February 27, 2009
THE GREAT UNWINDING
No one expected good news, and the expectations were met.
Today's update on 2008's fourth-quarter GDP was ugly, the ugliest in 25 years, in fact. The economy contracted by 6.2% at a real, annualized seasonally adjusted pace in the last three months of 2008. That's much deeper than the 3.8% decline originally estimated by the government.
Painful, but no one should be shocked, given the general economic and financial climate. But let's be clear: the embedded message in today's revised numbers from the Bureau of Economic Analysis is sobering. The principal reason it's sobering is that the main driver of economic activity has stumbled and the prospect for a quick turnaround is about as likely as waking up on the surface of Neptune tomorrow.
It's not an exaggeration to say that consumer spending has hit a wall and crumbled as a result. Perhaps the only surprise is that it took so long for a retrenchment in consumer spending habits. But fate can only be delayed so long. The willingness, bordering on obsession for borrowing in 2002-2007 has finally come back to haunt Joe Sixpack, and by extension the wider economy, which is heavily dependent on personal consumption expenditures. The implosion of the financial industry has, of course, exacerbated the trend, as has the collapse of the real estate bubble. In short, a perfect storm, the effects of which are only now being fully realized.
America has long been a nation of consumers, and there's much to cheer about on that front. Consumption generates economic growth and spending has been no small part over the generations in powering the American dream of building wealth and prosperity. But there's a limit to everything, and at some point even a good thing becomes excessive. At some point in the recent past that limit was breached.
Excess certainly looks like an appropriate label for consumer borrowing in 2002-2007, when the household balance sheet became laden with debt to an extent that was as shocking as it was fated for a day of reckoning. The details are there for anyone willing to take the time and pore over the Federal Reserve's Flow of Funds Report.
The reaction to the mountain of debt is now underway. As our chart below shows, consumers are finally facing facts and cutting spending. If a purchase can be delayed, it will be; if spending can be minimized, it is. No wonder, then, that durable goods spending—the so-called realm of "big ticket" items like washing machines and refrigerators—is falling rapidly. If you don't need it, you don't buy it—the new mantra of for a new generation of consumers who've been dragged kicking and screaming to this revelation of unvarnished necessity. Only services spending has been spared, which is largely a function of essential services like medical purchases in this category.
The bottom line: consumers are aggressively repairing their balance sheets after a long stretch of doing the exact opposite. The front line in the restoration is cutting spending, anywhere and everywhere. This process has only just begun. Given the magnitude of the former excess levels of spending and debt creation, the mending of household balance sheets will run on for some time, probably for far longer than is widely expected. The repercussions will be far and wide. It's not the end of the world, but it is the start of a new era that will reorder the consumer mindset.
Exactly how long this pullback rolls on is the question. For now, it's clear that the unwinding is upon us, and the worst of it is going to roll on for several quarters, perhaps several years. It's a process that's long overdue, fundamentally necessary and destined to be painful. Coming to terms with reality is never easy, but it is refreshing and healthy…eventually.
The Beta Investment Report
A new monthly newsletter from The Capital Spectator featuring strategic market analysis
for investors using ETFs and index mutual funds in a dynamic asset allocation framework.
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February 26, 2009
DESPERATELY SEEKING EQUILIBRIUM
The first priority for repairing the economy, or at least for stopping the bleeding is returning prices to something approximating equilibrium. There's still more work to do, as suggested in the inflation forecast embedded in the spread between the nominal and inflation-indexed 10-year Treasuries.
As our chart below reminds, the market is far from convinced that the deflationary risk has passed. It's open to the idea…maybe. But not convincingly, at least not yet.
As of last night's close, the Treasury market is forecasting inflation of just under 1% for the decade ahead. That's higher than the near-zero inflation expected at last year's close and into early January, and so by that meager standard the outlook has improved. But relative to a normal state of affairs, the trend of late suggests there are worries anew that pricing pressure is set for another burst of deflationary wind.
The rise in the spread from 2008's close through early February suggested that pricing equilibrium was on the mend. A "normal" state of affairs is one of inflation, albeit ideally one measured in the 1%-to-2% range. Economic growth requires a bit of inflation and so without it there's trouble afoot. As we've discussed, there's been reason for thinking that maybe, just maybe, general pricing trends might soon stabilize. Even if that's true, there's no reason to think that the economy won't suffer through bouts of additional deflationary windstorms. In fact, we're expecting no less.
The potential for another setback on that front is reflected in the falling spread in the chart above. More direct signals of the risk come in today's updates on new orders for durable goods and new home sales. The news on both counts for January is by now a familiar refrain: decline.
Fed Chairman Ben Bernanke said earlier this week that recession could possibly end this as this year comes to a close. "If actions taken by the administration, the Congress and the Federal Reserve are successful in restoring some measure of financial stability—and only if that is the case, in my view—there is a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery," he told Congress.
Perhaps, although events between now and then will test everyone's confidence that the sun will again shine on the economy. The manic depressive nature of business cycles—particularly ones as extraordinary as this one—will be on display, and then some. The key challenge remains one of stabilizing the correction so that the deflationary revaluation in prices generally doesn't spin out of control. There have been signs that the seeds of stability planted by the Fed and increasingly the Congress are taking root. In short, the past six months could have been a lot worse. But the storm is still raging and the danger that the sprouts may yet be washed out to sea hasn’t vanished.
Prices eventually find equilibrium. That's both the good news and the bad. Finding equilibrium, after all, is another way of saying that current prices must fall. At what point will prices fall enough to spur demand? The government can't change this relationship in the long run, nor should it try. Prices worth the name must reflect supply and demand in order to convey useful economic information that in the long run is essential to promote and nurture growth. But for shorter periods, there's a case for government intervention. Even so, the burning question: Where does equilibrium lie? No one's really sure yet.
The capital and commodity markets are struggling to gain some confidence on when, or if the deflation risk has passed. The encouraging signs so far this year offer reason to think that the worst is behind us. But that's still probably a case of premature optimism. The deflation that currently threatens is, like most deflations, powered by an excess of debt, which the U.S. is awash in.
