May 29, 2009
THINKING ABOUT RISK PREMIUMS
What should we expect from Mr. Market? The answer's always in doubt, but strategic-minded investors should run through the numbers anyway.
It's hard to overrate the value of taking a hard look at investing assumptions. By continually putting an expected price on risk, we become better investors. There are no crystal balls, but the next best thing is improving our skills in the art and science of discounting the future as a tool for enhancing return…maybe.
As an example, in the next issue of The Beta Investment Report we forecast an expected equilibrium risk premium for the market portfolio of 2.5%. We arrive at that forecast from summing up the individual forecasts for each of the major asset classes based on their market-cap-informed share of the total portfolio. Overall, it's a long-term prediction based on an equilibrium assumption and, we believe, a reasonable benchmark forecast, for reasons we discuss in some detail in the newsletter. But we can't be sure that our forecast is accurate and so we need to stress test our assumptions a bit. Here's a very brief illustration of the basic concept, including some of the give and take that keeps us forever wondering about what's coming.
If we assume a 3.0% risk-free rate for 3-month T-bills, our 2.5% risk premium forecast for the market portfolio becomes a 5.5% annualized total return outlook. But that's nominal. We also need an inflation forecast for estimating our real, or inflation-adjusted return.
Let's be generous and assume that inflation will be modest 2.0% going forward. That's a bit higher than the market's 1.8% inflation expectation, based on the spread between the yields on the nominal and inflation-indexed 10-year Treasury Notes. Yet 2.0% inflation is also below the 3.0% inflation that prevailed during the 20 years of the Great Moderation through 2008.
Putting it all together, expecting 2.0% inflation and a 5.5% nominal total return for the market portfolio leaves us with a 3.5% real annualized total return. But let's remember that forecasting is difficult, especially about the future, as the old saw goes. As such, we should assume that our predictions are subject to error. The question is how much error?
If inflation ends up at 3.0% instead of 2.0%, our real return falls to 2.5%. At 5.5% inflation, our real return is zero.
But perhaps actual inflation will be lower than our expectations. Or perhaps our risk premium projection of 2.5% will be higher. Meanwhile, a confident investor might project a higher return by skewing his asset allocation to, say, U.S. stocks because he thinks returns there will exceed the market portfolio's expected risk premium.
Then again, let's consider another alternative. We could buy a 20-year TIPS and lock in the real return of 2.42%, based on last night's close. That's nearly as high as our market portfolio risk premium forecast, which is a nominal return. Why is the TIPS market offering what appears to be a high real return? Are TIPS prices too low? Or is our risk premium outlook too low?
There are no definitive answers if we're looking forward. But until we start plugging in the numbers and making assumptions, the difficult business of making investment decisions is that much tougher. In a perfect world, we could simply extrapolate historical returns into the future. That would make our job as investors rather easy. Alas, it's not quite so simple. Historical returns are a volatile lot and it's not clear which historical period applies to the immediate future that awaits.
What should we do? Before we can begin making judgments about asset allocation, we need a neutral (or minimally biased) reference point for assessing the market outlook. In short, we need an estimate of equilibrium risk premiums for individual asset classes and the portfolio overall. From this foundation, we can amend the market-inspired asset allocation based on our risk preferences and expectations.
Estimates of equilibrium risk premium offer a basis for adjusting the asset allocation, if at all. Expecting that future returns will deviate from the implied equilibrium predictions in the short-to-medium term suggests changing the passive market-cap asset allocation. For instance, let's say that an investor is quite a bit more bullish on U.S. stocks for the next 3-5 years compared with the assumption in the long-run equilibrium risk premium forecast. Adapting that view into an asset allocation strategy translates into raising the U.S. equity weight over the market-cap weight; a more bearish perspective calls for a lower-than-average market-cap weight.
Most investors should probably accept the market-cap weight; in practice, almost no one does. Then again, that probably explains why the market portfolio's track record looks pretty good over time relative to actual portfolio results. To understand why, we need to make some assumptions beyond risk and return by also considering taxes and trading costs.
