August 31, 2009
EXPERIMENTING WITH NEGATIVE INTEREST RATES
As the world's original central bank, it's fitting that Sweden's Riksbank has become the first to breach the zero-bound line by lowering one of its key interest rates to negative 0.25% since July 8.
The drop in the price of money below zero is reportedly the first of its kind. The dip refutes the idea that the zero bound was a barrier for monetary policy beyond which no central bank could tread. Back in 2004, Fed Chairman Ben Bernanke (a Fed governor at the time) co-authored a research paper that advised that "the nominal policy interest rate may become constrained by the zero lower bound."
Well, so much for a constraint at zero. The Riksbank dropped rates below zero in early July with no more effort than falling out of a chair. Granted, Sweden's -0.25% deposit rate (the rate that banks receive on accounts held at the central bank) isn't the main tool of monetary policy in the country. That's reserved for the repo rate (the Riksbank's Fed funds equivalent) and it remains at a positive 0.25%, or roughly in line with the current Fed funds rate. Nonetheless, the precedent has been set. Dropping rates below zero has come and gone in the modern age of central banking and the financial world is still standing.
In practical terms, the Riksbank's -0.25% deposit rate means that banks with accounts at the central bank are paying Riksbank 0.25% in interest to keep deposits at the institution. In effect, the arrangement turns the concept of a bank account on its head. Instead of earning interest, depositors are paying the bank to maintain the accounts.
The rationale for the policy is that the negative interest rate will create a disincentive to hoard money, which creates an additional layer of headwind for an economic recovery. In these precarious economic times, that's considered a risk worth avoiding.
To be sure, there are hazards in going negative. For instance, as Wolfgang Münchau notes in today's Financial Times, central bankers worry that 1) negative interest rates as a broadly used policy tool remain experimental with unknown consequences; 2) breaching the zero bound might destroy the money market business; 3) negative rates might inadvertently promote speculative activity above and beyond the normal incentives offered in the private sphere.
On the other hand, negative interest rates may be a potent weapon in combating deflation and otherwise promoting economic recovery in the face of an extraordinary economic contraction.
Rest assured, the Federal Reserve and other large central banks in the world are nowhere near the point of following in the Riksbank's footsteps. That's because there's no need to drop rates below zero in the U.S. and elsewhere at the moment. The worst of the Great Recession seems to have passed. True, a number of major risks still threaten, starting with the prospect that the "recovery" will remain unusually tepid for an extended period. As a result, the possibility of another recessionary dip and/or deflation can't be ruled out.
This much, however, is clear: the negative interest rate has officially become part of central banking's arsenal. Although its application is currently limited to one institution, it's not yet clear that this smallest of clubs won't expand before the Great Recession formally becomes history.
August 28, 2009
IS THIS WHAT ECONOMIC ANEMIA LOOKS LIKE?
Personal consumption expenditures rose by 0.25% last month, which looks encouraging on the surface, in part because it's the third straight month of gains, albeit modest gains. The superficial message appears to be that the consumer is repairing his capacity and willingness to spend.But this is premature.
The government's stimulus efforts remain a key source of support for consumer spending, most notably through the so-called cash-for-clunkers program, i.e., government-subsidized auto purchases. But as one economist tells Bloomberg News today, “The cash-for-clunkers program helped auto sales but hurt other sales, which shows consumption remains weak. Consumers don’t want to spend on other things and cannot spend, to some extent, because income growth is still anemic," opines Christopher Low, chief economist at FTN Financial.
Meanwhile, disposable personal income continues to sink, albeit just modestly in July vs. a 1.1% loss in June. “The fiscal stimulus that boosted disposable incomes in the spring is now fading,” advises Paul Dales, an economist at Capital Economics, in a report to clients via the Christian Science Monitor. “Excluding the fiscal stimulus, incomes have been trending lower for the last seven months.”
Reversing the trend will ultimately require a rebound in the labor market. So far, the best one can say on this front is that job losses are slowing. That's encouraging, but only relative to the recent past, when job destruction was accelerating.
There's nothing in today's update on personal income and spending that changes our fundamental view that the "technical" end of the recession is here or imminent but that it will be followed by a long period of negligible growth.
Learning to live with anemic growth is the new new challenge, and the learning curve has only just begun.
August 26, 2009
Is today's update on new orders for durable goods a sign of an approaching V, U or W? Translated: Is the economy poised to rebound sharply and deliver strong growth—a V recovery? Or is a U-type future, with slow to negligible growth, approaching? Even worse, could an imminent rebound be little more than a prelude to a second recession, a.k.a. the W cycle?
That summarizes the great questions that prevail as the world attempts to handicap the winding down of the Great Recession. As always, the central challenge is that we're left with a great unknown, even if today's news on durable goods suggests otherwise.
As monthly numbers go, July's update for the series is undoubtedly encouraging. New orders for manufactured durable goods in July increased 4.9%, the U.S. Census Bureau reports. That's the third increase in the last four months and the largest percent gain in two years.
No one can deny that such news constitutes progress. Ditto for the accumulating evidence in other economic reports that the economy, if not quite on the mend, is no longer contracting. A number of clues have been suggesting no less for months, as we've been discussing on these digital pages for some time, including the all-important weekly updates on initial jobless claims. Additional support for thinking the economy's stabilizing arrived in yesterday's upbeat news on consumer sentiment and housing prices: both are rising.
