September 30, 2009
HOPING FOR ABSOLUTE, BUT SETTLING FOR RELATIVE
It's all about employment now. More of it would be better, although we may have to settle for losing it a slower pace for a bit longer.
The U.S. Labor Department will dispatch the official update for September nonfarm payrolls on Friday. Meantime, dismal scientists, pundits and fans of macabre labor stats are making estimates and crunching the numbers on hand.
Wanted Technologies, an employment analytics firm, expects that nonfarm payrolls will fade by 167,000 in September. If so, that would be an improvement over August's loss of 216,000 jobs, albeit a relative improvement.
Absolute improvement, unfortunately, doesn't look imminent. The ADP employment report released this morning advises that the employment rolls shed 254,000 in September. That's better than the 277,000 loss in August, as per ADP, but we're still stuck in the land of relative progress and the odds of returning to Kansas quickly still look slim.
Julia Coronado, senior U.S. economist at BNP Paribas in New York, states the obvious when she tells Bloomberg News that “the state of the labor market is still very weak” and job destruction is “weighing on wages and income,” which remains a "headwind to growth.”
Joel Prakken, chairman of Macroeconomic Advisers, says bluntly that the crowd should be prepared for more losses for the foreseeable future. Although the rate of loss has been diminishing, "employment, which usually trails overall economic activity, is likely to decline for at least several more months, with losses continuing to diminish," he says via MarketWatch.com.
If September's payrolls give ground once more, as seems likely, that'll mark the 21st consecutive month of job destruction for the U.S.—a record string of retreats since the Great Depression. The pain will end soon, but not yet. Then comes cleaning up the mess.
As we've been discussing for some time, the real challenge still awaits. Ending the job loss is critical, of course, but pulling the labor market out of its hole by way of net employment growth on a national basis is a much bigger hurdle. Alas, as Friday's numbers are likely to show, that all-important task is still premature in terms of topical issues du jour.
September 28, 2009
STRATEGIC PERSPECTIVE IS (STILL) A RADICAL IDEA
Investment advice runs the gamut in the known universe of finance. Some of it's good, some of it's less so, but the majority of it is just plain misguided if not detrimental to the long-term interests of investors. It's an old story, but it's also a perennial, and therein lies the problem for most people trying win (or at least not lose) in the money game.
The central challenge for the average investor, perhaps even the average institutional investor, is that the global capital markets are rife with complication, short-term noise, nuance and lots of trap doors. Adding to this burden is the fact that much of what passes as investment intelligence is anything but, mainly because it lacks perspective and basic understanding of the essential business of portfolio design: risk management. There are simply too many "experts" running around dispensing advice to buy this, avoid that and otherwise recommend that investors engage in an ill-advised effort to second-guess market prices at every turn.
Yes, there are some who can beat markets, but it's the rare individual investor who excels in picking securities across multiple asset classes. We take a different view in the monthly issues of The Beta Investment Report. Instead of starting from the belief that we have full clarity on the future path of risk and reward for the global capital and commodity markets, we assume that a fully diversified portfolio of all the major asset classes, weighted by the market values, is a robust benchmark from which to begin analysis and ultimately tweak Mr. Market's passive allocation to suit our financial needs.
It's a radical idea, based on what passes for standard operating procedure in terms of counsel in the media and the offices of financial advisory. But it's a strategy that draws strength from 50 years of economic research and quite a bit of supporting empirical evidence that tells us that this is a logical and productive way to begin our investment journey.
That's one reason why we regularly profile the major asset classes each month on these digital pages, as we did early this month here, in our end-of-month update. We go into much more detail in The Beta Investment Report, but the basic goal is the same: strategic perspective. It's not a short cut to quick profits, but it's a valuable way to begin the all-important task of gaining perspective.
Looking at past returns by itself isn't enough, of course. We must also consider how a passive mix of the major asset classes has performed over time, and how this benchmark's risk profile evolves amid the give and take of market and economic trends. In addition, we need to keep an eye on the major asset classes individually by studying them, tracking them and comparing how the price of risk varies today vs. the past. Another critical element is paying close attention to the business cycle with an eye on understanding how it unfolds, where we're at currently and what the trend implies for the near-term future over, say, the next three to five years.
Ultimately, the goal is one of becoming comfortable with estimates of risk premiums for the major asset classes, individually and collectively. With that information in hand, we can begin thinking about how to reassemble Mr. Market's passive asset allocation for building portfolios to suit our own needs. Indeed, everyone (and every institution) should customize asset allocation to satisfy a particular set of financial circumstances, including a unique set of liabilities and expectations.
The default strategy (not to mention an easy strategy) is simply buying all the major asset classes and weighting them by their relative market values. But this is the optimal decision only if you have an infinite time horizon and generally fall into the category of an average investor in terms of risk and return needs and expectations. To the extent that you don’t fit that profile—and nobody does—there's a case for adjusting the passive asset allocation.
