January 30, 2009
Q4 GDP TUMBLES, AS EXPECTED
Today's report on last year's fourth-quarter GDP wasn't good. In fact, it was quite ugly. But it could have been a lot worse.
Even so, the 3.8% contraction in the economy in 2008's final three months was the steepest decline since 1982. The previous recession in 2001 never came close to what's unfolding now. The 1990-91 slump was deeper, but even that will look mild by the time the current downturn has run its course.
In other words, we're now in the thick of the worst recession since the early 1980s. That said, the crowd was expecting a far deeper loss. The consensus forecast for Q4 GDP was -5.5%, according to Briefing.com. By that standard, the reported 3.8% retreat was a surprise.
Of course, today's GDP report is the first of three estimates from the government and so we must brace ourselves for the possibility of downward revisions. But for the moment, it's fair to say that the recession isn't quite as bad as some had feared, at least if we're using GDP as a benchmark.
That's a thin reed, of course, since it's likely that the pain will run on for some time. There's also little reason to cheer the fact that imports are falling and inventories are rising, both of which helped limit GDP's decline from being steeper than it otherwise would have been, at least on paper.
Meanwhile, no one should be complacent about the overall trend. Last year's third quarter posted a mild -0.5% setback, but the wealth destruction became materially worse in Q4. The first three months of this year are likely to be no better and even money says it's likely to get worse for a quarter or two.
Indeed, there's no way to put a positive spin on the fact that consumer spending—the main engine of economic growth for the U.S.—continued to decline at a robust pace in Q4. Personal consumption expenditures fell a hefty 3.5% in last year's final three months, almost as fast as Q3's 3.8% decline. The pain is especially acute in durable goods spending, the so-called big ticket items such as appliances. The huge 22% fall in durable goods spending in Q4 is certainly humbling; it's also a sign of just much has changed in the consumer mindset.
Yet there was a bit of good news. Spending in services by consumers actually rose in Q4, advancing by 1.7%. That compares favorably to Q3's marginal loss. Given the heft of services in the economy, the growth is particularly important to offset weakness almost everywhere else.
Alas, the export machine that had offered so much hope last year as a buffer to economic pain elsewhere is now in full retreat. Exports fell 20% in Q4, the deepest drop in many a moon. Imports slid as well, although not quite as fast.
Overall, today's GDP report is a reminder that we're now in the midst of what promises to a deep recession, perhaps the worst since the Great Depression. The great question is how all the government stimulus will affect GDP this year. The monetary stimulus is only now starting to filter through the economy, and it will be soon followed by another round of fiscal stimulus. Stay tuned.
January 29, 2009
DREAMING OF BETTER DAYS
Looking for a sign of sunnier days when a storm is raging is human nature. Homo economicus is an optimistic creature at heart, although that optimism is now being put to the test.
On first glance at today's update on new orders for durable goods, there's reason to hope if only because the flow of blood appears to be slowing. As expected, new orders fell last month—again. The good news, if we can call it that, is that the 2.7% decline constitutes improvement next to November's 3.7% fall or October's crushing 8.5% loss.
A sign that the worst is behind us? A tempting notion, although a closer look suggests that such thinking is still premature. One reason is that looking at new orders excluding the government's defense spending reveals a much steeper decline last month: -3.6%., and that's deeper than November's 1.7% loss for new durable goods orders ex-defense. The implication: spending plans among consumers and businesses is still weak and getting weaker. Meanwhile, looking at the year-over-year change in the broad measure of durable goods orders reveals a far uglier scenario, and one that appears to be deepening. Indeed, new orders were off by more than 20% last year, the lowest annual pace since 2001.
Looking again on the bright side, the government continues to mount a rescue operation, with a new round of help coming from Congress as it attempts to juice the economy again. The fiscal aid, combined with the ongoing monetary stimulus via exceedingly low interest rates will show results. But not yet, and probably not for several months at the earliest before even the faintest signs of stabilization appear. In the meantime, we can still dream of better days.
January 28, 2009
REINVENTING FOMC COMMENTARY
The press release that follows the Fed's FOMC meeting today may offer clues about how the central bank will proceed now that it's out of conventional monetary policy ammunition. Then again, maybe not. We're all trapped in gray zone of trial and error about what to do next and the Federal Reserve is also now faced with grasping at straws.
Typically, an afternoon FOMC press release attracts interest for an update on where short-term interest rates are headed. Today, and probably for some time to come, everyone already knows the answer. The Fed controls short rates, starting with the all-powerful Fed funds, but with the effective Fed funds at roughly 0.16%, the mystery about what comes next is, like the price of money, virtually nil.
Yet Bernanke and company may yet surprise us by dropping fresh clues about how the Fed plans to practice unconventional monetary policy from here on out—quantitative easing, to use the phrase of the dismal science. The details are a work in progress, although the immediate goal is still clear: stabilize general price levels.
We won't belabor the issue of deflation today, in part because we've discussed it often in recent months, including here and here. Let's just say that the D risk is still very much with us, and so the Fed has a fair amount of work to do in the months ahead.
The market appears to understand this, at least by way of monitoring Fed funds futures. For the year ahead, all the contracts are expecting Fed funds to remain under 60 basis points, and quite a bit lower for the immediate future.
Long rates remain in a holding pattern as well. The yield on the benchmark 10-year Treasury Note is in the 2.5% range and it may go lower yet, depending on what the next round of inflation reports reveal, although those won't arrive for several weeks.
Meantime, there's plenty of guesswork about what the Fed's next move. "With rates going nowhere for some time, the market's focus will be on whether the Fed will be looking to buy government (or corporate) securities in the near future," Sacha Tihanyi, an analyst at Scotia Capital, opines via AFP.
John Authers in today's FT argues that the critical variable is housing prices. What can the central bank do on that front? "The Fed can give details on quantitative easing— the ugly phrase for the art of buying bonds so as to push down the yields they pay, and stimulate the economy with lower rates, especially for mortgages," he writes. "If there is a single key variable to determine when the crisis in the US banking system can be brought under control, it is house prices. The further they fall, the higher the likely default rate on the mortgage-backed securities that banks now hold on their balance sheets."
Unfortunately, the news on housing prices is still discouraging, even after several years of a falling market. One of the latest bits of housing data shows that prices fell again last month even as sales perked up. Existing home sales rose 6.5% in December, albeit driven by distressed sales at bargain prices, the National Association of Realtors reports. Nonetheless, the median national price of existing homes in the U.S. still dropped by a hefty 15.3% last month.
Even if the Fed is successful in fending off deflation, which we expect it will be, that by itself isn't a cure for what ails the economy. "Ben Bernanke is rightly concerned about deflation right now," Desmond Lachman of the American Enterprise Institute explains in The Christian Science Monitor. But that's merely step one in a multi-step recovery program. "Getting inflation back into the system … is not going to be sufficient," Lachman notes.
Convincing banks to lend and consumers and businesses to borrow is arguably the next big step beyond containing the deflation risk. Solving the latter will be easy by comparison. The real challenge will come later this year in trying to promote growth. But first things first, and so we await today's Fed commentary.
January 27, 2009
TALKING ABOUT GINNIE MAE BONDS ON THE INSIDE VIEW
Safety and a higher yield? Typically you can have one or the other. But sometimes you get both. That's the case with bonds issued by the Government National Mortgage Association, or Ginnie Mae, as it's commonly known.
In today's episode of The Inside View, we take a closer look at Ginnie Maes in a conversation with David Ballantine, lead manager of the Payden GNMA Fund (PYGNX). As he explains, Ginnies are mortgage-backed bonds fully secured by the U.S. government. That means Ginnies are effectively of the same credit quality as U.S. Treasuries. Yet Ginnies also tend to offer a yield premium over Treasuries. Currently, Ginnie yields are generally available at 140 basis points over Treasury bonds, Ballantine says.
According to Morningstar, Payden GNMA ranks high for trailing performance in the past five years among intermediate government portfolios. The portfolio's 7.7% total return in 2008 was not only one of the fund's better years since it was launched in 1999; last year's gains also looks attractive generally, given the steep losses almost everywhere else in the capital markets. That's no guarantee that the fund will continue to excel, of course. Indeed, the strong gains in Treasuries and GNMAs in 2008 offered a bullish tailwind generally last year, and one that's not likely to be repeated.
Keep in mind, too, that Ginnies bear prepayment risk as mortgage-backed bonds. That risk tends to rise when interest rates fall and homeowners are inclined to pay off old mortgages by refinancing at lower rates. Then again, interest rates have already fallen to levels unseen in decades. That raises questions about the future for bonds generally, although one might wonder if the outlook is different for Ginnies.
With investors looking for a safe haven and a decent yield, it's a perfect time to take a closer look at these bonds as an asset class and consider the possibilities, and risks. With that in mind, listen in as Dave Ballantine discusses an obscure but intriguing corner of the U.S. government bond market…
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January 26, 2009
RECESSION UPDATE: SAME OLD, SAME OLD, ALTHOUGH...
