April 30, 2009
The main point of optimism in yesterday's first reading of Q1 GDP is the jump in consumer spending. But as today's update on personal income and expenditures for March reminds, there's still quite a bit of uncertainty left as to whether consumption is truly on the mend.
Much of what registered as increased consumer spending in this year's first quarter came in January. A convincing follow-through still awaits. As our chart below shows, the bump just ahead of March 2009 was a first-of-the-year rise in both disposable income and personal consumption spending. It was a welcome reprieve from the crushing setback in late 2008. But the trend is fading and last month's consumption dropped relative to February. Disposable income, meanwhile, was flat in March.
The main question is whether the realities of the broader economic climate are finally weighing on American households as they ponder the toxic combination of falling housing values, fewer jobs, higher unemployment and burdensome debt levels built up over the years. The government's massive stimulus efforts over the past year have helped slow the tide, but the correction in consumption and consumer attitudes will roll on.
Adding to the challenge is the recent uptick in the 10-year yield. The Fed has been working overtime in trying to keep long rates low, which is to say below 3%. But now Mr. Market is rebelling. The 10-year closed above 3% for the third day running yesterday. That's the first time it's run above that level since the Fed announced on March 18 that it would buy long-dated Treasuries outright in order to keep rates low. Immediately following the news, the 10-year yield dropped by an extraordinarily steep 50 basis points to around 2.5%. Now the yield's above 3%. And the higher rates come at a time with little or no worries about inflation.
Of course, one could argue that the apparent topping out in new jobless claims suggests that the recession may be at or near a trough. We've suggested as much recently, including here, and our reasoning is here. And today's update on new filings for jobless benefits offers a fresh datapoint to argue that the business cycle may have bottomed.
But we must distinguish between a bottom to the recession and the renewal of economic growth. If we have an "L" recession, the bottom could last qiute a bit longer than the crowd expects. All the more so given the depth and magnitude of the current downturn.
In short, there's reason for optimism and its counterpart. Deciding which one has the upper hand will still take more time.
April 29, 2009
ANOTHER PAINFUL GDP REPORT
The government's advance estimate of GDP for the first quarter was worse than expected—quite a bit worse. The consensus outlook called for a 4.7% drop, according to Briefing.com, but the government says the decline was -6.1%.
The good news is that GDP reports are old news, and so today's dire numbers have already been digested in various reports in past weeks and months. But there's always the future, and it's debatable how much has changed in April, or is set to change in May.
Meanwhile, it's clear that the U.S. economy's performance for January through March was quite grim. The 6.1% drop in real annualized GDP for Q1 was just below the 6.3% fall for 2008 Q4. Both numbers are among the steepest quarterly declines in 50 years. The fact that the two came back to back only makes matters worse. The question is what's in store for Q2?
There's reason for modest optimism. One reason is that consumer spending actually rose in Q1, with the economically sensitive durable goods sector showing especially robust performance. That's a sharp turnaround from the sharp declines in last year's second half, when Joe Sixpack all but abandoned discretionary spending habits. But virtually everything else for this year's Q1 tally lost ground, which is to say that private investment and exports gave way in this year's first three months.
If you're feeling hopeful, you might take solace from the improving readings of consumer sentiment and use that as a basis to predict that Q2 will show continued growth in consumer purchases. The Conference Board yesterday reported that its widely monitored Consumer Confidence Index soared in April. Lynn Franco, director of The Conference Board Consumer Research Center, said in a press release that accompanied yesterday's announcement:
"Consumer Confidence rose in April to its highest reading in 2009, driven primarily by a significant improvement in the short-term outlook. The Present Situation Index posted a moderate gain, a sign that conditions have not deteriorated further, and may even moderately improve, in the second quarter. The sharp increase in the Expectations Index suggests that consumers believe the economy is nearing a bottom, however, this Index still remains well below levels associated with strong economic growth."
The notion that the consumer is prepared to start spending consistently, much less abundantly still looks hasty. The rebound in consumption in the first quarter appears like a reaction to the dramatic declines of late-2008. And if you look at retail sales so far this year, the trend suggests that consumers are increasingly cautious. Indeed, the robust gain in January virtually evaporated in February and turned into an outright decline for March, the Census Bureau reports. Perhaps April will break the trend.