None of this is particularly shocking, although the timing was always in doubt. But surely no one expected the U.S. economy, still the world's largest, to remain in downsizing mode indefinitely. The emotional bias in the dark days of this year's first quarter may have convinced us to see a continually dire future. But the recession at that point was already more than a year old, by NBER's accounting, and the natural economic order tells us that recovery arrives eventually. Meanwhile, the massive countercyclical efforts of the Federal Reserve, plus the fiscal stimulus embraced back in February, was sure to have an impact. In fact, one might argue that President Obama's reappointment of Fed Chairman Ben Bernanke to a second term is formal recognition of the success in the central bank's aggressive actions intent on slowing if not ending the downturn.
What's more, the financial and commodity markets have reacted by elevating prices, in effect offering additional corroboration that the business cycle was turning. But while it's tempting to see us headed for a V recovery, the odds seem to favor a U. We've been forecasting just that future for some time by emphasizing that the "technical" end of the recession was imminent if not already here but it would be followed by a tepid recovery.
As welcome as that revised outlook is relative to what preceded it, there's a danger of overlooking the risk that follows this time around. Namely, a series of generational adjustments that threaten to conspire by leaving the economy in a weakened state for an unusually lengthy stretch. The most conspicuous risks: the likelihood that consumer spending growth will remain subdued for some time and the labor market will be slow to respond to so-called recovery.
There are any number of other challenges looming as well, starting with the nuances tied to the timing and magnitude of the Fed's so-called exit strategy. The challenge looks unusually bland at the moment, but it won't stay that way. Indeed, to the extent the economic recovery is stronger than expected, the exit strategy problems will be that much bigger.
Perhaps then the principal question is: Has the crowd priced in the post-recession risks that await? The first half of the business cycle has been unusual on a number of levels, as the last two years remind. We're probably just about midway, perhaps a bit more, through this extraordinary period. Thinking that the second half will be any less rocky and risky is asking for too much.
Still, it's easy to remain complacent. Looking at positive short-term changes in economic measures that are cut in half over longer stretches is reassuring. But climbing out of this hole will take time and the task faces many pitfalls. It's only human to minimize the potential hazards, but strategic-minded investors can't afford such luxuries. As we've arguing in The Beta Investment Report, the time for aggressive portfolio decisions was in this year's first quarter. From here on out, the money game is about to get much tougher.
August 24, 2009
THE POWER & PERIL OF RECENT HISTORY
Expectations are driven by many things, but recent history usual tops the list when it comes to the crowd's outlook on things to come. No wonder, then, that investors are feeling pretty good about the prospects for equity markets, which have been soaring this year.
As our chart below illustrates in no uncertain terms, 2009 ranks as one of the best calendar years in terms of positive returns…so far. The "worst" performer, based on our slicing and dicing of the major regions/markets for the world's stocks, is Japan, dispensing a relatively slight 7.5% total return so far this year through August 21, according to data from Standard & Poor's. On the opposite extreme is the nosebleed ascent for Latin America, which is up an astounding 71% year to date.
It's been hard to lose money in equities this year. Virtually every corner of the global stock market is sitting on tidy gains. Along the way, claims of talent if not genius are once again being thrown about in the active management community, conveniently overlooking the fact that equity beta, which is available to everyone at virtually no cost, has delivered much of the heavy lifting this year.
But whether it's passive or active management that's provided this year's powerful gains, the bigger challenge is maintaining perspective about the future and how it will compare with the recent past. It wasn't that long ago that the crowd had abandoned equities in favor of near-zero yields in government bonds. Today, with extraordinary trailing returns staring us in the face, the temptation to extrapolate the recent past into the immediate future is once again calling.
The general lesson is that cycles prevail, in the economy and in the capital and commodity markets. These cycles are difficult to read, much less exploit in the short term. Yet strategic-minded investors can mine valuable intelligence in the ebb and flow of cycles for medium- and long-term horizons, a core principle that drives our analysis in The Beta Investment Report.
But we must be cautious. No lone market factor—be it dividend yield, volatility, correlation, etc.—can tell us much in isolation. Only by putting a range of variables into historical perspective can we begin to see the future with a bit more clarity, if only marginally.
Should we ignore recent price action? No, not entirely. Price momentum is a powerful force, especially in the short run, as recent history reminds once again. But that contrasts with the primary financial challenge that looms for most investors: funding long-term liabilities. Allowing recent history to dominate your worldview is tempting if not emotionally satisfying. Deciding if it's also strategically intelligent is something else altogether.
August 19, 2009
PULLING THE PLUG ON THE GREAT STIMULUS
Warren Buffett advises in today's New York Times that the Great Stimulus must one day be clipped as the Great Recession fades. As the Oracle of Omaha explains, the "enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects."
We've been making a similar argument for some time, although the cause seemed lost when we advised in May that the crowd should recognize that the Federal Reserve must begin raising interest rates at some point. That future has been easily ignored, and perhaps for obvious reasons, given the economic events of the past year or so. But the arrival of Buffett's warning suggests that sentiment may be set to turn by focusing the crowd's gaze on the inevitable. If so, that's healthy, if only because recognizing the risks that loom, as opposed to the ones that just passed, is always a productive exercise in managing money and otherwise boosting one's odds of survival.
As we wrote in May, "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."
If more pundits and policymakers are on board with this outlook, chalk up another win on the side of progress. But lurking behind this rise in enlightened thinking is another problem, which can be summed up as the expectation that the central bank will begin tightening at a time when it's clear that the economy is on a sustainable path to recovery. A nice idea, but like fairy tales and campaign promises, danger lurks in accepting such notions without question.
For the same reason that mere mortals can't hope to sell exactly at market peaks or buy at bear-market bottoms, the Fed is destined to be early or late at the start of the next great change in monetary policy. This is a critical point because it belies the notion that the Fed will be able to tighten monetary policy at just the right time and keep everyone happy in the process. Wrong. Not only does the Fed face a tough challenge in purely monetary policy terms, the potential for political and even economic fallout are commensurately large as well.