This morning's update of the Conference Board's leading economic index (LEI) shows a modest gain last month. But let's be clear: The increase is neither unexpected nor a sign that economic growth is imminent.
As we discussed last week, monetary stimulus these days is in overdrive, and to an extraordinary degree. In turn, that boosts the upside bias of most statistical measures designed to anticipate future economic activity, including the Conference board's LEI as well as our own gauge of the future. Normally, this boost would offer strong reason to think that a rebound is near in the economy. But given the depth of the economic challenges, even unusually potent levels of monetary stimulus aren't delivering the usual punch.
The Conference Board's leading economic index "rose modestly in December, mainly due to the continued and very large positive contribution from real money supply," the organization's press release explains. "The yield spread also contributed positively to the index, helping offset the continued declines in building permits, the average workweek, supplier deliveries, and initial unemployment claims."
Looking at the longer-term trend gives a better picture of what's unfolding. Indeed, LEI is off by 5% in December compared to July 2007, the most recent peak. "And, it would have been weaker without the very large expansion in inflation-adjusted money supply in the last four months," the Conference Board notes.
The Board's LEI is composed of 10 factors, of which only four posted gains last month. The two biggest increases came via a surge in inflation-adjusted money supply and lower interest rates. The only other two positive LEI contributors in December: new orders for consumer goods/materials, and manufacturers’ new orders for nondefense capital goods. Everything else in LEI—60% of the index—suffered varying rates of decline last month. Even so, the monetary stimulus overwhelmed the real economic activity measures, leaving a superficial impression that economic recovery is just around the corner.
That's possible, of course, but by our reckoning such thinking remains premature. For the immediate future, and quite possibly through the first half of this year, the best hope for thinking that economic stabilization is near comes by playing the optimist for expectations of a new round of fiscal stimulus from the U.S. government, currently expected to be $825 billion.
Meanwhile, there's the news today that existing home sales for December rose by 6.5%, although that was tempered by the simultaneous 15% drop in housing prices. Nonetheless, one can speculate that a bottom in the economic cycle is near. That doesn't mean that growth is near, but the first priority these days is stopping the bleeding.
What we can say for sure is that the monetary stimulus effort is running at full throttle and, over time, will go a long way toward fending off deflation and economic contraction. No one knows for sure if it'll be successful, but it's clear that an effort to win this war is gaining momentum. But this will be no quick fix, and so the next few months may not change all that much, at least from a monetary policy perspective alone. Perhaps the pending fiscal stimulus currently in design by the Obama administration will change the dynamic for the better.
Yes, there's reason for cautious optimism, albeit only for expecting that the deepest part of the economic pain may end later this year. Forecasting anything much more than that is, for the moment, more of an exercise in hope rather than economic forecasting. Nonetheless, the forces aligned with stabilizing the economic troubles are gaining a head of steam. With a bit of luck, the pump priming will show some traction. But not yet.
January 25, 2009
FIREFOX PROBLEM RESOLVED...
A quick note to readers: We've fixed the glitch with Firefox. The code for the podcast player posted on CS was creating problems for some versions of Firefox. No more. There's still an issue using Firefox via the links at the top of the page, but that too will soon be set right. Meantime, Explorer continues to work just fine throughout CS.
January 24, 2009
A NOTE ABOUT INTERNET EXPLORER & FIREFOX BROWSERS
If you're reading The Capital Spectator using Internet Explorer, this web site should look fine. Reading the site with Firefox, alas, throws the web site askew. We're looking into making sure that CS reads cleanly in all browsers. Unfortunately, this is a daunting task for your technologically challenged editor. To paraphrase Star Trek's Dr. McCoy, "I'm a writer, not a web designer."
In any case, until (and if) we solve this technical glitch, it's best to vist the Capital Spectator by way of Microsoft's Internet Explorer. Thanks, and sorry for any inconvenience.
January 23, 2009
TALKING ABOUT EQUITY INVESTING IN THE LONG RUN ON THE INSIDE VIEW
Stocks for the long run. The idea became popular in the 1990s, although these days it looks a lot less trendy. So it goes after a year of crushing losses in the equity market. Yet there's a more fundamental reason for taking a fresh look at the conventional wisdom behind the idea of stock investing for the long term.
As the title of a new research paper asks: Are Stocks Really Less Volatile in the Long Run? In today's episode of The Inside View podcast, we discuss the paper and some of its implications. We also hear from one of the co-authors, Lubos Pastor, professor of finance at the University of Chicago Booth School of Business. He co-wrote the paper with Professor Robert Stambaugh of the Wharton School.
The new research raises a number of questions about some popular notions of equities and the degree of risk they harbor in the long run. In the upcoming February 2009 issue of The Beta Investment Report, we'll be looking closely at how these questions relate to designing and managing asset allocation. Meantime, here's a preview…
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January 22, 2009
MORE PAIN, NO GAIN
The holiday break in rising jobless claims is over and the lines at the unemployment office are once again growing longer. That's the message in this morning's update of new filings for jobless benefits.
Initial claims jumped sharply to 589,000 for the week ended January 17. That matches the level posted for the week through December 20. The bad news is that we're again at the high point for the cycle so far. Unfortunately, there's no reason to think that new jobless claims won't go higher still. Indeed, a reading of other economic statistics far and wide virtually assures that bearish future. Since this data series is considered a "leading" indicator, it also looks like the unemployment rate, which generally lags initial claims, is set to rise further as well.
Adding to the evidence that the momentum in the labor market is still negative, and is likely to remain so for some time, is the latest reading for continuing jobless claims. The update today is through January 10 and relates that we're now at just over 4.6 million, up 97,000 from the previous week. That puts continuing claims at just under the high for this cycle, set in the week through December 27.
It's hard to overestimate the relevance of the labor market's influence for the economy. Much of the fuel for economic growth, starting with consumer spending, is closely tied to employment trends. Wage income, in other words, is the critical element that breathes life into economic expansion. When that economic stimulant is on the defensive, it has far-reaching effects.
No one, then, will be shocked to learn that new housing starts fell again in December at a steep 15.5% seasonally adjusted annualized rate, the Census Bureau reports. New building permits also tumbled, falling nearly 11% in December vs. November. The decline in permits, a leading indicator for the housing sector, continues to speak loud and clear: construction activity in residential real estate will continue to slow.
The forces of recession and contraction, in short, are now in control. As we discussed yesterday, the best current hope for slowing the descent flows from the massive stimulus via monetary policy, which is increasingly being joined by a comparable fiscal effort engineered by Congress and the White House. But there's no sign yet that the government's efforts to right the economy is having much, if any effect, although one can argue that the pain would be much worse in the absence of Washington's aid.
In any case, all eyes are looking for a sign, any sign, that the bleeding will stop. When might that magic day arrive? For clues, Paul Kasriel, director of economic research at Northern Trust, recommends watching the leading economic indicators (LEI). "When the three-month moving average of the LEI quits declining, this will be a strong signal that a recovery is on the horizon," he writes in a research note earlier this week. "Right now, the LEI are not signaling that a recovery is imminent. But we will make a bet with you. The behavior of the LEI will signal a recovery before the consensus of economic forecasters does."
January 21, 2009
FALSE SIGNALS AND REAL HOPE
Today is the first full day of President Barack Obama's administration and, as everyone knows, the new commander in chief has his work cut out for him. With a fresh start before us in Washington the question on the home front remains: What's up (or down) with the economy?
In broad terms, the answer is obvious, and the numbers only lend statistical support. Clearly, tough times lie ahead, with the next 6 months or so looking set to be the toughest. But how does that square with our proprietary measure of U.S. economic activity (CS Economic Index), which bounced sharply higher in November, the last month with the full compliment of data pieces for calcuating this benchmark? What's more, based on preliminary data for December, the November bounce looks set to hold.
Alas, the rise is something of an illusion for the time being since only two factors out of the 17 in our economic index are driving the bounce skyward. Granted, the pair is on steroids trying to bring aid and comfort to the ailing economy. Statistically, the changes in those two factors are enough to push the entire index upward. Even so, those two lone bullish factors alone, unfortunately, aren't likely to spark a recovery of any substance for the foreseeable future. Looking out later in the year offers some hope, but first let's talk about the immediate future.
The two factors doing all the heavy lifting in our economic index are money supply and the interest rate spread. Both were in overdrive in November in terms of generating pro-recovery fuel to an otherwise shrinking economy. The rate spread was particularly bullish, although the growth-oriented bounce from money supply was robust too. Collectively, the pair overwhelmed the negative energy elsewhere in the economy, at least when measured on an average basis.