Beating the market is hard, in part because making accurate predictions is difficult. But even forecasts that are reasonable are in danger of being irrelevant, or worse, once we factor in the cost of trading and paying the government, say, one-third of any profits. That implies that we need more than reasonably good predictions to overcome the frictions that harass actual portfolios; we probably need stellar forecasts. No wonder that alpha's so scarce.
May 28, 2009
READY OR NOT, INTEREST RATES ARE RISING
Is it an ominous sign, or just another step on the journey back to normalcy?
For the moment, the jury's out, but there's no question that the benchmark 10-year Treasury Note's yield is upwardly mobile these days. Yesterday's jump to 3.71% elevated the yield to its highest since last November. What does it mean?
One interpretation is that the yield is simply returning to something approaching normalcy. As the threat of economic and financial disaster recedes, the price of money is expected to return to levels that prevailed before the world seemed to be coming apart in the last four months of 2008. That implies a return to the 3.5%-4.0% range for the 10-year, a range that was prevalent for much of last summer.
But in the current economic climate, nothing is quite as benign as it appears. Recall that it was only in March that the Federal Reserve announced that it would buy long government bonds to keep long rates low as part of its efforts to stimulate economic recovery. Immediately following the news, the yield on the 10-year dropped by an extraordinary 50 basis points in a single trading session, closing at around 2.5% on March 18. As of last night, the 10-year yield was 120 basis points higher. What does that say about the Fed's plans to keep rates low?
One theory is that Bernanke and company have failed because the market has called their bluff by raising long rates despite the central bank's best laid plans. Following this line of analysis, the Fed has diminished its prestige and influence by promising to keep long rates low and failing miserably at the task.
Perhaps, although one could reason that if the economic outlook has improved since March, which arguably it has, the central bank may no longer be so keen to sit on long rates. It surely hasn't gone unnoticed that the sea of liquidity that's been created over the past 12 months presents an inflation risk if left untended once the economy recovers. It's reasonable to assume that pulling back on the extreme state of monetary injection must be done gradually, over time, in which case the recent climb in the 10-year yield may be one example of letting the market move rates back toward equilibrium.
Adding to the notion that the worst of the recession may be behind us is this morning's news that the trend in new initial jobless claims continues to moderate, which suggests that this data series has peaked. If so, that's a sign it's no longer appropriate to price long bonds on the assumption that Armageddon is lurking in the shadows. (For some background on jobless claims as a window into the timing of the business cycle, read our post from last week.) Adding to the positive news is today's report that new orders for durable goods orders for April rose 1.9%. It'll take many more months of growth to repair the huge drop in orders over the past year, but at this stage every positive sign is welcome.
Nonetheless, it's still too early to declare victory over the dark forces of contraction that continue to stalk the land and so rising long rates may still pose a risk. One of the more worrisome theories is that the 10-year yield is rising primarily because of inflation fears rather than optimism about growth's prospects. In that case, higher yields will only increase the challenge that awaits in trying to juice the economy.
It's not yet clear where the truth lies. As such, we're now entering a new phase for the economy and one with an evolving mix of challenges and questions. Deciding if higher yields are good or bad news will take time. Meanwhile, the market being the market, one can't rule out a fall in yields in the near future and rendering the current discussion moot. Stranger things have happened. But while we're still struggling to figure out what comes next, it feels like we're at a critical juncture. Exactly how critical and why it's critical isn't yet obvious. But if the 10-year yield continues climbing, rest assured that the money game is about to change in more than a trivial way.
May 27, 2009
IS THE SMALL-CAP VALUE BETA STILL RELEVANT?
It's been 17 years since the professors Eugene Fama and Ken French penned the first of several papers that identified small-cap value as a separate equity beta worthy of special consideration. The basic idea is that stocks that are generally shunned by the crowd, as indicated by a low price-to-book ratio, are riskier than the market overall. Investors who are willing and able to hold this risk are rewarded with above-average returns in the long run.
There are a number of theories for why small-cap value stocks generate returns that are higher than implied by the standard interpretation of modern portfolio theory. One idea is that small-cap value is a proxy for the risk tied to the economic cycle. During recessions, small-cap value shares are especially vulnerable and so investors are especially keen to shun this group. In turn, the fear generates an above-average expected return for small-cap value.