What does "adjusting" mean? A whole lot more than we're prepared to write about in one blog post. That's one reason why we publish The Beta Investment Report, which goes into the details on a monthly basis, including analyzing the major asset classes; reviewing the associated index mutual funds, ETFs and ETNs; reviewing new investment research that furthers the goal of enhancing our strategic portfolio perspective; tracking the broad trends in the business cycle; and more. For readers who're interested in a relatively comprehensive and formal argument for this approach in one fell swoop, your editor has written a book on the topic and it'll be published by Bloomberg Press in February: Dynamic Asset Allocation: Modern Portfolio Theory Updated For The Smart Investor).
Depending on who you are as an investor, you may dispense with some, most or even all of Mr. Market's asset allocation. But for most folks, drifting too far from the true market portfolio—as defined by our Global Market Index—is probably a mistake. Simple statistics dictates that half of the world's investors will trail a passive mix of the major asset classes in the long run, and perhaps over the short- and medium-term periods as well. After adjusting for taxes and trading costs, it wouldn't surprise us to learn that quite a bit more than half will trail this benchmark.
On that note, our Global Market Index, which is comprised of a passive mix of the major asset classes, generated an annualized total return of a bit more than 4% for the 10 years through the end of August 2009. By comparison, the U.S. stock market (Russell 3000) was just about flat over that period and U.S. investment-grade bonds (Barclays Aggregate Bond Index) rose by 6.3%. Did your portfolio beat GMI? If so, how much was due to luck vs. skill? And if you trailed it, well, are you prepared to change your strategy?
To follow this not-exactly-fair example through to its logical conclusion, one might ask: What was the average investor thinking about ten years ago? Recall that in the latter half of 1999, few were arguing on behalf of bonds while much of the conventional wisdom called for stocks in large if not overwhelming quantitites for the long run.
The point is that most predictions are vulnerable, especially when looking out over multi-year periods. The fact that mere mortals are generally at a disadvantage in this regard is a potent reminder that we should think twice before dismissing the true market portfolio as a basic framework for designing and managing portfolios through time. But even this simple but powerful advice is ignored in the wider world.
That's not terribly surprising if you consider that investment perspective rarely looks useful or even compelling in the short term, as suggested by our review of recent trends in the major asset classes. But just as sure as the sun will rise tomorrow, ignoring the strategic issues is likely to incur a toll, perhaps a heavy or even fatal toll on investment results. Recent history makes this point in no uncertain terms, as does a broad review of the capital and commodity markets and decades of research from financial economists. Why, then, do so many seem to ignore strategic perspective? We have our theories, although a formal attempt at answering the question is beyond our job description.
Meantime, we now return you to the investment casino game already in progress….
September 25, 2009
A SETBACK FOR DURABLE GOODS ORDERS
If you're looking for a measure of the challenge that awaits, new orders for durable goods are a useful place to start.
Durable goods are arguably at the front line of economic activity. Purchasing big-ticket items, like cars and aircraft, take some degree of confidence in the near-term economic outlook as well as one's personal (or corporate) financial condition. In times of economic distress, delaying such purchases is tempting. You can always buy a car next month.
With that in mind, the modest rise in new orders for durable goods in July was heartening. As many economic observers have noted, the fact that such measures of spending and consumption were no longer plummeting was good news. All the more so when July's durable goods orders posted a tidy gain. Some pundits said this was evidence that an economic recovery of some magnitude was imminent. But as we said last month in the wake of the July durable goods report, climbing out of the hole will take longer than usual.
And when we say hole, we mean it. As the chart below reminds, new orders for durable goods are far below the levels that passed for normal previously. This is no isolated case. The charts look similar for a range of economic metrics, such as housing starts, industrial production and retail sales. Reparing this damage will take time, and government efforts to juice the economy won't offer a quick fix, even if the data point du jour suggests otherwise at times.
Indeed, after July's pop in durable goods orders comes word this morning that new orders for durable goods slumped 2.4% in August. That's hardly the end of the world, and in fact some corners of the report show growth last month--mostly in the primary metals sector. Nonetheless, today's update reminds that there's risk of expecting too much too soon at this point in the business cycle.
Yes, recovery will come, but it won't come easily or quickly. Ultimately, the requisite elixir is growth in the labor market. Unfortunately, there are precious little, if any, signs of a rebound on this front. That raises the question as to whether the green shoots of late are primarily due to the government's monetary and fiscal stimulus?
If the answer is yes, then we must turn to the more fundamental inquiry: When will the recovery begin that's powered mostly by the internal dynamics of the marketplace? That too is coming, but timing is debatable. But if the crowd has jumped the gun with premature expectations of a true recovery, another round of repricing risk may be coming.
September 24, 2009
WILL THE POSITIVE MOMENTUM SPREAD?
The update on new fillings for unemployment benefits is cheery once again, at least in trend if not absolute numbers. Initial jobless claims dipped to 530,000 last week, the lowest since mid-July and sharply below the peak for this cycle—674,000 for the week through March 28, 2009.