By rate spread we're talking of the difference between the yield on the 10-year Treasury Note less the effective Fed funds. Thanks primarily to the dramatic fall in Fed funds in November, which continued in December, the rate spread widened sharply and thereby moving definitively into positive territory, which generally is a bullish signal for the economy. Why? Because a positive sloping yield curve—rates are higher as bond maturities lengthen—historically accompanies economic growth. By contrast, a negatively sloping yield curve—rates fall as maturities lengthen—is a sign of distress/economic contraction.
Based on the rate spread, this measure went negative in July 2006 and stayed negative until February 2008, when the spread moved back into positive territory. Looking back, it turns out that the recession warning posed by the arrival of a negative yield curve in mid-2006 was an accurate forecast of an approaching recession, which officially began in December 2007.
Fast forward to November 2008 and the rate spread is telling us that it's now in high gear as an economic stimulus. That is, short rates are extremely low relative to long rates—despite the fact that long rates are also bouncing around at historically low absolute levels. Based on this measure alone, one might be bullish on the immediate future, assuming this was a normal cycle. But as we know, the times are anything but normal and so even the unusually bullish stimulants coming from the money supply and interest rate factors aren't yet dispensing their usually pro-growth influence. The reason is that the negative drag from everything else is, for the moment, still too much to overcome. Indeed, the lagging and coincident factors in our broad economic index are either flat lining or still declining.
The good news is that at some point all the monetary stimulus will take root and promote expansion. All the money has to go somewhere and eventually it'll go into corners of the economy other than banks accounts and T-bills. Banks will one day lend and businesses will borrow. In addition, now that the Obama administration is at the helm, we expect a fresh round of fiscal stimulus to compliment the monetary efforts now running at full speed.
Guessing when all this will produce some measurably positive change in the economy proper is the great question. Given the depth and magnitude of the economic headwind, we're not expecting much for the first half of this year, perhaps longer. Even when signs of growth, or at least stabilization emerge, they're likely to be tenuous, slipping temporarily back into negative territory and keeping everyone on pins and needles.
Recovery worth the name is going to take time, and perhaps a fair degree more time than we've come to expect over the past generation, when growth returned fairly quickly after a downturn.
As such, strategic-minded investors should pace themselves and use the next several quarters productively to restructure their portfolios for the day when the storm passes. As we'll discuss in more detail in the February issue of The Beta Investment Report, the ongoing economic and financial turmoil is wrenching but it also offers substantial opportunities for dynamic asset allocation strategies.
That said, the next several months are undoubtedly going to be rough, replete with surprises, false starts and lots of noise in the markets. Economically speaking, there are still a number of big unknowns lurking in the near-term future too. Investors should brace themselves for more volatility, and at the same time prepare to take advantage of it.
Risk management, in other words, has never been more important, or potentially more rewarding.
January 20, 2009
SIGNS OF A YIELD SPREAD THAW?
Late last month, we discussed the fact that the strange case of parity had arrived for the yields of the 10-year Treasury and its inflation-indexed counterpart. The conventional 10-year yielded a mere 13 basis points over the 10-year TIPS as of December 26. That was highly unusual, as we pointed out, in part because a conventional Treasury should normally pay a substantial premium over an inflation-indexed bond of the same maturity as compensation for bearing inflation risk.
Of course, the "normal" scenario applies when inflation is generally the path of least resistance. Over the grand course of history, that's far and away the standard scenario, as fiat currencies have a perfect record of fomenting inflation. But in the shorter term alternative afflictions are possible in the realm of monetary economics, as the last few months remind.
Getting back to our story, last month we observed that when the yields of standard and inflation-indexed Treasuries were virtually identical, buying the inflation-indexed bond was a no-brainer. Why? Because there's no reason to turn down a Treasury security that offers both inflation insurance at essentially no extra price. Yes, that apparent deal may not look so good if deflation prevails over the life of the bond, which in this case is the next 10 years. But few are expecting such a long-running case of deflation over the next decade, at least not yet--thus the perceived opportunity.
The fact that the two yields were more or less comparable to begin with is a reflection of the strange state of finance these days. Although it represented a rare opportunity for bond investors, it's not an encouraging sign generally. As such, one might reason that the widening spread between the two yields in recent weeks, as the chart below shows, is something to cheer. Even so, we shouldn't break out the champagne just yet.
The yield spread is still quite low and abnormally low. As of last Friday's close, the spread had widened to 55 basis points, up from just 13 basis points when we wrote about this last month, although that's still a fraction of the 225-basis point average spread since 2003.
The widening spread this month is due equally to market changes in conventional and inflation-indexed Treasuries, albeit for different reasons. Since late last month (Dec. 26), the standard 10-year Treasury Note's yield has climbed slightly by 20 basis points to 2.36%, as of last Friday. Over the same stretch, the 10-year TIPS' yield has fallen by 22 basis points to 1.81%.
What does it all mean? On the one hand, the consensus outlook for inflation has risen, if only slightly and off a bottom of roughly zero. As such, it's too soon to say if the change is just trading-related noise. Nonetheless, the market's now expecting that inflation will average roughly one-half of a percent for the next 10 years. Late last month, the market was in effect forecasting no inflation to speak of for the decade ahead.
In the upside-down world we currently live in, that constitutes progress, spare and vulnerable though it is. A little bit of inflation, in other words, is just what we're looking for to stave off deflation. Keeping a lid on it in the longer run will prove to be a tough challenge, but for the moment higher inflation is something to celebrate when deflation is a real and present danger.
Alas, it's still too early to say if we're on the cusp of witnessing higher inflation, even though the Federal Reserve is working hard to deliver just that outcome. We're going to have to several months before more concrete signs of the Fed's deflation battle emerge. But for the moment, a thin reed of hope is tenuously peaking through the January deflationary ice. Let's hope the spring thaw comes early this year.
January 19, 2009
Martin Luther King Jr. had a dream and so does Professor Robert Shiller. Civil rights trump financial freedom, of course, in the grand scheme of priorities and so I don't presume to equate one with the other. That said, it's a lot tougher to maintain civil rights in the long run without some progress in building and maintaining financial freedom and so on some level we all have a vested interest in advancing both.
Certainly we can all agree that prudent, sound advice on matters financial helps everyone as well as the economy generally. Assisting the masses in the cause of building, growing and preserving wealth won't solve all the world's problems, but it helps. With that in mind, Shiller's piece in the Times yesterday raises the idea that promoting financial literacy is productive as public policy. It's also timely, given the huge losses suffered recently by so many investors, large and small. "Many errors in personal finance can be prevented," he writes. "But first, people need to understand what they ought to do."
Alas, financial literacy seems to be the exception rather than the rule in the world of dispensing investment advice. We can debate how to go about changing that, but there's no doubt that clear thinking on managing money is in short supply. Given the current economic and financial climate, a solution is needed post haste. Letting the masses fumble what is increasingly a central decision for securing their retirement security is the equivalent of fiddling while Rome burns.
The basic solution is recognizing the world as it exists. Finance doesn't have hard-and-fast rules like physics, but there are some essential truths. Indeed, the challenge of investing begins by forging a bit of order out of the chaos of markets and developing a strategic framework for making investment decisions. That comes from taking advantage of what we've learned over the decades about how to manage money wisely.
That's not easy for the uninitiated, in part because practical investment strategies don't come naturally to homo economicus. Money does strange things to the brain, as Jason Zweig explains so convincingly.
As such, progress here takes a fair amount of study and a willingness to stay focused on monitoring the markets and keeping up to date on financial research and the lessons learned in the money management business. No mean feat, and so it's no wonder that hiring an advisor is often the best solution for those who have neither the time or inclination to immerse themselves in the finer points of portfolio management.
Even so, everyone needs a basic financial education. After all, it's your money. The idea that you can turn over your retirement portfolio to a financial advisor and remain completely uninformed about what constitutes sound money management is an accident waiting to happen. Just ask the many investors who were burned by one Bernie Madoff.
All sound investing begins by reviewing the choices in the broadest terms. As I explain in the inaugural issue of The Beta Investment Report, the 1,000-mile journey of investing begins with asset allocation. The default choice on that all-important strategic front is the market portfolio, defined as the world's capital and commodity markets, each weighted initially by their respective market values. In effect, this portfolio represents Mr. Market's asset allocation.
This is the ideal benchmark because it owns everything, or at least everything that's reasonably accessible for the average investor in terms of liquid, organized markets and available via index mutual funds and ETFs. The returns associated with this definition of the market portfolio are available to everyone, and it requires no skill or trading to tap into what has proven to be a reasonable return over the long haul. That's one reason why I monitor and analyze this benchmark, among other things, on a regular basis in my newsletter.
Finance theory teaches that the market portfolio is the ideal investment for the average investor with an infinite time horizon. Obviously, that describes no one. The challenge, then, is deciding how to adjust the market portfolio to suit your particular investment needs. The key factors for making this decision include your time horizon, investment objectives, tolerance for "risk" and other variables. Once you're clear on those items, you can begin to figure out how to change the market portfolio to satisfy your financial goals.
