous yield premiums over Treasuries in some corners of the bond world—including "investment-grade" corporates—Richelson is more conservative than ever when it comes to investing in what's generally the most conservative asset class. He expects tough times ahead for the corporate world and that makes him anxious about the sector's prospects. The high yields, in other words, don't look enticing after he considers the risk in 2009 and beyond.
The lofty yields in munis, on the other hand, represent "enormous opportunity," he says. He's also intrigued with inflation-indexed Treasuries, even though deflation is the big worry at the moment.
For the full conversation on what Richelson's thinking for bond investing these days, take a listen…
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December 29, 2008
WELCOME TO PARITY
Deflation is here. The question before the house: How long it will last?
Ideally, it's just passing through, albeit throwing everyone into a temporary tizzy with worries that the U.S. is set to repeat the Japanese experience. Certainly the Federal Reserve is working over time in trying to make sure the disease is short-lived. But for the moment, at least, prices are generally falling, as we've discussed, including here.
The great experiment in trying to keep a sustained case of deflation at bay is upon us. The immediate danger is that consumers and businesses expect deflation to persist. As many studies have shown over the years, along with more than a fair bit of empirical evidence, expectations are critical factors in determining the level of inflation and its cousin, deflation. Once the Fed loses the battle on managing expectations, monetary policy becomes much weaker.
On that note, we must recognize that one measure of expectations, in the form of market prices for expected inflation, is clearly flashing a warning signal. Expected inflation for the next 10 years, based on the spread between nominal and inflation-indexed 10-year Treasuries, was a mere 0.13%, as of December 26, 2008. That's down from nearly 2.6% in July, as our chart below shows.
The collapse in inflation expectations is hardly surprising, given what's been going on in recent months and the related descent of interest rates. It would be a miracle if inflation expectations hadn't fallen sharply in the current climate.
From an investment perspective, one might wonder how to think of TIPS vs. conventional Treasuries these days. We can start by recognizing that most of the collapse in inflation expectations is due to the fall in yields on conventional Treasuries. TIPS yields have fallen too, but not nearly as much. The result, as our second chart below reveals, is that something close to parity now prevails for nominal and real (inflation-indexed) yields on Treasuries.
Normally, conventional Treasuries yield more than their inflation-indexed brethren. Why? The extra yield is compensation for exposing one's investment to the ravages of future inflation, if any. Conventional Treasuries only guarantee a nominal yield; TIPS only guarantee an inflation-adjusted yield.
Expecting some level of inflation is the normal state of affairs. Inflation, in the long run, usually dominates, thus the yield premium in conventional Treasuries. But these aren't normal times and so the yield premium for standard Treasuries has shrunk to almost nothing compared with TIPS. And rightly so, if we accept that deflation is the bigger risk at the moment.
In any case, real and nominal yields on 10-year Treasuries are roughly comparable. Buying either security means that you're locking in a yield for the next 10 years of slightly above 2%.
If you expect inflation to one day return, as your editor does, buying the 10-year TIPS is a no-brainer, since you currently don't have to accept a lower yield relative to conventional Treasuries and at the same time you receive an inflation hedge, effectively at no extra cost. Of course, buying an inflation-protected Treasury means locking in a real yield, which at just over 2% looks low relative to what's been available in past years, i.e., real yields as high as 3% to 4%. Nonetheless, a TIPS purchase also provides a varying nominal yield, and if/when inflation returns, nominal yields will rise.
But while running the printing presses at full steam implies that inflation will one day return, perhaps with a vengeance, we can't be absolutely sure about timing or even if higher inflation is fate. We believe it is, but, hey, the future's never fully clear. Meanwhile, some investors and traders are betting that deflation will run on for some time, perhaps longer than expected, and perhaps even for the next 10 years.
Pick your future—and your poison. We don't know which strategy will work out best, but we're supremely confident that one side of this coin will suffer badly. Alternatively, you could hedge the future with a passive allocation to Treasuries and buy an equal mix of nominal and inflation-indexed 10-year Treasuries.
If nothing else, at least we know this: investment choices are just as tough in times of crisis as they are when bull markets are everywhere.
December 26, 2008
A DELICATE BALANCE: CONSUMPTION & SAVING
Spending is out, saving is in. The trend not only has legs, it has depth and magnitude, as the personal income and spending report for November reminds. But at a time when prices are falling generally, the gap between spending in nominal terms (i.e., before adjusting for inflation) and real terms (after inflation) is growing. Ditto for personal income. Therein lie some of the critical opportunities and risks for 2009 and perhaps beyond.
Let's start with the basics. U.S. disposable personal income dropped 0.2% last month in current dollar terms, the Bureau of Economic Analysis reported on Wednesday. That's down from a slight 0.1% rise in October and the first monthly fall since July. A sign of the times, given the recession now in progress.
Troubling as the trend is, spending fell even more: personal consumption expenditures crumbled by a hefty 0.6% in November. That's not as steep as October's plunge in spending, as our chart below shows, but the general trend remains intact, namely: down. For obvious reasons, Joe Sixpack is no longer shy about avoiding trips to the mall.
All of that is in the familiar statistical terms of reporting in current dollars, which is to say before adjusting for inflation. As it happens, inflation is conspicuously absent in general terms these days, as we've been discussing. As a result, after converting spending and income into real terms (adjusting for inflation, or deflation, as is the case at the moment), the trend looks quite different compared to looking at the numbers through a current-dollar prism.
In real terms, disposable personal income rose—yes, rose—by 1.0% last month, which is in sharp contrast to the modest current-dollar decline. Meanwhile, personal consumption spending advanced by a robust 0.6% in November in real terms—a complete turnaround from the 0.6% loss in current dollar terms.
Why the huge difference? Deflation. It's debatable if deflation will stick around for any length of time. Certainly the Fed is pulling out all the monetary stops to kill the deflationary trend. Similar efforts are underway on the fiscal front, with the incoming Obama administration planning to roll out a new round of government-sponsored stimulus to complement the former and current spending sprees. In terms of our chart above, it's easy to get the black line to rise: printing more money and handing it out never falls to boost income, at least in nominal terms and in the short term. The great debate is how to find success on the far tougher chore of elevating the red line (spending).
As for the here and now, the general decline in prices is giving cash an embedded positive return in real terms. Today's dollar is worth more tomorrow because goods and services are cheaper with each passing day. True, not every product or service is declining in price. The price of medical care, for instance, is still rising. But broadly speaking, prices are falling and that means that Joe Sixpack's paycheck is rising in real terms even if it's unchanged or declining slightly by current-dollar measures. Similarly, despite the nominal fall in consumer spending last month, real spending rose, thanks to deflation.
To some degree, the real increases in spending and income are technical adjustments that aren't fully reflected in the everyday lives of people. But the deflationary winds aren't just an accounting trick. A dollar buys more today than it did yesterday, and it'll buy more tomorrow than it does today. Yes, that's yet another channel of stimulus. Consumers can take advantage by consuming more without spending more. Or, they can repair/enhance household balance sheets because saving another dollar in nominal terms translates into an even higher rate of real savings.
But economic decisions, it seems, are a double-edged sword in extreme at the moment. Certainly there's a bright side to deflation if you're a consumer/saver. The dark side is that the trend threatens to inspire savings to the extent that non-essential spending and investing is delayed indefinitely. That's a problem because while it's great to be a consumer/saver when deflationary winds are blowing, it may be hard to keep/find a job if consumption takes an extended holiday.
True, given the past excess in consumption, a bout of savings is just what the doctor ordered. But when does the solution become a problem?
Alas, there's no free lunch. There never is. The challenge here is that economic growth requires spending even as consumers need more savings. Something on the order of 70% of the American economy is powered by consumer spending. If nominal spending dries up because everyone's waiting for cheaper prices, household balance sheets will enjoy some much-needed enhancement. In the short term, however, there may be a price to pay for that a new-found desire for thrift. Such are the risks if/when an economy tries to reverse a generation of excess consumption overnight. Depending on how this all unfolds, we may be headed for the dreaded deflationary trap in 2009: lower prices induce more savings, which fuels lower prices, which inspires more saving, etc., etc. It's not fate, of course, but the risk is there.
Given the state of the economy at the moment, there's a fine line between higher savings and promoting a deflationary trap. The U.S. may soon discover exactly where that line is drawn.
December 24, 2008
A SHORT WINTER'S NAP...
The Capital Spectator is taking a few days off to celebrate Christmas. We also plan to sleep late, refrain from editing past midnight and kick back with an eggnog or two. Heck, we might even sing a few carols. But not for long: We'll soon return to our usual publishing schedule. Meantime, to all our readers, here's wishing everyone a happy holiday and a prosperous new year. Cheers!
December 23, 2008
DISMAL SCIENCE TALK
The year is almost over, but some forecasts warn that the economic challenges have only just begun. For some perspective on what to expect, we spoke earlier today with Bob Dieli in today's episode of The Inside View, the third installment in our new podcast talk show.
