June 29, 2009
It's been a tough year for value stocks. Is that surprising? No, although it reminds that Mr. Market prices certain slices of the equity market differently throughout the business cycle.
For the year through June 26, the rebound in equities has been powered mostly by growth stocks, according to Russell indices. As the chart below relates, growth stocks in general have been the conspicuous leaders through the first half of 2009.
This is hardly surprising in light of the unfolding story in financial economics over the past generation. Return premiums are linked with macroeconomic risks, which means that investors are compensated over the long haul for taking certain risks. Some of those risks pay higher rates than others and if you wait long enough, you'll probably realize the higher returns. All the more so if you pay attention to the fluctuating price of risk in the short term.
The small-cap value (SCV) factor (as originally outlined by Professors Eugene Fama and Ken French) is among the most widely known return factors beyond the market overall. The source of SCV's higher return through time is higher risk linked to the business cycle. Economically, there can be no free lunches, at least in the long run and so any expectation of earning a higher return must be connected with assuming a higher risk.
Since 1928, small-cap value stocks have posted a clear return premium over U.S. equities generally, as defined by the S&P 500 and its predecessor benchmarks, based on analysis of data from Ibbotson/Morningstar (see graph below). Even over somewhat shorter periods, although well beyond "trading" horizons, small-cap value has held up well. For the 10 years through the end of last week, for instance, the small-cap Russell 2000 Value Index posted a 5.4% annualized total return, comfortably above the 1.4% loss for U.S. stocks overall, as measured by the large-cap Russell 1000 Index over that stretch.
Why should investors expect to earn higher returns in SCV? Chart 1 above offers a clue, namely: In the short run, small stocks trading at low prices relative to book value and other accounting metrics tend to be more vulnerable in tough economic times. There are a number of reasons for this, as many economists discuss in the literature published over the years. The simple answer is that small firms trading at low valuations tend to be shaky operations to begin with and so the arrival of a macroeconomic headwind makes the prospects for success even more remote.
Individual companies perish, but as an asset class small-cap value shares survive, although not without a roller coaster ride in the interim. For obvious reasons, most investors shun risk during recessions, especially one that's been as deep as the current contraction. But as Professor John Cochrane at the University of Chicago likes to say, someone holds these stocks, even in the worst economic recession since the Great Depression. The question is why? The answer is intimately tied up with the connection between economic cycles and how Mr. Market prices assets.
Of course, investing and risk management are always about the future. That leads to the perennial question: What comes next? Will small-cap value stocks continue to outperform? That's always a topical question when this slice of the equity market is suffering, as it is currently. Looking backward is one thing; committing real money today in anticipation of a repeat performance is something else.
In fact, no one can be sure that SCV will remain true to its historical trend. Yes, there are persuasive arguments for expecting the long-run future will look like the long-run past, but in the short term there's risk--considerably more so than the long-run past suggests. That's one reason for being cautious about betting the farm on SCV, which is to say holding lots more of these equities than the market-cap equity indices do.
On the other hand, if you're persuaded that there's an economic logic to SCV's historical return premium, owning a bit more of these stocks above Mr. Market's asset allocation looks reasonable. Just remember, even if your bet pays off, it'll come at a price, as the first chart above reminds.
June 26, 2009
THE GREAT EXPERIMENT BEARS FRUIT...SO FAR
One day we'll look back on 2009 and wonder what all the confusion was about. All will become clear and we'll know when the recession ended, when the bull market began anew and how and why the cycle turned. Meanwhile, we're wondering if the data du jour can be trusted.
Judging by the numbers of late, clarity is upon us, or so it seems. Income and spending are up among consumers. What's not to like? If this keeps up, we'll be back to the good old days by, oh, let's say the third week of September.
As for what we know today, disposable personal income jumped 1.6% last month on a seasonally adjusted basis, the Bureau of Economic Analysis reports this morning. That's the biggest monthly gain in a year. Not bad for what we've repeatedly been told is the deepest recession since the Great Depression.
That's only half the fun. The government also advises that personal consumption expenditures gained 0.2% in May, the best since February.
Is it a miracle? No, it's just your tax dollars at work. As the BEA noted in its press release today, "the pattern of changes in personal income and in DPI reflect, in part, the pattern of increased government social benefit payments associated with the American Recovery and Reinvestment Act of 2009." In other words, the guys and gals in Washington continue to print money and distribute it, creating a revival that otherwise doesn't exist. The extent of the government's intervention can be surmised once we recognize that wages and salaries actually fell by 0.1% last month.
There are two ways to interpret the news. The optimistic view is that the government's stimulus efforts will steady an otherwise anxious consumer. By putting more money into his pocket, the incentive to spend is heightened and the odds improved that a return to old consumption habits is near. The government payments are a bridge until the day when the private sector can resume more of the burden of financing consumption.