Central banks, like the rest of us, are making real-time decisions with lagging data. Even worse, it takes time to assess if the decisions were timely, or not. The folly or fortune of policy choices made today will be evident a year or two hence. It's a bit like a surgeon working in the dark and then finding out a year later if the patient survived.
So be it. That's how running fiat currencies works: it's a job that's highly subjective in real time. The question is whether the crowd understands what's coming. Normally, the margin for error is relatively wide in the highly subjective business of central banking. These days, that margin has shrunk considerably, even if the ramifications won't be obvous for several years.
No one will ring a bell at the ideal moment for tightening. The fact that the Fed's timing wasn't perfect in the years running up to the Great Recession reminds that fallibility infects the institution, just as it does every other area of human decision making.
What's more, when the Fed launches the new monetary era, the criticism is likely to be deep and broad, from politicians and investors, businesses and the people on the street. No one has perfect information and insight, but that doesn't stop anyone from thinking (and speaking) as if they did. The net result: lots of noise and confusion.
With the benefit of hindsight at some point, it's a virtual certainty that we'll recognize that the Fed was too early, or too late. Heck, maybe they'll get it exactly right this time, although we're not holding our breath. In any case, such things can only be determined after the fact.
The stakes are high, perhaps unusually high compared with previous business cycles of recent vintage. But at least we know what the two main threats will be. On the one hand, the central bank runs the risk of choking off the incipient recovery by tightening too early. At the other extreme, the central bank may wait too long and thereby give inflationary pressures a foundation to pester the economy for some time after.
No, these risks aren't absolute. One or the other may arrive but in moderate form, which still leaves the natural forces of inflation-adjusted growth to dominate eventually. Nonetheless, let's not forget that one or the other still looms. Markets and economies are forever evolving, as are the embedded hazards and opportunities. Perhaps the biggest risk of all is thinking otherwise.
August 18, 2009
INDEXING & TIPS: THE SAME OLD STORY
Last week, The Wall Street Journal published a story explaining why Pimco, the behemoth bond fund manager, believes active management is preferable for running a portfolio of TIPS, or inflation-indexed Treasuries. According to the article, "Pacific Investment Management Co….says that while indexing may work wonders in the stock market, with TIPS it often leads to missed opportunities and hidden costs." Meanwhile, you can find Pimco's research paper that inspired the article here.
Some commentators have picked up on the article and announced a variety of revelations to the masses, ranging from the idea that investing in TIPS is somehow different compared with owning conventional bonds and even stocks to allegations that the Journal story highlights a new smoking gun in the case against indexing.
Nonsense. Nothing's changed, even if the article suggests otherwise. Indexing is no more or less persuasive today vs. last year, for TIPS or any other asset class. The evidence begins with the fact that the long-term record speaks for itself, which boils down to the reality that beating the market is still very difficult over time.
Yet let's be clear: In an efficient market, there'll always be winners and losers relative to a germane benchmark. No indexer disputes that. But it's also true that alpha—delivering a return that's something other than the benchmark—sums to zero over time. This is basic fact is immune to debate. In other words, for every investor who beats the market, the index-beating results must come from other active managers who trail the market. There'll always be winners and losers, and in the middle, more or less, is a relevant index.
Professor William F. Sharpe outlined the details in a paper some years ago and The Arithmetic of Active Management remains essential reading for every investor, if only to provide a sober assessment of how money management operates regardless of your personal decisions. Sharpe sums up the lesson this way: "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."
Managing a portfolio of TIPS, or any other portfolio, doesn't jettison the arithmetic of active management. Any one manager may beat the odds, or suffer profoundly at the opposite extreme, but as a general rule Sharpe's arithmetic of active manage is enduring.
The idea that there's something different or special about inflation-indexed Treasuries doesn't stand up to the historical record. As one example, consider that for the five years through the end of last month, there were 25 distinct funds (mutual funds and ETFs) with trailing returns over that stretch, according to Morningstar Principia. The returns ranged from a low of 3.12% to a high of 5.27%. How has one of the leading index funds in the niche fared over that period? About where you'd expect a reasonably designed benchmark to be: in the middle. Actually, the iShares Barclays TIPS ETF (TIP) has delivered a bit better than average, posting a 4.64% average annual return for the five years through July 31, 2009.
Similar stories prevail for each of the major asset classes. The point here isn't that talented active managers don't exist. They do. Nor is our argument that investors should avoid active managers at all times. Pimco and many other investment shops offer valuable services to investors. Yet it's also clear that not all active managers are created equal, and even the good ones can charge excessive fees that take a toll over the long term. In short, using active managers introduces an additional layer of complication. That starts with the devilishly difficult challenge of identifying market-beating managers in advance as a long-run proposition. If you're going to pick an active manager, you'd better have a sound reason for doing so, which generally means doing a fair amount of proprietary research.
In fact, there's an even bigger problem with active management, and it's an issue that's widely overlooked. Namely, buying a mix of active managers to flesh out an asset allocation that approximates a globally diversified multi-asset class portfolio creates a number of hazards that aren't obvious when considering active management piecemeal. We'll be discussing the details in the upcoming September issue of The Beta Investment Report. As a preview, the best-case scenario value proposition for owning one actively managed fund fades as you expand the portfolio into additional asset classes.
Yes, indexing generally offers middling performance in the long run, and there's no escape from that future. For some, that's a reason to avoid index funds. In fact, that's the great strength of indexing, even if the details of why that's so are routinely lost in the story du jour and the rush to identify the market-beating fund in isolation of a broader portfolio strategy.