A nice idea, but how's it played out in the real world? Over time, the Fama-French 3-factor model remains intact. Consider the chart below, which compares small-cap value stocks (Russell 2000 Value Index) to large-cap stocks generally (Russell 1000) for the past 22 years. A $100 investment in each on May 31, 1987 would have grown to $660 in the Russell 2000 Value as of last night's close—about 25% more compared with putting a C-note into the Russell 1000 for the same period.
Of course, it's folly to think that small-cap value outperforms each and every day, week and year. So far in 2009, for instance, the Russell 2000 Value has shed 2.7% on a total return basis while the Russell 1000 is up 1.3%, as of yesterday. And as the chart above reminds, small-cap value can and does suffer extended stretches of underperformance. In the late-1990s, for instance, large-cap stocks were unusually dominant, as the rising black line during that stretch shows. But then the tables turned in 2002-2007, with small-cap value soaring vs. the stock market generally.
If we're looking for more convincing evidence of small-cap value's risk premium in the long run, consider how the 1926-2008 record for annualized total return stacks up:
Small value stocks: 13.4%
Large value stocks: 10.7
Small growth stocks: 8.7
Large growth stocks: 8.5
S&P 500: 9.6
Source: Ibbotson SBBI 2009 Classic Yearbook
Is there an enduring small-cap value effect? It certainly looks that way, although it's likely to be a rough ride in the short run at times. But if the small-cap value beta persists, which it seems to do, what does it suggest for investment strategy? One implication is that if you're intent on trying to "beat the market," raise your allocation to small-cap value stocks above the group's weight in a broad market-cap index. Meanwhile, if you're relatively risk averse compared with the average investor, hold a below-market-weight share (or even a 0% share) of small-cap value stocks.
One could also make a case for dynamically adjusting the small-cap value weight through time in an effort to further elevate the return relative to passively holding this corner of the market. Indeed, the chart above certainly encourages this idea, although it introduces an additional layer of risk and one that's likely to benefit only a handful of investors after adjusting for trading costs and taxes. As we reported in this month's issue of The Beta Investment Report, small-cap value represented about 4% of the total market capitalization for U.S. stocks.
Then again, even a buy-and-hold approach to small-cap value offers no guarantees. That's why they call it a small-cap value risk premium. But as the empirical record continues to suggest, there's an unusual amount of risk embedded in small companies trading a low prices relative to their book values. What's more, the effect holds in foreign developed markets too, as a number of studies show.
In the grand scheme of strategies that try to "beat the market," this one appears durable for the long haul.
May 26, 2009
IS THE BOND MARKET TRYING TO TELL US SOMETHING?
In absolute numbers it's easy to shrug off, but the trend appears to have gained new momentum over the past week or so.
We're talking here of the spread between the nominal 10-year Treasury Note and its inflation-indexed counterpart, a.k.a., the 10-year TIPS. The yield difference between these two securities is one of the more widely watched market-based forecasts of inflation. It's not infallible, but neither is it irrelevant. It does, however, offer a real-time measure of the crowd's outlook for inflation and as our chart below suggests, the market seems to be growing increasingly anxious.
In absolute terms, of course, it still looks trivial. The current 10-year inflation forecast of 1.73% is, by historical standards, quite low. And as the chart above reminds, we're still quite a ways from the 2.5% forecast that prevailed before all hell broke loose last September.
Nonetheless, strategic-minded investors should keep an eye on the trend, which at the moment is decidedly on the rise. Much of the increase in the inflation forecast comes from selling the nominal 10-year Note, which drives the yield higher. Last Friday, the conventional 10-year closed at 1.72%, up from less than 1% in mid-March.
The trend is hardly surprising. We've known all along that the Federal Reserve is intent on raising inflation to fend off the risk of deflation. That's been a wise policy, but it shouldn't be written in stone. The great question is when to turn off the liquidity machine? For the moment, the risk of acting too early and choking off any nascent recovery seem roughly balanced with the danger of letting inflation out of the bag by letting the liquidity injections run on too long. But balancing acts have a finite lifespan.
It's still too early to make definitive decisions, but the capital and commodity markets seem to be telling us that pricing pressure is no longer benign, as the buoyant markets so far this year in gold and TIPS suggest. If true, the next question: Are the so-called green shoots of economic recovery robust or simply a mirage? Unclear at the moment, and it's likely to stay that way for some time.