The unprecedented explosion in debt on consumer balance sheets over the past generation is now being addressed, and the most conspicuous evidence is the dramatic paring of debt. The sharp drop in debt outstanding among households as well as nonfinancial businesses late last year (as reported by the Federal Reserve's Flow of Funds Report) is as striking as it is necessary. Trees don’t grow to the sky, nor does debt. The repairing of household balance sheets was inevitable.
The only question now is whether the government can manage the healing process in a way that doesn't make the medicine worse than the disease. Your editor enjoys a modest bit of confidence that this necessary yet difficult goal is possible. But we're not prepared to say much more than that until and if prices generally find equilibrium. Unfortunately, we're still in the correcting phase, as today's reports for durable goods and new home prices suggest.
Yes, it's almost March, but there's still a long road ahead for 2009.
The Beta Investment Report
A new monthly newsletter from The Capital Spectator featuring strategic market analysis
for investors using ETFs and index mutual funds in a dynamic asset allocation framework.
For subscription information and to download a free copy of the first issue, visit BetaInvestment.com today!
February 25, 2009
THE CAPITAL SPECTATOR ON THE ROAD
Next month, your editor will visit the City of Brotherly Love to discuss a few topics that will be familiar to readers of these digital pages: asset allocation and rebalancing.
On March 19, at 11 a.m., I'll be speaking in Philadelphia on strategic portfolio issues large and small at the local NAPFA study group. The meeting will be hosted by the gracious folks at Wescott Financial Advisory Group, 30 South 17th Street, Philadelphia.
For more information about the meeting, including the cost for attending, please contact the study group leader: Chip Addis of Addis & Hill Financial Advisors. He can be reached at:
Among the subjects on the agenda:
* Comparing passive and active asset allocation strategies
* Reviewing the lessons for asset allocation after the bear market of 2008
* Analyzing rebalancing strategies as they relate to managing asset allocation
* Contrasting tactical asset allocation with rebalancing
* Using ETFs and index mutual funds for implementing asset allocation strategies
* The importance of seeing investing as a risk-management strategy rather than a return-chasing exercise
As an added incentive to join the fun, all attendees will receive a complimentary copy of the March issue of The Beta Investment Report. Hope to see some of you there!
February 24, 2009
WHY RISK (ALLOCATION) MATTERS
Bear markets are painful, but they're also educational. It's debatable if the crowd ever learns anything in the money game, but the lessons are there just the same.
One of the lessons from the recent and current correction is that portfolios that appeared diversified were in fact far more concentrated than casual observation implied. There are many ways to measure, analyze, design and manage portfolios so as to maximize diversification's benefits across asset classes. For the moment, we'll briefly consider one in particular—so-called risk budgeting or risk allocation. The March issue of The Beta Investment Report will go into more detail on risk allocation, but here's a brief overview of why the subject is relevant for strategic-minded investors.
In essence, the core insight of risk allocation is that there's more than one way to define multi-asset class diversification. The most popular, alas, may be the most vulnerable to erroneous signals. Vulnerable or not, looking at portfolio allocations based on the capital mix is widely used. For example, a $100,000 portfolio with 60% of the dollars in stocks and 40% in bonds reflects a 60/40 asset allocation in capital terms. But capital allocation is only one measure of asset allocation. What's more, it's often a misleading measure if taken at face value without the benefit of broader analytical context.
Think about what a 60/40 capital allocation implies: Only slightly more than half of the portfolio is exposed to equity risk while nearly 50% of the risk is tied to fixed-income beta. By that standard, the portfolio appears to be reasonably diversified across the two asset classes. That's reassuring, based on the reasoning that bonds tend to post low return correlations with stocks.
But if we leave the analysis there, we're asking for trouble. As it turns out, the stock market beta risk (defined as the volatility of return) is far higher than a capital allocation analysis alone suggests.
As a quick illustration, let's take a closer look at the numbers using the S&P 500 for stocks and the Lehman Brothers U.S. Aggregate for bonds, based on the trailing 10-year annualized standard deviations and correlations through the end of last month. (Data is courtesy of Morningstar Principia.) A 60% stock/40% bond mix of those two benchmarks delivers a portfolio with a 9.2 annualized volatility over the past decade. The first observation is that a 9.2 vol is considerably lower than the S&P 500's 15.3 standard deviation. Adding bonds clearly lowers the portfolio's overall volatility. The problem is that the remaining portfolio volatility is almost entirely dependent on equity beta, i.e., the risk allocation is heavily skewed toward stocks. Using some basic matrix algebra we can determine that 98% of the volatility risk in the 60/40 portfolio comes from equities and a mere 2% of the vol is driven by bonds.
The lesson is that looking only at capital allocations isn't enough when designing asset allocation strategies. Neither is the risk allocation methodology we described above, for that matter. To be sure, there are no easy solutions to building diversified portfolios. But this much is clear: allowing capital allocation analysis to dictate your decisions is an accident waiting to happen. Unfortunately, many investors do just that, in part because capital allocation analysis is easy and intuitive. It's also dangerous at times, as quite a few investors learned last year, when seemingly diversified portfolios took a beating.
What's a strategic-minded investor to do? The very, very brief answer is to think broadly about return opportunities and risk analysis. In short, pursue an enlightened asset allocation strategy. Those subjects, and more, keep us burning the midnight oil at The Beta Investment Report.
At the very least, no one can argue that looking at capital allocations alone will suffice for risk analysis. The crowd thinks otherwise, of course. But then again, the crowd suffered last year.
We're all risk managers now, as we've discussed many times, including here. The only question: How best to manage risk? We can start by recognizing that simple rules of thumb—e.g., a 60/40 portfolio diversifies away a big part of the risk—no longer suffice. In fact, such rules were always deficient. The fact that so many investors thought otherwise until recently is only more evidence that genius is too easily equated with a bull market. The illusion never lasts, of course, although that never stops the crowd from making the same mistakes.
February 23, 2009
TALKING ABOUT TARGET DATE FUNDS ON THE INSIDE VIEW PODCAST
Target date funds have become popular in recent years because they offer one-stop shopping for managing the asset allocation challenge. If you're retiring in, say, 2030, you can buy a target date fund to oversee your asset allocation with your retirement date in mind.