The darker view is that government-financed consumption is a tenuous lifeline that's a pale replacement for the real McCoy. As such, the burning question is one of asking when the labor market will revive? By that standard, there' still reason to be cautious about the remainder of 2009. The recession may be technically over, as we've discussed. But even making that leap of faith offers no short cut to good times.
The job market, after all, is typically the last to show convincing signs of recovery. For that reason, the National Bureau of Economic Research shuns employment trends for putting official dates on business cycle turning points. Minting new jobs, in other words, is usually the response to other economic stimuli. Conventional recoveries, then, don't begin with the labor market. Then again, this isn't a conventional business cycle.
Clearly, the government has moved heaven and earth to keep the economy afloat. Ours is an era of triumph for public-financed consumption. In both magnitude and timeliness, no government has ever acted with greater speed and depth in keeping the forces of contraction at bay. But that raises a question of whether Washington can keep the engineered consumption going long enough to wait for a bonafide economic recovery. We'll have an answer, perhaps soon. But at the moment we're still knee-deep in the first great macroeconomic experiment of the 21st century.
June 22, 2009
AN EARLY SUMMER RETREAT
The Capital Spectator will be taking a few days off, returning to what passes as normal around here on Friday, June 26.
GOOD NEWS...AND SOME OTHER STUFF
Another former Fed club member weighs in today on how/when/if the Fed unwinds the massive monetary stimulus it's created over the past year. Frederic Mishkin, a former FOMC member, summarizes the problem and the potential in today's Wall Street Journal, observing that there's good news and bad news embedded in the recent rise in long-term interest rates:
"One cause of the rise in long-term rates is the more positive economic news of the past couple of months, particularly in financial markets. The bad news is that long-term interest rates are higher because of concerns about the deteriorating fiscal situation, with massive budget deficits expected for the indefinite future. To fund these budget deficits, the Treasury has to sell large quantities of bonds both now and in the future, causing bond prices to fall and interest rates to rise."
Speaking of expectations, what's the market thinking? Based on the previous close of Fed funds futures on CBOT, traders think the central bank will begin tightening the screws ever so slightly in the second half of the year, as per the chart below. To be sure, there's still no inflation on the radar screen and it's not yet clear the economy has stopped contracting. But markets have a tendency to look forward. That doesn't make them right, but it doesn't stop them from considering the full range of possibilities and placing odds on what appears to be the most likely outcome.
June 21, 2009
IS IT EVER TOO EARLY TO WORRY ABOUT INFLATION?
Last month, Alan Blinder warned that the main risk in monetary policy was pulling away from the stimulus too soon. We responded by pointing out that there was also a danger of letting the liquidity surge roll on too long. The challenge is finding a balance between the two, we argued.
In a follow-up piece today, Blinder basically reiterates his earlier article, asserting that "inflation isn't the danger." But he hedges himself a bit this time, advising: "As long as expected inflation doesn’t rise much further, you should find something else to worry about."
We couldn't agree more. Inflation's never a problem, until it becomes one. For the moment, the market's expectation of inflation is, in fact, quite tame, as Blinder points out. But it's not today we're worried about.
Blinder says the Fed is aware of the extraordinary liquidity it's created and that the central bank will do the right thing at the right time. We all know what the right thing will be--tightening the monetary policy levers. Figuring out the right time to do so will be devilishly tricky. In fact, getting the timing exactly right is virtually impossible. The only question, then, is how do you want to err? Early or late?
June 18, 2009
SOME CALL IT PROGRESS
Nirvana for investing is getting tomorrow's news today. Impossible, of course, which leaves strategic-minded investors to search for the next best thing. That boils down to hard work.
Estimating expected return and risk is at the heart of intelligent investing. We still can't peer into the future with a high degree of certainty, but thanks to decades of inquiry in the realm of financial economics there's a modestly clearer picture of how the markets behave and what that means for asset pricing.
Explaining the details would take more than a few posts here, to put it mildly. Indeed, fleshing out the finer points is one of the reasons for launching The Beta Investment Report, which discusses new and existing research and updates the implications for multi-asset class investing on a monthly basis.
Meantime, consider a few examples of how the markets drop clues for estimating risk premia. Take the Treasury yield curve, which has gone negative ahead of every recession for the last 40 years, including the current downturn that began in December 2007, as per NBER. For obvious, and not-so-obvious reasons, that's a crucial measure for estimating the equity performance over the medium- and long-term horizons. Granted, it's not a timely indicator in the sense that recession may not arrive for a year or more after the fact. Nor can the indicator be blindly trusted to be a timeless, unerring metric of what's coming. There's always the chance that it could be wrong the next time. But there's quite a bit of economic research that suggests we should pay close attention to yield curves.