Definitive answers about the economic cycle are always ambiguous in real time. Normally, that's not a problem because the stakes aren't usually so high in managing the business cycle. But this time around, there's enormous pressure to jump start the economy after such a dramatic economic implosion and so the monetary and fiscal tools have been deployed to an extraordinary degree. The prospective risk of inflation, then, may be unusually high—unless the central bank puts on the monetary brakes at the appropriate time. The trouble is that no one's really sure of timing. There's also some debate about whether the Fed will have the discipline to do the right thing when the time for action arrives.
Lots of questions, but at the moment bond traders don't appear willing to sit around and hope for the best.
May 21, 2009
ANOTHER CYCLICAL CLUE
The jury's still out on when the recession will end, but the case for arguing that the pace of economic contraction is slowing got another boost this morning with the weekly update on initial jobless claims.
For the week through May 16, new filings for unemployment benefits dropped by 12,000 to 631,000, the Labor Department reports. That's a clear signal that the recessionary winds are still blowing hard. But as we've been arguing for several months, including here, a topping out in new reported claims may signal the negative economic momentum is ebbing. Today's update continues to suggest that we're at or near the trough of the recession. Or, if you're an optimist, you might think that the trough came a month or two back.
The reasoning for considering jobless claims as an early clue of the general economic trend is suggested by the historical record, as we explained here. By that standard, today's numbers lend a bit more confidence that the downturn's low point has arrived, or perhaps just passed. But keep in mind that even if that's true, that leaves plenty of recessionary months ahead before growth returns.
The NBER dates the start of the current recession to December 2007. If we assume that we're now halfway through the contraction, the return of growth is still a ways off. The IMF's current forecast for the U.S. predicts the economy will simply tread water next year. If you're a bit more bullish, you might expect modest growth for 2010.
All of this assumes that the dreaded double-dip waiting isn't waiting in the wings. Given the weakened state of household finances, consumer spending may fall further, in which case corporate spending would have to fill the gap to keep GDP from slumping longer and/or deeper than the crowd currently expects. That's a tall order at the moment: businesses are still likely to err on the side of defense these days. That will change, but until we get more visibility on consumer sentiment for the next 6-12 months, it seems unwise to expect corporate America to embark on a spending spree any time soon. Consumers, after all, account for about 70% of GDP, and so Joe Sixpack's outlook is critical. Given the lightness in his wallet, however, the case for caution is still compelling.
So, yes, today's news on jobless claims is welcome and encouraging. But it's still only one statistic. The odds remain high against a quick turnaround. Meanwhile, perhaps we have a 50/50 chance of sidestepping another round of economic weakness. But don't count out more bad news just yet. No matter how you slice it, this is still a vicious recession, and so negative surprises are still possible if not likely.
May 19, 2009
ALAN BLINDER'S HALF RIGHT
Former Fed vice chairman Alan Blinder warns of the dangers of slowing the central bank's printing presses too early and thereby repeating the mistakes of the mid-1930s. As he explains,
From its bottom in 1933 to 1936, the G.D.P. climbed spectacularly (albeit from a very low base), averaging gains of almost 11 percent a year. But then, both the Fed and the administration of Franklin D. Roosevelt reversed course.
In the summer of 1936, the Fed looked at the large volume of excess reserves piled up in the banking system, concluded that this mountain of liquidity could be fodder for future inflation, and began to withdraw it. This tightening of monetary policy continued into 1937, in a weak economy that was ill-prepared for it.
Blinder is right to warn against ending the liquidity injections too early. But that doesn't mean the party should go on forever. In a sign of the times, however, Blinder's mum on identifying that magic day in the future when the ambitious expansion of the money supply and the Fed's balance sheet should end and the monetary tightening should begin. He's quiet on this point for a very good reason: He doesn't know the date. Nor does anyone else, and therein lies the great challenge confronting the U.S. economy, and one that Blinder avoids discussing in his otherwise salient article on Sunday in the New York Times.