Here's where it gets tricky. Indeed, the choices are virtually infinite. That means that the hazards of doing too much usually outweigh doing too little. Indeed, a few examples of the options include: Changing the asset allocation relative to the market's mix; dropping one or more asset classes entirely; leveraging one or more pieces of the portfolio; introducing so-called alternative betas/strategies into the mix; managing the asset allocation tactically vs. using a milder approach by way of a modest rebalancing strategy that reacts to market trends rather than trying to anticipate them.
Putting these and other choices into some historical context with the present, while surveying the current investment landscape with an eye on finding where opportunity and risk lie, is the focus of The Beta Investment Report. Why? It's a fundamental focus that's directly related to bottom-line investment results.
Every investment strategy, at its core, reflects an asset allocation decision. The investor may not be thinking in those terms, but that's the paradigm just the same. Let's say you've assembled a small-cap U.S. equity portfolio, carefully selecting each stock with a rigorous methodology. You're convinced that this portfolio is all you need for the long haul. What's asset allocation got to do with that? Everything. In essence, you're making an extreme asset allocation bet in your portfolio by excluding everything save small-cap stocks. What's more, you're consciously trying to do the heavy lifting with alpha rather than beta, even though the former is likely to end up being a sizable driver of returns and risk.
All investment portfolios draw from the same capital and commodity sources. Whether you're running a global macro hedge fund or a plain vanilla large-cap long-only domestic stock portfolio, the basic financial DNA arises from a common gene pool. There are countless ways to reassemble and reengineer the genes. Regardless of the final outcome, the process begins by understanding the basic rules, surveying the fundamental choices and intelligently exploiting the opportunities (and staying mindful of the risks) as they ebb and flow.
There are other ways to manage money, of course, but it's debatable if they'll be as successful, if at all, in the long run. Fifty years of finance theory and a much longer legacy of real-world money management history teach us no less. Understanding why that's so is the first step in developing a successful investment strategy.
January 17, 2009
THE CAPITAL SPECTATOR IS NOW AVAILABLE ON THE KINDLE
There are many ways to read The Capital Spectator, and now there's one more: via Amazon.com's Kindle. If you'd like to subscribe to CS on your Kindle, please visit here.
For the uninitiated, the Kindle is an e-book reader sold by Amazon. Users purchase content and download it directly into their Kindle. Since its launch in late-2007, the Kindle has become the new new thing for reading books, magazines, newspapers and a sea of other published content. It's sort of the reader's equivalent of the iPod. It's quite a handsome device and offers a number of benefits for staying up to date on your favorite reads. For one thing, it allows you to carry around your personal library in your pocket.
For more information on the Kindle, including the option to purchase one, please use the link below. No obligation, of course. The Capital Spectator will continue to be available gratis through all the usual channels (for other options please see the "Subscribe" tab at the top of the home page). Meanwhile, for those who use the Kindle, we thought you'd like to know that the content menu for this e-reader just expanded by one. Happy reading!
January 16, 2009
THE DEFLATION BATTLE RAGES ON
For the first time since 1955, the consumer price index fell on a year-over-year basis. Last month's seasonally adjusted CPI slipped 0.1% for the 12 months through December, the Labor Department reports. On a monthly basis, the decline in CPI is more pronounced, falling by 0.7% last month--the third straight monthly decline.
Team Fed is working overtime trying to keep the visit relatively brief. By dropping the central bank's key interest rate to virtually zero and otherwise buying up assets that no one else wants, Bernanke and company are pulling out all the stops to engineer inflation back into the system. So far, the policy has yet to show results. But such actions take time to work. Eventually, and perhaps quite soon, signs of progress will emerge for keeping consumer prices on an even keel. The Fed, in sum, will win, and then the real work will commence. But that's a problem for another day.
Today, the central bank can't afford to lose this battle. Lower prices are nice, of course. More importantly, falling prices give consumers some relief from the ill winds otherwise blowing in the economy, and that's stimulative generally. But there's a limit to stimulus delivered in this form. If continually lower prices endure, the trend becomes toxic for growth and business expansion. And the bottom line is that the only way out of this mess is through growth and expansion.
In some respects, the Fed's raison d'etre is on the line here. If deflation persists, at some point one can imagine Congressional hearings and the like calling for a major reordering of the Federal Reserve. The institution, after all, is a creature given life by Congress and so the Fed ultimately exists and operates at the mercy of politicians. As such, the Fed's war on deflation is also a fight for survival to keep the central bank as it now stands intact.
Changes in banking generally are now being discussed openly. The prospect of nationalization, or something close, regarding several large private banks is topical these days. “We are down a path that this country has not seen since Andrew Jackson shut down the Second National Bank of the United States,” Gerard Cassidy, a banking analyst at RBC Capital Markets, tells the New York Times today. “We are going to go back to a time when the government controlled the banking system.”
Maybe, although for the moment a true nationalizing of such institutions as Citigroup is still unlikely. Yes, one can argue that a quasi-nationalization is already taking place, given the rising influence that Washington has over the finance industry via all the bailout money being extended to private institutions. But outright control and management of the banking sector by the federal government still looks improbable. Then again, we don't know what 2009 will look like and so one can never say never, especially these days. Perhaps we're idealists, but the lessons of modern economics insure that policymakers won't turn the clock back to the Age of Jackson in banking. More regulation and oversight is coming, but direct ownership and unfettered management of banks is doubtful.
As for the Fed, it's not too difficult to imagine that if deflation runs on for an extended period, and inflicts havoc on the economy, the incoming Obama administration and Congress may feel pressed to take even bolder actions to stem the tide of financial implosion. The front line of this battle is winning the war against deflation. It's not clear that if the Fed fails on this front the Congress can fare any better, but that wouldn't stop politicians from trying.
But we're fairly confident that the Fed won't fail. Deflation, we believe, will be slain and inflation will return. Timing, of course, is unknown, and since timing is increasingly the politically and economically sensitive variable in 2009, there's risk ahead—lots of risk, with predictions as well as with economics.
Still, there's reason for hope. Keep in mind that the CPI needs only to flat line for a while to keep deflation at bay. Stability seems likely in the months ahead if you expect, as we do, that the bulk of the decline in energy prices—gasoline in particular—is now behind us.
The energy component of CPI has fallen now for five months straight. It's too soon to say for sure, but it looks like November was the climax of the decline, with the CPI's energy index tumbling a hefty 17% that month. In December, energy fell again, although the pace slowed considerably to an 8.3% decline. Since gasoline makes up most of the CPI's energy index, we can look to the fuel for signs of what may be coming in future inflation reports.
On that note, the March '09 gasoline futures contract appears to be stabilizing, suggesting that perhaps the great energy selloff has passed. No guarantees, of course. Yes, gasoline demand over the past 6 months has taken a hit and so have prices. But unless you really are expecting the apocalypse, energy prices generally are set to stabilize.
Demand for fuel won't keep dropping by leaps and bounds month after month after month. Or so we believe. That's not to say that energy prices won't go lower still. But on a percentage basis, the big declines are behind us. That'll go a long way in helping battle deflation, and letting the Fed keep its fancy offices on Constitution Ave.
January 15, 2009
TALKING ABOUT "HARD CURRENCIES" ON THE INSIDE VIEW PODCAST
The Merk Hard Currency Fund (MERKX) stands out for one simple reason: It's turned a profit over the past 3 years. That's no mean feat for the past 36 months, a period when most mutual funds suffered declines.
In today's Inside View podcast, Axel Merk—the fund's portfolio manager and president of Merk Investments LLC—explains why his strategy has bucked the generally bearish trend. As a preview, Merk Hard Currency has a strategic preference for cash—non-U.S. cash and related investments, to be precise. That includes gold, foreign currencies and short-term debt instruments denominated in something other than greenbacks. "What we're offering is diversification in the current environment," he explains.
To hear more of Axel Merk's analysis, including his view on what's next for the U.S. economy and the dollar, tune in to the latest edition of The Inside View…
Please visit CapitalSpectator.podbean.com for more options with this and other Inside View podcasts.
January 14, 2009
RECESSIONS, BUSINESS CYCLES AND LOOKING FORWARD
Forecasting cyclical turning points in the economy (and inflation) is job one at the Economic Cycle Research Institute (ECRI), a New York consultancy. In fact, it seems to do so rather well, or at least it has in the past. Notably, ECRI has earned some well-deserved praise in recent years for correctly predicting the 2001 recession.
But the current downturn has been a little trickier. True, ECRI was warning of trouble in late-2007. Even so, the firm held out hope that a recession might be sidestepped. As discussed in a November 2007 report, ECRI explained that "the leading indexes are not yet in a recessionary configuration, thus a recession can still be avoided." Alas, it was not to be. With the clarity of hindsight, we know that the recession began in December 2007, as per NBER's official (albeit 12-month lagged) dating of the downturn's start.