Nonetheless, the yield curve can't be used in isolation. We need to monitor and analyze other metrics too, with an emphasis on considering a range of data series that aren't closely related. For instance, the dividend yield on the overall stock market fits the bill. It too has a powerful economic basis for dropping clues about the future, economists advise, in this case offering a more direct estimate of the expected equity market return. Alas, as a consistently timely metric over the decades, trailing dividend yield looks marginal as a signal of the future. But that's not the challenge it appears to be for a number of reasons.
Economists are only just beginning to piece together how the predictive abilities of any one factor fluctuate through time, partly in sympathy with the ebb and flow of the business cycle. In other words, different predictors offer a better view of the future only at certain times vs. other predictors. The implication: intelligently combining an array of predictors is more productive than any one factor suggests. The evidence that this is more than wishful thinking is becoming clear in the empirical research, as we discuss semi-regularly in The Beta Investment Report.
Consider, for instance, that dividend yield tends to offer a more robust outlook for returns during times of broad economic stress vs. during periods of economic expansion. Meanwhile, the yield curve is more productive as a tool for estimating the business cycle at times when the curve inverts. Recognizing those points and putting these two metrics together, then, offers a deeper, richer level of context on a strategic basis than either metric does alone. Of course, we need more than these two variables, but the basic idea is that more is better.
Let's be clear: Piecing together the limited evidence for what's coming isn't easy, nor is it necessarily intuitive. Even worse, it doesn't offer a sure bet, which is one reason for owning a broad array of asset classes that deviate only cautiously and intelligently from the market-value weights On the other hand, estimating returns based on the economic logic offers more promise for projecting returns vs. a naïve extrapolation of the long-term historical record.
Market behavior and asset pricing are still mysterious in many respects, but we're learning some of Mr. Market's secrets over time. To be sure, the old man doesn't tell us much; in fact, he's reluctant to tell us anything. The good news is that a few tidbits have spilled out over the decades.
June 17, 2009
A BULL MARKET IN FALSE DAWNS?
Flat to a slight upside bias. That about sums up the prevailing state of inflation at the moment, based on this morning's latest from the U.S. Bureau of Labor Statistics.
Seasonally adjusted consumer inflation rose 0.1% last month, up from zero the month before and a modest decrease in March. On its face, that's good news, as it suggests that the risk of deflation, if not quite passed, is looking more and more like a shadow of its formerly threatening self. Meanwhile, inflation as a clear and present danger also remains thin as an imminent menace.
We are in a transitory state, passing from severe danger to something less so. Anything's possible, of course, especially in the current climate. But barring some extraordinary and largely unexpected event, we're likely to press on through what we'll call a pre-recovery period, when the economic numbers improve relative to the recent past yet the numbers don't quite show the traditional bounce that typically accompanies the end of recessions.
"The economy seems to be out of intensive care," says David Shulman, senior economist at UCLA Anderson School of Management. "The freefall stage in dropping output and employment seems to be over, but the economy is still sick."
The prospect of false starts in the data looks quite high in the months ahead. The good news on one day will be reversed by bad news the next, and quite a bit of treading water at other times. The transition state that carries us from recession to growth, in short, will last longer than usual. The evidence will be particularly obvious in the lagging indicators, employment being the most conspicuous example. Indeed, the labor market is still shrinking and will probably continue to do so in the months ahead, perhaps followed by an extended bottoming-out period over several quarters. The economy's capacity to create jobs is likely to come later and be more tepid than has typically been the case following the end of recessions in the post-war era.
Extending the medical metaphor, Bruce Kasman, chief economist for JPMorgan Chase, predicts in BusinessWeek.com yesterday that "the economy will return to growth but not to health."
Last week we wrote of the "technical end" of the recession and our expectation that NBER would eventually get around to declaring the downturn's finish at, well, right about now, give or take a few months. That's good news relative to the recent standard of economic activity. But the technical demise of the recession isn't likely to bring easily recognizable good news on Main Street anytime soon.
As frustrating as that outlook is, it's even more hazardous than is generally recognized. If we're facing an unusually long transition period, there are specific risks linked to this abnormal state of affairs. That includes figuring out how and when to adjust monetary policy to balance two conflicting forces: deflation and inflation. As the former gives way, the latter isn't likely to suddenly pop out and yell "boo." Nonetheless, the future inflation risk isn't trivial, given the massive liquidity that's been created of late and the historical lessons that go with fiat currencies. As we discussed on Monday, the elevated risk this time around will be one of deciding magnitude and timing in adjusting monetary policy going forward. That's always a challenge, although it's likely to be especially problematic in the quarters ahead. Tightening monetary policy too soon may risk choking off a nascent but weak recovery; waiting too long to raise interest rates may give inflation a solid foundation to thrive, an especially troubling thought, given the massive amount of debt incurred over the last 12 months or so.