Indeed, the primary challenge for strategic-minded investors is one of designing and managing a mix of asset classes. You can triumph on that front with active managers, but it takes quite a bit more work than doing the same with index funds. Even more problematic is the risk of picking the wrong active managers. That may not be a challenge for the talented few who excel in asset allocation, but for the rest of us there's reason to wonder if we can manage the asset allocation intelligently and routinely pick an array of market-beating active managers.
August 14, 2009
IS THE "REAL" YIELD ON THE NOMINAL 10-YEAR REAL?
The highest real (inflation-adjusted) yields in 15 years for Treasuries are boosting demand, Bloomberg reported at the end of last month.
Halfway through August, there's no reason to think otherwise. The 10-year's yield hasn't changed much in recent weeks, closing yesterday at roughly 3.59%. Meanwhile, inflation, as defined by the consumer price index, appears in no imminent threat of rising.
The July CPI report shows that inflation was flat last month, the Bureau of Labor Statistics tells us today. For the 12 months through July, CPI was negative to the tune of -1.9%, the steepest fall in 60 years.
On the surface, it looks like deflation is roaring. But this bite is worse than it appears. The year-over-year comparisons for CPI are troubling, but it's temporary. Recall that oil prices hit an all-time high in July 2008. The energy driven inflation wave, as it turned out, wasn't set in stone either. But the damage to the inflation numbers was done and that legacy remains intact. As a result, comparing overall prices today with those of a year ago is doomed to reflect sharp price declines.
Meanwhile, energy prices fell sharply after peaking in the summer of 2008, along with prices of virtually every thing else. A repeat performance isn't likely, or so the stabilizing global economy suggests. Indeed, the price of crude seems to have found stability too. The implication: inflation won't be falling on a year-over-year basis when we look at the numbers in the quarters ahead.
Barring a sudden reversal of the stability that seems to be settling into the economy, the year-over-year CPI change is likely to be showing more modest comparisons by the end of this year and through 2010. Why? Because, you may recall, the world fell apart in the second half of 2008, dragging broad price indices down the rat hole in the process. Once we get to December 2009's CPI numbers, however, we're likely to see the case for deflation on a 12-month basis looking a heck of a lot weaker if not evaporating completely, assuming we don't resume an apocalyptic decline, which looks unlikely at this point.
Meantime, adjusting the 10-year Treasury Note by 12-month changes in CPI makes for an alluring chart, as our graph below shows. For July, the 10-year's CPI-adjusted yield was 5.46%, up from September 2008's negative 1.25%.
By the available numbers, buying the 10-year looks like a no-brainer. Prices generally are falling by nearly 2% a year. Meanwhile a nominal 10-year Treasury offers well over 5% real. A great buy, right?
We're suspicious. Unless you're expecting deflation to roar on, which we don't, the real yield in nominal Treasuries looks like a trap. Here's our reasoning. First, only nominal yields are set in stone with nominal Treasuries, which means that real yields for this series of government bonds can and does fluctuate.
For instance, let's say you bought the nominal 10-year Treasury at last night's close of 3.59%. Using the latest CPI report for July, that translates into a real yield of 5.49%. Nice. But imagine a year from now that CPI's running at, say, a positive 2% year-over-year pace, which isn't beyond the pale. Net result: your current real yield of 5.49% evaporates to 1.59%. (Remember, the nominal yield of 3.59% at the purchase date is fixed; only the inflation rate changes.)
As it turns out, a 10-year TIPS currently offers a similar real yield—1.80% as of last night's close. The big difference: the 1.80% real yield for the TIPS is fixed whereas the real yield for nominal Treasuries changes.
The bottom line: unless you're expecting deflation to continue or get worse, the real yield in the nominal 10-year looks dubious. Does that mean you shouldn't own Treasuries? No, since government bonds serve various purposes in a multi-asset class portfolio. But buying solely for the high real yield of the moment is too speculative at this juncture, at least for this observer.
To be fair, no one can predict inflation with any certainty and so a passive investor would own TIPS and nominal Treasuries as a hedge. Otherwise, this is no time to bet the farm on conventional Treasuries. Sitting on huge gains over the past year—indeed, over the past generation, the hour is late for expecting continued success with "risk free" bonds sans inflation protection.
August 13, 2009
DOWN BUT NO LONGER OUT
The Federal Reserve's FOMC meeting yesterday was a bit of a yawn, although the boys at the bank did tell us that "economic activity is leveling out." But they also recognized that the leveling isn't likely to lead to growth any time soon and so the central bank announced that it would keep the target rate for Fed funds at an extraordinarily low 0-0.25% range, as widely expected.
Nonetheless, it's clear that Bernanke and company have turned optimistic, if only marginally and relative to the deep pessimism of the recent past. That's no surprise considering that the supporting clues have been bubbling for some time. We've been arguing for months that the recession was near a technical end, in part due to the encouraging signs from the declining trend in initial jobless claims. This data series tends to peak at or just ahead of business cycle troughs, as we discussed in some detail back in March, which so far remains the high point for new jobless claims. Much of the credit can go to the Fed, which has been aggressively pumping liquidity into the system to slow and ultimately halt the downturn. The jury's still out on how the central bank plays its cards from here on out--i.e., the so-called exit strategy. But for the moment, there's reason for mild optimisim.
On that note, this morning's weekly update on jobless claims is a bit of a yawn too, advising that new claims rose a statistically insignificant 4,000 for the week through August 8. Still, the broader trend remains biased toward descent, if only marginally, as the chart below shows.