But as today's episode of The Inside View reminds, not all target date funds are created equal and so there's design risk to consider when choosing among these products. The critical variable in target date funds is the underlying index that governs the fund's strategy. As such, the design and management of the benchmark determines much of the success, or failure, for any given target date fund.
Today's guest, veteran investment consultant Ron Surz, knows a thing or two about how to build and analyze investment indices. His firm PPCA Inc. designs and sells a sophisticated suite of software tools for analyzing portfolios and investment indices. Ron is also president of Target Date Analytics, a consulting and research firm that designs target date fund indices, which are used by the SMART Funds Target Date Series.
As Ron explains in today's episode of The Inside View, index design is fate for target date funds. Unfortunately, not every target date fund is looking at a rosy future. One problem, he says, is a lack of a sound methodology for some target date benchmarks…
Please visit CapitalSpectator.podbean.com for additional options with episodes of The Inside View.
February 20, 2009
A WHIFF OF REFLATION, PART II
The January reprieve is now official. Deciding if it's also enduring is the question. For now, beggars can't be choosy. Inflation at this juncture, however spare, is good news.
Wholesale and consumer prices rose last month, as we expected they would. The deflation war isn't over, but there's reason to think that it can be won. Even so, winning will take time and setbacks are likely.
For now, let's recognize that consumer prices rose last month, just as they did for wholesale prices. The reason, as we explained yesterday for the pop in producer prices, was the rebound in energy.
CPI advanced 0.3% in January, the Bureau of Labor Statistics reported. That's the first monthly rise in headline inflation since July. Energy was no small source of the increase. The energy component of CPI jumped 1.7%, after falling for five months running.
We've been opining in recent months that energy prices wouldn't keep falling forever. That's obvious, of course, although it's a point worthy of fresh attention in the middle of a deflationary storm. To the extent that demand and supply for oil, gasoline and other fuels are approaching equilibrium suggests that one of deflation's key allies will soon stop dragging prices down generally. Calling bottoms is difficult, of course, if not impossible, so we must be cautious about forecasting when the energy-based deflation momentum will end. That said, given the dramatic declines since last summer, it's not unreasonable to predict that energy prices overall are likely to find their cyclical lows over the next 6-12 months, perhaps sooner.
Meanwhile, so-called core inflation (CPI less food and energy prices) is showing hints that maybe, just maybe, stabilization is near, as our chart below suggests. That's encouraging because it suggests that the general price decline may be bottoming out sans any assistance from the energy market. Among the areas that posted price increases last month: apparel, medical care, and food and beverages. In addition, housing prices were flat last month, according to CPI data, which represents progress in this climate.
Prices moving sideways generally would be welcome these days, but even that thin reed of good news remains vulnerable to the forces of selling and retrenchment. Much depends on how consumers will react in the coming months, and that in turn depends on the labor market. Unfortunately, it's still too early to call a top in the job less momentum. Yesterday's weekly update on new filings for unemployment was unchanged for the week through February 14. But the level of jobless claims remains far too high at this point to extend any comfort. That said, history suggests that new filings may be near their highest levels. Of course, that's based on the last few business cycles, which pale with the depth of the current ills. In short, it's still unclear if the recession monster's momentum is rising or falling.
In any case, the consumer is still unapologetically defensive and it's any one's guess how long that will last. By one estimate, the immediate future doesn't look promising on that front. Consumer sentiment on future spending plans in the next three months continues to deteriorate, according to the ChangeWave survey of 2,701 U.S. consumers was conducted February 2-9, 2009 (see chart below).
Certainly there are tough times ahead, and probably a few more big surprises. But let's be generous and assume that prices generally stop falling in the month's ahead. That's helpful, and essential. But the trend also takes away another leg for stimulating consumer purchases. Given the new-found penchant for saving and delaying consumption, one could argue that winning the deflation war will have some near-term blowback effects on growth.
There's no way around that scenario, nor is there any way to soft pedal the risk. That doesn't change the fact that nipping deflation in the bud is still priority one, regardless of the cost. Once that's confirmed, the long, hard slog of firing up economic growth can begin in earnest. Alas, that's going to be a much longer and tougher job than beating back deflation. But first things first.
February 19, 2009
A WHIFF OF REFLATION
Producer prices rose last month. That's good news in the war on deflation.
The news wasn't totally unexpected, as we discussed on Tuesday. The partial rebound in energy last month—heating oil and gasoline—is a key reason for the return of inflation to wholesale prices in January. The same forces suggest that tomorrow's update on consumer prices will also post a mild gain for last month.
Producer prices rose 0.8% in January on a seasonally adjusted basis, the Labor Department reported this morning. That's the biggest gain since July—in fact, it's the only gain since July. From August to December, wholesale prices fell in each and every month. That makes today's news of higher prices welcome since it suggests that price stability may be near. It's too soon to be sure, but for today, at least, there's fresh reason for hope.
The source of the last month's rise was the 3.7% pop in the energy component of the producer price index (PPI). It's not clear that energy prices won't resume their decline. Crude oil, as we write, is trading at around $35 a barrel in New York, well below its January average of roughly $40. Heating oil, natural gas and gasoline are also losing ground so far this month.
To the extent that the January's rebound in prices depends on energy, there's probably further deflationary worries ahead. In fact, you can just about count on it. Heating oil and natural gas prices no longer have seasonal support of winter and so as the warmer weather approaches, lower prices are likely. Meanwhile, the economic weakness that's still pulsing through the American economy is likely to bring another leg down in the demand for crude oil and gasoline.
Nonetheless, the heavy losses in energy are likely behind us. That doesn't mean that prices won't go lower. But expecting another 50% in crude oil, for instance, requires an exceptionally bearish outlook that looks excessive from your editor's vantage at the moment.
Maybe, just maybe, there's a bottom lurking in energy prices in the near future. That's the view of the energy team at Bernstein Research in London. In a research note sent to clients today, Bernstein opines with contrarian flair: "The outlook for the energy space now seeming as grim as it can be in 2009 and increasingly in 2010, we believe there is limited downside to the beta energy names and therefore it is the right time to make a relative valuation call for the North American energy stocks." Bernstein recommends that investment portfolios should be "increasingly overweight energy as the year progresses…"
We're not particularly fond of dramatic changes to portfolios based on industry trends and so we remain agnostic on such recommendations. Rather, we're intrigued by the fact that some energy strategists are starting to think that the great decline in energy prices, if not over, may be close to ending.