Overall, economic analysis faces unusually tough times in reading the incoming data and drawing reasonable conclusions about the implications for the future. As a basic example, our proprietary index of economic indicators, published in each issue of The Beta Investment Report, is currently flashing a robust sign of recovery, although this may be misleading because much of the rise has come from monetary policy and, so far, isn't convincingly corroborated in the real economy.
In short, interpreting the economic outlook promises to be quite difficult going forward, much more so than usual. Beware: The risk of false dawns is rising.
June 15, 2009
THE CASE FOR GRADUALISM IN MONETARY POLICY
New York Times columnist Paul Krugman writes today that it's too early to begin removing the monetary stimulus engineered by the Federal Reserve.
"A few months ago the U.S. economy was in danger of falling into depression," he notes in his column. "Aggressive monetary policy and deficit spending have, for the time being, averted that danger. And suddenly critics are demanding that we call the whole thing off, and revert to business as usual. Those demands should be ignored. It’s much too soon to give up on policies that have, at most, pulled us a few inches back from the edge of the abyss."
He may be right…or not. Debating the correct monetary policy is always topical in real time, and always unclear. As it happens, the stakes are unusually high in the current debate. The future, however, isn't necessarily any clearer, nor is it apparent that the Federal Reserve has suddenly transformed itself into an institution with omniscient powers.
Following the 2000-2002 bear market, the Federal Reserve decided that unusually low interest rates were necessary—for several years! Even though the economy had obviously recovered and was expanding at a healthy clip in 2003 and 2004, the central bank kept the price of money excessively low. The error didn't necessarily inflame inflation risk, but it did contribute to excessive investment in, among other areas, real estate by creating abnormal incentives for borrowing. Nor was this the first time that the Fed misjudged monetary policy.
Now we're faced with another potentially far-reaching decision on monetary policy. It's tempting to proclaim that all's clear and so it's timely to do this or that. But history reminds that what's obvious looking ahead may turn out differently after the fact.
Prudence suggests that there's no reason why monetary policy must go from one extreme to another overnight. If the central bank had full transparency about the future, and that spilled over into complete clarity about monetary policy in real time, there'd be a case for sharp, dramatic changes to the interest rates. But ours is a world of constantly grappling for perspective, day by day, using imperfect information that's out of date. Our forecasts are, at best, only partly reliable and so our policy responses must evolve rather than lurch from one regime to another.
With that in mind, it's clear that interest rates should rise going forward, but there's a great debate about how far they should rise and when the ascent should commence. Since we don't really have a good answer, we must hedge our bets. On the one hand, we can't let inflation out of the bag. Given the massive liquidity injections of late, and the inflation-prone history of fiat currencies, this is no idle threat.
At the same time, the risk of continued economic weakness shouldn't be dismissed either. There are reasons to be hopeful that that recession may be over, but it's still far from clear that the recovery will be robust or even long-lasting, as we discussed on Friday.
Navigating between these two extremes is the only reasonable strategy for mere mortals at this point until we have a better handle on discounting the economic future. Perhaps we'll have a clearer view in the weeks ahead; perhaps not. That said, the risk of maintaining the status quo for monetary policy still look minimal. But unless the next few weeks offer compelling evidence otherwise, it'll be soon time to begin raising rates, albeit marginally if only to show the market that the Fed is serious about fighting inflation in the future, if necessary.
Should we raise Fed funds to 1% next week? Of course not. But neither can we rule out a target rate adjustment to 0.25%-to-0.5% next month or perhaps the month after. Perhaps that will suffice for six months or longer, depending on what the data tell us.
If Churchill was a central banker he might advise that gradualism is the worst possible approach to monetary policy in a world of uncertainty—except when compared to everything else.
June 12, 2009
ANTICIPATING THE END, STILL WORRYING ABOUT THE BEGINNING
It's still not over, but it's getting close.
When we took a hard look at initial jobless claims as a leading indicator this past March, we wondered if this data series would live up to its historical record as a robust clue about the end of the recession. The answer is always in doubt in real time, but yesterday's data points certainly keep hope alive.
New filings for jobless benefits dropped to 601,000 last week, the lowest since late-January, the Labor Department reported yesterday. To the extent these reports hold true to their record over the past 40 years, there's still reason to think that the technical end of the recession has arrived or is imminent.
A bit of corroborating evidence arrived in yesterday's retail sales report, which revealed a seasonally adjusted rise of 0.5% for May, the first monthly rise since February. That's certainly welcome, all the more so since the gains were fairly broad, albeit with some exceptions. Nonetheless, there's a reason for our qualifying label of "technical" above in considering the end of the recession now or in the near future.