There are, of course, a number of other reasons behind our claim that the recession is at or near a technical end. From housing to credit spreads and beyond, the statistical evidence is mounting that the economic contraction has hit bottom. The Fed's FOMC statement yesterday constitutes formal recognition of what's been obvious to economic observers for some time.
But our standard caveat still applies: the end of the recession won't lead to growth any time soon in this cycle. What's more, we're still not sure that the crowd recognizes that the job of repairing the U.S. economy is going to be one hell of a long, tough slog. The big prize--employment growth—is still a ways off, and even when it does come it'll arrive meekly.
That doesn't necessarily mean that the stock market is set for dramatically lower levels. But the news cycle in the dismal science for the rest of the year into 2010 is likely to keep a lid on rallies. Having rebounded from apocalyptic pricing earlier in the year, equities are bouncing around at roughly fair value these days on a general basis. Elevating the market to sustainably higher altitudes is going to take more fundamental signs of economic recovery as opposed to what we've been getting lately, namely, indications that the economy is no longer contracting.
As we discuss in the August issue of The Beta Investment Report, strategic-minded investors should remain moderately exposed to risk to take advantage of the ensuing rebound. But they should also keep some amount of cash on hand as well to exploit the inevitable volatility that will arrive during the coming recovery, which threatens to arrive in fits and starts over an extended multi-year period. Our outlook for risk premia is still encouraging, although generally the expectations have fallen from this year's first quarter. The margin for error, in other words, is wearing a bit thin at the moment. Given the still precarious background, we're not yet convinced it's time to go cashless.
Indeed, there are more dark days ahead when the endurance and depth of the recovery will be questioned, perhaps rightly so. But today, the long-term outlook for risk still looks quite favorable for a multi-asset class portfolio, but the gains won't come easy to those who are impatient or easily frightened at the coming uptick in volatility. Then again, that spells opportunity for everyone else. But at a price, always at a price.
August 12, 2009
WHAT HAS TECHNOLOGY WROUGHT?
We're swimming in it. Or maybe downing is a better term. Whatever the correct label, the digital supply of financial and economic data, information and analysis is exploding. We can't get enough of it. Or are we getting too much? More to the point, Is it helping?
The question for strategic-minded investors is whether the growing amount of information is enhancing our investment results? This is a critical question, in part because the information revolution has only just begun. As David Leinweber notes in his fascinating new book Nerds on Wall Street: Math, Machines and Wired Markets, "We are just beginning to see the decentralized use of information technology in this industry."
The future, then, is sure to be one of even more financial and economic information. But is more really better when it comes to investing?
Back in the good old days, when your editor was a staff writer at Bloomberg, there was a brief, shining moment when I thought the financial world was my oyster. In the early days of the job, I was awed by the apparent possibilities that arose from sitting in front of a Bloomberg terminal, which was made available to all employees. The array of data, news and analysis at my fingertips was overwhelming, but I was determined to become proficient at leveraging this amazing machine for not only my day job but for my personal investments as well.
As it turned out, access to a Bloomberg terminal isn't a short cut to big profits. Don't misunderstand: It's a great resource, but simply having one doesn't necessarily make you a better investor, although not having one may put you at a disadvantage. But whether it's a Bloomberg terminal or the Internet, technology by itself doesn't automatically elevate returns. One reason is that hundreds of thousands of other people on the planet have access to the same information. Fighting a war with nuclear weapons, so to speak, is a clear advantage if your enemy is using bow and arrow. But if everyone has a large supply of ICBMs, the game is something of a standoff.
Some of the challenge is no doubt tied to my own limitations. Surely there are countless investors who are smarter, and so they're better prepared to make use of the digital revolution. But that's not an entirely satisfying answer. As one example, consider the long-run history of the equity mutual fund business. Looking at the grand sweep of performance for this lot offers precious little evidence that results are improving. If anything, they seem to be getting marginally worse.
How could that be? Today's mutual fund manager is armed with an array of technology that was beyond the pale in 1965, or even 1985, for that matter. In almost every other industry, technology inputs have enhanced results. Leinweber's book has a wonderful chart showing how energy use in refrigerators has dropped dramatically over the past generation, as have prices of what one might call a digitally controlled ice box. At the same time, the size of refrigerators has continued to climb. In short, today's ice boxes are bigger, more efficient and cost less.
Similar stories abound in everything from cars to medicine to aerospace engineering. Technology induced progress, it seems, is conspicuous in all corners of the modern world, with at least one glaring exception: finance.
Progress isn't obvious on Wall Street. By the standard of the one metric that everyone cares about—returns—it's not clear that investors are, on average, better off than their predecessors of earlier generations. And that was true even before the crash of 2008, or even the 2000-2002 bear market.
It's debatable if progress per se is even possible in money management. Oh, sure, there are investors who reap greater rewards on a level that's head and shoulders above what everyone else earns. Think George Soros and Warren Buffett, to cite the classic examples. Many more lesser souls have excelled too. Of course, one is reluctant to chalk up bonafide success in portfolio management to technology alone. Like Mozart and Einstein, some investors are simply born with raw talent. Technology helps, of course, but it rarely turns mediocrity into excellence.
As for the rest of us, is there any hope of progress from technology and the explosion of information? Not directly, although the prospect of investing smarter and reaping the rewards is still available. It's just not the prize that the man on the street expects.
Earning ever higher returns simply isn't possible on a grand scale. Never was, never will be. Rather, the great progress in financial economics and portfolio management is closely entwined with risk management. In turn, the opportunity to earn superior risk-adjusted returns is alive and kicking, as we've discussed many times, including here and here.