The downward trend suggests that the recession is over, but we're still waiting for some corroborating support, including continuing claims, which remain elevated. The implication: businesses are laying off fewer workers (initial claims) but those who are already receiving jobless benefits aren't finding work (continuing claims).
In search of clues that the economy's headed for a recovery that includes minting new jobs we're keeping an eye on the trend in initial jobless claims relative to continuing claims. Our second chart below offers a window on that front by indexing the two data series for direct comparison. (Note that continuing claims are reported with a one-week lag to initial claims and so to maintain consistency the graph below runs through Sep. 12.)
For the moment, there's not much downward movement in continuing claims. That's coming, or so we think, but the question is, When? And at what pace?
Our expectations are modest, at best, these days. The labor market threatens to be an ongoing thorn in this recovery. The crowd doesn't yet understand this point…yet. The accumulation of household debt and the ongoing financial repair that's necessary to offset the hefty consumption bills of the past several years will conspire with a skittish corporate mindset to keep growth in the labor market abnormally shallow for the foreseeable future.
Let's hope your editor's wrong. Meantime, the next big clue comes on October 2, when the September payrolls report is released. Will we finally see a gain after 20 straight months of loss? No comment, although judging by yesterday's monthly report on mass layoffs—such "events" went up by 25% in August—one might wonder if negative momentum is gaining strength.
But what of all the monetary and fiscal stimulus? Will the government's efforts to juice the economy start kicking in? How will we know if the plan is working? Watch consumer discretionary spending, economist Bob Dieli of the consultancy NoSpinForecast.com tells the Capital Spectator. More than two-thirds of the American economy is based on consumer spending. If the stimulus has any chance of dispensing a positive impact, it's likely to show up in personal consumption expenditures (PCE), he explains.
The latest PCE report tells us that consumer spending rose 0.2% in July over the previous month. That's a modest change, at best. Will the rest of year fare any better? The next installment on an answer arrives October 1, when the August PCE numbers are released. Dieli says if PCE growth is 0.5% on a "sustained basis" for the rest of year, that will go a long way in support of the argument that the stimulus is working.
What about payroll employment? Consumer spending ultimately depends on a healthy labor market. Dieli says that a labor market that's at least treading water if not creating jobs in the remaining months of 2009 would offer further evidence that the stimulus spending is productive. But reaching even that modest goal may prove challenging in the immediate future.
A worrisome sign is the sharp 6.6% jump in labor productivity in this year’s second quarter, according to the Labor Department. That's the highest rate since 2003 and it suggests that corporate America is learning how to produce more goods and services without expanding the payrolls. That's not encouraging. Nonfarm payrolls in the U.S. fell by 216,000 in August, as they have for every month starting in January 2008. Sure, last month's loss is smallest this year, and in that sense it's a step in the right direction. But the best you can say at the moment is that jobs are disappearing at slowing rate.
September 22, 2009
POLITICS & INVESTING DO MIX...EXCEPT WHEN THEY DON'T
Studying the election cycle and the stock market isn't new, but that doesn't stop inquiring minds from taking a fresh look at the numbers. CXO Advisory Group offers yet another perspective, albeit with middling results. As this research concludes,
"..there appear to be both long-term and short-term connections between the U.S. national election cycle and stock market performance, with presidential term year 3 (1) the best (worst) and a tendency for a brief election-time rally. However, the subsamples for presidential term year analysis are very small, so confidence in related tendencies is very low."
Meanwhile, a popular research paper from recent history advises that "the excess return in the stock market is higher under Democratic than Republican presidencies." Of course, that was from the vantage of 2003. Will the trend hold over the remaining years for the present incumbent? Based on the year-to-date returns so far, one might argue in the affirmative. But with the election more than three years away, a touch of modesty might still be in order.
SEI came to a similar conclusion last year, writing in a research note that "one year following [an] election, the average return of the DJIA was 2.18%. Here, the advantage goes to the Democrats, who averaged 5.43%, with the best year credited to Franklin D. Roosevelt, at 29.96% in 1944. Roosevelt also had the most negative return here; -28.68 during the first year of his first term in 1936. The average during the 9 Republican administrations was -1.07%."
Of course, some think there's enough of a challenge in predicting election outcomes alone without muddying the waters with adding stock market predictions to the game. If you're of a similar persuasion, Professor Ray Fair of Yale is your man. As one of the leading academics parsing the finer points of forecasting elections, he's well versed in the opportunities and limits of quantitative analysis and politics.
CORRECTION: INFLATION EXPECTATIONS AREN'T A CONSTANT
In our previous post today we mistakenly wrote that inflation expectations were constant. Twenty lashes for your editor. We meant to say that inflation expectations, along with the reported level of inflation, are constantly bouncing around, as any review of the historical record will show. We've updated the offending passge. Sorry.
The Treasury market's inflation forecast has remained fairly steady since May, hovering in the 1.5% to 2.0% range. As of Monday's close, the current outlook for inflation is 1.80%, based on the yield spread between the nominal 10-year Treasury less its inflation-indexed counterpart.