Although Bernstein's not predicting a new bull market in oil, the shop observes that spare production capacity is still "relatively tight." Meanwhile, Bernstein estimates that oil and gas are close to their "cash cost." The firm advises that "over time [oil and gas] prices cycle around the marginal cost of supply dependent on near term supply/demand dynamics." If we're at or near cash cost, that implies that a bottom is, if not imminent, close, as suggested by the chart below, which comes via today's Bernstein report.
Even if energy prices begin treading water, that would go a long way in helping keep deflation at bay. Meanwhile, the aggressively loose monetary policy is only starting to seep into the economy. As the year goes on, the substantial reflation efforts engineered by the Fed should start to show results. The big question is whether the broad economic environment continues to deteriorate and overwhelm the reflationary trend.
Yes, 2009 is the great year of transition, with negative and positive forces battling one another in an epic struggle to claim the future. Today's price report is but a small skirmish in a larger war. Then again, victory in war comes one battle at a time. Score one for the anti-deflation army. Just don't celebrate for too long. There's still plenty of fighting ahead.
February 18, 2009
WONDERING, WAITING, WORRYING
Market watching in the 21st century features real-time analysis to a degree that was the stuff of dreams even 10 years ago. The problem is that economic crises aren't likely to be resolved any faster today than they were 50 or 100 years ago.
Any one sitting in their bedroom can get institutional-quality quotes on securities these days. Meanwhile, an array of software-based financial analytical models with extraordinary power and depth can be deployed at affordable prices. But while we're all working on 21st century terms, the economic mess we're in is still likely to unwind at a 20th century pace. It's worth noting too that the factors that got us into this pickle were also familiar staples in the economic crises of yore.
Yes, economists have learned a lot over the years. But even assuming that the dismal scientists running the show today are smarter, some if not all of the 21st century intelligence is offset by the magnitude of the downturn currently running wild.
As a result, patience, fortitude and a long-term outlook remain the bedrock for investment success going forward. Some things never change. Most of us will lose our heads and run for cover and reduce all risk exposures to zero. Par for the course. That leaves prospective returns all the higher for disciplined investors. That doesn't make dealing with the catastrophe du jour any easier, but then no one ever said managing risk was easy over a full business cycle.
The trouble this time around is that the cycle is meaner and nastier than usual. Unfair? Perhaps, although today's problems come after an unusual and unsustainable run of kinder, gentler cycles. Some investors are shocked, shocked at the dire turn of events. But the warning signs were there are along. The remarkable period of calm and stability on the economic front couldn't go on forever, as we opined in April 2008. The month before, we warned that recession of some sort looked inevitable. The crowd hoped for better, but irrational optimism was again dealt the hand of fate.
So, what should we expect now? The past offers a few crumbs of perspective for how to think about the current ills. Let's start by remembering that the average length of recession since 1945 has been 10 months. The previous two recessions (1990-91 and 2001) were exceptionally short and shallow, lasting a mere 8 months each. The current contraction is now in its 14th month, according to NBER, and the hope that it'll be over in the coming months is probably asking for too much.
The longest recession in NBER's database is a crushing 65 months (1873-1879). In second place is the 1929-33 downturn that clocked in at 43 months. We don't expect the current ills will last that long, although we're likely to surpass the 16-month recessions of 1973-74 and 1981-82.
For what it's worth, we expect something on the order of a 24-month contraction, which would bring the contraction to an end at the end of this year. In turn, that would comfortably make this downturn the longest—and probably the deepest—since the Great Depression. Today's news of another round of declines in housing starts and industrial production for last month doesn't offer any reason to change our view.
What does this mean for the stock market? More of the same, of course. But again, historical context offers a bit of perspective. The average bear market for the S&P 500 lasted a bit more than a year. At the moment, the bear market is 16 months of age, based on the S&P's peak in October 2007.
Will this one run much past average? Maybe, although we're expecting the rout to be over by the end of the year, if not earlier. Getting from here to there, though, will deliver one hell of a bumpy ride.
In any case, we're confident that the market will bottom out ahead of the economy, assuming history's any guide. But no one should expect a quick and robust rebound, in either the stock market or the economy. Yes, this is one more cycle in a long list of downturns. But this one will last longer and cut deeper than most.
It's going to be a long year. Pace yourself.
February 17, 2009
Deflation still haunts the American landscape and until the threat subsides there will be no rest for anxious investors. But maybe, just maybe, the anxiety level will drop a notch or two with this Friday's update on consumer prices.
As we've discussed in recent months, including here, the perils of falling prices is upon us. In December, the CPI posted its first annual decline since 1955. Nipping the deflationary problem in the bud is second to none as a national economic priority and the Federal Reserve, Congress and the White House are on the job of trying to stabilize if not lift prices. Helping the cause is the mixed pricing trend in energy last month.
Energy prices fell sharply in late 2008, which helped bring CPI down. The energy portion of CPI lost ground for five months running through December, the Bureau of Labor Statistics reports. But as our chart below shows, energy prices in January started showing signs of stabilizing. Although spot prices for crude oil and natural gas continued to lose ground last month, gasoline and heating oil prices rose.
In the upside down world we live in at the moment, higher prices for energy and other goods are reasons for hope because they suggest that deflationary forces may be ebbing. It's still premature to declare victory in the war on deflation, of course. No doubt that the months ahead will provide plenty of mixed messages as the economy continues to struggle. But there's reason to think that this Friday's CPI report will offer a small sign that the risk of freefalling prices is slowing, if not passed.
Even if that's true, that by itself won't cure the problems that afflict the economy. But it's a start. Recovery is always preceded by stability, and one component of stability this time around requires an end to deflation. Will the next CPI update offer some good news on that front? Stay tuned.
February 13, 2009
WHAT DO CENTRAL BANKERS THINK?