To be sure, risk management takes in a lot of territory and so quick summaries of how to leverage the progress in this area are elusive. But the basic message needs no elaborate explanation: Stop chasing return and focus on managing risk, which is a more productive way to manage money and reach financial goals, particularly in the context of a multi-asset class framework.
Unfortunately, the explosion of information, aided and abetted by technology, suggests otherwise. Recognizing that this is a myth for long-run results is the first step toward winning the money game.
August 10, 2009
ASSET ALLOCATION: STILL RELEVANT AFTER ALL THESE YEARS
Some said it was dead. Others claimed it was misleading. Many simply ignored it, in good times and bad. But asset allocation is hardly dead. In fact, it couldn't be any more relevant.
The mistake that many investors make is comparing a multi-asset class portfolio to something riskier, such as any one asset class. In fact, there are countless ways to beat a multi-asset class portfolio over the short- as well as long-term horizons. Doing so after adjusting for risk, however, is far more difficult.
It's easy to find one asset class or one security with an expected return that's far higher than the market portfolio, which we're defining as all the world's major asset classes weighted by the market values. The problem is that there's something approximating an equal abundance of asset classes and individual securities with lesser prospects at any one time relative to the market portfolio. Distinguishing one from the other isn't impossible, but it's devilishly hard to do continually, year after year.
Does that mean we should simply buy and hold the market portfolio? Probably not, although it's worth pointing out that you could do a lot worse. Consider, for instance, one measure of the market portfolio, as defined by the Global Market Index (GMI), courtesy of The Beta Investment Report. For the 10 years through the end of July 2009, GMI posts a 3.8% annualized total return, which is considerably better than the 1.2% annualized loss for U.S. stocks, as per the S&P 500.
Still, the temptation is always there to do something else. There have been times in the past, and there will be times in the future, when U.S. stocks beat GMI, for instance. That's true for any of the various stock, bond, real estate and commodities components that collectively comprise GMI. Why not simply own the components with the highest expected returns and shun everything else?
The answer, of course, is that no one has 100% confidence in forecasting returns, in part because no one can see all the risks lurking in the distance. Then again, our confidence in peering into the future isn't zero either. Financial economists have turned up some useful insights over the years for projecting return and risk. In fact, in my upcoming book—Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor, to be published by Bloomberg Press in February 2010—I review, analyze and interpret the multi-decade history of research that should be the cornerstone of every strategic-minded investor's money management principles.
As for GMI, it should be no surprise that it beat the U.S. stock market over the past 10 years. After all, GMI holds a fair amount of bonds, both domestic and foreign, along with REITs and commodities, all of which post positive returns for the past decade. In fact, quite a few corners of GMI are doing well--quite well. Inflation-indexed Treasuries, for instance, post a 7%-plus annualized total return for the past 10 years through last month. Meanwhile, emerging market bonds are up by more than an annualized 11% over that stretch—the best performer among the major asset classes.
Ah, but who in July of 1999 recognized that emerging market bonds would beat everything over the next decade? Probably no one, or at least very few. The summer of 1999, you may recall, was a point when the equity market was soaring--U.S. stocks in particular. That convinced many that stocks were the only game in town.
Picking winners today isn't any easier today. Should we just abandon all hope and simply buy and hold the market portfolio? That's one solution, and it probably will do fairly well as a long-term strategy. But there are sound reasons for modifying the market portfolio, and that begins with adjusting it to fit each investor's particular circumstances, including time horizon and risk tolerance, which varies from person to person.
We can modify Mr. Market's allocation based on valuation and other factors that drop clues about the future path of individual asset classes. If stocks look attractive relative to bonds, for instance, we may want to change the passive mix as it currently exists. But we need to be careful here. To the extent that we alter the passive asset allocation based on forecasts (as opposed to risk tolerance and time horizon), we should do so cautiously and marginally, and in accordance with our confidence in the prediction.
A factor in an investor's confidence reflects his skills as an analyst. Suffice to say, some are better than others. Beyond individual talent, it's also important to recognize that expected return transparency ebbs and flows through time, along with the business cycle and other variables. At turning points in the cycle, which is to say moments of extremes, the general level of predictability is higher, if only slightly.
But make no mistake: we should practice dynamic asset allocation cautiously, and with eyes wide open. This is a difficult task and after adjusting for trading costs, taxes and the inevitability of error at times, few will come out ahead of the market portfolio in the long run. Alpha, as the saying goes, sums to zero, even when second guessing Mr. Market's mix. For those who are skilled at managing asset allocation, the market-beating results come exclusively from those who engage in this dark art and come up short of the unmanaged benchmark.
Asset allocation is still relevant, but no one ever said it was easy. The good news is that Mr. Market's asset allocation is pretty good template for considering the possibilities. But the further you move away from the passive mix, the more talent and confidence you'll need to make the trip worthwhile.
August 7, 2009
A NEW ERA DAWNS (PLEASE HOLD THE APPLAUSE)
Optimists will seize on today's news that the unemployment rate slipped last month for the first time in more than a year. Good news, to be sure, if only because it breaks the formerly nonstop rise in the monthly jobless rate. But the modest decline to a 9.4% unemployment rate in July from 9.5% masks the ongoing job destruction that roars beneath this otherwise encouraging exterior.
Nonfarm payrolls were lighter by a still hefty 247,000 last month, the U.S. Bureau of Labor Statistics reports. That's reassuring only by the dire standard of the far deeper monthly losses between September 2008 and June 2009. Relatively speaking, the labor market appears to be healing, or bleeding less profusely, to be precise. But equating this with good news is a bit like discovering that your boat has only nine leaking holes instead of 12. Your still taking on water, albeit at a slower rate, but the end result will be the same unless the trend changes: the boat sinks.