To be fair, ECRI was advising that a downturn was possible well ahead of December 2007. Today, the firm counsels that the recession is well entrenched and that economic contraction looks set to roll on. "The bad news is that the recession is going to continue for the next couple of quarters, and we know that objectively from the leading indexes," says Lakshman Achuthan, managing director of ECRI and co-author of Beating the Business Cycle: How to Predict and Profit from Turning Points in the Economy.
In an interview earlier today with The Capital Spectator, Lakshman talked of recessions, how we got into this mess and the outlook for, one day, better times. If you have a taste for the ugly details of the business cycle, read on…
Lakshman, ECRI did a nice job of predicting the 2001 recession. Were you ahead of the curve this time?
No, we were much more coincident, for a whole host of reasons. We said a recession was unavoidable in early March 2008. The reason we held out some hope that the recession could be forestalled was because of a weird confluence of events going on at the end of 2007 and early 2008 with respect to inventories—manufacturing stuff in the U.S. economy.
Typically recessions are kick started in many examples by a big inventory overhang that, all of a sudden, in sort of a Wile E. Coyote moment, give way and the floor falls out from under manufacturers. They realize that they have way too much inventory and they stop [producing]. That's how a lot of recessions tend to start.
But not this time.
No, it didn't happen that way. There was very little inventory and so we didn't have that kind of downturn in the economy. That gave policymakers the briefest window of opportunity to maybe push [the recession] off. But they weren't that worried and thought they had things pretty much under control. And we had growth abroad that was still drawing on U.S. manufacturers and so there was a widely held belief that we didn't have to worry about [recession] and that we were managing the home price decline and the emerging credit crunch quite well.
The economic cycle has in fact been some sending false signals, or certainly misleading signals in recent years, or so it seems. Inflation, for example, was running hot in the first half of 2008. But by the end of the year, deflation seemed to be the big threat.
Yes, it's been very schizophrenic. For example, the assumption in many models was that home prices couldn't go down; now the assumption is that they can't go up. All along the way there were plenty of prognosticators saying extreme things. Today there are some expecting a depression while others are expecting things to rebound in the second half of this year.
Looking back, you can see how this recession was set up. Certainly oil was part of the reason. We started to have oil spikes in 2005, and every year since then, through early 2008, we had oil spikes. Every time you had an oil price spike, someone warned of recession. When you had the housing market downturn begin in 2005, and you combine that with an oil spike, a lot of people saw recession.
But those were false signals, at least for a few years after 2005.
Right, and instead what we saw was that the economy accelerated to a four-year high with the growth rate in 2007. That's kind of an inconvenient fact. We actually grew faster than Europe in 2007. This wreaked havoc with all kinds of assumptions that decision makers had taken. In fact, the acceleration in 2007 may have lit the match for a lot of this credit stuff.
Because decision makers in the fixed-income markets and other markets were looking for a recession in 2007, but it never happened. You had the expectation on Wall Street, at Merrill Lynch and Goldman Sachs, for instance, of a 75-to-100 basis point rate cut by the Fed. And then one day in early June those two houses, which have a lot of followers, abruptly turned on a dime and said they didn't think there would be any rate cuts in 2007. What this did was immediately wreak havoc with all of the models pricing subprime credit groups, where the assumption was that rates would go down and so those instruments would maintain their credit ratings. The minute you took out the rate cuts, the guise fell away and everyone started running away from subprime debt very quickly. And that continues today.
So you had a housing price downturn that began in 2006 and then morphed into a credit crunch in 2007. These are massive things that take time to resolve. But they don't in and of themselves mean that you must have a recession. Our indicators were saying, yeah, things were bad, but it wasn't a guaranteed recession.
When did things take a turn for the worse in terms of triggering a real economic contraction?
We started to get a real recession risk in the second half of 2007. Our weekly leading index peaked in June 2007, about six months before the recession actually began in December 2007. In fact, by December 2007, our weekly leading index had plunged to its worst reading since the 2001 recession. However, because of these inventory issues I mentioned [there was an expectation that] maybe we would be able to buy a little bit of breathing room. That didn't happen. You saw the recession begin at the end of 2007. All the dead bodies started showing up in 2008 as the recession turbocharged the housing downturn and credit crisis.
What's the outlook now?
The outlook remains recession. Retail sales, the Fed Beige Books, industrial production, jobs growth—these are all coincident indicators and they confirm that we're in the most severe recession in the post-World War II era. This was forecast by our weekly leading indicators. Our leading index had earlier fallen to a 60-year low. So it's not a surprise that the coincident indicators are now weak.
What has changed in very recent weeks is that the leading indicators have begun to stabilize. I'm not suggesting that there's an imminent recovery ahead, but it is notable that we've gone from minus 30% growth rates to minus 25%, minus 28% or so. I suspect this is largely related to hope. We have a new year. We also have a new administration and some new stewards of the economy. There's talk of a new stimulus plan. The leading index may be showing there's some pause to this sharp decline. However, an objective reading of the index doesn't yet show a sustained recovery. That would require a very persistent and pronounced rise in the leading index for us to make that kind of forecast. What we know objectively is that the first two quarters of 2009 are going to be recession quarters.
The longest previous recessions were 16 months each, in the early 1970s and early 1980s.
If we date the current recession's start to December 2007, that suggests that we'll soon match the previous recessions' 16-month time frames. Does that mean we'll be getting close to the end of the current downturn later this year?
Saying at this point that the recession will end in the second half is really a coin toss—no one really knows. We don't know because the leading indicators haven't turned up yet. The bad news is that the recession is going to continue for the next couple of quarters, and we know that objectively from the leading indexes. The good news is that the leading indexes can't see that far. A lot of it is going to depend on, for example, the stimulus debate. If the stimulus is three times the proposed size and it happens quickly, then that's one extreme and so there's probably a chance of some kind of bump in the second half of 2009. On the other hand, if the stimulus is delayed, or adjusted down, maybe there's less chance.
Keep in mind that the recessions of the early 1970s and early 1980s were also international recessions. The number of countries in recession around the world today is the broadest we've seen since World War II. It's broader now than it was in the 1970s and 1980s in terms of the diffusion and pervasiveness of the recessions globally. That informs our view of what may happen in the U.S. There's a linkage: The broader the recession, very often the longer it is.
January 13, 2009
THE BETA INVESTMENT REPORT HAS ARRIVED
The Beta Investment Report, a new monthly newsletter edited by yours truly, James Picerno, has hit the streets. For a preview, take a peek at our sister site, BetaInvestment.com, where you'll find subscription information. In fact, we're giving away Volume 1, No. 1. Visit BetaInvestment.com to download a PDF file of the inaugural issue.
If you like what you read, please spread the word. Meanwhile, if you'd like to subscribe, here's a special offer exclusively for Capital Spectator readers: Visit BetaInvestment.com and then email us at the email address listed on that site to ask for the next issue. (Please remember to mention that you read about the offer here, on CapitalSpectator.com). We'll send the February 2009 issue when it's published next month, along with an invoice for the next 12 issues. That's 13 issues for the price of 12. If after reading the February edition you decide not to subscribe after all, no problem: you're free and clear--no questions asked. Keep the issue as a gift. But don't delay, as this offer expires at the end of this month, on January 31, 2009.
THE LAST DOMINO
The trade boom is fading. That's no great surprise, given the weakening state of the global economy. But the slippage in export-related activity comes at an especially challenging moment for the U.S.
Exports remained a bright spot for the U.S. economy last year. As other areas weakened in 2008, the American export machine bucked the trend. It was a timely boost, offering some hope that the approaching recession might be mitigated and perhaps even sidestepped altogether.
The high point came in last year's second quarter, when real (inflation-adjusted) export activity soared 12.3% on an annualized basis while GDP advanced 2.8%. That took some of the sting out of the drop in durable goods spending and a growing sense of unease otherwise in the GDP trend. In the third quarter, the export boom slowed but remained robust, rising 3.0%, in sharp contrast to the 0.5% decline in GDP.
The long-suffering dollar was no small advantage for juicing exports. As the greenback declined, the price cuts on American goods and services became increasingly attractive to foreign countries. Then in July 2008, the dollar began to rally. Although the U.S. Dollar Index has been trading in a range recently, it's still up sharply from its summer lows.
It was a tempting notion to think that exports would save us, although we warned last summer about expecting too much from the trend. "There's a limit to how much economic gain any nation can enjoy through a weakening of its currency," CS wrote in July. "Devaluation may offer short-term benefits, but the U.S. can't devalue its way to prosperity for very long."
The dollar's recent strength at the moment surely isn't helping U.S. exporting activity, nor is the credit crisis or the general economic turmoil blowing through economies around the world. Few analysts expected the fourth quarter GDP report to deliver anything other than a negative number. Today's trade update for November only strengthens that forecast. Exports dropped nearly 5.8% last month, the fourth consecutive montly decline.