Central bankers aren't gods, even if a few of them sometimes think otherwise. For proof of their mortal status one need only survey the various errors linked to this group in the 21st century. Yes, many central bankers made good, even superb decisions. But there were also some rather large lapses in judgment in matters of monetary policy and related matters in recent years. Arguably the ill-advised decisions overwhelmed the brilliant ones. A number of central bankers tell us so.
Of course, the private sector made more than a few errors too. In sum, the blame for the current troubles stretches far and wide. But when it comes to concentrated power, and the capacity for generating pain or pleasure, central bankers are second to none. They're an influential lot—influential on a grand scale. For that reason alone, listening to what they say is productive, or shocking—especially when they're deconstructing what went wrong in the run-up to the crisis now pummeling the global economy.
With that in mind, here are a few choice quotes (courtesy of The Bank for International Settlements) from recent speeches by members of world's most elite and potent financial club. We don't necessarily agree with all that follows, although much of what follows certainly rings true. In any case, we're listening closely.
Mario Draghi, governor, Bank of Italy, 16 December 2008
One striking aspect of the crisis is precisely how its unfolding has continued to catch both policy makers and private sector players by surprise. It started with defaults in a marginal segment of the financial services industry, then quickly spread to virtually all assets. From being a US-only event, it has become global, and in fact it is forcing and accelerating the redressing of world macro imbalances that have been with us for 15 years. The current recession is the result.
Amando M Tetangco, Jr., governor, Central Bank of the Philippines, 2 February 2009
The roots of the US financial crisis can be traced back to the early years of this decade when the United States aggressively eased its monetary policy to facilitate recovery from the dotcom bubble and the September 11 terrorist attacks. If you will recall, the US Federal Reserve began a cycle of cuts in the Fed funds target rate from 6.5 percent in May 2000 to as low as one percent by June 2003. On the fiscal front, large public deficit spending beginning in 2001 was pursued to prop up the economy which was then on the brink of recession. The low interest rate regime fueled a boom in mortgages, including among borrowers with doubtful credit histories or those fancifully called NINJA loans – that is, loans to No Income, No Job or Assets loans. Thus, house prices in the US began rising in 2000, surpassing the growth of disposable income. The excessive lending itself would not have brought in such great financial distress because if the borrowers turned out to be poor borrowers, then foreclosures would just have followed. However, what made this risky behavior turn into a crisis event was the bundling of mortgages by various financial institutions into complex securities such as collateralized debt obligations (CDOs) which were largely unregulated.
Hervé Hannoun, acting general, manager, Bank for International Settlements, 7 February 2009
The global financial crisis and its macroeconomic fallout have dramatically changed the agenda of the central banks, fiscal authorities and supervisors and regulators. The change is illustrated by a remark surfacing repeatedly in the current economic debate: “We are all Keynesians now.” In some sense, indeed we are. But history teaches us that, in designing economic policies, policymakers always need to look beyond the short time horizon that crises seem to impose on us. In my view, current expansionary policy responses risk a failure to capture two crucial and interrelated facets of the present crisis. The first is that it is part of an underlying adjustment towards more sustainable macroeconomic conditions. The second is that it is a crisis of confidence which requires a recognition of the rational expectations of economic agents and of the behavioral effects associated with expansionary fiscal policies. To restore confidence in a sustainable way, policy actions should be credible from a medium-term perspective, address existing economic imbalances and pay attention to economic agents’ expectations.
José Manuel González-Páramo, member, executive board,
European Central Bank, 6 February 2009
The start of the financial crisis was triggered in the summer of 2007 by the realisation that the risks associated with the US market for sub-prime mortgages were not properly reflected in the price of related instruments, particularly mortgage-backed securities. A market-wide reassessment of financial risk led to sharp increases in premia and spreads across all segments of the credit market. The rapidly falling market values of credit instruments hit both the net worth and the profitability of the banking system.
Philipp Hildebrand, vice-chairman, governing board, Swiss National Bank, 5 February 2009
Financial markets react to incentives, and these incentives were misplaced in the past. It is in our power to start lobbying for clearly defined and risk-limiting conditions. If the responsible authorities wish to enact more stringent regulation, we ought to give them our unconditional support.
Christian Noyer, governor, Bank of France, 11 December 2008
In many respects, the current crisis is about valuation. To be sure, the factors underlying and accounting for the crisis are numerous. However, one of its significant features is that the uncertainty surrounding the “true” value of complex financial instruments has undermined the confidence of global markets, increased uncertainty about counterparty risk and led to contagion across asset classes, financial markets and economic regions. The crisis has highlighted the fact that the valuation of financial instruments is not only a question of accounting. It raises issues about risk measurement and management by financial institutions, prudential issues via the definition of capital requirements and, more widely, financial stability issues. However, valuation is also without any doubt an accounting issue. It is therefore hardly surprising that the debate about the application of accounting standards to financial instruments is a highly topical one.
Jürgen Stark, member, executive board, European Central Bank, 10 December 2008
For too many years financial market participants were used to a macroeconomic environment with high global output growth, low inflation and very low interest rates. Macroeconomic policies led to global and domestic imbalances which became increasingly unsustainable with debt financed over-consumption in one region and high savings in other regions. An overall benign macroeconomic environment led to (i) a general carelessness or a tendency to under-price risks and (ii) to a search for yield which in turn accelerated financial innovation.
Lorenzo Bini Smaghi, member, executive board, European Central Bank, 9 December 2008
When analysing the current financial crisis the temptation might arise to attribute all the responsibilities to the excesses of the US financial system. I think this would be a mistake. While excessive debt creation and risk mispricing are clearly the root cause of the crisis, we should not forget that in order to make a market you need buyers and sellers. And this crisis is as much a crisis of sellers as of buyers.
February 12, 2009
TALKING ABOUT STOCK-MARKET FORECASTING ON THE INSIDE VIEW
In the new episode of The Inside View, your editor begins a series of discussions on the various techniques and methodologies for portfolio management. Today's show focuses on the Gordon equation, one of the building blocks for estimating prospective equity market returns.
The Gordon equation is one of several applications used for building the model portfolios in The Beta Investment Report. But like any forecasting tool, investors need to be cautious and understand how the Gordon equation is designed. Certainly the Gordon equation isn't flawless when it comes to divining the future, particularly in the short run. But used prudently, in context with other forecasting tools, it provides a good start for thinking about the investment outlook and designing an asset allocation plan.