Dieli's a familiar presence on these digital pages. We last checked in with Bob on December 2, when CS summarized his take on the challenges of trying to measure and survey the current state of the business cycle. When he's not talking with your editor, Dieli heads up RDLB Inc., his Lombard, Ill. economic consultancy that publishes its research at NoSpinForecast.com.
Bob's career in the dismal science began in the late-1970s, when he specialized in the challenge du jour: inflation. These days, deflation seems to be the bigger risk, as we discussed last week. Yet Dieli's not convinced that deflation is now fate for the U.S. economy, even if the latest batch of consumer prices suggest otherwise, as we discussed last week. For his reasoning, along with some thoughts on the economy generally, come pay a visit to The Inside View…
Please visit CapitalSpectator.podbean.com for more options with this and other Inside View podcasts.
FROM BIG SCANDALS, GREAT LESSONS FLOW
The Madoff investment scandal may be the biggest Ponzi scheme in history, in which case the swindle offers oversized as well as familiar lessons in what not to do with the care and tending of money.
Reading the ongoing news reports of how this crime was executed summons a range of emotions: frustration, sadness, shock and anger, to name a few. All the more so because so much of the investment pain was easily avoided. At least in theory.
The Madoff sting is only novel for its size, duration and complexity. Nonetheless, the fraud raises yet another opportunity to review the argument that risk management is always and forever the priority for investors. Common sense, perhaps, but it's also a rule that's constantly disregarded by far too many investors who somehow think they're immune to loss, legitimate or otherwise. In some cases such thinking may be due to ignorance, although greed and fear are almost always part of the equation as well, along with a healthy dose of hubris. Whatever the reason, ignoring risk management is like drinking and driving: you may be able to avoid hitting a wall tonight, but eventually you're going to crash if you don't change your habits.
If there's any good that comes out of the Madoff hoax, it's the reminder that investors should be risk managers first and performance chasers last, if at all. The point has been made countless times before in the investment realm, including our discussions over the years, such as here and here. But apparently the world needs another reminder, and probably always will.
Focusing on risk management is like breathing: it's a helpful tool for survival. Risk, after all, can be controlled to a far greater degree than return. A simple example, but hardly the only one: predicting the returns for individual stocks is difficult, if not impossible, particularly if you're look at many different equities. In that case, the risk of owning any one security is extraordinarily high. But with the decision to own a basket of stocks, the equity risk is effectively contained. What's more, we have a high degree of confidence that it will be contained, i.e., risk is lower compared to owning a handful of stocks. And if we add bonds and other asset classes with low and negative correlations to stocks to the mix, we can further enhance our control over the nature and extent of risk. We may give up some return in the bargain, relative to taking more risk with fewer securities. But a good risk manager/investor can maximize risk-adjusted returns and do quite nicely over time. (Finding that sweet spot is, in fact, the focus of our new newsletter, which is scheduled for launch next month. Details to follow.)
Such talk is par for the course on these digital pages, although it's hardly standard procedure in the wider world of investing, much to the detriment of the folks who fall prey to promises of big profits that are seemingly immune to the hazards that befall others. The instances of investors going off the deep end, and paying a heavy price, are many. In September, we discussed a pair of news reports that highlighted the folly of letting greed and overconfidence dictate one's choice of investment strategy.
The Madoff con only lends additional support to the realization that risk management doesn’t come naturally to investors. Today's Wall Street Journal provides another especially confounding example related to the Madoff affair. A woman, we're told, lost virtually her entire investment portfolio, valued at $2 million. To quote from the story, In 2001, acting on the advice of her broker, she poured something close to her life savings into a hedge fund linked to Madoff. "By October 2008, her account statement said her investment was valued at $3.8 million," according to the Journal. "On Dec. 11, Mr. Madoff was arrested and confessed to a $50 billion Ponzi scheme."
Even if you thought Madoff was the real deal, the first rule of risk management is never—never--put everything in a single investment, be it an asset class, your brother-in-law's dry cleaning business or an actively managed strategy, much less one that smelled funny. Regardless of how alluring the expected return, the future is always unclear, even if the market brochure says different. Depending on the investment in question, we can have varying degrees of confidence that the principal is safe; less so with regard to the prospective return, if any. But in the end, there's no guarantee and so you'd better make sure you know what you're getting into. Even then, betting the farm on any one thing, or any one manager is nothing more than rank speculation. Confusing that with investing is like comparing glass with diamonds.
Common sense, right? Apparently not. Why, for instance, didn't the steady returns that Madoff claimed to earn set off warning bells for his clients? Didn't they realize that such return histories are the stuff of dreams rather than a legitimate money management shop? If you're taking investment risk and your return series looks like a money market fund, it's time to wonder. Or, how about the tiny auditing firm that Madoff used to check his books? Didn't investors realize that a 3-person auditing operation was far too small to legitimately conduct prudent oversight on a firm claiming to manage billions of dollars? Then again, did investors even look at the auditing firm? One might reason that a cursory check is at least required before handing over millions of dollars to a firm with privately run investment strategies that, at the very least, looked like a black box.
Yes, the Securities and Exchange Commission failed to see the Madoff fraud, even though it was tipped off several times that something was wrong.
The SEC's failure is a scandal in and of itself. That said, let's be clear: You're asking for trouble if you're expecting the SEC to protect your portfolio. Yes, securities regulation is beneficial and necessary. But that's assuming the regulators take the time to investigate fraud when it's staring them in the face. Long story short: Don't assume.
As we've all learned (again) in these past few weeks, there's a limit to how much you can depend on others when it comes to risk management. It's your money: Keep it that way.
December 22, 2008
WISHING, HOPING & WATCHING
U.S. corporate earnings have been under pressure for some time, based on reported operating earnings for the S&P 500. Indeed, the bloom fell off the rose a year ago, when S&P earnings took a dive in 2007's fourth quarter from the formerly plush levels.
A lower level of earnings has prevailed ever since, as our chart above shows. But bottom-up estimates (as per Standard & Poor's as of December 16) are looking up for 2009. If the forecast proves accurate, by this time next year S&P 500 operating earnings will return to the heights of 2007. If such an earnings rebound is coming, the S&P 500 looks inexpensive based on the forward earnings multiple of 10.6, as per the full-year 2009 earnings estimate of $83.44.
Reuters reports that a key source of the expected earnings turnaround next year will come from none other than the ailing financial sector. That would be no trivial rebound, considering the current depth of earnings red ink weighing on the financial sector. But that will give way to positive earnings next year, or so we're told.
Consumer discretionary sector earnings are also thought to be poised to soar next year, rising 46% for full-year 2009 earnings, based on bottoms-up predictions. That's nearly twice the S&P 500's predicted earnings rise. In fact, only the energy, industrials and materials sectors of the S&P 500 are expected to suffer lower earnings in '09 vs. this year. The other 7 sectors for the S&P are on track for higher elevations.
It sounds like just the holiday treat we've been waiting for. Yet we must be wary of analysts bearing gifts. Indeed, bottom-up analysts as a group tend to be more optimistic relative to top-down analysts. Even so, the top-down crowd sees earnings growth for next too. The high end of forecasts among top-down calls for a rich $100 for 2009 S&P earnings, vs. $60 on the low end for this group's prediction, The Wall Street Journal recently noted.
For what it's worth, your editor is also confident that next year's earnings for the S&P will rise above this year's dismal results. But that's like saying Wall Street's bloodbath won't be so bad in 2009 vs. the last few months.
One of the few bright spots about life after the apocalypse is that a rebound of sorts is virtually guaranteed. Timing is always a question, of course, but rebounds eventually arrive. But no one should confuse a bounce off the bottom as a sign that a return to trend is imminent for corporate earnings. The economic headwind promises to be quite stiff next year, and it remains to be seen who'll have the stamina and the savvy to weather the storm.
Yes, government stimulus will be an increasingly positive force as next year unfolds. But unless you're expecting miracles, it's best to keep the celebratory champagne on ice for the foreseeable future. It took us years to get into this mess, it'll take more than a 2 or 3 quarters to get us out. That doesn't preclude a bounce, but repairing the damage this time will take more than running the printing presses at full speed.
December 19, 2008
SURVEYING THE DAMAGE (AND OPPORTUNITIES) IN REITLAND
Even by the standards of the great bear market of 2008, REITs have had an especially dreadful year. The Dow Jones Wilshire REIT Index has crumbled by nearly 44% in 2008 through December 18, 2008. The loss exceeds even the dismal performance of the U.S. stock market, which is down about 39% year to date, as of last night's close for the Wilshire 5000.
But as REIT prices have tanked, yields have soared. Equity REITs are yielding over 9% these days on a 12-month trailing basis. That's up from about 3.5% back in November 2006.