Indeed, one need only look at the still huge number of continuing claims for jobless benefits to recognize that the ranks of the unemployed have swelled to extraordinary levels and remain at painfully high levels. That bodes ill for a sustained rise in retail sales for the foreseeable future as well as a robust economic recovery that would be hailed as a real expansion on Main Street.
It's worth noting that the December 2007 start of the current (or recently ended?) recession, as per NBER, was only obvious well after the fact. Although there was growing wariness among some analysts and investors as 2008 unfolded, it wasn't until midway in the year that the writing was finally on the wall for all to see. No less will be true in reverse, and then some.
The depth of the past and current ills weighing on the economy will remain a heavy burden for many quarters and, to some extent, several years. The risk of a double-dip recession can't yet be ruled out. Ditto for worrying about a mild, virtually unrecognizable rebound that looks and feels like a weak recession to the man on the street.
It wouldn't surprise us if, late this year, NBER looks back and declares that the recession ended midway in 2009, or thereabouts. But while the technical finale to this nightmare is certainly welcome, what worries us is what comes after. This time, there's more reason to wonder than usual. Yes, the end may be near, but the beginning is still further away than it appears.
June 10, 2009
REPRICING THE FUTURE
Arthur Laffer advises in today's Wall Street Journal that it's time to "Get Ready for Inflation and Higher Interest Rates." The market's been telling us no less, as we've been discussing now for some time. Although the deflationary risk has been front and center since the financial crisis erupted last fall, the bigger challenge has always been the next phase, once the Federal Reserve succeeds in driving away the D risk.
One need only review the market's changing forecast of inflation in recent months to recognize that the future isn't likely to look like the past. In charts we've been posting semi-regularly, such as here and here,, the trend is clear: pricing power is returning. Yes, it's coming off an extraordinarily low base, which exacerbates the relative comparisons. But there's no question that the central bank has been using extraordinarily potent measures to resuscitate inflation from the grave. As we've been saying all along, we have every confidence that Ben Bernanke and company will be successful.
The market is increasingly of a mind to agree, as indicated by rising interest rates this spring in government bonds. The benchmark 10-year Treasury, for instance, now yields 3.86%, as of last night—161 basis points above 2008's close, according to data from the U.S. Treasury.
Meanwhile, the futures market is predicting that by this time next year, Fed funds will be at ~1.2%, up from the current target rate of 0-0.25%, as our chart below shows.
So far, the rise in rates and rate expectations is a good thing, as it suggests that economic equilibrium is returning and the appetite for risk is on the mend. But at some point it's time to start soaking up the massive liquidity that the Fed has created in the past year. Reasonable minds can debate on exactly when to begin and how far to go, but at some point, and perhaps fairly soon, the monetary equivalent of mopping up must commence.
Laffer's skeptical that reversing the liquidity injections will be reversed in a timely manner, if at all. "Alas, I doubt very much that the Fed will do what is necessary to guard against future inflation and higher interest rates," he writes.
We're not quite so pessimistic, although the history of central banking certainly offers plenty of reason to remain cautious on expecting that politically tough decisions will come easy. Indeed, one must be cognizant of the incentives that infuse a world of fiat money and mounting deficits and the political path of least resistance. As Milton Friedman once said, "Inflation is the one form of taxation that can be imposed without legislation."
June 8, 2009
THANK YOU, PETER
The world lost one of its foremost financial historians and analysts on Friday, when Peter L. Bernstein died in New York.
As an author, editor and investment strategist, Bernstein forged an analytical template for what is now common in the blogosphere, mainstream media and virtually everywhere else that assigns import to the money game: Reading the academic literature and interpreting it for a wider audience.
Bernstein wasn't alone in deciphering the hieroglyphics of financial economists for the masses, nor was he the first to make obscure research accessible. But few did it better. And in 1992, few were doing it all, at least not with the skill and depth that are Bernstein's trademarks.
Surely the history of financial education will record 1992 as a minor milestone: the year when Bernstein's Capital Ideas: The Improbable Origins of Modern Wall Street was published. As best sellers go, it was an unlikely success. Who would have thought that telling the story of how financial theory evolved could have been such a popular topic?
As a young journalist reading the book for the first time in the summer of 1992, I was stunned and amazed to learn of the efforts that had spilled forth from practitioners and academics over the years in trying to figure out how the market prices securities. I had a vague idea that the intellectual quest to uncover the hidden rules of money management had been unfolding for decades, and that index funds were the chief byproduct of those efforts. But it was Bernstein who brought the ideas to life. His great achievement is explaining the context and application for readers in a way that made the theories accessible to a wider audience.