As our chart below shows, this stability follows a period of extreme volatility, launched last September when the implosion of Lehman Brothers sparked a steep wave of selling in almost everything, government bonds being the leading exception.
The Treasury market's 1.8% inflation outlook contrasts with the most-recent 12-month change in the headline consumer price index, which dropped 1.5% for the year through August. But if we look at core CPI, which excludes the volatile energy and food sectors, prices rose by 1.4% for the 12 months through last month. That's just under the 1.8% inflation forecast implied by the Treasury market.
If future inflation for the next decade lives up to the current forecast, the pace of consumer price changes will compare well with the historical record. A world where inflation resides under 2% is favorable if we use the long-run past for comparison. But inflation expectations aren't a constant, which works well since inflation isn't set in stone either. And therein lies the potential for mischief making.
Such concerns will no doubt be on the agenda of the Fed's FOMC meeting, which begins today and concludes tomorrow. For the moment, however, the market expects that the central bank will keep monetary policy on an even keel, which is to say maintaining its Fed funds interest rate target of 0-0.25%.
As our second chart below illustrates, Fed funds futures project rates will stay unchanged for the next few months, rising slowly in 2010. If the futures market is correct, a year from now we'll see Fed funds at roughly 1.0%.
It all makes for a wonderful outlook. Inflation is low and expected to stay that way, save for a s-l-o-w rise in the months ahead from an extremely low base. As inflation projections go, this is about as good as it gets. And that's what worries us.
But for now, all's well. Enjoy it while it lasts.
September 17, 2009
A TALE OF TWO LABOR TRENDS
Today's weekly update on jobless claims shows another dip, which provides more evidence for thinking that the recession is over. But as we keep repeating, the technical end of the recession doesn't look poised to offer a quick, robust recovery this time. The qualification draws support from the uptick in the latest continuing jobless claims report.
As for the latest numbers, new filings for unemployment benefits dipped to 545,000 last week, down from 557,000 previously. New jobless claims are now at the lowest since mid-July and well under the peak set back in March. More importantly, the downward trend appears to remain intact.
What's worrisome is the fact that continuing claims ticked up for the week through September 5 (continuing claims are reported with a one-week lag behind initial claims). That suggests that the unemployed aren't finding new jobs. It's still early to make definitive conclusions, given that the recession is still a fresh wound in the economy's hide. Indeed, job creation is typically among the last corner to rebound after a recession.
Nonetheless, for reasons we've discussed previously, there's reason to be suspicious that the labor market is set to rebound strongly in the weeks and months ahead. Even assuming that jobs come back slowly as a general rule, the oulook for labor growth appears unusually sluggish in the months and perhaps years ahead. If our forecast proves accurate, one clue that it's coming to pass will show up in continuing claims that remain high or rise relative to initial claims. And that's just what seems to be happening, as our second chart below shows. We'll need to see how the two data series unfold in the weeks and months ahead, but for the moment we're cautious on expecting continuing claims to suddenly turn down and maintain the downward bias with initial claims. We'll see.
Again, it's still early in this part of the recovery cycle and so the jury's out on making final decisions. Indeed, there's still lingering fears that the recession isn't over, although that worry seems less relevant with each passing week.
In any case, we expect the crowd to refocus its attention on the labor market in the weeks ahead, and the prospects for quick satisfaction look dim on that front at the moment. The recent upturn in non-labor macro indicators suggests otherwise. But to the extent the marketplace is expecting a follow-through with jobs, it's too early to start the celebration.
September 16, 2009
TWO EXTREMES, ONE ECONOMY
We've been writing for months that the recession appears close to a "technical" finale but that the recovery would be slow, sluggish and generally vulnerable for an unusually extended period of time. Two stories in the latest news cycle echo our long-running commentary. In fact, the pair of stories makes the point better than we could.
First, Fed Chairman Ben Bernanke yesterday stated: "From a technical perspective, the recession is very likely over at this point" but "it's still going to feel like a very weak economy for some time," via MarketWatch.com.
Meanwhile, today's New York Times has a story that raises questions about how soon the housing market can function under its own power. At issue is a key piece of the government's fiscal stimulus—the $8,000 tax credit for first-time home buyers. As the Times observes, "When Congress passed an $8,000 tax credit for first-time home buyers last winter, it was intended as a dose of shock therapy during a crisis. Now the question is becoming whether the housing market can function without it." Although housing is but one piece of the economy, its trials and tribulations capture a core element of the economic turmoil of late. It may be too much to say that the housing market is a bellwether for the general economy, but it's close.
More to the point, the Times story reminds us of one of the potential drawbacks of stimulus, monetary or otherwise: markets may get used to the idea and so taking it away, which can cause secondary problems, depending on the exit strategy. That's not to say that stimulus was unnecessary. But in the rush to smooth over the crisis of the past year, cleaning up the mess born of the emergency financial and economic surgery promises to be the new new challenge in the months and years ahead.