Does the hefty trailing yield signal that it's time to start buying? Or do the expected risks still outweigh the potential rewards? For some thoughts on the hazards and opportunities that await real estate investment trusts, we talked earlier today with veteran REIT analyst Barry Vinocur, editor of REIT Zone Publications in Novato, Calif. In our latest episode of Inside View--our new podcasting series--Vinocur takes us on a tour of the battered landscape of publicly traded real estate.
Please visit CapitalSpectator.podbean.com for more options with this and other Inside View podcasts.
THE GLOBAL MARKET PORTFOLIO'S BRUISED, BUT VERY MUCH ALIVE
Mr. Market is hurting these days, but what exactly does that mean?
The world's capital and commodity markets are comprised of multiple asset classes, of course, and they don't often move in lockstep. The last few months are the exception, but this too shall pass, just as the tendency for bull markets to bloom everywhere during 2002-2007 gave way to something else.
It may not be obvious from casual observation of late, but if we consider longer periods the numbers suggest that owning multiple asset classes is still a worthy pursuit for strategic-minded investors. That may sound counterintuitive given all the red ink this year, but the global market portfolio has held up fairly well over time.
Consider our CS Global Market Index (CS GMI). Although it's suffered recently, for the past 10 years through November 2008 it's earned a modest but positive 2.95% annualized total return. (CS GMI is our proprietary benchmark of the world's major asset classes: global stocks, global bonds and global REITs plus commodities--based on U.S. futures—with everything weighted as per the various market values at the close of 1997.)
Three percent may look unimpressive, but keep in mind that gains over that time frame aren't universal. US stocks, for instance, are off by an annualized 0.37% during that stretch, as per Russell 3000. Bonds, on the other hand, are in the black for the 10 years through November 2008. The Lehman US Aggregate, for example, is higher by an annualized 5.28% for the decade through last month.
The point is that the major asset classes over time exhibit varying degrees of risk and return, as our chart below reminds, even if sometimes it seems otherwise. The variety is good news for investors who hold a proxy for the world's market beta, such as something along the lines of CS GMI.
One of the implications of our chart above is that while anything can happen in the short run, over time the global market portfolio is tough to beat. A key reason is that picking winners, month after month, year after year, is tough if not impossible for most folks. Ditto for sidestepping trouble ahead of the crowd.
Note the straight purple line in the chart, which is a linear performance trendline of CS GMI. In the short run, there's bound to be winners and losers relative to the global market portfolio. That raises the possibility of beating CS GMI by picking asset classes or securities within those asset classes and/or timing some or all of the asset classes. No doubt there are investors who can win this game, although history suggests that most will end up with average or worse results. Indeed, after deducting trading costs, taxes and other active management frictions, the club of winners tends to dwindle over time. Performance numbers by and large bear this out.
That doesn't mean that active management is always and forever a bad idea. But we must be careful about how we use active management. The devil, in other words, is in the detail.
Indeed, CS GMI isn't a one-size-fits-all investment concept. Theoretically, CS GMI is the optimal portfolio for the average investor for the infinite future, a description that obviously applies to no one. But CS GMI is a robust benchmark for comparing and analyzing investment strategies. It's also a great place to begin researching investment options. CS GMI is the default portfolio. The burning questions: How should your portfolio differ from the default portfolio and, more importantly, why?
Focusing on such strategic issues, along with offering deeper analysis of the world's betas, is the mandate of a newsletter that your editor will soon launch (please stay tuned for details). Does the world really need another investment newsletter? Yes, if it dispenses something that forever seems to be in short supply: strategic investment perspective. And that is exactly what The Beta Investment Report will bring to subscribers. Stay tuned.
December 18, 2008
WELCOME TO OUR NEW PODCASTING SERIES
These are glorious days for value investing. Sale prices abound and sellers are eager to make a deal.
The challenge for buyers is separating the wheat from the chaff. Same as it always was, although given the economic backdrop there's a lot more chaff than wheat these days and so caveat emptor has rarely been more germane to the money game, regardless of strategic focus. That's the price of opportunity, one might say. Nonetheless, there are a lot of bargains out there if you know where to look--and how to look.
For starters, value-minded investors need to distinguish among assets with encouraging prospects that happen to be trading at discounts to fundamental value from those that deserve to be priced on the cheap. Figuring out which is which with an eye on profiting from the knowledge was Ben Graham's forte, of course. Among the celebrated value investor's countless disciples is one Jon Heller, CFA and president of KEJ Financial Advisors in Newtown, Pa.
Value investing is a redundant phrase for Heller, who headed up the equity analytics department for many years at Bloomberg L.P. before opening his financial planning practice. The premise of looking for dollars trading for pennies is synonymous with the basic concept of "investing," he believes. Until recently, that was a rather tedious affair, although it's recently become a lot more interesting and potentially a lot more productive.
We last talked with Heller in June, when he discussed his Cheap Stocks 21 Net/Net Index, which he writes about along with other value-oriented subjects on his Cheap Stocks blog. With the end of the year approaching (mercifully), and the opportunities for value investing seemingly in surplus, the timing is right to chat with this aficionado of "deep value" investing.
Heller also happens to be our debut guest on our newly launched Inside View podcasting series for The Capital Spectator. Going forward, your editor will routinely be interviewing a variety of investment strategists, economists and other guests of note in finance and economics. But first, let's start the show…
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STIMULUS TODAY, HANGOVER TOMORROW?
Governments are now working overtime in dispensing monetary and fiscal medicines intended to renew, restore and revive battered economies. In time the aid will quicken the economic heartbeat, although exactly when and to what degree is unknown. The patient has for years gorged on any number of goodies, ranging from the sweet treats of leverage and the candied delights of easy money to roller-coaster thrills of irrational investing.
The party, of course, is over, and the cleanup may go on for some time—probably longer than we expect. In a somewhat haphazard and increasingly desperate effort to ease the current and future pain, governments are dishing out unprecedented rounds of stimulus pills. For obvious reasons, everyone's watching each new step in what promises to be a long run of conventional and unconventional programs intent on propping up economies from east to west, north and south and everywhere in between.
But while the lion's share of attention is on the medicines, what might follow once the patient is no longer in imminent danger of cardiac arrest? In a speculative exercise of considering the possibilities, we offer the following thoughts for the post-crisis world order, which one day will arrive, amazing as it seems at the moment.
Yes, inflation. Strange as it sounds to talk about inflation at a time when deflation seems to be stalking the U.S. economy, it's never too early to think about the natural state of economic affairs. One day (don't ask us when), all this stimulus and its baggage will be yours. Pulling back on the sea of money washing ashore will eventually require the mother of all mopping-up campaigns. Assuming, of course, the Fed and central banks around the world have the stomach for the task.
Make no mistake: pulling back will be tough, very tough. Imagine the scenario a year from now. Let's make a big assumption and say that the economy's showing signs of life and GDP manages to post a modest 1% rise in Q4 2009, with more of the same expected for 2010. Higher interest rates would certainly be warranted, relative to the near-zero levels of the moment. Perhaps much higher rates will be required. But will Bernanke and the boys be willing and able?
The political pressure to keep the stimulus going will probably be immense. Meanwhile, warnings of higher inflation at some point are likely to fall on deaf ears for an extended period. Higher inflation, after all, is just what the Fed wanted by lowering rates so low and so arguments for containing the revival in prices will initially dismissed.
Yes, the inflation beast will work his way back into the director's chair. He always does, and he has a thousand tricks up his sleeve. His task will be all the easier if the deflation mindset takes root, which looks increasingly possible.
Nonetheless, some corners of finance are worried about the longer-term risks. That includes the dollar sellers and the gold buyers. Yes, deflation is a risk, but in the long run history tells us that inflation always comes out on top eventually.
What's more, a sudden change in the weather is hardly beyond the pale. Recall that inflation worries were all the rage earlier this year. Yet that fear quickly gave way to deflation. Expecting smooth and gradual changes on the pricing front may be asking for too much in the 21st century.
Just as inflation worries have been banished in recent months, so too are the headline-grabbing predictions of $200 oil. These days, that's a forecast with one too many zeroes.
But let's be clear: the recession-inducing fears that are pushing oil lower these days will eventually abate. That doesn't mean oil will suddenly resume its skyward run at the first sign of economic stability. But marginal growth in oil demand isn't dead; it's merely hibernating.
China, India, and, yes, the United States will one day be in need of more oil. Yes, green technology will slow future demand for fossil fuels. But unless you're expecting miracles, the world economy will almost certainly be consuming more oil in 3 to 5 years compared with today. The crowd, however, will be focused on demand trends over the next year or two and thereby conclude that high oil prices are forever gone. Oil companies will be pressured into agreeing, resulting in a sharp decline in searching for and developing new oil fields. Those are the seeds that will push prices higher once more, perhaps to new all-time heights, although probably not for several years.
* The Bubble of 2013?
No one knows where all the stimulus will wind up, but there are pretty good odds (and a fair amount of historical precedent) suggesting that exuberance will eventually reanimate itself with all its immoderate excess intact. Some say that Treasuries are now a bubble waiting to burst, courtesy of interest rates that can only go higher from here. Perhaps, although it's a safe bet that one day, perhaps sooner than we expect, bubble sightings will return.