The ideas of modern portfolio theory (MPT) were, of course, well known in certain money management circles in 1992. Twenty years earlier, institutional investing first became captivated with the concepts of portfolio optimization, the capital asset pricing model and the efficient market hypothesis—ideas that had been fermenting in academia since the 1950s. In the seventies, the concepts attracted real money.
The rest, as they say, is history, but no one will confuse it with the end of history. To say that the capital ideas, as Bernstein called them, remain controversial is an understatement. Although trillions of dollars now reside in index funds the world over, it's fair to say that the underlying theories that spawned the products remain contentious. Active management, which is to say something other than indexing, still dominates the money game, and probably always will.
That's partly a reflection of the money game. Investing, unlike the hard sciences, can never be "solved," forever keeping alive the hope that greener pastures await over the next hill. What appears to work today sometimes looks questionable, if not irrelevant tomorrow, inspiring investors to dig deeper, think differently and otherwise look for superior strategies.
To the extent that there are enduring truths in investing—a debatable idea on its own—some of those truths appear to be captured in the capital ideas, which offer valuable perspective for thinking about the nature of markets and the process of designing and managing portfolios.
No, capital ideas aren't perfect, but neither are they a static set of ideas resistant to change, as some pundits incorrectly assume. In a book I'm finishing up for Bloomberg Press (tentatively titled Dynamic Asset Allocation), I review some of the critical changes in the academic literature over the last 30 years in an effort to show how modern portfolio theory has evolved. One of the inspirations for undertaking a project which has consumed much of my spare time over the past several years is, of course, Peter Bernstein.
But while capital ideas continue to progress, the core lesson is still unchanged. Risk, in short, is the key to understanding the markets. No surprise, then, that risk is the recurring theme in what I consider the must-read trio from Bernstein: Capital Ideas, along with its sequel: Capital Ideas Evolving and also Against the Gods: The Remarkable Story of Risk.
You may or may not agree with MPT, but reading these three books can only make you a wiser investor. Academics aren't omniscient, but they have turned up some useful ideas over the past 50 years, and some of those ideas are worthy of deeper study. Peter Bernstein does a masterful job of telling us why.
In essence, the crucial lesson is that we're all risk managers now. The details remain controversial, but to the extent that investors recognize this basic challenge suggests that finance has enjoyed a bit of progress through time.
On that point, all strategic-minded investors owe a debt of gratitude to Peter Bernstein. He didn't invent capital ideas, but few have done a better job of explaining the underlying principles.
June 5, 2009
ANOTHER BATCH OF QUANTITATIVELY INSPIRED HOPE
In early March we asked: When Will It End? At the time, we argued that watching the weekly squiggles of new filings for jobless benefits was a productive effort for estimating when the cycle would turn.
The reasoning is that a careful study of history shows that initial jobless claims have a habit of peaking concurrently or just ahead of the technical end of the recession, as defined by the National Bureau of Economic Research. Waiting for NBER to proclaim the downturn's denouement isn't practical, since the organization takes its sweet time on such matters. Watching initial jobless claims, then, may be a more timely reading of what comes next for the business cycle. It shouldn't be analyzed in a vacuum, but as part of a broader review of leading econoimc indicators it's a valuable tool for discounting the future.
Today's jobs report, along with yesterday's update on jobless claims, offer another round of data releases for thinking that our counsel in March is still valid. Although the economy shed lots of jobs again last month, the decline was relatively mild compared to the magnitude of losses in the recent past. Nonfarm payroll employment fell by 345,000 in May, or roughly half the average monthly decline for the prior 6 months, the Labor Department reports.
Meanwhile, yesterday's update on initial jobless claims shows that new filings fell again last week, dropping to 621,000. That's still high and on its face the one number implies the recession rolls on. On the other hand, the trend of late offers some encouraging clues. As our chart below illustrates, last week's claims are still well below the peak of 674,000 that was set back in the final week of March. By virtue of its general decline over the past two months, modest though it is, the jobless claims indicator continues to predict that the recession has ended. We can't be sure, of course, at least not yet. But for the moment, there's mounting reason for hope, which is bolstered by today's jobs report.
Of course, the technical end of recession, especially one as painful as the current one, isn't easily forgotten. Indeed, while the leading indicators point to recovery, the lagging indicators, as expected, continue to get worse. Unemployment, for instance, rose last month to 9.4% from 8.9% in April. More of the same is probably coming.
In terms of people's lives, the official end of the recession is likely to have little meaning for many months or even quarters. The signal that Joe Sixpack is looking for—the creation of new jobs—is still probably a ways off. Nonetheless, a thousand-mile journey must begin with the first step, and so an economic recovery necessarily begins quietly, starting with the end of the recession.