Arguably that's a challenge that's superior to letting an economy implode, if in fact that really was a risk, as it seemed to be at times last fall. But the nature of trying to manage the business cycle imposes costs too. In effect, we're now faced with managing a chronic risk in the economy in exchange for minimizing if not sidestepping the acute risk that arose last autumn. Was the exchange worth it? The default answer is that the outcome will be a wash, when measured over the long run. In the short term, however, the details are messy.
September 15, 2009
AUGUST'S RETAIL REBOUND
Today's update on retail sales certainly lends more credence to the notion that the economy is stabilizing and perhaps even poised for modest growth. Indeed, the 2.7% rise in seasonally adjusted retail sales in August was the highest monthly increase since January 2006.
Even better, a closer reading of the report shows that gains were broad based--only furniture/home furnishing stores and building materials/garden equipment establishments posted lesser sales on the month, seasonally adjusted.
But we should be cautious in reading too much into the numbers. Keep in mind that motor vehicle sales lead consumption higher in August. The government's cash-for-clunkers stimulus program was clearly a factor. But the auto phase of the government's fiscal stimulus is history, at least for the moment.
There's more fiscal stimulus coming, of course. Only a fraction of the $792 billion stimulus monies have been spent, according to ProPublica. Meanwhile, the Federal Reserve continues its liquidity injections on the monetary front. Deciding how it all translates into retail sales, or not, and other economic measures is the new new game in the dismal science. At least one economist (Robert Hall of Stanford) thinks that the slow rollout of stimulus spending may be a postive. He considers a macro model that shows that "the much criticized slow ramp-up of the stimulus was actually benecial," via a paper presented last week at a Brookings Institution conference.
Meanwhile, we should be mindful of how far retail sales have fallen recently in absolute terms, a sore statistic that's minimized by looking solely at percentage changes. As our second chart below reminds, retail sales last month were roughly 7.5% lighter relative to the all-time high set back in November 2007, the month before the recession officially began, as per NBER. Regaining the lost ground in absolute terms is going to take time and come in fits and starts. True for retail sales and for other critical corners of the economy, most notably in the labor market, which is still losing ground based on the latest numbers. Stimulus may be helpful, but it can't last forever, and the jury's still out on when Joe Sixpack's able and willing to return to his consumption habits of yore sans Uncle Sam's help.
Nonetheless, we're encouraged by the various signs of stabilization and rebound, including today's retail sales numbers. It could have been worse. Recovery has to start somewhere, even if it's marginal, tenuous, subject to revision and the byproduct of government help.
In any case, today's gains don't surprise us. As we've been writing for some time, several metrics have been pointing to improving odds for an upturn in the business cycle. The details are messy, but the basic trend has been suggested in a variety of economic reports and statistics in recent months. Today's retail sales report provides one more data point for embracing what we've been seeing since at least March: hopeful signs for the future are bubbling. But in some respects the easy work is over. A big question: When will the economy begin to walk on its own?
The answer lies in the future. Meantime, we'll get another clue in next month's retail sales report that offers spending habits in the post-cash-for-clunkers climate. Meantime, we dodged another bullet.
September 11, 2009
LOOKING BACK: FROM PEAK TO PRESENT
It's been a long, strange trip in the nearly two years since October 2007, when the U.S. stock market peaked. The details of the journey have been dissected ad infinitum, on a tick-by-tick basis. But what of the big picture? How does a broad review of performance among the major asset classes stack up since October 2007?
We can start by considering total return indices for the usual suspects by setting benchmarks to 100 for everything as of the close of October 2007. The chart below shows how the major asset classes have performed since then through the end of August 2009. (For the underlying indices that represent the asset classes see our post here.)
Another view on the same history is presented in our second chart below, which ranks the total returns for October 2007 through August 2009.
We spend a lot of time analyzing the major asset classes on the pages of The Beta Investment Report. The primary goal is searching for some perspective in managing multi-asset class portfolios and squeezing out a bit more return without taking on more risk. That begins by considering the rebalancing opportunities related to comparing performance. That's the easy part. By that standard, foreign government bonds appear to need some trimming while buying REITs looks productive, for instance, relative to results from October 2007 through last month.
Our benchmark in our strategic travels is our proprietary Global Market Index, which is a passively allocated mix of all the major asset classes weighted by the respective market values. (GMI was initially launched on December 31, 1997 and its asset allocation among the major asset classes has fluctuated with the market tide, untouched by human hands, ever since.) This index is no panacea, but it does give us a sense of what an unmanaged, objective measure of everything dispensed in terms of risk and return. That's no silver bullet, but it's a productive way to start considering the investment options.
GMI is a proxy for the true market portfolio and forms the basis of our analysis in The Beta Investment Report. You can see how GMI has fared in the first chart above by looking at the bright green line in the middle. It's no accident that it's produced a middling run relative to its components since October 2007.