Bubbles, writes John Kemp of Reuters, are no accident. "It is the direct consequence of the Fed's asymmetric response to shifts in asset prices." Much will depend on whether the reflation policy is, at the appropriate time, wound up and put in the closet. In theory, it's a no-brainer. In practice, there are complications.
Finally, we bring all this up mainly as a reminder that it's always difficult to maintain strategic perspective. Two years ago, when all the major asset classes were rising, few could imagine the current pain of the moment. Similarly, looking at where we're headed several years from now looks about as relevant as studying the moons of Saturn. But the future keeps coming, even if we're not looking. It's tempting to make all our investment decisions based on what happened yesterday, but we're all probably better off keeping our strategic-investing focus on what's likely to unfold several years from now. No easy task, to be sure. Par for the course if you're intent on winning the investment game.
December 17, 2008
RESEARCH BRIEF: LOOKING FOR CLUES IN ECONOMIC VOLATILITY
Volatility isn't the only measure of risk, but it's a critical one in strategic investing. One need only look at recent history for real-world confirmation. Indeed, volatility has rarely been so extraordinarily high as it has been in 2008. No wonder, then, that real and perceived levels of risk have taken wing.
Volatility analysis has long been popular in the money game and it's also been a fertile area of study at the macroeconomic level. And yet there's been little research into how economic and market volatility interact. Helping fill some of the gap is a new academic paper: "Macroeconomic Volatility and Stock Market Volatility, World-Wide," by professors Francis X. Diebold (University of Pennsylvania and NBER) and Kamil Yilmaz (Koç University, Istanbul).
A widely held assumption about the relationship between the stock market and the broader economy is that the former anticipates trend changes in the latter. But Diebold and Yilmaz's research suggests that the relationship may actually work the other way around when it comes to volatility trends.
"Markets aren't necessarily forward looking in terms of volatility," says Professor Yilmaz in a recent interview with CS. "What we know is that markets are forward looking in terms of returns. If markets expect that the economy will do better, then the stock market booms because it's looking forward. However, this doesn't imply that causality runs from return volatility to fundamental volatility [i.e., that markets are anticipating GDP volatility]."
Based on his research with Diebold, macroeconomic volatility appears to be a predictor of expected cash flow volatility in the stock market. In other words, higher economic volatility anticipates higher cash-flow volatility.
"Overall, there are periods when countries have higher fundamental volatility and during those times the stock market can't be expected to be less volatile," Yilmaz says.
December 16, 2008
STARING AT THE FLOOR
This is what the end of the line looks like.
The Federal Reserve announced this afternoon that it was "establishing a target range for the federal funds rate of 0 to 1/4 percent." This is a bit like a fish issuing a press release that it will hereafter be swimming in water.
The target rate for Fed funds is lowered anew to just above zero, but the effective Fed funds (which is based on actual banking transactions) is already there, and has been for some time. Nonetheless, Bernanke and the boys are right to announce the new lower range for the target Fed funds, which works out to as much as a 75-basis-point cut from yesterday's target rate. Just don't hold your breath for an encore performance when the next FOMC meeting commences on January 28-29.
As is now crystal clear, the economy is weak and getting weaker and a similar sucking sound is abundantly clear in prices, as we noted earlier today. To a man with a hammer, the world looks like a nail. For the Fed, a general decline in prices and slumping economic conditions cry out for monetary stimulus. Today, the central bank was still able to satisfy. But from here on out it's time for plan B.
The new world order of unconventional monetary policy easing begins now. Yes, the Fed has been practicing the dark art of quantitative easing for some time. One example: using various levers to lower long-term rates, which is usually the province of market forces. On the surface, there appears to be some traction on this front. The 10-year Treasury yield, for instance, is quickly plunging toward the 2% mark. Just two months ago it was 4%. Of course, it's not clear if the fall in the 10-year is due primarily to Fed efforts or just the general fear of deflation and recession or a little of both. There are many questions in the new world order and few concrete answers.
Along those lines, it's generally unclear just how effective quantitative easing will be, in part because its track record is sketchy and the medicine has been rarely applied. The great deflation of Japan offers the most recent experiment in nontraditional monetary policy of magnitude. Alas, the jury's still out on whether it was a success, failure or something in between. Looking for clues about how to proceed from Japanese deflation is a bit like looking for consensus on the Internet: lots of information wrapped in a hurricane of debate.
Consider a 2006 essay by the San Francisco Fed: "While there is little evidence that quantitative easing [in Japan] stimulated overall lending activity, there does appear to be some evidence that quantitative easing disproportionately supported the weakest Japanese banks." But there's no free lunch because "in strengthening the performance of the weakest Japanese banks, quantitative easing may have had the undesired impact of delaying structural reform."
"Some of these alternative policy tools are relatively unfamiliar," Russell Jones, global head of fixed-income research at RBC Capital Markets, told Reuters last month. "They may raise practical problems of implementation and calibration of their likely economic effects."
That doesn't mean we shouldn't embrace innovation at this juncture, but we shouldn't expect miracles either. The good news is that quantitative easing comes in many flavors, and so there's more than one way to skin this monetary cat. Imagination may count for much in these times. If something doesn't seem to work here, one can trying an alternative effort over there. Good thing, too, since the marginal risk of experimenting at this point is virtually nil relative to the risks of letting economic weakness and deflationary tendencies build.
But it's hard to overemphasize the fact that we're now in a gray area of monetary policy, a type of never-never land that has little precedent in the modern era, at least in the U.S. Graham Turner of GFC Economics is correct when he warns that it's best to keep an open mind about the possible outcomes from here on out. In an October essay in FT's economists' forum he wrote, "There is no guarantee that such a radical monetary policy will succeed. Central banks may have left it too late. Cutting the Fed funds target to 0% is necessary, but is unlikely to suffice. Driving the 30-year Treasury yield down to Japanese style levels, of 1% or so, may not be enough either."
The key problem is that much of the current woes seem to have unfolded/accelerated in the wake of Lehman Brothers' collapse in September. Rarely, if ever has such a large economy deteriorated so quickly and with such force and depth. That's made the challenge immensely more difficult. It was, after all, only a few months ago that oil was climbing to absurdly high records and inflation was still considered a real and present danger. But now we have the opposite threat. Six months sometimes makes all the difference in the world, even in the dismal science.
The world has changed—radically, and it may change radically yet again. Exactly what does, or doesn't suffice for monetary policy in the weeks and months ahead remains an open debate. No doubt there'll be definitive answers after all this is over. The playbook for monetary policy may be rewritten as a result. But for the immediate future, it's anyone's guess what happens (or should happen) next. No doubt we'll here lots of policy recommendations from far and near. Making sense of it all, if at all, may be the toughest challenge.
MORE TROUBLE WITH PRICES
For the second month running, consumer prices fell. And by more than a little, invoking the specter of deflation once again.
CPI slumped by a hefty 1.7% in November on a seasonally adjusted basis, the government reports today. That follows October's 1.0% fall. More dramatically, last month's tumble is the deepest monthly decline in CPI since the Labor Department began keeping records on this series in 1947. Meanwhile, MarketWatch.com reports that the 1.9% non-seasonally adjusted fall in CPI is the steepest monthly rate since January 1932—the height of the Great Depression.
Meanwhile, core CPI (which strips out food and energy) is unchanged, following a slight decline in October. As this is the Fed's preferred measure of inflation, even a central banker can't deny that inflationary pressures have evaporated, at least for the time being.
Looking at the more familiar year-over-year calculation of headline CPI, consumer inflation is still positive, running at 1.0% for the 12 months through November. Even so, that's down sharply from October's annual rate of 3.7%. At this rate, CPI will soon be falling on an annual basis too.
As striking as the news is, a decline of some magnitude in CPI was expected, partly based on the earlier report of the ongoing decline in producers prices. Nonetheless, the sight of broad price indices sinking month after month in both the consumer and wholesale markets raises the question of whether this is merely a temporary state or something with more endurance?
We've been writing about rising deflation risk for some months now, and it's clear that the beast is here. It's still unclear how long it lasts, and so for the moment one can be optimistic that an unhealthy downward spiral in prices isn't fate.
Keep in mind that the massive monetary stimulus engineered by the Fed has only partly filtered into the economy. Monetary policy has a fair amount of lag time, perhaps a year or more. With each passing month, the aggressive liquidity injections will work deeper into the consumer and business sectors. Few expect a sudden rebound in spending and lending, but at this point simply keeping prices steady would be no small accomplishment.
Another reason to think that prices may soon stabilize comes from the fact that heavy drops in energy prices are currently leading CPI's descent. The energy component of consumer price inflation has lost ground for four months straight, with November's whopping 17% fall the biggest so far. But energy prices can't keep falling off a cliff month after month. Yes, the world economy is headed for tough times, which is paring demand for oil, gasoline and other fuels. But the lion's share of the price cutting relative to the highs of last summer is behind us.