No one will be shocked by the trend, although it's a humbling reminder that the economy has nowhere to hide. Employment, consumer spending, and so on have each fallen victim to the ill winds of recession. Exports are no exception. As we discussed on Friday, this is the eye of the economic hurricane and, as a result, all news from the dismal science is likely to be discouraging news for the time being. Not forever, but for a few quarters at least. Time moves slowly when you're waiting for a bottom.
January 12, 2009
BIG RISKS, BIG OPPORTUNITIES
The future is always unclear, and therein lies the chief source of risk in the investment challenge. The degree of risk isn't continuously steady. It ebbs and flows, like market prices and the careers of Hollywood actors.
The fact that risk levels are dynamic suggests a connection. But our ability to model the connection and draw lessons is limited. In fact, at some points the relationship between risk and expected return is especially foggy.
This is one of those times, a state of affairs that creates unusually large opportunities and equally above-average risk. As such, all the usual caveats, and then some apply. Yet recognizing this condition is the first step toward exploiting the opportunity and/or defending oneself against the higher risk.
Macroeconomically speaking, a major risk overhanging the capital and commodity markets relates to the question of deflation and inflation. That is, which one will prevail? Moreover, will one dominate only to give way to the other? And if so, what will the timing be? Being on the wrong side of this uncertainty will be painful, perhaps financially fatal, and so it's the rare investor who can afford to make an all-or-nothing bet. Regardless of your view, a bit of hedging never looked better—just in case.
Certainly there are strong arguments for each possibility, including deflation first, then inflation, which happens to be your editor's bias. But others argue that deflation will linger for a lengthy stretch and so the practical risks of inflation are virtually nil for the foreseeable future. Still others forecast that inflation remains the imminent risk, even if it's not obvious in current data. The chief evidence for this outlook comes from the massive surge in the Federal Reserve's balance sheet, i.e., the printing of money on a scale rarely seen in order to combat the current economic slowdown/contraction.
The fact that intelligent analysts and economists can debate the future on such starkly different terms only highlights the higher levels of risk of late. That's in sharp contrast to debates of the recent past, when dismal scientists were arguing if the economy was set to grow by 2.0% vs. 2.3%.
A telling example comes in the current issue of Barron's and its roundtable discussion. Consider this exchange between Fred Hickey (High-Tech Strategist); Mario Gabelli (Gamco Investors); Marc Faber (Marc Faber Ltd.); Oscar Schafer (O.S.S. Capital Management); and Bill Gross (Pimco):
Hickey: It's hard to predict the market when you don't know what the Fed will do. The Fed has tripled the size of its balance sheet and is plowing ground we have never seen before. Here are my facsimiles of deutsche marks from Weimar Germany [holds up sheaf of papers]. They collapsed in value when Germany started printing money after World War I. It happened very quickly and it can happen again.
The Germans were successful at reflating. But they weren't successful in saving their economy. [Federal Reserve Chairman Ben] Bernanke is on record saying, "I will not make the mistakes of the 1930s. I will not make the mistakes of Japan in the 1990s." He is pushing the limit right now.
Gabelli: So you're saying he's going to make the mistake of the Weimar Republic?
Hickey: There is a possibility of that. Every month that there is a horrible employment, report the government prints more money.
Gabelli: It took Weimar Germany a brief time.
Faber: The worse the economy, the more they will print. It is like in Zimbabwe now, and Latin America in the 1980s. They had large deficits and printed money, and in local currency everything went up. But the currency collapsed.
Schafer: Isn't the federal government increasing its balance sheet to offset the private sector?
Gross: Exactly. The situation isn't similar. The Weimar Republic basically reflated to get out from under its wartime debts. Zimbabwe is a situation unto itself. In the U.S. there has been asset destruction in the trillions of dollars that has to be repaired. To say the Fed's balance sheet has expanded by a few trillion dollars and that this will create hyperinflation is a miscalculation.
Faber: I'm prepared to bet Bill that in 10 years the U.S. has very high inflation. With growing fiscal deficits that may reach as high as $2 trillion next year, it will be hard for the Fed to lift interest rates in real terms. Once they push up rates again, there will be another disaster.
Gross: Marc, you're smarter than that. You know that credit creation is at the heart of economic growth, and to the extent that credit creation has been thwarted, stultified, basically cut by 10% or 20%, economies can't grow.
Faber: The U.S. economy is credit-addicted. In a sound economy, debt growth doesn't exceed nominal GDP growth. Would you agree with that, or do you think debt should always grow at a faster pace than nominal GDP?
Gross: I'm with you there.
Faber: We come at this from different perspectives. You run a company that manages money, and I'm an outside observer of the U.S. financial scene, though I have to admit I bought some U.S. stocks for the first time in 30 years.
The fact that smart people can see such wildly divergent possibilities on inflation and deflation reminds that the potential for instability is alive and kicking. As Abby Joseph Cohen, senior investment strategist at Goldman Sachs, explained in the roundtable talk, "It is important to recognize that we are not starting from a point of equilibrium, where the economy and the credit markets are working properly. Instead, the Federal Reserve is acting aggressively to provide liquidity not just to the U.S. economy but the global economy." She added: "In many ways, the Fed is acting as the central bank to the global economy."
It doesn't take a genius to recognize that the Fed's not designed for such a broad increase in its mandate. Yes, to a certain extent the U.S. central bank has, for some time, been dispensing monetary medicine for the globe. That's one thing, when the global economy was humming along nicely; it's something else in a time of severe asset deflation and recession, the likes of which we haven't seen in decades.
So, yes, there are huge opportunities in the current climate, but those are tempered with huge risks. As such, a prudent risk management strategy is essential. For strategic-minded investors, that begins with taking advantage of sharp discounts on price at those times when available. In fact, the discounts were unusually large about a month ago. Prices have since popped. Did you take advantage of the pessimism? Or are you inclined to jump on the bandwagon now?
The macroeconomic risks are unusually large these days, but the biggest threat to investment success remains a familiar monster that dwells inside each of us: emotion that favors running with the crowd for, say, asset allocation decisions. Taming that beast is still the greatest challenge.
January 9, 2009
MORE GRIM NUMBERS FROM THE ECONOMIC FRONTLINES
This is the eye of the economic hurricane. Right now. Today, this minute. The debate necessarily focuses on how long it lasts and what can quickly, efficiently ease the pain and ultimately return the economy to a growth mode. Meantime, we're knee-deep in the grip of recession—recession with a capital R. This is what a severe downturn looks and feels like.
This morning's grim employment report for December provides the latest installment of the ugly details. Indeed, the jobless rate popped up to 7.2% last month from 6.8% and is likely to climb further before all is said and done. Meanwhile, nonfarm payrolls shrunk again by more than 500,000 for the second month running, as our chart below shows.
With the December numbers in, that makes for a perfect record in 2008: Every month last year was a losing proposition for jobs, with the trend getting worse as 2008 unfolded. So far in this cycle, nearly 2.6 million nonfarm jobs have been lost to the recession, which NBER says began in December 2007.
That pegs the current recession at 13 months, or within shouting distance of the 16-month downturns of 1973-75 and 1981-82, the longest NBER-defined contractions since the Great Depression. It's likely that we'll beat the 16-month mark easily this time, short of a miraculous turnaround before April. Don't hold your breath. The breadth and depth of the job loss is in high gear and the process must play out in the coming months. Indeed, the 524,000 jobs that evaporated last month came about equally from the goods-producing and services sectors. In short, the labor ills are infecting every corner of the economy, including the world of services, which is responsible for the lion's share of U.S. unemployment.
At some point, the seeds of an eventual turnaround—or at least stabilization—will presumably show up in the all-important category of consumer spending. Alas, the pain there has only recently begun and so we must pace ourselves in expectation of even middling news on that front. The latest readings for spending in the holiday season just past sends a clear message: Joe Sixpack and his friends are shutting their wallets—tight. “Consumers have clammed up,” Ken Mayland of ClearView Economics explains to Bloomberg News. “The reduction in consumer credit doesn’t stop here, and will spill over into 2009. Households are bolstering their balance sheets.”
Another blunt assessment comes from Retail Metrics' Ken Perkins, who wrote in a note to clients (via CNNMoney): "Consumers are clearly feeling significant levels of pain and curtailing consumption accordingly."
The priority then is 1) stop the bleeding; 2) help the patient get on his feet again. That's not going to be easy for a number of reasons, starting with the fact that consumers now recognize that they've overspent for too long. In the pervious recession, consumer spending barely blinked, despite the carnage ripping through the corporate world, particularly in tech. But that was due to more than a little diversion engineered by the Fed. The central bank under Mr. Greenspan spared no expense in 2000-2002 in wielding the monetary levers to lull Joe Sixpack back to the mall. The mantra of Don't Worry, Just Spend worked then, but it won't now.