The burning question is (always) whether we can enhance the results of GMI? In theory, yes, although in practice it's difficult, at least over time. In the short term, however, the challenge looks tempting, perhaps even easy. For example, simply buying TIPS or foreign government bonds back in October 2007—and shunning everything else--would have done the trick. Of course, how many of us were that smart? For some perspective on this challenge, think about which asset class today is likely to be the leader (or at least beat GMI) over the next two years. Are you willing to bet the farm on your decision? Or, perhaps you might hedge your bet by owning a few other asset classes? If so, how big a hedge? And how should it be structured? And what parameters will determine how you'll manage the mix through time? Etc., etc.
Therein lies the enduring challenge in asset allocation: Figuring out what's hot, what's not and what looks likely to track the historical average is at the core of portfolio strategy. The markets drop some productive clues at times in this quest for above-average performance, as we discuss routinely in The Beta Investment Report and in greater detail in our upcoming book Dynamic Asset Allocation. But there's no guarantee of success. That's not to say that we shouldn't try to improve upon GMI's results. But we should be careful about straying too far or trading too much. That includes keeping our expectations under control and focusing on risk management. In general, we shouldn't think that success will come easy as a long-term proposition.
In the very long run, those who outperform GMI are likely to be matched in numbers by those who trail the benchmark. That's true for the full range of strategies and risk appetites in the world, ranging from aggressive hedge funds down to more conventional strategies. Most of what goes on in the world of money management involves trading some piece (or two or three) of GMI's primary components, either among the components of a given beta or among the betas writ large.
The choice of how to proceed therefore begins by considering owning everything, using ETFs and/or index mutual funds. Replicating GMI translates into doing nothing via holding a passive mix weighted of the major asset classes as defined by market value. In practice, virtually everybody tweaks this benchmark to fit their specific situation. Eventually, some wind up ahead the benchmark, some don't. The details of improving your odds for staying in the latter category are messy. But at least we know where to begin in terms of a truly objective benchmark.
September 10, 2009
MORE GOOD NEWS IN THE LABOR MARKET...MAYBE
This morning's update on initial jobless claims offers more encouragement for thinking that the economic contraction has bottomed out. That's still distinct from proclaiming the arrival of a recovery worthy of the name, as we've been discussing for months, including here and here. Nonetheless, the downward trend in initial jobless claims—a valuable leading indicator of the business cycle, as we explained back in March—continues to signal that the recession on a broad macro scale is over or nearly over.
Granted, last week's decline in new filings for jobless benefits to 550,000—the second-lowest so far this year—may be skewed because of this past weekend's Labor Day holiday. As always, we'll have to wait for more number crunching by our trusty servants in Washington. Meantime, the chart below doesn't give us any reason to think that initial claims aren't biased toward lower levels in the future, albeit erratically and slowly, but downward nonetheless.
Another encouraging trend in today's unemployment numbers arrives by comparing initial claims with so-called continuing claims, by far the higher number of the two. Indexing this pair to measure the trends on an apples-to-apples basis suggests that we're finally seeing some progress in reducing continuing claims, as our second chart below shows.
Continuing claims reflect the ranks of the unemployed who've previously been collecting jobless benefits. A decline in this series suggests—emphasis on "suggests"—that people who've been on the unemployment rolls are finding work. Generally speaking, a decline in initial jobless claims is all the more persuasive if continuing claims are falling too. As the second chart directly above suggests, there now appears to be greater downward momentum in both series, which is encouraging, at least on its face.
We qualify the last point because it's not yet clear if the decline in continuing claims is a quirk. One possibility is that continuing claims is falling for less than bullish reasons. For example, the shrinking number of continuing claims may reflect that the jobless are falling off the government's radar because their unemployment benefits have expired.
In short, the data looks mildly encouraging as reported but we're still a long way from declaring the Great Recession over as it relates to Main Street. (Wall Street's perspective is another story.) But this much is clear: a recovery of some degree in the labor market is critical in order to repair the damage of the past year or so. Today's numbers tell us there's still a lot of pain, but at the very least today's report suggests that the trend isn't getting any worse and maybe, just maybe, it's getting marginally better.
RETHINKING THE CONSUMER ECONOMY: CLUE #23
It's not quite the proverbial canary in the coal mine, but it looks like one. Heck, when even Joe Sixpack's formerly obsessive spending habits are on the defensive you know something's changed. Such is the message that even gambling revenues from casinos and lotteries are facing a downfall for the first time, according to The New York Times.
"The decline [in gambling] comes as states are rapidly expanding gambling in hopes of stemming severe budget shortfalls, and it indicates that gambling is not insulated from broader economic forces like recessions, as has been argued in the past," the paper reports today.
Among the reported losers: Illinois' gambling revenue is off $166 million in fiscal year 2009 vs. the year earlier; Nevada suffered a $122 million retreat; and New Jersey claimed its slide was $62 million.
Is nothing's sacred in the Great Recession's reordering of spending priorities? Apparently not, with the possible exceptions of Washington's immutable habits with money and certain personal services performed in red light districts. Otherwise, Joe Sixpack's playing a new game these days and it isn't roulette. If you can't count on the crowd's arrival in Vegas and its lookalikes around the country, good luck with trying to sell an extra truckload of wide-screen TVs next week.