One obstacle that's not quickly resolved is that there's still lots of debt to work off and it weighs heavily on household balance sheets. Adding to this negative pressure is the ongoing decline in home prices, based on the latest reading of the S&P/Shiller-Case Index. The rate of decline is slowing, but it's not yet clear that a bottom is imminent for real estate.
On the positive side, one can argue that the corrections that have roiled virtually every corner of the economy will soon lead to something less painful. Recessions don't last forever, even deep, global ones. But what's not yet widely understood by the crowd is that the end of the recession isn't likely to lead to a new era of growth any time soon. Meanwhile, the jury's still out on whether the worst of the economic contraction has even passed.
There are still many mountains to climb, but for the moment we're still just a few steps above the valley's lowest point.
April 27, 2009
DIVING INTO THE NUMBERS
The "long run" isn't everything, but it's something, which is to say it's relevant. Studying it, then, is productive. It shouldn't dominate decisions for designing and managing asset allocation, but it's a great place to start.
The long run is everywhere when perusing the latest edition of Ibbotson SBBI 2009 Classic Yearbook. For the uninitiated, the book is a feast of data, reviewing all the usual measures of stocks, bonds and now REITs and a touch of commodities. Here is the epitome of slicing and dicing the numbers when it comes to investment research, at least when defined in the dead-tree medium. You're not really familiar with the trends and the profiles of the major asset classes until you've spent some time poring over SBBI.
Critics say that SBBI unfairly promotes the long-term perspective, elevating it to god-like status. Perhaps, although there's no shortage of short-run data to consider and so everyone can find their favorite bias in these pages for forecasting risk and return premia and considering how the game unfolded in the past.
We can't possibly do justice here to the treasure trove of statistical insight in SBBI, but we can give you a flavor for what awaits. We're also adding our own contextual spin to the numbers in the next issue of The Beta Investment Report.
SBBI won't give you a short cut to easy profits, but it'll open your eyes to the possibilities, and the risks, in the capital and commodity markets. With that in mind, here are a few choice cuts in the freshly published edition of this grand book…
April 23, 2009
THE PEAK STILL HOLDS
It's too soon to declare that the worst of the recession has passed, but it's also premature to dismiss the idea. We are, in short, in a never-never land of waiting and watching, and this game may roll on for many a moon.
To help pass the time, we're watching the data as it comes in, including initial jobless claims. As we've written, this is one of several metrics that may offer clues about when the business cycle reaches a trough. Like any one statistic, it can't be fully trusted, and so we must look to a range of data points. But history suggests that as single measures of broad economic trends go, this one's unusually useful in trying to peer into the future, or so it's been in the past.
With that in mind, we turn to this morning's update on new filings for jobless benefits. As the chart below shows, the encouraging drop through the week of April 11 has since given way again to the forces of darkness via last week's seasonally adjusted rise of 27,000 new filings. But the hope that we've seen a top isn't lost yet.
History suggests that initial claims will top out concurrently or perhaps even slightly ahead of the recession's formal bottoming. Yes, we must look to other signals for context before we make any definitive conclusions. For the moment, the jury's still out, but the good news is that it's not yet clear that the recession's getting worse, or so the trend in initial jobless claims suggests.
The question is whether we're due for another surge in bad news for the labor market? The economy is still too precarious to rule out the possibility. On the positive side, despite the robust rise in claims last week, the trend in the chart above still doesn't preclude the possibility that we've seen a peak. Deciding if in fact that's true will take another month or two of data. Meanwhile, evidence that we're not peaking requires only one weekly surge skyward.
April 20, 2009
After the huge losses in markets last year, the long knives have come out on diversification.
It seems that everyone now shuns the idea of owning multiple asset classes. Curiously, no one was complaining in 2002-2007, when bull markets prevailed in just about everything. Of course, the crowd has a habit of promoting (or remaining quiet when it comes to critical comments) about strategies that are working in real time. After the fact, it's all a bunch of hogwash. So be it. That's the nature of finance: History, and what passes for intelligent counsel, is constantly being rewritten to suit the moment.