There may yet be more declines in energy coming. In fact, we expect as much. But the magnitude of future declines, if any, will almost surely be smaller. Nor is it unreasonable to expect that energy prices generally will soon tread water, albeit at substantially lower levels compared with recent history.
As for the other components of CPI, well, that's another story. The transportation slice of consumer prices retreated by nearly 10% last month—the fourth month in a row of red ink. Housing prices are weakened last month, although just barely. But not every is posting price discounts. Prices for food, apparel, education/communication and medical care all managed to rise last month. Deflation hasn't yet infected everything, and therein lies more reason for hope.
Still, no one will wonder why Fed funds futures are pricing in a 50-basis-point cut at the Fed's FOMC meeting later today. If accurate, that would bring the target Fed funds down to 0.5%. As extraordinary as a 0.5% will be in historical terms, at this point it's something of a formality to reflect reality since the effective Fed funds (which is based on actual banking activity) is already at a scant 0.14%.
In sum, the war to head off inflation is in full swing. The Fed can't afford to fail in this battle. Allowing deflation to build a head of steam at this point is tantamount to economic suicide. It must be stopped, even at the risk of letting inflation out of the bag down the road. Controlling inflation, after all, is well understood, even if the political will isn't always there. Fighting deflation, by contrast, is far tougher and so pre-emptive medicine is preferred.
The challenge before us is defeating deflation with unconventional monetary policies, supported by aggressive fiscal stimulus. Since there's not a lot of precedent for the former, one might reason that the fiscal side of the ledger will have to do the heavy lifting, which necessarily depends on the political process. 'Nuff said.
Yet the task is not insurmountable. Indeed, monetary and fiscal policies will be that much more effective if consumer prices merely stabilize in the coming months, or at least stop dropping so rapidly. But that, as they say, is a big "if." Stay tuned.
December 15, 2008
It's no secret that risk premia have taken wing in recent months, as our chart below illustrates. Nor is it any mystery as to the cause. Prices have slumped like a rock in a lake, and that's boosted trailing yields and interest rates to the sky. What's less obvious is if it's time to avail oneself of the relatively rich offerings.
Alas, the answer to this perennial question is always debatable. Even in the best of times, the wisdom of investment decisions is always in doubt, albeit in varying degrees depending on the context du jour. But this is a major hazard only if you're betting the farm on a given day or limiting your investment world to a narrowly defined subset of assets. Avoiding those dangers are essential for sound investing and sound sleeping, although it doesn't allow us to completely sidestep uncomfortable choices or mistakes. Nonetheless, it's a solid basis for putting our investing strategies on a firm foundation for improving the odds of long-term success.
On that note, your editor is of a mind to begin indulging. In fact, we've been suggesting that in recent months and the advice stands anew. Not because we have a crystal ball. Indeed, the capital markets still face tough times, perhaps for an extended period. Looking back a year from now will dispense exactly the right strategy, although that and 50 cents will buy you half a pack of gum in the here and now.
The task of taking advantage of higher prospective returns must begin at some point. Waiting for the "all clear" bell looks great on paper, but in the real world market bottoms and tops are identified only in hindsight. By that time, a fair amount, perhaps most of the rebound is behind us. Yes, there's always a good case for waiting, but there's a risk in times like these that the waiting becomes habit. Patience is a virtue, but even virtuous behavior has limits.
CS is an advocate of multi-asset class portfolios and adjusting portfolio allocations over time by taking cues from current conditions and reasoned projections of the economic and financial climate. In other words, we're fans of holding a mix of stocks, bonds, commodities, REITs and cash and adjusting the mix based on current and expected conditions.
We don't take this view lightly. Rather, ours is a perspective born after years of reading the financial literature, interviewing some of the world's best strategists, crunching the numbers and analyzing real world results. In an effort to consolidate and categorize what this reporter has learned, we're currently writing a book on the subject and will soon launch a newsletter dedicated to the topic (details to following in coming days and weeks). But for this post, the point is simply that winning the investment game requires action. Reasoned, well-timed, informed action, to be sure; but action just the same.
It's tempting to think that we can put off crucial investment decisions until the buy and sell signals flash with unmistakable clarity. But the transparency arrives only in the rearview mirror, once we've sped past the opportunistic junction. In real time, the challenge of investing is working with an unknown future and wondering if our analysis today will prove worthy tomorrow.
There are several defensive tactics to employ to limit the associated risks without giving up too much of the prospective return. One is refraining from making bold changes to asset allocation in a short time period. Alternatively, one can and should practice an ongoing rebalancing/tactical asset allocation program. In addition, we should emphasize changing portfolios at times when conditions appear to favor our odds of enhancing future returns.
By that standard, 2008 has become an increasingly opportunistic year in terms of higher expected returns. That's not to say that the trend won't continue; if fact, we expect as much and so we must pace ourselves in terms of shifting assets into asset classes with better prospects while reducing allocations in those areas with declining expected returns.
Perhaps the crucial point is that dynamic asset allocation is a process rather than a one-time event. Time diversification, in sum, is crucial for strategic-minded investing. We can't see peaks and troughs in markets in advance and so we should embrace apparent opportunities modestly, over time.
In essence, this is all about finding the optimal approach for exploiting the time-honored notion of buying low and selling high. As we discussed in 2006-2008, the extraordinary gains in everything was a signal to begin winding down risk exposures, albeit modestly, systematically and over time. We now encourage the flip side of that counsel.
Yes, we're were early in recommending lowering risk levels in 2006-2008, and we're likely to be early now in proposing that strategic-minded investors begin elevating their risk exposures. That's the nature of contrarian-based investing, arguably the only prudent approach for long-run investment strategies.
No one said it would be easy; in fact, it's downright awkward at times—like right now. So it goes in a world where mere mortals are faced with making imperfect decisions using limited information. As Winston Churchill might have said if he was an investment strategist in 2008: It's the worst investment strategy available, except when compared to everything else.
December 12, 2008
THE "D" RISK KEEPS RISING
Deflation with a capital "D" may still be a remote possibility, but it's getting tougher to dismiss the idea that deflation light is here.
Exhibit A is this morning's update on producer prices, which fell 2.2% last month. That's the fourth month running that wholesale prices turned south. We can debate exactly when, or if a deflationary climate has begun, but once it's clear to everyone that the big "D" has arrived it's probably too late to do much about it. Simply put, if there's any hope of slaying the deflation dragon, the opportunity is a pre-emptive one. But that leads us back to the question: Is deflation really here? Or is the ongoing price retreat only temporary?
One can argue that collapsing energy prices are the primary cause of the downdraft in wholesale prices. True enough. But energy prices won't keep falling forever. Indeed, crude oil has fallen sharply since the summer, when it set an all-time record of $147 a barrel in New York. In December, crude's been trading under $50. Yes, crude and other energy prices may go even lower, and that would keep downward pressure on general price indices. But aren't we close to the bottom of this downward spiral?
Perhaps, but not just yet. The warning signs of deflation are mounting, which suggests that pre-emptive action is still the prudent choice. The good news is that the Federal Reserve and central banks around the world recognize the threat and have begun reacting accordingly, i.e., administering higher doses of liquidity as an antidote to falling prices. The bad news is that the medicine isn't working, at least not yet. Perhaps all the previous stimulus will soon kick in and do the trick, but the evidence is still elusive. That suggests that even stronger measures may be needed, including fiscal stimulus.
Alas, the latest news on that front for the moment is discouraging. We're speaking of the proposed government bailout of General Motors, which appears dead in the water in the U.S. Senate. The argument for keeping GM from imploding is stronger these days, given the deflationary winds swirling about. It's unclear just how much deflationary suction a collapsing GM might generate, but whatever it is it's sure to be too much since there's a surplus of similarly negative winds blowing from other sources. That includes retail sales, which the government tells us fell again in November—down 1.8% from the previous month and off 7.4% from a year ago.
In normal times, the economy could absorb the fallout of GM and perhaps some other troubles. But these aren't normal times and there's more than a few deflationary events unfolding at once. As the overall downward pressure on prices mounts, so too does the risk that deflation light may metastasize into something more serious.
The risk associated with GM is all the greater now that conventional monetary tools are nearly out of ammunition. The effective Fed funds rate was a scant 0.11% yesterday. Recognizing that negative interest rates aren't a possibility, the game shifts to fiscal stimulus and unconventional monetary easing by the central bank.
But that opens a new can of worms since fiscal stimulus is subject to political risk, as the Senate's snub of the GM bailout reminds. Meanwhile, there's not a lot of precedent with unconventional monetary policy and so trying to juice the economy on this front amounts to an experiment running in real time. To be sure, the Federal Reserve will find some success with engaging in innovative tools and strategies. But it's debatable if such actions will suffice in keeping deflation at bay, assuming it's really a threat.