We're not completely confident that the contraction has ended. Indeed, the fall in jobless claims, although obvious so far, isn't fully convincing. A dip below the 600,000 mark, however, would help tip the scale in favor of optimism. Nonetheless, the trend so far can't be denied, at least not today. Anything's possible when it comes to the slippery business of projecting economic trends in the short term, but the odds that it's over are rising, or so the numbers suggest.
Keep in mind that jobless claims are but one of several forward-looking indicators predicting revival. In the June issue of The Beta Investment Report, we report that our proprietary index of leading indicators continues flashing a strong signal that recovery is near, or at least that the downturn's momentum is lessening.
Even if the recession is over, and one day it will be, there remains the bigger question: What magnitude of rebound awaits? On that point we remain quite wary. One reason is that if a rebound is underway, the shift implies a new set of challenges lurking in the future, starting with the issue of debt, interest rates and inflation, all of which threaten in the medium- to long-term outlook.
But for now, let's savor the moment. There are a few extra data points that offer reason for mild optimism. Monday, of course, is another day.
June 3, 2009
NO SIGN OF INFLATION. SO WHY WORRY?
Inflation's still not a risk but arguably neither is deflation. We're not quite ready to officially claim that the D risk has been vanquished, but we're close. As it turns out, we're not alone.
The bond market is increasingly inclined to turn the page on the fear that a deflationary spiral may threaten. But if the deflation risk is passing, as it seems to be, the change doesn't mean that inflation is back. There's no switch that turns one off and the other on as cleanly as flicking on a light.
The ebb and flow of the economy is a process, an evolution. What we're seeing now, or so it appears, is a transition from a heightened risk of deflation to the absence of that risk, which isn't to be confused with inflation. At least not yet. There's no law that says inflation must quickly follow deflation. But neither is there any force that prevents one from turning into the other. Much depends on what the central bank does; not today but next month, next year and beyond.
Inflation, when it does bite, tends to creep up on you, slowly, quietly, working its way into the economy virtually unseen. It doesn't suddenly arrive one day with fanfare and press releases. More typically, the crowd wakes up one day and realizes that inflation is back. The good news is that there are usually early warning signs. Interest rates, money supply, commodity prices, and so on. The challenge is figuring out in real time what constitutes a legitimate warning vs. noise.
For the moment, the market's telling us that deflation's a fading hazard. As the chart below shows, the implied inflation rate in the bond market (based on the yield spread between the nominal 10-year and inflation indexed Treasuries) was just under 2% as of last night's close. That's still comfortably below the 2.5% rate that prevailed before the financial system ran amuck starting last September. But it's also up sharply from the near-zero levels of December and January.
That's not necessarily surprising or even troublesome. Fearing the worst last fall, the Fed quickly dropped short rates to near zero. The medicine appears to be working, which is to say that Bernanke and company are engineering higher prices. But it's the momentum we fear. Not necessarily today, but down the road.
Some commentators say that all the talk of inflation is premature and perhaps misguided. In his column last week in The New York Times, Paul Krugman advises readers that "when it comes to inflation, the only thing we have to fear is inflation fear itself."
That's a reassuring thought, but unfortunately it runs contrary to the historical record. Maybe this time is different, but we don't know. But the past is certainly clear. Except for a few extraordinary examples to the contrary, inflation has been the norm. For the most part, it's been manageable, although sometimes it spins out of control, as it did in the 1970s and early 1980s. Recessions, of course, have a habit of pounding inflation back into the ground. Even after the current downturn ends, its after-effects are likely to put a lid on pricing pressures and so there's reason to be sanguine about future inflation threats.
The ever-trenchant Martin Wolf advises in his FT column today that there's no economic basis to fear inflation, at least not now. "The jump in bond rates is a desirable normalisation after a panic," he writes. "Investors rushed into the dollar and government bonds. Now they are rushing out again."
The question, of course, is when is it safe to start worrying about inflation? The implied inflation rate for the next 10 years is roughly 2%. That's low by historical standards and if it stayed there for the next generation the central bank could claim a well-deserved victory in maintaining price stability, at least by the standards of the 20th century.
But no one knows if inflation will rise to, say, 2% and stay there or keep climbing. Again, much depends on what the central banks do from here on out. One can make an economic case that exploding government debt and massive liquidity injections aren't destined to raise inflation pressures, as Wolf and others explain. That's a reasonable view, but if you're charged with protecting assets, such claims that all's well aren't entirely persuasive.
The bond market, along with the gold and forex markets, are discounting the future and all its risks and they're telling us that the risk of higher inflation is on the march. It's quite possible that the markets are wrong and so inflation will remain a shadow of its former self. Let's hope so. But there's no way of knowing for sure. Strategic-minded investors should hedge their bets. Inflation may remain benign, but it may not. The markets are struggling to put a price on this uncertainty.