The latest attack comes from Jim Rogers, celebrated trader and promoter-in-chief of commodities as the solution to what ails investors everywhere. For the record, we like and respect Jim Rogers. He's earned a well-deserved reputation as a trader who's made a fortune in a business where success is rare. His record speaks for itself. But we disagree vehemently with his latest commentary on diversification, which he equates with a cheap trick dreamed up by brokers trying to fleece clients. Here's what he said, verbatim, courtesy of an interview last week with BusinessWeek:
Diversification is something that stock brokers came up with to protect themselves, so they wouldn't get sued [for making bad investment choices for clients]. Henry Ford never diversified, Bill Gates didn't diversify. The way to get rich is to put your eggs in one basket, but watch that basket very carefully. And make sure you have the right basket. You can go broke diversifying. Ask anyone who's diversified in the last three years. They've lost money.
With all due respect, Jim, you're not being fair to diversification, nor does it appear that you fully understand what it is, what it's designed to do, or not do, and what's required of investors who manage a "diversified" portfolio. We'll be diving into these questions and the related lessons in more detail in the next issue of The Beta Investment Report, but here are a few thoughts as a preview.
First, let's define diversification, which can mean different things to different investors. The standard definition relates to diversification within an asset class—owning a broad equity index fund, for instance, vs. one stock. That by itself doesn't mean an investment portfolio's diversified. That higher standard requires owning multiple asset classes, with an emphasis on those that tend to move with some degree of independence. The classic example is a portfolio comprised of stocks and bonds, although there are many more combinations available in the 21st century.
On that note, diversification with stocks and bonds performed quite well last year relative to owning stocks alone. Although equities were crushed last year, a broadly defined fixed-income fund did quite well. One example is the iShares Barclay Aggregate ETF, which posted a 7.9% total return in 2008.
Meanwhile, the asset class that Jim Rogers loves so much—commodities—suffered one of its biggest losses last year, to which we're reminded of the proverb in Luke: Physician, heal thyself. Jim has been promoting commodities in recent years, and for quite a while it was a great call. But not last year. Perhaps owning something more than commodities wasn't misguided after all.
Ultimately, asset classes are neither good nor bad, although their expected returns and risk vary through time. The key lesson: the price of risk means something, all the more so because it keeps changing. That implies that we should pay attention and adjust asset allocation accordingly. In a perfect world, with absolute foresight, we wouldn't need diversification or asset allocation. We'd simply pick the best investment destined to dispense the highest return.
Unfortunately, it doesn't work that way. Sometimes even the smartest investors make mistakes, reminding that we're all fallible. With limited insight into the future, prudent investors will hedge the risk. The breadth and depth of the hedging will vary depending on the individual or institution. Some of us are more risk averse than others.
Meanwhile, some of us are more confident than others about what's coming. Jim Rogers, for instance, is still bullish on commodities, as he explains in the interview noted above. (As a digression: Was he bearish on commodities a year ago?) In any case, let's say you agree that commodities look like a great play on the future. Let's say too that you're wildly bullish on commodities. Are you going to put your entire portfolio into commodities? Or how about putting everything into agricultural commodities? Rogers is apparently quite bullish on the likes of corn, wheat, etc.
We'd recommend otherwise, even if you're the world's smartest commodities bull. Yes, you might want to overweight commodities, perhaps aggressively, relative to the passive weight implied by Mr. Market. But shunning diversification entirely? It's hard to think of a more dangerous piece of advice, especially for the masses. Then again, your editor isn't a highly regarded trader and so maybe we're just uninformed.
April 16, 2009
IS THE TREND FINALLY OUR FRIEND?
This morning's news that new claims for jobless benefits fell last week is the best news yet for thinking that the recession has peaked. It's still too soon to break out the champagne, as we'll explain. But for the moment, a collective sigh of relief is in order. Maybe.
As the chart below shows, new filings for jobless benefits tumbled by 53,000—the biggest weekly drop since December. More important is the trend. Since reaching a seasonally adjusted high for this cycle of 674,000 for the week through March 28, new jobless claims have fallen in each of the subsequent two weeks, lowering the total to 610,000 last week. That's still an unmitigated sign of recession, but the recent fall also begs the question: Does the downshift have legs?