Indeed, virtually every corner of the labor market was taking on water last month, including the major sectors of goods producing industries (which lost 128,000 positions in July) and the all-important services sector (which shed 119,000 jobs last month). Perhaps we should keep the buckets handy for a bit longer.
Nonetheless, it's important to recognize that the slowing pace of job destruction isn't chopped liver. Ideally, the trend continues and later this year we'll reach zero job loss. We expect no less in the coming months, short of a spectacular turn for the worse in the economy, which at this point looks unlikely.
The monetary and fiscal stimulus engineered by Washington since the crisis began has been helpful in slowing the recessionary forces, and some of that progress can be seen in the chart above. For another take on the improving picture in the labor market—i.e., the decelerating rate of bad news—take a look at the trend in ongoing fall in new filings for jobless benefits, as we discussed yesterday. Other encouraging clues include signs that the housing market may be bottoming out, if it hasn't already. These and some other trends suggest that Q3 2009 GDP will be flat and perhaps even post a small gain, thereby giving more support to the idea that the technical end of the recession is near.
But as we've been emphasizing for some time, the technical end of the recession threatens to be far less satisfying this time in the business cycle. To be clear, a jobless recovery of some magnitude may be looming on the horizon, and it may roll on for longer than the crowd expects. Robust growth in the labor market is essential at this point, considering that a towering 6 million-plus jobs have been lost since this recession began in December 2007. Without a revival in the jobs creation, the expected rebound in the economy is less than assured as a solution to what currently harasses.
Perhaps we're being overly pessimistic, although for the moment there's some reason for at least reserving judgment about the breadth and endurance of the approaching "recovery." Consider, for instance, our second chart below, which compares initial jobless claims and continuing jobless claims on an apples-to-apples basis. The divergence between the two in recent months is clear, namely, the decline in initial jobless claims has yet to be matched by a commensurate fall in continuing claims. The implication: while job loss is slowing, the mass of the previously unemployed are not yet finding work.
Granted, continuing claims tend to lag initial jobless claims, and so we shouldn't rush to judgment. There's still time for continuing claims to decline without yet raising warning flags. But the hour is late. This is already the longest downturn since the Great Depression and the economy's still bleeding jobs at more than 200,000 a month. At this late stage, even moderate bleeding digs us deeper into a hole that's already quite deep, making it that much more difficult to escape. The only solution is an even stronger recovery in the labor market, which at this point is open to some debate.
So, yes, we're happy to see that the unemployment rate fell a bit. But from where we stand, that's virtually irrelevant. As we've been discussing for some time now, the big challenge is still ahead of us. Staving off a deeper economic contraction was essential, and arguably that job is complete. But now comes the far tougher task of rebuilding what was lost. Unfortunately, quick and easy solutions total exactly zero.
August 6, 2009
THE LONG & WINDING ROAD AHEAD
The trend is still our friend when it comes to initial jobless claims, a valuable leading indicator for assessing turning points in the business cycle. (For some background, see our analysis published in March.) But increasingly it's the lagging indicators that worry us. Topping the list of concerns is the trend in nonfarm payrolls, which continues to sink at an unhealthy pace. Will tomorrow's update on the employment picture for July tell us different?
Before we consider the possibilities, let's review today's good news. New filings for jobless benefits slipped by 38,000 to 550,000 for the week through August 1, the U.S. Labor Department reports this morning. And not a moment too soon. Recall that new filings rose last week, prompting worries that perhaps the trend was reversing, which could indicate that the recession might roll on longer than previously thought. In light of today's update, we can rest a bit easier, although we're still a long way from repairing the damage that has unfolded in the economy over the past year.
Indeed, even an optimistic reading of recent economic trends should recognize that the bulk of the good news, such as it has been lately, suggests the economy has hit bottom, which is something quite different than declaring that growth has returned. In fact, the jury's still out on whether we have truly reached the trough in the business cycle. There are a growing number of reasons for thinking that we have, including the downward trend in jobless claims, which have a long history of peaking concurrently or just ahead of the end of the recession. But let's be clear: Full and complete confirmation of the expectation that the recession has ended will only come after the fact. We'll simply have to wait and see. For now, however, it's still reasonable to think that the worst of the contraction is behind us.
But that leaves the still sobering challenge of climbing out of the hole. Having fallen into the ditch, we're of a mind to rejoice that we've hit bottom and sustained only minor injuries, which is to say injuries that are something less than the catastrophic wounds that many feared were inevitable in late-2008 and early 2009. Alas, lifting the economy out of this gully is going to be tough, much tougher compared with recoveries in previous post-recession periods. Once we get beyond the point of comparing current conditions to the deeply depressed results of late last year and early this year, the outlook will look a lot less encouraging than it does now.
For that reason, we continue to emphasize that the technical end of this recession appears imminent if it hasn't already arrived. But the great challenge is on the post-recession period. Perhaps the first big news of this new era will come tomorrow, when the government delivers the update on nonfarm payrolls for July. The consensus forecast calls for a loss of 300,000 jobs, and that's the favorable prediction relative to the bigger decline of 440,000 anticipated by All About Hiring Demand.
Granted, a 300,000 job loss, or even a decline of 200,000, would represent substantial progress vs. the much bigger losses of past months. Yet therein lies a prime example of why the recovery this time will be unusually slow and subject to setbacks. Indeed, the crowd is likely to cheer if tomorrow's employment report advises that 300,000 jobs were lost last month. But keep in mind that more than 6 million nonfarm payrolls disappeared since the recession began in December 2007. Returning employment to where it was at the recession's start will take a powerful recovery, the likes of which are nowhere in sight at the moment.