What's the Gordon equation is telling us these days? Tune in for the answer…
Please visit CapitalSpectator.podbean.com for additional options with episodes of The Inside View.
February 11, 2009
GEITHNER'S "STRESS TEST"
It's big, it's bold, but it's also vague. And that's the problem.
Treasury Secretary Timothy Geithner yesterday explained the new new plan to solve the financial crisis that ails America. Alas, as articulated yesterday, the plan is short on solution details and long on general notions of what needs to be done.
The challenge is figuring out how the latest effort will work and, more importantly, deciding if it'll fare any better than its misguided predecessors. At the moment, that's a challenge with no immediate answer. As the David Byrne and Brian Eno audio montage intones, "America is waiting for a message of some sort or another."
Certainly the size of the announced plan is a bold stroke. How could $2 trillion be otherwise? We know that some of the money will go to buying up the so-called toxic securities that weigh heavily on the health of banks, and that's a step in the right direction, as the experience with the Resolution Trust Corp. suggests. Taking some of illiquid assets off banks' balance sheets should, in theory, help increase lending, which remains tight even at low interest rates. But the details matter, and it's not yet clear what the fine print will say.
“We need more details from Treasury on how exactly it plans to remove bad assets while protecting the taxpayer,” Senator John Kerry, a Democrat and a senior member of the Senate Finance Committee complains via The New York Times. “We have zombie banks that are weighed down because their liabilities exceed their assets. Without a precise mechanism for addressing toxic assets, it will be difficult to increase lending.”
Similar opining can be heard from economists, including a former IMF economist who now teaches at Harvard. “Tim Geithner did a great job in painting the broad strokes of the problem and laying out general principles, but it was a big disappointment not to have more details,” Ken Rogoff tells Bloomberg News.
Yes, Geithner promised to "flesh out the details" soon, presumably within the next few weeks, maybe in the next few days. Unfortunately, in the current climate, the only thing the secretary managed to do was to stoke more anxiety by introducing yet another strain of uncertainty into the marketplace. The last thing we need now is more indecision and ambiguity.
Sure, the government needs to act, but it needs to act intelligently. If yesterday's Geithner show is an indication, the latest round of talking points isn't quite ready for prime time. We feared as much when we learned over the weekend that the Treasury Secretary's scheduled speech to the Congress would be delayed 24 hours. As it turns out, Geithner should have delayed it a few more days, perhaps by a week or even more. As we learned yesterday, in the wake of a sharp selloff in the stock market, it's better these days to say nothing than to make broad comments that leave much to the imagination.
Meanwhile, the administration has been at fault by lifting expectations over the past week that it was going to announce a solution. The President has been talking up Geithner's big debut in Congress. But the optimist talking points, as much as they're welcome, were premature. No wonder, then, that the markets suffered an attitude adjustment as the reality set in that the big solution was really just another bout of talking without backing up the chatting with a concrete plan of action.
The good news is that the Geithner has only lost the first battle rather than the war. But time's running out, and so is patience. Certainly he'll have another chance to repair some if not all of the damage. But neither the Obama administration nor the economy can afford another halfway effort at explaining what happens next. The stakes now are higher than they were on Monday for bringing clarity and intelligence to the fore. Another stumble may result in even bigger financial pain, and not just in the price of equities.
"The uncertainty the government has created has made it nearly impossible to price many securities," says Douglas Dachille, chief executive of First Principles Capital Management, tells The Wall Street Journal.
At this point, no one's sure how the money will be deployed or what the rules are that will govern its usage. That's a problem. Yes, the White House is talking to Congress about just those details and a clearer plan will undoubtedly be hammered out, perhaps within a few days. Meanwhile, this is water torture, and the Obama administration probably recognizes the misstep in speaking out before a sufficient level of specifics was available for public consumption. Meanwhile, we're told that the plan was intentionally vague. Really? The White House reportedly says it wanted to be warm and fuzzy on the plan so as to give everyone an opportunity to put their two cents into the $2 trillion idea. So much for good intentions.
"First, we're going to require banking institutions to go through a carefully designed comprehensive stress test," Geithner advised yesterday. Apparently he's not kidding. But stressing out the financial industry with half-formed commentary isn't helping.
So far, however, the damage is still minimal, at least in terms of the term spread in government bonds, which is one measure of the credit crunch that's taking a toll. Nonetheless, the spread in the 10-year Note and 3-month T-bill is still over 250 basis points while the 10-year/2-year spread is just a hair under 200 basis points. By comparison, a year ago the 10-year/3-month spread was 130 basis points and the 10-year/2-year spread was 169 basis points. At the extreme low levels of interest rates generally in 2009, a wider spread would reflect running for cover into the arms of short-term government paper. That's a sign of distress in this climate if the spread is primarily a function of near-zero rates on the short end, which basically describes the current situation.
One test of the Obama administration's success on its bailout plan in the coming weeks and months will be to convince investors to move assets out of T-bills and into risky assets. An indication of that will be higher yields in T-bills, which are just hovering above zero. So far, no one's budging.
February 9, 2009
THE BOND GHOULS STRIKE BACK
For a brief, shining moment, there was convergence. Now there's confusion.
The bond market isn't taking any chances. Yes, deflation's a risk, but judging by the sentiment among traders in government IOUs, expectations appear to moving ever so toward the bias that the Fed will be successful in its question to elevate inflation from the grave.
The jury's still out on that score, at least in terms of timing. And that may make all the difference if you're a trader. In any case, the 10-year Treasury Note closed above 3% on Friday, an act of defiance to conventional wisdom that we haven't seen since November, according to numbers from the U.S. Treasury's web site. Meanwhile, the yield on the 10-year inflation-indexed Treasury has inched lower, staying below 2.0% since early January. The result: inflation expectations are on the rise, moving above 1% this month for the first time since October.