This is a critical question because, as we've written, initial jobless claims are a valuable forward-looking indicator for estimating when recessions bottom out. In our March 6 piece, we looked at the historical record and found that initial jobless claims peaked concurrently with, or sometimes ahead of the formal end of recessions since the late-1960s. That's valuable information since identifying the end of the business cycle downturn is much easier after it's obvious to the crowd. The National Bureau of Economic Research, which officially dates the start and end dates of recessions, makes its proclamations long after the fact. Meanwhile, most of the popular metrics for gauging the state of the economic cycle, such as the unemployment rate, are lagging indicators and so they're among the last to reveal when the recession has turned, much less ended.
Initial jobless claims, then, are a better albeit less-than-perfect metric to watch for gauging when the cycle may turn. There are other leading measures to watch as well. Indeed, the stock market's upturn of late has arguably been signaling that the worst of the recession has passed.
But while it's tempting to pronounce the cycle has turned, such thinking is still premature for a number of reasons. That includes the view of some economists that last week's numbers should be ignored because it came during a holiday week following Easter. Meanwhile, the war on deflationary pressures is still raging and key sectors of the economy are still bleeding quite heavily. The latest clues include yesterday's news that consumer prices posted a modest decline in March. Meanwhile, the government advises today that housing starts continue to sink (falling nearly 11% last month vs. February), as did new building permits (down 9% last month), a signal that the outlook for a rebound in construction remains dim.
Let's also recognize that even if the recession has bottomed out, that's a long way from saying that a return to growth is imminent. It's likely that the economy will tread water for several quarters at the least once the economy stops contracting. And while the stock market appears inexpensive, or at least fairly priced, it's still too early to expect that profits are set to rebound any time soon—for reasons we'll be discussing in more detail in the next issue of The Beta Investment Report.
Still, it's not too early to begin elevating risk exposures in those asset classes and their subcategories that are most attractively priced. If we were supremely confident what was coming, we'd be more aggressive in our adjustments to asset allocation. Alas, we're only mortal, and so we continue to act accordingly.
Meantime, we're watching the leading indicators and trying to figure out if the apparent dawn is real or false. Coming to something more than a guess will take a few more weeks, perhaps a few more months. Let's hope it doesn't require several more quarters.
April 14, 2009
DEFLATION: NOT QUITE DEAD (AGAIN)
The case for remaining cautious on the economic recovery grew a bit stronger today with the updates for wholesale prices and retail sales. Both registered declines, suggesting that strategic-minded investors should stay opportunistically cautious.
The economic data in recent months offered reason to think that the deflationary risk might be fading. That hope hasn't faded entirely, but it's a tad weaker today than it was yesterday, in light of news that retail sales slipped 1.1% last month and wholesale prices retreated by 1.2% in March.
The crux of the investment challenge since last fall has been deciding how to choose between the relatively attractive prices of risk vs. the implications drawn on the expected headwinds for the economy. In theory, the former will compensate for the latter. The danger is thinking that we know the magnitude and duration of the latter.
The case for seeing the glass half full is that the expected depth and extent of the economic contraction might be lessening. The evidence, albeit slim, is that the war on deflation is beginning to show progress. As we wrote last month, "deflation is on the run…for the moment, anyway," a ray of optimism born of reading the consumer price report for February, which advised of a slight increase in prices. Slaying the deflationary beast was and is critical, as the prospects for stabilizing the economy, much less repairing it are dim until the D risk is thoroughly dispatched.
Unfortunately, the demon may not be quite dead yet. Like a bacterial infection that seems to withdraw only to return, just as the patient is feeling better, deflation still threatens…again, or so the March report suggests. Deciding if it has legs remains an open question once more.
The 1.1% drop in retail sales last month is too large to pass for a statistical glitch. All the more so after looking at the even-larger tumbles last month for sales of motor vehicles and parts (-2.3%), furniture and home furnishings (-1.7%) and electronics and appliance stores (-5.9%).
The Producer Price Index isn't quite so distressing, even though it posted a 1.2% drop last month, the first monthly decline since December. Much of the loss is related to energy, which resumed its general price retreat last month after registering gains in January and February. Taking out food and energy prices, the core PPI was flat in March.
Tomorrow's report on March consumer prices will offer more clues about deflation. In the meantime, it's still too soon to declare victory. For what it's worth, your editor's guess is that we're going to play a game of deflation's dead/deflation's alive for the balance of the year.