The point is less about trying to throw cold water on the post-recession outlook and more about reminding everyone that patience will be essential for the period that awaits. We're going to be hearing a lot about green shoots and recovery in the weeks and months ahead. Yes, that's coming, but it's going to be quite a while before the trend has any significance on Main Street.
August 4, 2009
MORE GOOD NEWS/BAD NEWS
The recession continues to take its toll on the American consumer, new government data released today advises. Disposable personal income dropped a hefty 1.3% in June, reports the Bureau of Economic Analysis. On the other hand, consumer spending rose 0.4% in June. Alas, the pop in Joe Sixpack's willingness to spend is less than it appears.
But first, a closer look at the fall in personal income. One reason for the retreat was the fading of the one-time government stimulus checks (American Recovery and Reinvestment Act of 2009) sent in May. In fact, the loss wasn't nearly as steep once you ignore the government stimulus factor for the last two months. Excluding the checks from Uncle Sam reveals a far more modest 0.1% drop in personal income for June vs. the month before.
More troubling, however, is the ongoing decline in wages and salaries, which fell again in June vs. May by 0.4%. Indeed, it's been falling nonstop since last November. Therein is the frontline attack on the economic outlook. Ok, we all know that the labor market is critical for economic growth. Why, then, is consumer spending up 0.4% for June? One reason is that spending on gasoline rose for the month, thanks to a generally ascending price for fuel. Indeed, consumer spending on energy goods and services jumped a dramatic 8.3% in June, vs. just 0.2% for May, BEA advises in today's update.
But let's be optimistic and recognize that the deepest contraction in the business cycle since the 1930s is easing. There's a strong case for arguing that the technical end of the recession is near, if it hasn't already arrived. But the great question continues to be one of identifying more durable signs of growth, and the jury's still out on that treasure hunt. The end of the recession and the start of a rebound, as the crowd will discover, aren't synonymous this time.
Nonetheless, Ed Yardeni of Yardeni Research advises clients in a note yesterday:
If nothing changes during Q3, real GDP will be up 4.6% during the quarter. This isn’t our forecast. It is arithmetic. If there is no change in final sales to consumers, business, governments, and foreigners, and if nonfarm inventories are unchanged, that’s how much real GDP will increase. This is because nonfarm inventory investment was minus $144.4bn (saar) during Q2. If it is zero during the current quarter, real GDP will surge. The inventory investments component of real GDP has been negative for five consecutive quarters, the longest stretch since Q1-2001 through Q1-2002.
Yes, indeed, but the more pressing issue is not whether GDP will post a rise in the next quarter; rather, the great unknown is the labor market.
“We’ll see a weak economic recovery by past standards,” James O’Sullivan, an economist at UBS Securities, tells Bloomberg News. “For a sustained pickup in consumer spending, we need a clear-cut improvement in the labor market.”
Alas, the only clues to date are that the trend in jobs destruction is slowing, which no one will confuse with job creation.
Rest assured, the recovery will come. In fact, from an economist's perspective, the numbers in the second half of this year are likely to inspire. The deepest fears of six-to-nine months ago are proving to be exaggerated. So it goes in economic forecasting. But it's going to take a lot more a slowing contraction to convince Joe to start making fresh runs down to the local mall to pick up an extra wide screen television.
Yes, we've come a long way since last autumn, although in some ways—arguably in the most crucial ways—the journey has only just begun.
August 3, 2009
THE GREAT RELIEF RALLY ROLLS ON
The financial gods were kind again to the major asset classes in July. Everything was up, and mostly with strong gains.
As our table below shows, it was hard to lose money last month, a.k.a. a refreshing change from the recent past. Of course, if you were sitting mostly in cash, there was little to celebrate with a virtual zero to the month's total return for 3-month T-bills. Inflation-linked Treasuries didn't do much better, but everything else did.
Emerging market stocks were the big winner, closely followed by REITs, foreign developed market and U.S. equities. Risk, in other words, paid off quite handsomely in July. With such widespread gains of more than modest means, our Global Market Index—a passively allocated mix of the major asset classes—also posted a strong total return of 5.5% last month.
In fact, the capital and commodity markets have been rallying since March. Granted, the performance in June was mixed and unimpressive, but generally speaking otherwise the returns have been positive for much of the past five months. The question now is whether the rally was/is 1) a reaction to the realization that the darkest fears of last year and early 2009 were exaggerated; or 2) an expectation that a meaningful economic rebound is imminent.
If the answer is 2, and the crowd believes strong economic growth is near, a bit of an attitude adjustment may be in order. Meanwhile, for those who are still buying in recognition that the global economy will survive, albeit in somewhat hobbled form, it's not clear that the trade has further to run on that reasoning alone. It is, to be blunt, a bit late in the day for rationalizing higher prices solely on the basis of #2 above.
U.S. stocks, for instance, are thought by some to be at fair value vs. the relative bargain pricing that prevailed early this year. And that's the optimistic view. Indeed, economist Andrew Smithers estimates that U.S. equities are 20% overvalued, The Economist reported last week.
As we've been discussing for some time, including here and here, our view is that the gap between the technical end of the recession and the arrival of a robust economic rebound will be unusually long this time around. Does the crowd agree? It's hard to say exactly, although we're erring on the side of caution by holding a bit more cash than we otherwise might be if this was a "normal" business cycle.
Yes, the rally this year is warranted, but it's getting harder to argue for rising asset prices without a commensurate change in the macroeconomic fortunes. That will come eventually, but as Friday's GDP report for Q2 suggests, it's going to take time, perhaps more time than the crowd currently realizes.