Yes, Fed Chairman Ben Bernanke tried to pull a Greenspan out of his monetary hat in an effort to replay past fortunes. But with interest rates mind-numbingly low and consumers unwilling to take the bait, the last, best hope shifts to the fiscal front and the U.S. Congress.
President-elect Obama is now in full swing with speeches laying the groundwork for a massive new government stimulus plan. Undoubtedly something of the sort will arrive soon. But getting from here to there will be messy. The political bickering over new spending ideas has already started, even within Obama's own party, and so there's reason to wonder what exactly will emerge from Congress, and when.
That leaves watching and waiting for signs that maybe, just maybe, the storm will ease. At this point, a mild recession would be a huge improvement over what's currently blowing through the U.S. With all the previous government stimulus efforts coursing through the system, and the promise of more coming, there's reason to hope that later this year there will be signs of a bottom in the recession. Even then, a quick and robust turnaround won't be imminent.
We must walk before we run, but given the current conditions we should be happy with merely crawling.
January 8, 2009
MORE DEBT, LESS FILLING
The selling of the 10-year Treasury Note (and the corresponding rise in yield) since December 31 is still just a blip, but is it a blip of things to come?
The 10-year's yield closed yesterday's session at roughly 2.5%. Yes, that's still historically low, although it's up from the 2.04% low touched last month. Noise, perhaps, although some of the noise of late sends a suspicious mind wandering.
That includes the echoes reverberating from this morning's advisory in the New York Times: "China Losing Taste for Debt From U.S." In the current climate, when the U.S. government is pulling out all the stops to spend money, and sell Treasuries to fund the plan, it's hard to ignore a headline casting doubt on America's single biggest source of lending these days.
“All the key drivers of China’s Treasury purchases are disappearing — there’s a waning appetite for dollars and a waning appetite for Treasuries, and that complicates the outlook for interest rates,” Ben Simpfendorfer, a Hong Kong-based economist at the Royal Bank of Scotland, tells the Times.
Complicates is a somewhat ambiguous reference, although we all know what he means. Rates may be inclined to go higher at some point. Perhaps not yet, perhaps not for a long time. But in the long run, it's hard to see how the boys in Washington can engineer another outcome. True, that and 50 cents will get you a cup of coffee when it comes to searching for profitable trades for next Tuesday. But if you're inclined to gaze a bit further into the future, there's quite a bit of meat on this bone.
Then there's the story's reference to a senior central bank official in China, who reportedly said late last year that the Middle Kingdom's foreign exchange reserves kitty has been doing the unthinkable lately: dwindling. It's no great surprise to learn that the great wall of exports flowing from China is slowing, given the current economic climate in the global economy. But if this is a trend with legs, there's going to be trouble ahead in bond land, perhaps more than the casual observer of the financial scene recognizes.
But, wait—there's more. Much more. Debt, that is. The Congressional Budget Office projects that the federal deficit will reach an unprecedented $1.2 trillion, or 8.3% of GDP, as the chart below shows. In testimony yesterday to Congress, acting CBO director Robert Sunshine delivered a message in direct conflict with the imagery that his surname conjures: "The major slowdown in economic activity and the policy responses to the turmoil in the housing and financial markets have significantly affected the federal budget," he advised. "As a share of the economy, the deficit for this year is anticipated to be the largest recorded since World War II."
Is it any wonder that holders of government debt, here and abroad, might be feeling a bit skittish? As we wrote on Tuesday, the mounting debt load, current and future, on the U.S. government is old news, but it has legs. For the moment, those legs keep getting longer and stronger. Before this is all over, this story may be on running on stilts.
January 7, 2009
TALKING ABOUT ASSET ALLOCATION ON THE INSIDE VIEW PODCAST
The year just passed put many investment strategies to the test, including asset allocation and diversification. Indeed, virtually all the major asset classes suffered in 2008. What, if anything, does that say about asset allocation and the concept of owning multi-asset class portfolios? Did asset allocation stumble? Or did it live up to expectations despite the turmoil?
In today's edition of The Inside View, we posed those questions and more to Richard Ferri, founder and CEO of Portfolio Solutions, a fee-only investment advisor in Troy, Michigan that specializes in designing and managing portfolios for individuals and small institutions using index funds and ETFs—at a charge of just 25 basis points. Rick is a respected authority on asset allocation and index-based investing. He's written several books on these and related subjects, such as All About Asset Allocation and The ETF Book. To hear Rick's take on asset allocation these days, including his reasoning for why it's still the foundation for prudent investing, take a listen…
January 6, 2009
AN OLD STORY…WITH LEGS
It's an old story, but it's getting worse and so ignoring the 800-pound elephant in the room is getting tougher by the month.
Deficits and debt are mounting and changing the trend won't be easy. We can debate if the U.S. will muster the intestinal fortitude necessary to even slow the pace of red ink's ascent, much less reverse it. But in terms of absolute and relative levels of debt on the country's balance sheet, the future looks assured, as a growing chorus of observers warn.
That includes a fresh advisory from the St. Louis Fed. The title says it all: Deficits, Debt and Looming Disaster: Reform of Entitlement Programs May Be the Only Hope. "For the fiscal year 2008, the federal government’s deficit totaled $455 billion, the largest ever for a single year," Michael Pakko, an economist at the bank, writes. "In the final days of the fiscal year, which ended Sept. 30, the total federal debt rose above $10 trillion for the first time."
To put the numbers in perspective, a chart from the article is illuminating, albeit in a grim sort of way. As a percentage of GDP, federal debt is roughly at the depths reached in the 1980s, the last time that such fiscal worries were front and center. Given the incoming Obama administration's plans to spend, spend, spend, it's a safe bet that when all the budgetary dust clears, the debt troubles of 20 years ago will pale by comparison.
Yes, there's a strong case for arguing that what this country needs (again) is a good $800 billion (stimulus) cigar. This writer and many others have warned frequently over the past several months that as troubling as a spending spree is at this point, the alternative—deflation—is worse. Unfortunately, the only way to prevent deflation at this point is to shovel money into the economy, as we've discussed. We'd prefer another choice, but engineering a different scenario required different policies in years past. But having let the fiscal burden grow, we're now between the rock and the hard place with the deflationary winds blowing directly in our collective faces. Simply put, this is no time to balance the budget.
Yes, we as a nation should have been focused on that goal in years past, when the economy was growing and deflation was nowhere in sight. Oh, well. That was then and this is now.
The deficit and debt troubles are old news, of course. Countless observers of the economic scene have long been warning of the challenges that will eventually come home to roost if we don't amend are spendthrift ways. A year ago, yours truly contributed to this genre of essays and penned an article more than a year ago by the name of "The $64 Trillion Question: Is the long-term budget outlook really a ticking time bomb—and does the Federal Government need a financial advisor?" A dark bit of reporting, to be sure, but revealing just the same.
The sad news is that the outlook has continued to worsen since the article was published, and more of the same is on tap for the foreseeable future.
The St. Louis Fed piece sums up the primary challenge in all of this by advising that "the long-term fiscal outlook for the U.S. requires serious attention. The retirement of the Baby Boom generation and a slowing rate of growth in the labor force will create a demographic time bomb in which entitlement growth threatens to swamp available resources."
You don't need an advanced degree in economics to recognize that the promised future liabilities of the U.S. look unsettling. Ultimately there are only so many fixes. One is cutting spending, which means pulling away the government's promises to some degree on, say, Medicare and Social Security. Good luck with that one.
Then there's the old standby of raising revenues with higher taxes. Ideally, that would be funded by a surge in economic growth. Otherwise, the task becomes more politically risky. Nonetheless, raising taxes looks a bit more likely, perhaps even inevitable, relative to the prospects for cutting services. Even so, it'll be a while before anyone's brave enough to talk up that idea, at least among the politicians running the show these days. Indeed, in the current climate, President-elect Obama is now the leading advocate for tax cuts, as Bloomberg News reports.
Another solution, if you can call it that, is to inflate our way out of the problem. As history suggests, that's the usual path, in part because it's subtle and politically easy. No one ever votes for higher inflation; it just sort of happens and—surprise, surprise—everyone's shocked.
As we write, that's just what we're doing. Big time. Spending is the only game in town. But it has consequences. It always does. Indeed, there are any number of implications for investors given the fiscal outlook. Economist David Hale discusses an obvious one in today's FT: "Precious metals could emerge as a hedge for investors suspicious of central banks and fearful that inflation will be the simplest solution to the challenge of global deleveraging."
The flip side of that advice is worrying about Treasuries. In a world where the printing presses are running flat out, and interest rates are at record lows, the future for Treasuries, which posted powerful rallies last year, looks shaky. No wonder, then, that Barron's advises to "Get Out Now," warning that Treasuries are in bubble territory.
Summing up, deflation first, followed by inflation. Details on timing to be determined. Next question.