April 13, 2009
THE NEXT HURDLE
It's hard to dismiss the ongoing news about China's anxiety over its massive holdings of American debt. What's worrisome for China is ultimately a concern for the U.S., with fallout that may come sooner than we think.
“We have lent a huge amount of money to the U.S. Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried," Chinese prime minister, Wen Jiabao, said last month. It was a rare public admission of apprehension by a high-ranking Chinese official on the delicate and increasingly precarious lender-borrower relationship that describes the U.S. and China.
Today comes word that China's purchases of U.S. bonds slowed in the first two months of this year, according to new data from China's central bank, The New York Times reports. "Chinese reserves fell a record $32.6 billion in January and $1.4 billion more in February before rising $41.7 billion in March, according to figures released by the People’s Bank over the weekend," the Times notes. The trend may now be reversing, although the notion that a pivotal point in the U.S.-China financial relationship may be near remains intact.
The fear is that China will slow (cease?) buying new Treasuries, a decision that's likely to force up interest rates in the U.S. For the moment, there's no reason to dismiss that scenario, at least when it comes to the recent trend in the yield on the benchmark 10-year Treasury Note. As the chart below shows, the march upward to the 3% mark is alive and well.
What makes the rising yield in the 10-year so striking is that it comes in the wake of the Federal Reserve's announcement last month that it would directly target lowering rates on long Treasuries. The market's initial reaction was to buy Treasuries, which resulted in one of the biggest one-day drops in interest rates on record. For a time it looked like Bernanke and company had struck gold. But confidence that the central bank has complete control over the long end of the curve has been evaporating in recent weeks.
As the above chart shows, the 10-year yield collapsed by around 50 basis points on March 18, down to around 2.5%. As of April 9, the 10-year's yield had climbed by to roughly 2.9%, just under the level where when the Fed made its bombshell announcement last month.
High interest rates in the U.S. necessarily make the dollar more attractive, at least for a time. No wonder, then, that the buck's value is rising in forex markets in recent weeks, in sympathy with higher interest rates on the 10-year. The U.S. Dollar Index is just about at the highest level since the Fed's March 18 disclosure, a news event that had initially sent the buck tumbling. Meanwhile, commodity prices generally have been inching higher as well, as per the CRB Index. Commodities are generally priced in dollars, so it's no surprise that a strong dollar equates with higher commodity prices.
Higher interest rates are almost surely the path of least resistance in the years ahead, in part because the U.S. deficits are sure to be large in the wake of all the monetary and fiscal stimulus of late. The problem is that the arrival higher interest rates now, this week, next month, next quarter come at an especially inopportune time: before the economy has sufficiently recovered. The Fed surely seeks to keep long rates below 3% for the rest of the year, or so one might speculate. But it's not clear that the markets are willing to go along for the ride.
In the old days, the Fed's powers were such that it had more control over keeping interest rates low and thereby providing the economy with ample monetary stimulus until the forces of growth rose anew. Engineering that scenario this time may be tougher, much tougher. One reason is that much of the control over future rates has been transferred to foreigners, courtesy of holding large quantities of U.S. debt. That may not be fate that rates will rise. Indeed, China surely wants to keep U.S. rates low in order to boost growth here, which will promote imports of Chinese goods. But no one really knows how these forces will play out.
Perhaps the cycle will be salvaged if the economy rebounds quicker than the crowd expects. Alternatively, the Chinese and other foreigners decide to buy large quantities of Treasuries in the months and quarters ahead. There are solutions to the current dilemma, but no one should expect that they're a forgone conclusion.
April 9, 2009
THE MORE THINGS CHANGE...
Banking crises are old hat in capitalism, and much of what ails us these days is first and foremost a banking crisis. The question is whether that matters in diagnosing the cause, and the apparent solution for the recession du jour? It does…maybe.
Economic contractions brought on by a banking crisis must be distinguished from downturns born of what some might call the growth cycle's old age. In the latter, the central bank takes away the proverbial punch bowl in an effort to reduce the risk of inflation. An extended period of economic growth tends to elevate inflationary pressures, which compels central bankers to raise interest rates. Elevating the price of money, in turn, raises the risk of recession.