On a positive note, one could point to the fact that on a 12-month rolling basis, wholesale prices are still rising. But the trend can't be ignored. In August, the producer price index was advancing by a hefty 9.7% on a year-over-year basis. That's fallen rapidly every month since, down to a mere 0.2% rise in wholesale inflation in November from a year ago. The train is rolling and it's unlikely to stop any time soon. The only question is whether we let it roll on or do we try to derail it?
There are risks both ways, although from our perch we're more worried about letting deflation build a head of steam. It's too late to avoid risky decisions. That said, doing nothing looks like the much bigger risk.
December 11, 2008
DEMAND FOR JOBLESS BENEFITS KEEPS RISING
Another update on the labor market and another reason to worry.
The offending statistics today come in this morning's news on initial jobless claims, which rose sharply last week to 573,000. At this point, no should be shocked to learn that the lines at the unemployment offices around the country are growing longer by the week. Nonetheless, the rapid increase in striking, as our chart below shows.
Even by the negatively skewed standards of late, last week's 58,000 rise in new filings for unemployment was unusually large —the highest weekly advance, in fact, in more than three years.
No less worrisome is the ongoing advance for continuing jobless claims. The advance number for the week through November 29 is 4.429 million: up 338,000 from the previous week and up 68% from a year ago.
In short, more people are losing their jobs and more people are collecting jobless benefits for longer periods of time.
The obvious message here is that the negative momentum in the labor market has a head of steam and looks set to run on. The good news, if we can call it that, is the possibility that "technical factors" boosted the numbers last week. As MarketWatch.com reports today,
Several technical factors could have boosted initial claims last week, a Labor Department spokesman said. The week after Thanksgiving is traditionally the one with the biggest increase in first-time claims, and the government's seasonal adjustment factors may be overstating the increase this year.
Even so, no one should mistake the larger trend underway: broad and deep job destruction in the U.S. economy and increasingly throughout the world. The ramifications are being felt everywhere, from lower retail sales to falling commodity prices. As Reuters reports, retail sales in November suffered their biggest drop in five years. Meanwhile, the International Energy Agency now predicts global oil demand will contract this year for the first time since 1983, via Bloomberg News.
The basic connection is clear: Job destruction ultimately leads to demand destruction, which in turn brings lower prices. This is an especially potent relationship in economies that depend heavily on consumer spending, as the U.S. does. The primary fuel for consumer spending is, of course, employment income. Given the magnitude of the labor pains, it's assured that lower prices and lower demand will be the norm for some time. There's a lag effect, after all. The men and women who sign up for unemployment benefits today are sure to cut their spending tomorrow, and for as long as they're out of work.
Today's varied economic ills are the byproduct of events from the past weeks and months. By that logic, the continuing layoffs today will bring negative reverberations to the economy well into 2009.
At some point the negative momentum stops and a new equilibrium for the economy emerges. The various efforts by the government, now and in the future, will bring that day of a new equilibrium and stability closer than it would otherwise be sans intervention. But it's too soon to make reasonable assumption about timing. It's still unclear how much power this tidal wave has, although even casual observation suggests this is one heck of a perfect storm.
December 10, 2008
IS AVERAGE PERFORMANCE FATE?
The Wall Street Journal today reports that Bill Miller has "destroyed" his former reputation "as the era's greatest mutual-fund manager." Miller's downfall is hardly surprising, given the severe bear market this year. Indeed, Miller (who runs Legg Mason Value Trust) has lots of company. Humbled active managers are everywhere these days.
Miller was long thought to belong to a different breed—a super investor, if you will. This, after all, was the man who beat the S&P 500 every calendar year from 1991 to 2005. As the Journal noted, that's "a streak no other fund manager has come close to matching."
But now the streak is over and Miller has rejoined the overcrowded ranks of mediocrity. Again citing the Journal story: Miller's Value Trust has crumbled by 58% over the past year—20 percentage points deeper than the S&P 500's loss.
An accompanying chart in the article (see below) shows the fund's entire history relative to the S&P. For quite a long time, an investor who owned Value Trust from the beginning enjoyed serious bragging rights. Year after year, the fund beat the S&P. At the market's peak in late 2007, an investor who invested $10,000 in Value Trust in 1991 was sitting on nearly $110,000, or about twice as much as you would have had if you owned an S&P 500 index fund over those years.
But the gravy train has ended. In fact, as the chart above shows, a 1991 Value Trust investment is now roughly in line with what you would have earned with an S&P 500 index fund.
Is this all just coincidence? Perhaps, although one could argue that it's just one more empirical bit of evidence that it's tough—very tough—to beat the market over the long run. In the short run, of course, anything's possible, including lots of statistical noise in returns. As such, one might wonder how often the appearance of investment "skill" is merely a temporary fad that's fated to buckle under the pressures of market efficiency.
To be sure, the market's not perfectly efficient, especially in the short run. In fact, one can make a persuasive argument that Mr. Market suffers severe bouts of irrationality at times. What's more, some investors have a talent for exploiting the short-run inefficiency. But over a period of years, bubbles and other so-called anomalies seem to give way to efficiency, or a bias toward efficiency.
No, you can't prove it, and so the debate about whether active managers add value is endless. But there are clues to consider. A simple one comes from poring over the long-term numbers for mutual funds, which usually reveals that there are precious few managers who beat their benchmark. The usual suspects are to blame, including the relatively high costs of active management and trading and the inevitable risk of making the wrong bet at the wrong time, which is sometimes fatal.
There is a certain logic to the idea that few, if any, investors can beat the market over time. For the same reason that small companies can't maintain higher earnings growth rates as they become bigger companies, there's a limit to how many investors can beat the market. Someone's always earning above-average rates of return, of course, especially when view in a short-term mirror. But it's tough to keep it up the high-wire act. That's not surprising. In fact, it's more or less fate, as Bill Sharpe explained years ago in The Arithmetic of Active Management. As he explained, "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."
Yes, any one manager can post radically different results relative to the average performance of active managers or the market. That includes radically poor results as well as spectacular gains. Over time, however, the pressure for keeping everyone's returns average, at best, is powerful. Active management is based on the notion that an investor can escape this fate. Yes, some manage this Houdini act quite well, or so it appears. But it's a tiny minority, and even then one always has to wonder if the genius du jour is living on borrowed time.
December 9, 2008
PICTURES FROM THE IMPLOSION
We all know the story, but if you're inclined to review the gory details and, perhaps, enhance your historical perspective along the way, the Bank for International Settlements has just the report you're looking for.
Yesterday's release of the December 2008 installment of the BIS Quarterly Review is a sobering publication, to be sure, given the events of late. Indeed, children and squeamish individuals may want to avert their eyes.
Having pored over a number of similarly recondite treatises in recent months, your editor is up to his eyeballs in official reviews and reflections. Newspapers are great for immediacy, but a broader, deeper perspective is essential. If you only read (or selectively scan) one of these documents, and you have a preference for academic accounts of financial chaos, put this one on your short list.
Granted, there are no silver bullets, smoking guns or secret formulas here. But BIS staff does a yeoman's job of summarizing, analyzing and condensing the greatest financial implosion since the Great Depression. Stepping back and considering the implications, lessons and, as Kurtz would say, the horror may not be anyone's idea of fun. But there's something to be said for taking a hard look a major economic events, and this early draft of history does as good a job as any as delivering the analytical goods. For those pressed for time, simply reviewing the graphs offers a mini-education in the finer points of post-mortem financial analysis.
That said, here's a bit of eye candy (click for larger images), courtesy of the newly minted BIS review:
December 8, 2008
STIMULATING TALK OF STIMULUS
The pummeling that has infected every corner of the global equity market this year may or may not be near its end, but thoughts of brighter days are inspiring pundits and traders alike. It may be fleeting, of course, like so many rallies before it this year that soon faded. But for the moment, hope springs anew.
The reported stimulus behind the pop in foreign markets today is, well, the prospect of more stimulus. President-elect Obama worked the talk shows over the weekend, promising to spare no effort in propping up, bailing out and rebuilding once he takes up residence in the White House. Like-minded statements from governments around the world recently are helping nurture the idea that more stimulus efforts are coming.
It's anyone's guess if this is the catalyst to unleash a sustained rally. Certainly the global combination of enticing equity valuations, battered prices, cheap money and pledges of state spending are turning heads. Timing is always in doubt, but with so much red ink in stock markets everywhere, Mr. Market is now discounting a fair amount of pain, as our table below suggests.
The great unknown is the global economy in 2009. More to the point, are equities now sufficiently discounted for what awaits next year? Perhaps, although the answer will only arrive in daily doses. The future, in short, is still as unclear as ever, and perhaps a bit more than usual. Indeed, the recession in the U.S. is still in its early stages.
Nonetheless, strategic-minded investors with high levels of cash should be slowly, methodically putting that money to work in equities and other asset classes that have taken it on the chin. It's still too early to bet the farm that the rebound has arrived. Yet the hour is also getting late for favoring excessive amounts of cash and ignoring everything else.