Overlooked or not, there will come a day when the great countercyclical monetary operations of the Fed should cease and desist. That doesn't mean that the efforts to juice inflation will end, at least in a timely manner. To the extent that they don't and they should, the American economy will suffer. Inflation, in sum, lurks in the future, just as it always has and always will. That's the nature of paper money. The issue is one of deciding to control the beast, and it's never too soon to plan ahead.
There's no imminent danger, of course. The seasonally adjusted consumer price index was flat last month and over the past year it's fallen 0.7%. Clearly, there's no pressing reason to raise interest rates at the moment, nor does the futures market expect Fed funds to rise any time soon. But as the Fed's aggressive monetary actions over the past year become deeply embedded in the economic fabric, expecting inflation to remain dormant indefinitely is expecting too much. Indeed, the Fed is effectively spending all its efforts on reviving inflation, and we, for one, think that it'll be successful.
So, too, does the man running the Fed, or so he said when he was a Fed governor expounding on the powers of the printing press when it's controlled by a resolute central bank intent on devaluing the currency, a.k.a., creating inflation. The trick at this juncture is to devalue just a bit so as to perk up the economy without unleashing disagreeably high levels of inflation. Meanwhile, it's hard to overlook the fact that the mountain of debt piling up on the U.S. government's balance sheet would be eased as inflation rises. Paying lenders back in devalued currency has more than a little precedent, and it's hard to believe that the allure will hold no sway in Washington in the years ahead.
In any case, Bernanke is confident about the prospects for elevating the general level of prices, or so he said back in 2002, explaining that "under a paper-money system, a determined government can always generate higher spending and hence positive inflation."
The use of the word "always" sounds rather definitive. The only question is timing. So, yes, Blinder's counsel that the Fed should be mindful of raising interest rates too early and thereby repeating the mistakes of 1936 is germane. But let's remember that his advice addresses only half of the monetary risk that awaits. At some point, the economic trends will shift and waiting too long to raise interest rates will be the primary hazard. We don't know if the turning point will come in a few months or a few years, but we shouldn't delude ourselves that it's never coming.
May 15, 2009
A BRIEF HISTORY OF THE GLOBAL MARKET PORTFOLIO
It all looks obvious in hindsight. It always does. But the future has its own brand of consistency: It's always unclear.
The good news is that the future's not as unclear as we once thought it was. Revelations in financial economics over the last 20 years or so gives us reason to think that returns are partly predictable when looking out over the medium-to-long-term horizons. In the short term, momentum seems to play a role, perhaps a dominant role.
The trick is figuring out how to blend these insights into one strategic vision. One piece of the puzzle is keeping an eye on the evolving relationship of asset classes through time. On that note, the chart below offers a preview of what we'll be studying in more depth in the next issue of The Beta Investment Report. The graph shows how the major asset classes performed relative to one another from the end of 1997 through April 30, 2009. It's a busy graph and so as a favor to your eyes click on the larger version.
The primary message is that there's been plenty of volatility in the various components that make up the total market index. Speaking of which, our proprietary Global Market Index, a passive weighting of the major asset classes, has performed more or less as you might expect relative to the world's capital and commodity markets. In other words, GMI's delivered average performance, give or take. (The heavy broken black line in the chart above is GMI.)
That's another way of saying that GMI has beaten some asset classes since 1997 and trailed others. The question, as always: Which asset classes will beat GMI in the future? It may be tempting to simply pick the ones that have outperformed in the past as repeat winners, but that's misguided. Diversification works over time, but a lot depends on what you pay for the individual pieces. That's especially true if you're planning on besting GMI. The price of risk, in other words, is critical.
Unsurprisingly, generating alpha relative to what' available to everyone as beta is tougher than it looks, as the mediocrity in much of the active management industry suggests. That's not to say that we should simply lie down and accept GMI as the best we can hope to achieve. But neither should we assume that besting Mr. Market's asset allocation will be easy. Finding the sweet spot is primary mission. After that, the details get messy.
May 14, 2009
SLOW AND SLUGGISH, AND THAT'S THE OPTIMISTIC FORECAST
Today's update on wholesale prices and new filings for unemployment benefits strengthens the case for thinking that the worst of the economic crisis is behind us. Or perhaps it's better to say that the numbers du jour don't derail the case for optimism. But as we opined yesterday, and repeat today, there's likely to be a longer-than-usual gap between the recession's trough and a return of what the crowd recognizes as a sustained rebound in growth of some magnitude.