Of the two basic drivers of recession, the former describes the source of our current predicament. The missteps by the financial sector, in other words, planted the seeds of this downturn. Recessions born of banking crises aren't unprecedented, but they're relatively rare. Good thing, too, since the blowback is particularly difficult to solve, at least in a timely and obvious manner.
In a recession brought on by higher interest rates, the solution is usually one of reversing the process and thereby dispensing cheap credit to the system. But in a banking crisis, cheap credit doesn't offer its usual stimulating effects.
In the rush to find solutions, there's a temptation to ignore history, which may be one reason why recessions will always be with us. Consider that in an age long ago and far away, bankers extolled the virtues of their club. In that world, extending credit to would-be borrowers was the exception rather than the rule. Some complained that only the highest rated borrowers had access to loans. Whatever the virtues, and vices, of this clubby system, it didn't preclude the arrival of banking crises, or the recessionary effects thereafter. Witness the crisis of 1907, that gave us the 1907-1908 recession.
The 1907 calamity also inspired the Pujo hearings of 1912, which were designed to root out the evils of the "money trust," of which J. P. Morgan was the leading member. Out of these Congressional hearings came the "solution," a.k.a., the Federal Reserve, which was founded a year later, and general push to expand the possibilities of lending. In the course of subsequent decades, that lofty goal would be achieved on a level that seemed impossible in 1912.
Fast forward to 2009, when the world laments the fact that credit was extended every which way in years running up to the banking crisis of 2008. In those days of easy money, securing a loan was common, ordinary and frequent. For a time, all seemed right, and some argued that the country was a better place because democracy had finally come to the business of lending.
Now we know different, or at least we think we do. But what's striking in all of this, as we bemoan the decline and fall of banking standards that allowed virtually anyone and everyone to access the credit markets, is that we've come full circle from a century ago. In less than 100 years we've traveled from an era when credit was reserved for the wealthy and the connected to the early 21st century when, until recently, lending required little more than a pulse. The only thing that's remained constant is the banking crisis.
We should be humble about thinking we know how to prevent the next banking crisis. That doesn't mean we shouldn't try. But progress in finance comes slowly, if at all. Legislation changes, banking standards evolve, and the price of money fluctuates. Greed and fear, however, are still forever.
April 7, 2009
RISK: THE SOLUTION AND THE PROBLEM, ALWAYS AND FOREVER
Risk never gives investors a break. It's constantly baiting us, dispensing false signals and generally throwing landmines on the path that appears as a smooth trek to easy gains.
Consider that the past 20 years have been particularly fruitful in financial economics for identifying sources of partial predictability in certain data series. A few examples include dividend yield and other fundamental valuation measures that have shown robust results for estimating the equity premiums for medium- to long-term horizons. The shape of the yield curve and the spread between interest rates on corporate and Treasury bonds have also shown encouraging results as predictors.
In fact, there are a number of factors that are worth monitoring on a regular basis for estimating the price of risk in the major asset classes. No surprise, then, that watching dividend yield, the term structure of interest rates and a host of other metrics, and inferring risk premia and asset allocation from the analysis informs much of our work in The Beta Investment Report. The danger is thinking that the investment challenge has been solved.
It hasn't, nor can it be, lest the risk premia that investors chase is arbitraged into oblivion. But fear not: nothing approaching that future is possible in this universe. For every clue identified in the financial literature as productive for estimating risk and return, another intrepid researcher presents the case for staying cautious if not skeptical on reading too much into the previous studies. That's the nature of risk, and it forever stalks the best laid plans of mice, men and optimistic investors everywhere.
An recent example comes by way of a study that's forthcoming in the Journal of Quantitative Analysis (a working copy is available from the Federal Reserve). After studying 20,000 data points from 40 international markets, the paper advises that the partial predictability of the dividend yield that's been identified in the U.S. equity market fades when applied in foreign bourses. The "empirical results" are a bit more encouraging for using interest rates and yield curves as tools for peering into the future, although the limited power of these factors seems to work best in developed markets.
The study's message raises fresh questions about the reliability of dividend yield, interest rates and yield curves for estimating return and risk. Previous research, starting with a number of studies in the late-1980s, suggested that studying such factors was useful. Should we now jettison 20 years of near consensus in financial economics and look elsewhere for discounting the future?