Across-the-board losses—even deep ones—don't automatically spawn bull markets, of course. For all we know, the pain could run clear through 2009 and beyond. That said, the argument for some modest reallocating/rebalancing allocations from cash to risk is compelling. For our money, this is a process that should continue over time, and so strategic-minded investors must pace themselves, and their redeployments.
Yes, one can always rationalize that it's best to wait for even better deals. But if you can't at least begin to nibble at the relative bargains now, what makes you think that you'll have the discipline to do it next year? Or the year after that?
Successful investing over the long haul entails psychological and analytical battles. The former, by far, is the greater challenge. Markets sometimes offer bargains, sometimes not. The critical variable is deciding how to react prudently given current conditions. Easy to say, tough to implement. But in the end, it really does come down to: Buy low, sell high. The devil, as always, is in the details, but this is still the core of investment success. But as history reminds, few will be able to capitalize on this iron law of money management.
December 5, 2008
MORE JOB DESTRUCTION
Our long-running worry that the economy's suffering would get worse before it gets better finds ample support in this morning's employment report for November. Nonfarm payrolls plunged by 533,000 last month, the U.S. Labor Department reports. That's the steepest monthly decline since 1974 and the sixth-worse number on record going back to 1939.
The labor market, to be frank, is bleeding, and it's not obvious that blood will stop flowing soon. The negative momentum has a head of steam—no question about it. Whatever monetary quivers the Federal Reserve has left to play should be deployed post haste. That includes dropping the Target Fed Funds Rate to 50 basis points, perhaps even to 25 basis points while ratcheting up efforts on so-called quantitative easing, which is to say the full array of unconventional monetary policies. With interest rates so close to zero, all that's left with monetary policy are the irregular methods of injecting money into the economy. It's not clear that such efforts will provide much additional stimulus, but at this point there's little reason not to try.
The main front in the war to battle deflation and recession now shifts in earnest to Congress and fiscal stimulus. Alas, there's a bit of a political issue tied to this idea at the moment. The economy can't wait for President-elect Obama to assume the presidency late next month. Allowing the economy to fend for itself over the next 7 weeks risks letting an already troubling situation fester into an even deeper problem. The Bush administration needs to reach out to the Obama camp and the two sides need to work as one with the lame-duck Congress.
It's debatable how much fiscal stimulus is needed, but whatever the number it should be big: $500 billion at a minimum, although double or even triple that amount isn't beyond the pale. We don't make that recommendation lightly. The details of how it spent matter too. The brightest minds in economics, hopefully, will advise the politicians on how to spend a new round of fiscal stimulus to insure maximum stimulative results. In any case, the stakes are clear: If the government has any hope of keeping the economy from further deterioration, the window of opportunity is closing fast and so bold, effective action is required soon.
Of course, the argument for acting now may not look all that compelling if we limit our gaze to the unemployment rate, which rose to 6.7% in November from 6.5% previously. By historical standards, that doesn't look excessively alarming. But the depth of the jobs destruction in nonfarm payrolls last month speaks loud and clear about where the unemployment rate is headed: higher, perhaps much higher.
The leverage and excess built up over the years is unwinding, and it's now infecting virtually every corner of the economy. Indeed, other than in the government and education/health services areas, job losses were the norm across the economy last month. Notably, the usually robust services industry shed a huge 370,000 jobs last month alone, more than half of the total jobs lost in the nation. Services, which collectively employ the lion's share of the country's workforce, have only recently started losing jobs. That's not surprising, since services tend to hold up better than, say, manufacturing, which feel the pain first when the business cycle starts to falter. Nonetheless, the magnitude of losses in services highlights the depth of the recession that now has the economy by the throat.
"This is a clear employment blowout. Firms are reacting as dramatically as they can to make sure they have cost structures they can survive the recession we are in," Joel Naroff, president of Naroff Economic Advisors, tells Reuters today.
Turning around the negative sentiment won't be easy, but an all-out effort has rarely looked more convincing. The moment for action on the fiscal front has arrived. Yes, the thought of creating so much government debt raises a host of issues for the years ahead. But doing nothing courts even greater risks. We must wage war on the enemy as it arrives, and for the moment the monster at the door is recession with a capital "R". Dealing squarely with the beast is, for the moment, priority one, two and three.
December 4, 2008
HISTORY ISN'T BUNK, BUT IT CAN BE TRICKY
It may be premature to start planning for a sustained stock market rally, but it's never too early to look for perspective on what's in store for the future.
We've been collecting odds and ends that lend a bit of insight into matters cyclical, including the burning question: When will the bear market end? In terms of declines, the current tumble (as of Nov. 20) is the deepest in the post-World War II era, based on the S&P 500,
Before the latest rally, in late November, the year-to-date loss in 2008 for the S&P at one point exceeded even the 43.3% total return selloff of 1931, according to Morningstar's Ibbotson division. It's anyone's guess if we'll ultimately end up in record negative territory once this year's final trade prints. Yes, there are only 14 trading sessions left to 2008 after today, and as of last night the S&P 500 was off by less than 40% on a total return basis. Painful, to be sure, but a bit better than the year-to-date loss of 47.7% as of November 20's close.
Now for the main event: recovery. Once the rebound begins in earnest, the gains tend to come quick. Alas, the financial gods don't make announcements at the bottom. Only hindsight can definitively spot troughs, leaving mere mortals to guess in real time. Educated guesses, perhaps, but guesses just the same. So it goes with short-term forecasts.
It's tempting to think that reasonable minds can piece together the bits and pieces of evidence to figure out where we are in the cyclical. Indeed, there's a large cottage industry dedicated to just that pursuit. But as a recent essay by the Hussman Funds' Bill Hester reminds, such tasks are tougher than one might expect.
Consider the ebb and flow of S&P 500 operating earnings in relation to the end of bear markets and recessions. "It's best to tune out any forecast for the performance of next year's stock market that is based on expectations for near-term earnings growth," Hester counsels. "There's almost no correlation between year-over-year earnings growth and stock market performance."
The numbers tell the story, Hester continues. Comparing the nine bull markets since 1953, he observes a wide (read: random) array of trends in the changes of S&P 500 operating earnings during the first two years of newly minted bull markets. The quickest and biggest earnings recovery came in the two years following the 2001 recession. "This instance is unique because that bull market began almost 16 months after the recession ended (partly because valuations were still unattractive at the end of the recession)," he notes.
Impressive but hardly typical. Seven of the nine earnings recoveries over the past 50 years were uninspiring in varying degrees. Particularly discouraging was the 20% fall in operating earnings for the S&P 500 even two years after the 1990-91 recession, which was one of the shortest on record.
The point is that earnings have been known to rise (or fall) for many months after a recession's run its course and the stock market's rebound is in full swing. Trying to figure out which scenario Mr. Market has in store this time around is one more reason to remember that investing's still as much art as it is science. Alas, all financial artists aren't equally endowed with talent, which is why there's a case for keeping at least a portion of one's long-term equity exposure in a buy-and-hold pattern over time.
Yes, there's a compelling case for dynamically adjusting one's equity allocation over time, depending on the signals du jour, such as dividend yields. But betting the farm on market timing carries its own set of risks. And as the above stats remind, if you miss the first few months of the rebound, you're likely to miss out on a lot. Caveat emptor.
SOMETIMES A BLIP IS JUST A BLIP
One blip a trend does not make.
Yes, we're all eager for any sign of hope on the economic front, and so the slight upturn in our broad measure of the October data looks encouraging. But it's probably just noise—a refreshing bit of noise from the larger bearish trend, but noise just the same.
We're talking here of our propriety CS Economic Index, which is an equal-weighted measure of 17 leading, coincident and lagging indicators that track the broad trend in the U.S. economy. Leading indicators make up nearly half of this benchmark's weight. As our chart below shows, October posted a small rise in the index—the first after four straight monthly declines. (The complete range of monthly economic data for any given month arrives at a lag, and so October's numbers were only recently complete as of last Friday.)
Alas, it's not the start of a rebound. A big part of the blip in October can be traced to lower interest rates, which register positively in our index. Normally, lower interest rates dispense a bullish tonic for economic activity now and in the future. Unfortunately, the times are anything but normal. Lower interest rates, although they look encouraging on paper, have lost a fair degree of their stimulative power in the real world at present.
The Federal Reserve, in short, is now pushing on a string, to quote the popular phrase. With fears of deflation and continued economic weakness in 2009, lower interest rates alone won't change sentiment, at least not for the foreseeable future. That won't stop the central bank from lowering rates to zero, but no one should expect something approaching free loans to suddenly reverse all that's befallen sentiment in the U.S. in recent months.