For the moment, the opportunity to buy a 10-year TIPS at virtually no extra cost over its conventional counterpart looks like a train that passed by. As we've discussed, hopping on board the train when it was in the station looked like a no-brainer to some degree, in part because such events rarely happens. Indeed, it's not supposed to happen. Mere mortals are supposed to pay extra for the privilege of hedging future inflation. If you'd rather not, conventional Treasuries will suffice, albeit at the risk of ending up on the losing side of higher future inflation, if any—the bane of unhedged fixed-income securities everywhere.
Yes, the fleeting stretch of convergence now looks like a buying opportunity—hindsight never fails to tell us what we should have done. The question now is whether the parting of the ways for nominal and real Treasury yields is a sign of things to come or just another bout of volatility as the world comes to terms with deflation and recession?
We don't have a no-risk answer, but here's what it looks like from our vantage. In a word, politics. The Obama administration is poised to unveil the next critical step in its efforts to soften the credit crisis and otherwise help return something akin to normalcy to the American economy. It's unclear if upping the ante for bailing out the banks will make a significant dent in the various financial ills that afflict the country, but the White House is going to give it the old college try. That's in addition to the huge fiscal stimulus plan being worked out in the Senate. Considering the world afterward is a reasonable exercise, and so we have some of the motivation for selling Treasuries.
In the best of circumstances, this political high-wire act would keep a bond investor worth the name on pins and needles. But the stakes are especially high and the circumstances are less than perfect. Unsurprisingly, some fixed-income types appear to be getting cold feet, at least for the moment, and so the path of least resistance is arguably selling nominally priced Treasuries. How could it be otherwise until and if fresh evidence of deflation comes our way. With no pricing news to speak of, traders look elsewhere for guidance. What they find is a lot of discussion and debate about what comes next in Washington.
As Bloomberg News reports, "Banks are 'looking for clarity, we’re looking for this to be the complete package,' said Wayne Abernathy, an executive vice president at the American Bankers Association. 'If they [the Treasury Department] don’t have the details spelled out they will just freeze the market.'"
If so, better to sell first and analyze the details later. For the moment, at least, there are no details. Treasury Secretary Timothy Geithner delayed the announcement of the new bailout plan—originally scheduled for today—to tomorrow. Meanwhile, everyone's placing bets and making forecasts. Will the new plan work? What if it doesn't? And how is all the monetary stimulus going to affect future inflation? Lots of questions, lots of debate. Answers to come. Some of them may even be as expected.
February 6, 2009
SPEND, SPEND, SPEND. BUT WHO PAYS?
Paul Krugman in his New York Times column yesterday chastises the Obama administration for not pushing for a sufficiently large enough stimulus package to juice the economy.
"Would the Obama economic plan, if enacted, ensure that America won’t have its own lost decade?" he asks. "Not necessarily: a number of economists, myself included, think the plan falls short and should be substantially bigger."
Given this morning's news that the economy shed nearly 600,000 nonfarm jobs last month--the biggest monthly loss since 1974--the case for government stimulus never looked stronger. All the more so if deflation threatens, which it clearly does.
But no one ever said that spending vast sums of money--the current stimulus plan circulating in Congress now tops $1 trillion--insures a quick fix for the economy, or any fix. That doesn't mean that government stimulus should be off the table, but no one should expect that spending such astronomical amounts of money comes without risks.
Benn Steil, director of international economics at the Council on Foreign Relations, wonders where the financing for the stimulus will come from. As he writes in today's FT,
Nobel Prize-winner Paul Krugman, who calls today “The Keynesian Moment”, justifies such a trillion dollar investment programme on precisely the Keynesian foundations that Rueff demolished – the claim that money “would otherwise be sitting idle”. When Mr Krugman buys his stimulus bonds, I am curious where the “idle” money will come from. Will he sell stocks? Bonds? Withdraw funds from the banking system? If it is not to come from a cash box, it is not idle, and Mr Krugman can only fall back on the hope that the government will use his funds more productively than businesses can.
February 5, 2009
NEGATIVE MOMENTUM STILL HAS THE ECONOMY BY THE THROAT
If the recession now underway was a "normal" contraction, the near-term investment outlook might look quite a bit better. More than a year into the downturn (as we are now) might seem like a good time to start buying in anticipation of the rebound. But this isn't your garden variety downturn, and so economic and financial metrics remain under a suspicious cloud even when they're looking bullish.
That includes our proprietary economic indices that track the general trend for the U.S. As the chart below suggests, in theory there's reason to be bullish about the next several quarters. In practice, however, playing defense is still recommended.
As we discussed last month, the Federal Reserve's printing money faster than at anytime in recent memory, perhaps more so than at any other time since the institution was founded in 1913. The massive liquidity injections are, of course, registering loud and clear in our economic measures, particularly for the leading index, which looks ahead by 6 to 12 months. So it goes when the effective Fed funds rate has continuously remained under 1% since October, and under 0.5% since early December. Currently, it's hovering in the ~0.2% range.
Typically, such an easy monetary policy would be working its usual magic by juicing the economy. But not this time, at least not yet, which speaks to the magnitude of the economic headwinds currently blowing through these United States. Virtually all of the fundamental economic metrics in our index—i.e., industrial production, commercial and industrial loans, employment, etc.—are still falling. As a result, the incredibly strong rebound in the leading index in the chart above must be seen for what it is: a reflection of monetary policy that's in overdrive but not yet producing stabilization, much less growth, in the wider economy.
Alas, this morning's update on weekly jobless claims suggests the contraction is still gaining momentum. New filings for unemployment benefits—a forward-looking economic signal—surged again last week to a seasonally adjusted 626,000—the first time claims rose above 600,000 since a brief spike north of that mark since the early 1980s.
History tells us that initial claims tend to surge higher in one final, dramatic rise, followed soon after by a robust decline and then some backing and filling as the worst of the initial claims trend passes. At that point, one could reasonably say that the recessionary momentum has ebbed, even if the aftershock rolls on for some time afterward.
Of course, such a peak is only obvious in hindsight. In the meantime, there's plenty of room for speculation about whether the current surge above 600,000 last week marks the peak. For what it's worth, we expect even higher levels of jobless claims.
That said, it's clear that the Fed's efforts are in overdrive to quickly get to the other side of the peak. Congress is now lending a hand, too.