Actually, that's the wrong way to look at designing and developing investment strategies. There's always someone throwing cold water on your assumptions, or offering a new idea that promises new and improved results.
A better approach is to recognize that there are no silver bullets, even though we're all susceptible to thinking otherwise. To the extent that we can develop context and perspective about forecasting risk premia, the insight is likely to come from multiple sources. What's more, there's no assurance that the list won't evolve through time.
Any one factor will wax and wane as a window into the future. What looks more like an enduring principle is the idea that we should estimate return premia indirectly, by way of monitoring and modeling risk factors. That's in contrast to attempting the Houdini-like trick of predicting returns directly.
That said, we need to recognize that the relevant risk factors for estimating return premia aren't a stable lot. Fortunately, the degree of relevance for individual factors doesn’t change overnight, but it does change. Our only hope for keeping the instability on the margins is by watching a mix of factors, each chosen because there are compelling reasons for doing so.
The reasoning is that while some variables will rise and fall through time as useful measures, absolute failure across the board is highly unlikely. Assuming, of course, you build models with a robust mix of risk variables that exhibit minimal cross dependence. Ideally, we're looking for risk factors whose relevance can't be arbitraged away easily, if at all. A quick example: the so-called January effect is relatively ephemeral, since ambitious traders can simply buy sooner. On the other hand, risk premia related to the business cycle is far more durable.
So, yes, we're constantly wondering if this or that variable has lost some or all of its power as a predictor. Even under the best of circumstances, a lone factor offers limited visibility into the future. None of this should come as a surprise. If you go fishing for risk premia, there's always a chance that you'll come up empty handed. That's why they call it risk premia. Yet risk premia aren't a figment of our imagination: they do exist and they can be captured. It's not easy, nor is it for the feint of heart. And what appears to be a skillful harvesting of premia in the short run tends to be an illusion.
In other words, prudence, modesty and a healthy respect for the unknown are critical for generating success in the money game. And that starts by recognizing that risk premia are constantly being repriced and that the rules that govern success and failure in reverse engineering the associated prices are subject to change without advance notice. Other than that, investing's a breeze.
April 3, 2009
THE EMPERORS AREN'T FIDDLING, BUT ROME'S STILL BURNING
The cheering over the positive news from the global summit of the so-called G20 nations is well deserved, but no one should think that all's well.
It's one thing to pledge more stimulus money and promise tighter financial regulations. That’s all well and good, and the stimulus efforts are especially timely at this point. But let's be clear: a new round of global stimulus will, at best, slow, perhaps stop the bleeding at some point, but probably not until later this year, at the earliest. As for economic growth, it's far too early to think of such things.
In fact, a fair amount of the good news dispensed by the conference of the world's biggest economies is related to what didn't happen. If the talkfest had ended with recrimination and a muddled outcome, as some thought was likely, the global economy would suffer that much more. Think of Nero playing his fiddle with Rome in flames.
Fortunately, the outcome was one of a modestly productive and coordinated effort, or at least the promise of such. Fiddling, one might say, was kept to a minimum. The key news boils down to a commitment to continue printing money to stem the tide of economic contraction and its dreaded byproduct of deflation.
The extra stimulus will help, and as today's employment update reminds the world's biggest economy still needs assistance of some magnitude. Unemployment rose to 8.5% last month, up from 8.1%, the U.S. Department of Labor reports. Driving the jobless rate higher is the ongoing trend of job destruction. As our chart below shows, nonfarm payrolls continue to recede at a painfully steep pace. Last month's evaporation of 663,000 nonfarm jobs isn't the biggest on record, but it's big enough to snuff out any thought that recessionary winds will soon end.
A month ago we discussed some of the tools for estimating when GDP would stop contracting. One observation is that initial jobless claims have historically offered an early sign of things to come. When this leading indicator appeared to be topping out, there was hope that the worst had passed. Alas, we reasoned a month ago that the economic trouble would roll on, as suggested by initial jobless claims, and we're sticking with that forecast.
Our broad reading of the leading measures of economy tells us so, as we discuss in the April issue of The Beta Investment Report, which will be published shortly. First among equals in those measures is the trend in initial jobless claims. Indeed, two years ago the metric was flashing a warning. In 2009, we expect it will remain a valuable window into gazing into the future, along with other economic trends.