What, then, are we to make of the sharp rise in commercial and industrial loans in October? This lagging indicator rose strongly, which helped boost our CS Economic Index. C&I loans grew by more than 4% in October, and were higher by 15% compared with a year earlier, according to the Fed. As Richard Yamarone (director of economic research at Argus Research) explains in The Traders Guide to Key Economic Indicators, higher C&I loans "are an indication that businesses have a favorable economic outlook, and are willing to build and expand their operations, and finance these plans via loaned monies." True enough. Most of the time, that is. But in the current climate, higher C&I loans may not be the bullish indicator they otherwise would be.
A recent paper from two Harvard economists advises that fear may be driving the increase in commercial loan making of late ("Bank Lending During the Financial Crisis of 2008"). Companies are increasingly eager to have more cash on hand to fend off disaster, as opposed to investing for growth. As such, a jump in C&I loans may be a sign of distress for the time being. (Hat tip to Jon Hilsenrath of the Wall Street Journal for pointing out this research.)
What about the rise in industrial production in October? The 1.3% jump looks encouraging on its face. But that too is something of an illusion. A big chunk of the rise was tied to the restarting refineries and drilling rigs in and around the Gulf of Mexico after the shutdowns due to hurricanes Gustav and Ike. Factoring out the storms and a strike at Boeing, industrial output would have slipped by 0.7%, according to the Fed via Bloomberg News.
In short, the upward blip in our economic index is just a blip. Our leading index of economic indicators, which continued to fall in October, suggests as much. So too does the red ink in most of the other economic indicators for October. The temporary respite, it seems, will soon give way to additional economic retrenching.
December 3, 2008
DEBATING THE VALUE OF ZERO
Just a few short months ago, it was unthinkable. A year ago, it was beyond the pale. But the extraordinary arrived yesterday when the 10-year Treasury yield fell to lows previously unseen.
The 10-year closed on Tuesday at 2.69%, a record low. The embedded message is clear: the market expects deflation, or something close to it. In the rush to find a safe haven, investors are bidding up the prices of government bonds to extreme levels. In turn, yields are falling to depths few thought possible.
The primary source of this outlook is, of course, the weak economy. "The big picture background for these very, very low Treasury rates is the weakest economy we've seen in at least a generation," Jay Mueller, senior portfolio manager at Wells Capital Management, tells BusinessWeek. "We're looking at a severe recession and the Treasury markets are reflecting that kind of an outlook."
The favored policy response for deflation is cheap money, and the Federal Reserve is moving heaven and earth to engineer just that. Indeed, the effective Fed fund rate is roughly 0.5%. But that invites the challenges that come with the so-called zero bound.
Make no mistake: we are increasingly in uncharted territory. The limited history of fighting deflation, real or perceived, insures passage into the unknown as rates approach zero. Adding to the confusion: some influential inflation hawks are warning that deflation isn't a clear and present danger.
St. Louis Fed President James Bullard yesterday said that further rate cuts elevate the risk of stoking deflation in the U.S. That runs counter to the widely held view that lower interest rates are a key weapon in keeping deflation at bay. Nonetheless, he's warning of the opposite, as per this report from Bloomberg News:
“I’m more concerned at these very low levels about the Japanese outcome” last decade, Bullard said today in an interview, while noting that deflation isn’t an immediate threat. Japan’s central bank “went to zero” with its main interest rate, and “deflation becomes a self-fulfilling thing and you are stuck at zero.” ... “I have not been a fan to going to really low levels,” Bullard said in an earlier Bloomberg Television interview. “Why is it zero this time? I don’t quite get that, though I know some people want to go in that direction.” ... “There are limits of what you can do with interest rate policy,” he said. “We have a market conditioned to think of interest rates as the definition of monetary policy.”
Meanwhile, Philadelphia Federal Bank Reserve President Charles Plosser questions the idea that deflation is a risk. As he explains in a recent speech reported via Reuters, falling prices of late "has prompted some commentators to suggest that the U.S. is facing a threat of sustained deflation, as we did in the Great Depression or as Japan faced for a decade. I do not believe this is a serious threat."
The bond market thinks otherwise. The January '09 Fed funds futures contract is now priced in anticipation of a 50-basis-point rate cut, which would bring the target Fed funds down to 0.5%.
Additional rate cuts at this point may or may not be productive, depending on who's talking. But for good or ill, there's not a lot of mystery these days about where monetary policy is headed.
December 2, 2008
The recession officially began this past January, NBER tells us. With that out of the way, we can now focus on the burning question: When will it end?
There are many clues for pondering the timing of the business cycle. Calling the turning point in advance is never easy, and in fact it's quite a bit harder these days. The magnitude of the economic and financial ills is to blame. In a perfect storm, when nothing seems to work and the crowd is ever more skeptical, simply locating your hand in front of your face is tough. An additional complication is the Fed's pre-emptive monetary policy of late. Traditionally, the Fed hikes rates to slow the economy. This time the central bank was cutting rates in anticipation of a recession. For good or ill, Bernanke and the boys are nearly out of rates cuts. That's a problem if the recession turns out to be longer than usual.
Meanwhile, the usual data suspects for profiling the business cycle are throwing out more than their fair share of confusing signals these days. As Bob Diele of NoSpinForecast.com recently advised clients, different economic and financial measures are making different forecasts about timing of the economic contraction. Has it only just begun? Or is it near its end? Or somewhere in between. Depending on the data points one chooses to highlight, all three scenarios look plausible.
Consider the chart below, courtesy of NoSpinForecast.com, which was published a few weeks back. If we ignore the NBER's announcement, a simple review of GDP numbers suggests economic activity peaked earlier this year, perhaps after 2008's Q2, which posted a 2.8% annualized real rise in GDP. The casual observer might think that Q3's -0.5% fall in GDP is a good candidate for dating the start of the recession, all the more so since most economists think Q4 will suffer an even bigger decline and 2009's looking quite weak as well.
Nonfarm payrolls are making a similar forecast. Year-over-year comparisons of this series have a habit of diving sharply ahead of the trough. The labor market has certainly been weak this year, suggesting that the peak may have just passed. Diele notes that year-over-year comparisons of nonfarm payrolls tend to coincide with periods when the economy's at its worst.
The stock market is sending signals that we're even deeper into the cycle and therefore closer to the cyclical trough than GDP or payrolls suggest. As Diele explains, the stock market has a history of tumbling in advance of the trough. Given the huge losses in equities this year, including recent hefty negative signs for rolling 12-month changes, one could reason that Wall Street is telling us that it smells a bottoming out in economic activity.
Then there's the spread between long and short rates, which is advising that the economic trough is well behind us and that the recovery phase has begun. Again quoting Diele, the yield curve tends to invert ahead of the trough. With that in mind, what are we to make of the fact that the curve has inverted on and off for several years? The naïve explanation suggests the economy is set to rebound soon. (Don't hold your breath.)
The above metrics are usually in sync when it comes to identifying where we are in the business cycle, Dieli says. This time, however, there's quite a bit more variety in the messages. Perhaps that's par for the course in a year when any number of rules of thumb and otherwise prudent guides have fallen off the wagon. The challenge is figuring out which metrics harbor the faulty signals. For our money, we're particularly suspicious of the financial spread, which is another way of predicting that the contraction still has a ways to go.
December 1, 2008
A BIT LESS RED INK FOR NOVEMBER
The all-out bleeding ceased in November. Yes, it was still a painful month for some asset clases, but November offered a break from the across-the-board losses that humbled September and October. Bonds made all the difference.
With the exception of high yield debt, bonds generally staged a comeback in November, providing some respite from dramatic declines otherwise still in force. U.S. bonds led the bounce, with the Lehman US Aggregate Bond Index rising a robust 3.3% last month, as our table below shows. Foreign government bonds in developed markets were a close second, advancing 3.2%. Even the battered world of emerging market debt rallied, tacking on 1.7% in November. TIPS and of course cash were in the black as well.
Everything else, however, continued to suffer. REITs were especially hard hit--again--in November, crumbling by nearly 25%. That follows the even bigger loss in October, when REITs dropped more than 32%. Since the summer, REITs have been nearly cut in half.
Striking as the REIT losses are, they're hardly out of character. As the chart above reminds, double digit losses have been the norm in the recent past. Nor is it obvious that the correction is over. The market will continue discounting the possibility of future economic and financial problems until investors are convinced they have a veneer of visibility about what's coming. For the moment, confidence about anything is in short supply, and so sellers still have the upper hand.
But let's be grateful for small miracles. The fact that November provided some relief, temporary thought it may be, from the onslaught of complete loss suggests that maybe, perhaps, the all-out carnage may be past. Valuations generally are somewhat attractive and so long-term investors are starting to consider the opportunity for the future rather than obsessing over the losses from the past.
Nonetheless, there's still likely to be plenty of volatility in the future, along with some knuckle-gripping declines in asset classes. Confidence is shattered and the crowd is still sizing up the depth of the recession that's only just begun. But for the moment, a small milestone arrived last month when some of the red ink was banished from the scorecard. Some might call that progress.