Yes, the glorious day of a peak in initial jobless claims is coming, but it's not here yet.
February 3, 2009
SEPARATING TRICKS FROM TREATS
Mr. Market is a tricky devil. Or is he a manic depressive, as Ben Graham suggested all those years ago? Whatever the appropriate psychological label, you've got to stay alert in the money game when he's your opponent. You've also need to remain willing to act when he drops something more than subtle hints about the future.
That's not always obvious when your perspective is the past month, or even the trailing 12 months. A short-sighted view of the recent past is the main temptation, though. The world is awash in tactical observation. Reaching for a bit more strategic context, on the other hand, seems perennially unpopular, or at least underestimated.
That's a mistake, of course, since stepping back and looking at the big picture throws us a strategic bone every now and again. Don't misunderstand: tactical analysis is helpful, even essential. We do a fair amount of it, in fact. But using it in isolation, without the benefit of strategic review, is like driving with a loose wheel: It'll work for a time, but it's going to get you into trouble eventually.
The good news is that strategic perspective is available for the asking. Assuming the crowd's paying attention. But regardless of who's watching, or not, the clues are there. No, they don't come with instructions, and quite often they're wrapped in statistical noise. But they're there, and sometimes the embedded message is a bit clearer than usual.
Consider how the planet's equity markets appear when surveyed in a strategic framework. One example comes via total return comparisons among the major equity regions. As our chart below reminds, stock markets around the world appeared to be overheating by 2007, if not sooner. Some markets were hotter than others, of course: in particular, the markets of Emerging Europe and Latin America—the two lines that surged highest in our graph in 2007. Having taken flight to extraordinary heights, these two markets were poster children for favoring increasing caution in equity allocations as 2006 turned to 2007 and then to 2008. We suggested no less, including this post from 2006.
And in November 2006, we admitted that "our over weighted cash allocation continues to burn a hole in our pocket."
Yes, the trend in 2006-2007 looked unsustainable from the vantage of 2009. But the crowd didn't think so at the time. Why not? What's changed? Everything, of course.
Learning to deploy a more objective analysis to market conditions in real time is the critical challenge. Make no mistake: forecasting expected returns is tough, really tough. In fact, it's almost impossible, at least if you're trying to do it consistently on a near-term outlook basis.
But if you look at a broad range of tactical and strategic market metrics across asset classes, along with macro economic signals, sometimes the future looks a bit less fuzzy. That's especially true at extremes. The above chart is one example, although no one should think that looking at performance alone extends much confidence about tomorrow. It helps, but only in context with a broader reading of markets and economics.
It also helps if you do this full time, which we do for our newsletter, The Beta Investment Report. It's not rocket science, necessarily, but successful investing does take a commitment to pay attention and putting risk management ahead of performance chasing.
Turning a profit in the short run—perhaps even a very big profit—can sometimes look easy, as it did in 2006 and 2007. The world was up to its neck in those years with money managers touting spectacular returns for the then-trailing 3-5-year return histories. The trick is looking good over a full business cycle, or two. There are actually a few managers who can make that claim in 2009, but there's no danger that their numbers would overwhelm a medium-sized conference room.
February 2, 2009
January was another rough month for most asset classes. It was tempting to think there were legs to December's rebound, which ended the non-stop crushing losses of September-November. Eventually, the genuine rebound will come. In the meantime, there are false starts, as January reminds.
The good news is that last month wasn't a complete sea of red ink. That's an improvement over September's and October's across the board losses in the major asset classes. Nonetheless, the gains keeping us out of total red last month rested thinly on high-yield, emerging-market and inflation-indexed bonds.
Even cash (3-month T-bills) suffered a loss for January, albeit a mere -0.01%, which rounds out to zero on our table above. That's the second month in a row for losses in cash, following December's -0.02% retreat. How could T-bills lose money? With short rates falling to virtually zero recently, a slight uptick in T-bill yields was enough to tip returns just under zero on a monthly basis.
It's now looking like December was one of those infamous dead-cat bounces. The selling going into December had been so deep and so broad as to inspire some across-the-board bargain hunting. The unusually rich yields corporate and muni bonds, for instance, were just too tempting to pass up, even in a severe recession. REITs too attracted value investors in December, a month that witnessed an exceptionally strong surge of buying for the asset class.
But bargain hunting has its limits, at least until there's more confidence about the economic and political futures.
Investors still don't have a good sense of how much pain is coming this year, or when the pain will begin to ebb. Keeping everyone on pins and needles is the political bickering over the fiscal stimulus package now being debated in Washington. The Senate is set to start reviewing the $900 billion stimulus plan today. News reports this morning tells us that both Republicans and Democrats in the Senate are intent on changing the legislation. Exactly what that means for the fate of this massive new spending bill remains unclear. Given the precarious state of the economy, any worry that the stimulus plan might be delayed or even killed is keeping investors on edge.
There's also a fresh round of worry bubbling in the Treasury market. After last week's FOMC statement failed to lay out specifics on how the Fed would proceed in its reported plans to lower long Treasury rates (which are usually controlled by the market), bond traders went into sell mode. The benchmark 10-year Treasury Note closed last week at 2.844%, the highest in about 2 months.
Overall, there's no shortage of worries in finance and economics, and the political scene isn't doing much at the moment to calm nerves. Nevertheless, all the volatility is creating opportunities for those who keep their head and stay focused on return and risk for 3-to-5 years out. As we explain in more detail in the soon-to-be-published February issue of The Beta Investment Report, our broad survey and analysis of prospective return and risk among the major asset classes looks modestly encouraging.
Even so, Mr. Market never gives much, if anything, away for free. The price of alluring future returns these days requires suffering an above-average dose of anxiety in the short term. For those with a deft hand on the levers of risk management and an eye on the future, the anxiety is more than tolerable relative to the expected payoff. That doesn't make investing easy, of course; if anything, the money game's getting harder. Working twice as hard for the same return is probably a rough estimate for what awaits.
If you're up for the challenge, there's gold in them thar hills. But first, there's probably another dead cat bounce or two waiting in the wings. There are still quite a few weak hands to shake out of the market's trees—a necessary condition for laying the groundwork for alluring prospective returns for anyone who stays calm and focused.