September 8, 2009
MARKETS, MACROECONOMICS & THE FED
The market's taking a beating lately, and we're not talking here about investment returns. Rather, the theory that market prices offer valuable information is on the defensive…again.
The latest assault came over the weekend in Paul Krugman's New York Times Magazine article "How Did Economists Get It So Wrong?" Among the various indictments in the story is the charge that the efficient market hypothesis (EMH) is a principal cause of the economic ills that afflict the U.S.
Attacking EMH has become a popular sport recently, which is to say more popular than usual. Some of these attacks are exaggerated, others are misleading and some are just plain wrong, especially when it comes to interpreting (and often dismissing) EMH as it relates to investing. We've written about such issues regularly over the years and tackle the subject in more detail in our upcoming Dynamic Asset Allocation: Modern Portfolio Theory Updated For The Smart Investor, which will be published in February by Bloomberg Press. Meantime, let's focus on one point in Krugman's story regarding the management of the economy.
Krugman writes that "the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place."
Among the alleged smoking guns presented are the decisions by former Fed Chairman Alan Greenspan, who ran the central bank until 2006 and embraced a market-oriented approach to monetary policy. But equating the Fed's monetary policy under Greenspan, and currently under Ben Bernanke, with EMH is problematic.
The idea that the Fed's monetary policy and EMH are one and the same is a stretch. Yes, the price of credit is partly set by the market, i.e., supply and demand, although most of the market's influence resides at the medium and long-term points on the yield curve. Meanwhile, the Fed's influence is dominant at the short end of the curve, and the tool of choice is the Fed funds rate. But just because the Fed chooses to set Fed funds at a particular rate doesn't necessarily mean that rate also reflects supply and demand.
The Fed, in other words, manipulates the price of money at times. That may or may not be productive at times, depending on other factors. Even so, one can argue that a central bank is a necessary evil for reasons that start with the idea that the economy needs a lender of last resort. But the question before the house is: Was the Fed remiss in managing the economy in the years leading up to 2008? We can never answer definitively because we don't know how the economy would have fared if the Fed had done something different. Nonetheless, we can look back and consider what happened and review the context for the decisions by the central bank.
On that note we'll present one bit of evidence. In the chart below, we graph the real (inflation-adjusted) Fed funds rate on monthly basis for the past 20 years. Note that the real Fed funds rate has been negative three times since 1989. At such times the question is whether a negative rate is warranted?
Today, one could argue "yes," given the weak state of the economy at the moment. But what about 2001-2005? Allowing Fed funds to remain at negative real rates for nearly four years looks like a crucial error in monetary policy. Such extraordinarily low real rates almost certainly contributed to the excesses that came back to bite the economy in 2008, including an excessive degree of speculation in the housing market.
This is a critical issue for several reasons. One is that economists of the monetarist persuasion argue that monetary policy casts a long shadow over the health of the economy. Accordingly, if the Fed makes poor decisions in managing monetary policy, the economy will suffer sooner or later. In fact, there's a strong case for arguing that the Great Depression was largely a byproduct of poor monetary decisions. The central bank was also responsible for much of the economic troubles in the 1970s. And it looks like the Fed made a poor decision in keeping interest rates too low for too long during 2001-2004. Initially, in the wake of the market correction of 2000-2002, low interest rates were warranted. The problem was one of keeping the price of money too low through 2005.
If flawed monetary policy is a critical reason for recent macro events, it's not clear that this is a direct indictment of the efficient market hypothesis or the idea that market prices generally contain valuable information for investing as well as managing economies.
So, what's the solution? Krugman suggests that we should discard EMH. But there's another answer and arguably a superior one: improve the Fed's monetary policy.
Alas, there's no silver bullet here, although there are some changes that could help. That starts with dispensing with the standard that Greenspan established, which favored the idea of letting one man have an undue influence over interest rates. In short, the maestro approach to monetary policy has some problems.
There are a number of alternatives, and most of the good ones involve letting the market provide more input into the setting of Fed funds. Yes, that's right: we need more of the market's influence in the design and management of monetary policy, not less. Less is what got us into this mess, despite what some EMH critics argue. It's tempting to equate Greenspan's decisions with what an EMH-inspired approach would do, but that's misleading. It's unconvincing to argue that because Greenspan dismissed the idea of financial bubbles that also means that his decisions were defacto EMH-inspired choices. Greenspan was making activist choices that weren't necessarily based on market signals. As it turned out, some of his choices were wrong. The lesson is that individuals make mistakes, and so we should be wary about letting one Fed chairman amass too much influence over the setting of interest rates, regardless of what he thinks or says.
A better approach for setting Fed funds is incorporating more price information from commodities, housing, the stock market, to name a few key variables. There's also a case for setting a stated inflation target that the Fed is routinely targeting and that everyone can judge. There's some of this going on now, but there's still too much mystery surrounding the Fed's operations and how it reaches decisions about monetary policy. In turn, that fosters the possibility of making decisions that stray too far from what the market implies interest rates should be.