In any case, it's the trend rather than the absolute levels that worry investors. Estimating the true rate of inflation is always a contentious subject. But while we can all argue over the numbers, the trend is less obscure, and it's the trend that has some of us worried. Taking out a bit of insurance, then, seems reasonable. Should we bet that house on higher inflation? Of course not. But neither should we discount it entirely. It may be different this time, but 300 years of central banking keeps us wary on buying into yet another argument that a new era has arrived.
June 1, 2009
Today's update on personal income and spending deserves a closer-than-usual inspection. The devil, along with the government's stimulus program, is in the details.
First the good news, such as it is: disposable personal income rose a strong 1.1% in April, the Bureau of Economic Analysis reports. That's a gain worthy of an economic expansion of the strongest order. What, then, is it doing here, in the middle of the deepest recession since the 1930s?
The government, to cut to the chase, has learned a thing or two about Keynesian economics since FDR was delivering fireside chats. But while Washington now excels in handing out checks to the masses in a timely manner, it hasn't yet figured out how to get Joe Sixpack to spend the state's stimulus payments. Could a mandatory spending bill be the solution? Or perhaps the government could transfer the payments directly to the retailers and cut out the middleman, i.e., the consumer. In fact, there's already some of that in play as we speak. Large corporations that should have disappeared continue to operate, albeit on the kindness of government handouts.
In an effort to juice consumer spending, which remains the workhorse of the economy, the government's sending money to taxpayers far and wide. But as our chart below shows, the consumer is wary of spending these days. Disposable personal income rose sharply in April, but personal consumption expenditures slipped by 0.1%. Other than the spending increases in January and February, Joe Sixpack's consumption habits have receded in every month since July 2008.
In search of some perspective, it's worth noting that disposable personal income rose 1.1% in April, but wages and salaries were unchanged for the month. How did the economy manage that trick? The government's various spending efforts helped bridged the gap. But so far, consumers seem intent on banking any income and/or reducing the considerable debt burden that weighs on American households. The knee-jerk reaction to run off to the mall and buy a new TV is now MIA, at least for the moment.
It's debatable how soon consumer spending will rebound. Even more precarious is deciding how much it'll rebound. Meantime, there's no doubt that spending is out, saving and paying off debt is in.
As we've discussed for some time, the recovery this time will be unusually slow and vulnerable to setbacks of one kind or another, including an end to government stimulus at some point. Having survived a near-death experience, the economy now faces an extended period of water torture.
This may be the worst recession since the 1930s, but that doesn’t preclude spectacular runs of bullish behavior in the capital and commodity markets. In fact, the economic context of late probably inspires strong bouts of buying.
But let’s not become complacent about supersized gains in beta. It’s been a great ride over the past several months, recalling the glory days of 2003-2007, when virtually everything was running higher and producing a bumper crop of self-proclaimed money management geniuses. But the basic fuel behind these gains of late—recognition that the world won’t end after all—is fading as primary mover of securities prices. Investors may start requiring more conventional catalysts, such as earnings and a plan for growth. Survival alone may no longer suffice as a reason to throw money at an asset class.
In any case, the recent past looks quite stellar. May was the third installment of a powerful rebound in markets around the world. Virtually everything was up last month, with emerging market stocks and commodities exhibiting particularly strong leadership.
But as the 1-year column reminds, even the three-month rally has only made a dent in the losses of late-2008. Save for bonds in the developed world, everything’s still showing a loss for the 12 months through May.
As for the last three months, no one should be surprised that strong rallies have become so common. After the crushing losses that preceded the great spring rebound of 2009, it was virtually inevitable that prices would recover once it became clear that life would go on. But like all great snapbacks—and this one ranks, so far, as one of the broadest and strongest on record—the question is: What comes next?
One could argue that the ricochet higher since March has been fueled mostly by reversing the apocalypse-based pricing that seems less applicable. The global economy is no longer precariously perched on the brink of implosion and the markets have reacted accordingly. But the all-or-nothing paradigm of the recent past is giving way to a more nuanced economic perspective. It’s time for post-apocalyptic pricing. There’s just one problem: No one’s quite sure of the pricing rules yet, in large part because the the rules generally for the money game ahead are still being hammered out.
The task of pricing assets based on what comes next is destined to get a lot tougher. It’s looking increasingly likely that we’ll survive, but in exactly what form remains to be seen. Putting a proper valuation on the new world order is destined to be arduous since it’s still unclear how this new world order will function. Presumably, the politicians will alert us at the proper time.
Meantime, we can bask in the glory of the past three months.