Meantime, there are two more data points that support a somewhat brighter outlook of our still-speculative forecast that the cyclical low point, if not imminent, is near.
Let's begin with the producer price index (PPI) report for April. Wholesale prices rose 0.3% last month, the government reports. That's in contrast to the 1.3% drop in March. Yes, PPI remains volatile, and on a year-over-year basis there's outright deflation. But as the monthly readings suggest, maybe, just maybe, we've found some stability in prices.
Still, as the chart below reminds, there's still quite a bit of play in the month-to-month numbers. It wouldn't be surprising to see a sharp decline next month or the month after. We'll just have to wait to confirm, or deny, our suspicion that wholesale prices are in the process of stabilizing after the earth-shattering blowback from the financial and economic crisis of late.
That said, news that monthly prices aren't in free fall is encouraging for thinking that the deflationary threat is passing. As we've discussed repeatedly since this crisis began, including here and here, preventing deflation from taking root is the essential first step for returning the economy to something approximating a normal state. If prices are allowed to decline, the headwinds for growth become far stronger. But there's reason for mild optimism.
It's still too early to declare the deflation battle won, but neither is there reason to think that we're losing the war. But let's wait and see what tomorrow's news on consumer prices brings.
Meanwhile, today's update on initial claims for jobless benefits continues to suggest that we're at or near the recession's trough. We've written about the value of this data series as an early indicator of the cyclical bottom, including our review of the historical record. The basic lesson is that new filings have a tendency to peak at or just ahead of the technical end of the recession, as per NBER's definition. For a couple of months now it appears that jobless claims are peaking, and so we've been writing about the possibility since March that NBER will eventually label the current period as the end of the current economic contraction.
On the other hand, today's news that new filings rose by 35,000 last week to 637,000 appears to throw cold water on the idea that the recession may be technically at an end. But as the chart below shows, new jobless claims of 635,000 are still within the range of what may prove to be the peak for this cycle. The high point so far was set in late March at 674,000. Last week's total, although up from the previous reading, is still comfortably below the peak.
Nonetheless, we're still in a period of erratic economic behavior and it remains to be seen if we're merely in a temporary lull that precedes another round of pain vs. a true cyclical bottom. Hope springs eternal, but we still need more data to make a stronger declaration that the worst has passed. And even if it has, patience is still required.
The official end of the recession isn't likely to bring a material change in the discouraging economic news. The technical end of recessions still bring plenty of pain for Joe Sixpack in the ensuing quarters. The fact that this recession is the deepest since the Great Depression suggests that the recovery period, whenever it commences, will be unusually slow and sluggish. And that's the optimistic outlook!
May 13, 2009
BETWIXT AND BETWEEN
Today's update on retail sales for April wasn't bad, but it wasn't good either. We suspect that more of the same is coming, in retail sales and other economic numbers. The worst of the recession appears to be passing, but the best of the rebound is still nowhere in sight.
Retail sales slipped a mere 0.4% last month on a seasonally adjusted basis, the Census Bureau reports. As declines in this series go, that's the mildest downturn yet since the recession began in December 2007. That's all well and good, but let's not forget that the outright monthly gains in retail sales of January and February have faded. Are we now settling into to a period of treading water? Perhaps.
To be sure, there were some bright spots in today's report, including gains in retail sales in the auto and building materials sectors. But overall, the message in today's update is that momentum in retail sales appears is conspicuously absent. Changing the dynamic will take a sharp turnaround in the labor market. That glorious day, however, is nowhere in sight.
Retail sales are but one indicator, of course. The problem is that broader measures of economic activity aren't yet telling us that growth is near. The majority of the 17 economic indicators we track for The Beta Investment Report are still falling, as the chart below shows.