Meanwhile, as you can see from the second chart below, initial jobless claims continue to rise. Until its ascent slows and flattens, there's little reason to think that the general economic turmoil is set improve. The labor market is ultimately the foundation on which much of the nation's prosperity depends, and so as long as the job market is hurting, we're inclined to stay cautious.
In contrast to initial jobless claims, the unemployment rate is a lagging indicator and so waiting for this metric to show improvement insures that the capital and commodity markets will have already anticipated the rebound. That's one reason why watching initial jobless claims is so productive, since it offers some clues about where unemployment is headed and when the recession will end, which in turn helps us develop some context for thinking about asset allocation.
On the positive side, the monetary stimulus is now digging deeper into the economy and it's starting to have some effect. For example, investors are growing weary of earning nothing on T-bills. In fact, that's just what the Federal Reserve wants to hear. By dropping rates to zero, the central bank is trying to induce investors to look more favorably on risky assets. For several months, investors were inclined to sit tight and ignore the Fed's message. But lately there's been some movement toward reconsidering risk, as the recent gains in the stock market suggest.
But embracing risk full out is still premature. We're watching for signs to tell us that it's time to be more aggressive, but so far those signs aren't there. Indeed, as we detail in the upcoming issue of The Beta Investment Report, our proprietary measure of leading economic indicators has started showing signs of renewed weakness after bursting higher in recent months. Some of this is a reflection of the fact that the monetary stimulus is about as aggressive as it can be.
The good news, thin though it's been so far, has been primarily related to thinking that the deflationary risk is ebbing. Maybe. But even that's mere speculation, based on a few pieces of data of late. It's still not clear if the good news on deflation is something concrete, or just statistical noise.
Yes, we're inclined to nibble on the margins at risk, as we have been for some time. That's largely a reaction to valuations, which remain relatively compelling compared to what Mr. Market offered a year or two ago. Waiting for absolute clarity insures you'll earn little over the yield on cash. But we still need more confidence that the worst has passed on the economic front before making bolder bets on risk. Unfortunately, we can't make that call yet. We could be wrong, of course, but that's the nature of swimming in risky waters. The possibility of earning a risk premium is offset by the chance of earning less than the risk-free rate, even when it's zero.
April 1, 2009
THE CAT BOUNCED...AGAIN
March was kind to the broad asset classes, and not a moment too soon. After February's across-the-board declines, and virtually the same in January, a respite from the turmoil was overdue. Even in a global recession, prices don't fall continuously.
But they do fall, and it's not clear that the markets are through with discounting additional economic troubles. One sign for concern is that as markets rose last month, the estimates for the world economy worsened. Both the IMF and OECD are now projecting outright declines for global GDP this year. The OECD's projection is quite a bit worse, anticipating a 4% drop in the world economy vs. a relatively mild fall of 0.5%-1.0%, according to the IMF's estimate. That may look mild on a single-nation basis, but in the context of the global economy it's quite steep, not to mention unusual.
But for the moment, there's March. As our table below shows, everything popped last month. Equities across the world delivered a stellar performance, with emerging markets soaring by more than 14%. U.S. equities generated a robust gain as well in March, advancing nearly 9%.
March, in fact, was one of the better months for stocks generally in many a moon, proving if nothing else that powerful rallies can and will show up in nasty bear markets. But let's not forget that we're in a bear market and it's not yet over. Economically speaking, there's not much confidence about where we are in the cycle. Yes, there have been some encouraging signs recently, as we've discussed, including here and here. But the full brunt of the global recession isn't yet known. By our reckoning, coming to terms with the beast will take another quarter or two, perhaps longer.
The equity market will no doubt play its traditional role of anticipating the rebound, which means that prices will start turning up well ahead of macroeconomic data confirmation. But it's still too early to assume that the turning point is in sight.
That said, there's an enormous amount of money in cash and equivalents. At some point, perhaps sooner than we think, the crowd will grow weary of earning nothing. The appetite for risk is set for a rebound. But not yet. Strategic-minded investors will want to stay vigilant however, and take advantage of selling. But it's still premature to call for outright buying.