Monetary policy is too important to be left solely to a handful of people. Individuals aren't gods, even if they work for a central bank. Meantime, let's also recognize that the further marginalization of market forces isn't an answer either. Prices running skyward during 2002-2007 in a wide range of assets, from homes to commodities (including gold) to stocks and bonds, were telling us something. Unfortunately, it's not obvious that the Fed was listening.
September 4, 2009
BETTER BUT STILL FAR FROM HEALTHY
It's getting better, or at least the pain is lessening. But no one will mistake the labor market as healthy at the moment. Nor is it obvious that salvation's coming any time soon.
Nonfarm payrolls dropped again last month. The good news is that the loss of 216,000 jobs in August was the smallest decline this year and noticeably under July's revised 276,000 retreat, the government advises today. On that basis, August represents a step in the right direction. Certainly the trend has improved considerably since the average 648,000 monthly drop that prevailed in this year's first four months.
Nonetheless, our economic outlook that we've been discussing for months remains intact. On the one hand, the technical end of the recession is imminent if it isn't already here. By that we mean several things, starting with the growing probability that third-quarter GDP will show a small gain when the government issues its first estimate on October 29. But the return of broad economic growth—meager or otherwise—will be accompanied this time by a weak labor market.
Employment growth is always among the last to revive after a recession. The difference now is that the labor market will recover later and remain subpar for longer relative to every post-recession period since World War II. Today's update on August employment offers no reason to think otherwise.
Our second chart below captures our dualist outlook for the technical end of the recession paired with an unusually slow recovery in the labor market. By indexing the trend over the past year for initial jobless claims (red line) and continuing jobless claims (black line) we can compare the two on an equal footing. Briefly, the ongoing decline in new filings for unemployment benefits signals that the recession may be near a technical end. (For some background on using initial jobless claims as one factor in predicting the business cycle's trough, see our analysis published in March.) Meanwhile, continuing claims reflect whether workers are finding new jobs after some period of existing among the ranks of the unemployed. Judging by the trend in this data, there's still no compelling reason for optimism, which suggests the economy's capacity to mint new jobs on a net basis is still a ways off. Continuing claims have come down from the peak set earlier in the year, but it's debatable if the decline is wavering.
The labor market it seems will remain the primary thorn in the economy's recovery. Consider, for instance, that labor productivity jumped sharply higher by 6.6% in the second quarter—the most since 2003, the Labor Department reports. The message here is clear: corporate America is adapting to the times by producing more goods and services with fewer workers.
As we've been writing for some time now (including here, for instance), the biggest economic challenge is still in front of us. It's been tempting to think otherwise. Yes, the worst of the financial crisis appears to be behind us and the economy seems to be on the mend in broad terms. But that good news masks the bigger challenge that awaits: reviving the labor market. Unfortunately, that's going to take more time and effort than simply cutting interest rates to zero, printing money, putting toxic securities on the Fed's balance sheet and passing multi-billion-dollar stimulus bills that create more light and heat than enduring jobs growth.
In sum, the acute problems have passed. Now we're facing the challenge of managing the chronic ailments that afflict the economy.
September 1, 2009
THE RETURNS OF AUGUST
August was another hot month for REITs. It wasn't even a contest relative to the other major asset classes.
The Wilshire REIT index soared in August with a 14.6% total return, building on a 10%-plus gain in July. For the year through the end of last month, REIT performance isn't quite so spectacular, advancing a handsome but far-from-first-place 10%.
Of course, it wasn't that long ago that some were saying that REITs were headed for the trash bin of asset class returns. So it goes in predicting: in the grand scheme of the universe, it's right just as often as it's wrong. No wonder, then, that in the long run it's difficult to beat something approximating a true market portfolio, such as our Global Market Portfolio Index. Yes, some manage to win, but many fall behind relative to what finance theory tells is the optimal portfolio for the average investor with an infinite time horizon.
Meanwhile, back to the horse race. At the bottom of last month's tally of the major asset classes are emerging market stocks and commodities, both of which posted fractional losses in August. For the year so far, however, no one will confuse the returns of emerging market stocks with commodities. Developing market equities surged more than 48% so far in 2009 vs. a far more modest gain of 7.4% for commodities this year through the end of last month.
In fact, a relatively wide range of returns among the major asset classes looks set to be a trend with legs. That will represent a step closer to the historical norm, as we discuss in some detail in the soon-to-be-published September issue of The Beta Investment Report. In other words, the high correlations of the recent past among the world's capital and commodity markets are giving way once more to a broader range of return independence.
That's good news, since it suggests that there's more opportunity in holding and managing a multi-asset class portfolio. It also means more risk, including the risk that portfolio returns will vary by quite a bit more, for good or ill, in the months and years to come.
The money game is changing, as it always does. A different set of opportunity and risk awaits. The days of everything running higher are probably history. Whether the crowd's ready or not is debatable.
In any case, Vive la différence!