Since our official call back in March 2008 that the recession had arrived, the chart above has given us little reason to expect that a return of economic expansion is imminent. Our cautious outlook looks all the more relevant as the Fed's huge monetary stimulus of the recent past recedes as a force for stabilizing the economy. It was a bulwark against an even deeper strain of decline, but it was only a temporary stopgap. Eventually, the economy seeks an equilibrium level, even if government intervention slows the process. But as the weeks and months pass, the natural economic forces of supply and demand dominate. Indeed, in the chart above, the sharp bounce from last November to this past February is giving way to the forces of contraction once more.
As Yogi Berra said, It ain't over till it's over. This recession isn't over, even if the worst of the contraction is behind us.
May 8, 2009
The momentum in the front line of the recession still favors the dark forces of contraction, today's update on employment for April suggests. One can argue that there's a bright side to the job destruction, but that's still wishful thinking. Indeed, it's hard to put a positive spin on a retreat of 539,000 for nonfarm payrolls last month.
Yes, that's better than the 699,000 drop in March, but then that's not saying much. The hope is that the slowing pace of job loss is a sign of better times. Perhaps, although we shouldn't expect too much too soon. The vanishing act in jobs continues to be widespread and deep, affecting both the goods-producing sectors as well the services side of the economy.
Still, the worst of the labor market's contraction may be behind us, which is a reasonable forecast, as the apparent topping out in new filings for jobless benefits suggests. Yesterday's update on weekly claims for unemployment benefits implies no less. But a slowing rate of job loss isn't the same thing as job growth. Even if the labor market contracts at a much slower rate of, say, 200,000 jobs a month for the rest of the year, that's still another 1.6 million fewer workers earning a paycheck by New Year's Eve.
Meanwhile, in the here and now, the labor retreat in this recession is already much deeper than any downturn in a generation, according to the Economic Policy Institute. And more losses are likely in the months ahead. But let's assume no more labor contraction. We're still facing quite a challenge in rebuilding. Just to return to the pre-recession labor market status, the economy at this point needs to create 7 million new jobs, according to EPI. That's a daunting number if you consider that nonfarm payrolls grew by 7.9 million in the 5 years through the end of 2007. But that was a period of robust growth, cheap money, a roaring bull market in all the major asset classes, and a real estate boom of unprecedented proportions. Don't hold your breath for a repeat any time soon. The reason is debt. There's lots of it, and it weighs especially heavy on household balance sheets.
The oft-cited statistic that consumer spending accounts for 70% of GDP is relevant here—painfully so. Indeed, it's going to take time for Joe Sixpack to work through the twin challenges of falling house prices and the growing odds that our hero will be out of work for some time.
Meanwhile, as if all this wasn't tough enough, there's a new threat afoot in the rising yield on the benchmark 10-year Treasury Note. Yesterday, the 10-year closed at roughly 3.3%. That's up sharply from the ~2.5% level reached right after the Fed's announcement on March 18 that it would directly buy long Treasuries in an effort to keep rates low. The question here is whether the Fed's losing control of its ability to keep the price of money low. Eventually, the market will have its way, which is to say that rates will rise. The hope has been that Bernanke and company would be able to keep market forces at bay long enough to allow growth to take root. At the moment, there are renewed concerns about the viability of this plan.
All of this raises questions as to whether the recent stock market rally has gotten ahead of itself. Ed Yardeni of Yardeni Research, in a note to clients this week, advises that while U.S. stocks have rallied sharply since mid-March, forward earnings for the S&P 500 have dropped. The expectation seems to be that earnings in the coming quarters will bounce substantially higher and validate the higher equity prices.
Hope, it seems, remains the main support system behind the renewed optimism on Wall Street, or what's left of it. But hope only gets you so far. Soon, and perhaps sooner than the crowd thinks, hard numbers showing recovery will be required to keep a fresh round of selling from returning. Otherwise…
For what it's worth, we're not yet confident that the old market lows won't be tested anew.
May 5, 2009
CONSIDERING THE NEXT PHASE
In late-March, we asked: Is the medicine working? By medicine we meant the massive injection of liquidity into the economy as a cure for fending off deflation and laying the groundwork for recovery. At the time, we were mildly encouraged, in part due to the rising inflation forecast as derived from the spread between the nominal and inflation-indexed 10-year Treasuries.