January 5, 2009
REASSESSING FAIRY TALES
The U.S. stock market is on track to deliver its worst decade of performance on a calendar-basis since the record keeping began on such things, we're told. Shocking as that is, it's not the end of the world, although it does reveal a few things about what's been happening in equities (and the collective mind of investors) over the years.
"Unless there’s a significant rally in 2009, the 2000s will prove to be the worst performing US stock market decade ever, actually losing money for the first time," writes Ron Surz of PPCA Inc. (an investment analytics/software firm) in a research note today. "It will take a whopping 40% return in 2009 to make investors whole for the decade."
The context for this increasingly likely outcome for this decade is driven home in one of Surz's graphics, which we reproduce below:
What stands out in the above graph is the seemingly abnormal behavior in equities for this decade thus far. If you listen carefully, you can almost hear the cries of anguish and anger around the country as investors come to grips with the fact that for the first time the cupboard is bare—and shrinking— for equity returns in this decade.
The losses in U.S. equities generally will bring a fair amount of pain and suffering to investors near and far. Is this a sign of the financial apocalypse? Does it mean that equity investing is no longer compelling? Or is there a larger truth here?
Your editor comes down on the side of the latter. That doesn't make things any easier, of course. Nor do we want to minimize the genuine hardship that such an extraordinary equity loss has and will inflict on investors via their 401(k) accounts, pension funds and other financial holdings. But let's also recognize that what's shaping up to be an unprecedented decade of hammering for the stock market shouldn't come as a total surprise.
Indeed, there is no law in the universe that says that stocks must deliver positive returns during each and every 10-year calendar stretch. Indeed, there's nothing magic about measuring returns in one 10-year period that begins on December 31 and ends exactly 120 months later. To the extent that 10-year records (or other time periods) are worth reviewing in search of broad investment trends, one might also consider looking at rolling time series. But we digress.
As to calendar-based decades, positive performance has been the trend in the past, largely because the U.S. economy has a habit of growing over time, which in turn dispenses various financial treats for corporate America and their shareholders.
On that note, how does the record on GDP growth compare with the rise in corporate profits? For a summary, consider the following:
Clearly, the trend of late in corporate profits has deteriorated to the point of contraction. Although the U.S. economy was still growing as of last year's third quarter, the Q4 GDP update is widely expected to go negative too.
Over the longer term, however, it's also clear that corporate profits and GDP have been rising, and therein are the key drivers of the stock market's gains over the years. In fact, so far in this decade, through last year's third quarter, GDP and corporate profits remain in the black. Last year's fourth quarter and this year will be another matter. But leave that aside for a moment and recognize that the decade through 2008's third quarter looks about par for the course, if not better.
How, then, could the stock market be posting a loss for this decade? One possible explanation starts by looking at the 1-year bar for corporate profits in the graph above. The steep loss in profits is, of course, widely recognized by investors, and its arrival has been expected for some time—thus the falling stock market over the past year or so. Yes, GDP for the year through 2008's Q3 was still holding up, but that too shall tumble once numbers for Q4 and beyond are published.
Still, why should the stock market returns behave any differently in this decade vs. previous decades? Economic recessions and tough times for corporate profits are old hat and yet the stock market's managed to post gains in each decade from the 1940s on. What's changed this time?
The answer, we believe, lies in the extraordinary bull markets (may they rest in peace) of the past 20 years. The party, if you will, got a bit overextended and now we're knee-deep in cleaning up the mess.
If you go back to the first chart above you'll note that the 1980s and 1990s witnessed unusually strong gains in the stock market. Until recently, those gains were extended in the 2000s to similarly sky-high heights. The idea that three unusually robust, back-to-back decades of stock market gains were possible, much less assured, was a fairy tale, of course.
Were there any warning signs that the fairy tale was destined to crumble? Absolutely, although timing was always debatable. But the clues were out there and many observers of the capital markets had been pointing them out for years. Most investors ignored the warnings, and thought that was no risk involved. But the proverbial jig is now up. A clear grasp of the obvious, as a result, is now widely circulated among formerly disengaged investors the world over. Some might even go so far as to call that progress, along with a few other choice names.
If we use the widely cited 10% average return for stocks in the long run, one can well imagine that this decade will have to give back some of the above-average returns earned in the 1980s and 1990s. Painful? Yes, but if you were thinking otherwise you were expecting too much based on the historical record.
The good news is that expected returns for U.S. equities look pretty good, at least by historical standards. No, that's not a prediction that 2009 will be a banner year for equities. But after so much carnage, prospective returns in equities are now encouraging. Why? For the same reason that the outlook for equities in early 2007 looked discouraging: valuation.
January 2, 2009
WHAT A YEAR IT WAS!
Two-thousand-and-eight is gone—and good riddance. But the blowback will be with us for some time, on a number of fronts. And that starts with reviewing the previous 12 months.
As our first table below shows, red ink was spread far and wide in 2008 in almost everything other than cash and bonds. Otherwise, double-digit losses were the rule last year. But if we look at the monthly tally for December, the view looks decidedly better. REITs, in particular, rebounded sharply last month, surging nearly 18% in December.
Most of the other asset classes followed suit, albeit with lesser although still robust gains for the month. The exceptions are cash and commodities. It's too soon to tell if the worst is over or if the rally is merely a fleeting affair in an ongoing bear market. But given the extent and breadth of the carnage, it's tempting to think that maybe, just maybe, positive returns await in asset classes other than cash.
Speaking of cash, a few words about last month's performance of 3-month Treasury bills (our proxy for cash) is in order. Although our table above lists December's performance for cash as zero, the number's in red because the return is slightly negative for 3-month T-bills if you carry the return out to two digits: -0.02%. In the grand scheme of the universe, no one will lose any sleep over this microscopic loss. But the fact that T-bills—the classic "risk-free" asset—posted a loss of any degree is extraordinary, and so it speaks to the times we live in.
Indeed, monthly losses in T-bills are so rare that it doesn't register in our databases, which admittedly only go back to the 1980s for "cash." That's not to say that it never happens, but you'll have to go back quite a ways to find monthly red ink in this corner of finance.
The source of last month's slight loss is no mystery, at least. The explanation starts by noting that the yield on a 3-month T-bill slipped to just about zero at the end of November—an astonishing state of affairs in and of itself. Then, in December, the T-bill yield rose a bit, albeit to a mere 0.11% by December 31 from roughly zero a month earlier. Slight as that is, it was enough to tip the monthly return to negative in the 3-month T-bill for two reasons. One, for much of December, the 3-month T-bill barely gave investors any yield to speak of, and since yield is the only source of return for these securities the pickings were fated to be slim at the end of November even under the best of circumstances. Add the fact that T-bill yields rose slightly set the stage for an ever-so-slight loss (rising yields translate into lower prices in bondland).
The fact that even cash could post a loss is a sign of the times, of course, although investors had bigger problems than worrying about miniature losses in T-bills. Indeed, as our second table below reminds, 2008 was a horrendous year for most asset classes. Horrendous, but not entirely surprising, at least in terms of how 2008 compared with previous years. Yes, the depth of the losses are shocking. But the reversal of fortune was overdue—long overdue in some cases.
Consider emerging market stocks, which lost more than 50% last year. Shocking as the loss is, the volatility is not out of character for the asset class. Indeed, as the chart shows, emerging market stocks had been posting gains of 20% to 50% for each and every calendar year during 2003-2007. That extraordinary five-year stretch of price increases had to end eventually, of course, and for anyone who expected otherwise, well, they were living in a dream. Surely if an asset class can post a 50% gain in one year—as emerging markets did in 2003—something similar is possible if not likely on the downside.
A similar lesson applies to the formerly high-flying world of REITs, which also enjoyed an extraordinary bull market run that finally started coming apart in 2007 and continued in 2008.
Yet not everything was about losses in 2008, a year that witnessed potent gains for some corners of the bond world, which once again makes the case for owning a globally diversified portfolio. Foreign government bonds denominated in foreign currencies, for example, was an exceptionally bright light last year and so if you didn't own the asset class (via BWX, for instance), your portfolio probably paid a price.
The point is that cycles endure, even if the details aren't always 100% clear. What goes up in price eventually comes down. Meanwhile, lower prices precede higher prices. Although one must be extremely cautious about applying that view to individual securities, it generally works well over time when it comes to asset classes, which have a habit of surviving, which is more than one can say for some individual companies or certain bonds.
Timing, of course, is always debatable, even with broad asset classes, which is an argument for maintaining some mix of the world's capital and commodity markets through thick and thin. The question, as always, is how to structure the mix and manage the betas through time?
As it happens, that's the focus of a new monthly newsletter (The Beta Investment Report) that your editor will launch later this month (details to follow on CapitalSpectator.com). For the moment, though, we're simply gazing backward, in search of some basic perspective. Knowing where you've been and what history looks like is the foundation for looking into the future and assessing risk as well as opportunity. As always, a surplus of both awaits. The critical challenge is fleshing out the details, which is the mandate of our soon-to-be-launched newsletter.