More than a month later, there's still reason for optimism, perhaps more so, thanks to the so-called green shoots that suggest better days ahead. Yet the rate spread, which is to say the market's inflation outlook, hasn't changed much since late-March. The current forecast is for inflation of 1.4% for the next 10 years, just barely up from around 1.3% from the end of the first quarter. In both cases, that's a healthy change from expecting flat pricing, as was the case at the end of 2008. Low inflation as far as the eye can see would be nice, but is that a reasonable expectation?
In the months ahead there'll be a thin line between a healthy rise in inflation expectations and the potential for burdensome pricing pressures later on. Deflation is a hazard to be avoided for a number of reasons. Although we can't quite shut the book on the danger, the odds look increasingly in favor of mild inflation for the foreseeable future, as the chart above suggests. Behind this reasoning is the growing sentiment that the recession is at or near a bottom. Is it time for the Fed to begin tightening? Or are the green shoots still too tentative?
"We're seeing more indications of perhaps a bottoming in the economy," Bill O'Neill of LOGIC Advisors tells Dow Jones. "So there is an increasing—and it will continue to increase—concern surrounding inflation potential."
Gold, the perennial inflation hedge, seems to be considering the possibility, although this market hasn't quite made up its mind. The price of the metal has been hovering around $900 for much of this year, just below its all-time high of $1,033, set back in March 2008. The 10-year Treasury yield, meanwhile, has been climbing, recently bumping up against 3.2% on renewed worries that inflation may now be the bigger risk. Even so, a 10-year yield of 3.2% is still quite low.
None of the inflation anxiety is worrying the stock market, which has now reversed the selloff in the first quarter. Indeed, the S&P 500 is now marginally up on the year, as of last night's close, on expectations that by the end of this year the economy will be sitting up and prepared to get out of bed.
The big question is whether all the renewed hope that the worst is over is really just the byproduct of a bear market bounce in markets and inflation expectations? Given the extreme waves of selling last year and into March, a rebound was all but assured if the world economy didn't collapse. As we now know, it didn't. There are still lots of problems, but we'll all be here next year and so it was time to reprice assets upwards to reflect a humbled but otherwise enduring economic climate.
Investors have cheered the signs that the U.S. economy no longer seems to be contracting at an accelerating pace. Given the fears of what could have happened, that's certainly a reasonable response. Deciding that you're not going to fall into the abyss is always encouraging. But that's still a long way from arguing that growth is imminent, or that the economy won't tread water for a year or two.
The first phase of the post-apocalyptic visions that prevailed six months ago may be over. If so, now we're faced with the more difficult chore of deciding how to repair and rebuild the economy to foster growth while containing inflation. The hardest days are yet to come. Unless you're expecting a seamless transition, keeping some cash at the ready still makes sense, albeit less so than in past months. Volatility isn't banished, it's only hibernating, which suggests another round of value-oriented pricing opportunities in the major asset classes.
May 1, 2009
ANOTHER BOUNCE IN APRIL
April was another solid month of recovery for the capital and commodity markets, building on March's rise. There's still a long way to go to repair the damage of September through February. Indeed, it'll probably take years for all the asset classes to return to old highs. But for the moment, there's reason to be optimistic, if only tenuously.
The big winner last month: REITs, which surged nearly 33%. Even so, this slice of the capital markets has been so heavily battered over the past year or so that even an extraordinary run does little to reverse the damage.
The lone loser in our horse race was inflation-indexed Treasuries, which slipped 1.9% in April, although for the year so far the asset class is up 3.6%. Otherwise, everything posted a gain. Our passive global market portfolio index climbed a robust 6.6% last month, an improvement on March's roughly 5% advance. Year-to-date, GMPI is off by a fractional -0.5% vs. -1.4% for U.S. stocks, based on the Russell 3000.
It's tempting to think that the danger's passed. Not quite. As we explain in this soon-to-be-published May issue of The Beta Investment Report, strategic-minded investors should remain wary. Yes, expected returns look enticing. But there are still many economic and financial challenges ahead and no one should underestimate the potential for short-term volatility.
In short, these are productive days for designing and managing asset allocation, but you'll have to work hard to generate and keep every basis point of risk premium from here on out. That starts with maintaining steely discipline. Last we checked, there are still no free lunches available.