October 30, 2009
POST-GDP WAKE-UP CALL
Today's income and spending report for September takes the shine off of yesterday's glowing GDP news. A closer look at what unfolded in the third quarter has now arrived in terms of the impact on consumer sentiment and the ongoing pain from the labor market. The upward momentum that was all the rage in August, which provided potent aid in the bullish Q3 GDP trend, took a turn for the worse in last month of the quarter. The fear is that the negative sentiment will roll on into the final months of the year.
The government today reports that real disposable personal income retreated by 0.1% last month and personal consumption expenditures tumbled 0.6%. We noted yesterday that the Q3 GDP report, encouraging though it is, would be succeeded by a war for growth and today's numbers only bolster the forecast.
On the income side, we can sum up the challenge with the news that government payments were the only positive contribution to employee compensation in September. No wonder, then, that spending momentum is fading as the government's stimulus efforts recede. Consumer spending isn't necessarily headed for a persistent decline, but neither can we assume that it's set to regain territory lost over the past year.
Yesterday's GDP news, which revealed that consumer spending was up by a healthy 3.4% in the third quarter, sparked a wave of commentary in favor of the idea that Joe Sixpack had returned to his old habits. But today's income and spending report, which offers a more granular look at the third quarter, suggests otherwise. The gains in August, driven by government stimulus, have given way to the somewhat more sobering reality of September.
"The consumer went out spending in August, but once that incentive [from government stimulus programs] was taken away they didn’t have the same reason to spend as much,” Jonathan Basile, an economist at Credit Suisse, tells Bloomberg News.
It was always naïve to think that consumer spending, which represents some 70% of U.S. GDP, would snapback quickly. There's a price to pay for the crisis of the past year in terms of trips to the mall. It's been tempting to think that the full sacrifice that will be meted out in consumer land is behind us. In fact, quite a bit of the blowback may still be in front of us.
October 29, 2009
Q3 GDP IS UP, BUT THE WAR FOR GROWTH HAS ONLY JUST BEGUN
It's official: the U.S. economy expanded by 3.5% in the third quarter, the Bureau of Economic Analysis reports today. Encouraging as that is, it's neither a surprise nor anything near to closure for the financial and economic hurricane of the last year or so. But it is a step in the right direct, albeit a tentative and not-yet fully confirming step that the walk ahead will be equally brisk.
Nonetheless, good news is worthy of celebration at this point, if only for a moment. After four straight quarters of retreat, a gain in GDP is no trivial change. All the more so when we dive into the numbers and learn that the expansion was broad based. All the major categories that factor into the final GDP calculation posted healthy gains in Q3. That is, personal consumption expenditures, gross private domestic investment, exports and government spending were higher during the three months through September. That compares with red ink on those ledgers in past quarters, save for government spending and a mild rise in consumer spending in Q1 2009.
Otherwise, this is the first time in more than a year (or two, depending on your perspective) since the GDP report showed unambiguous growth across the board. If there's a single report that confirms that the economy has dodged a bullet—i.e., avoided a deeper, prolonged contraction—today's update is it. Thanks largely to Bernanke's Fed, the central bank's great mistake in the 1930s—keeping monetary policy too tight after the economic slump—has been avoided this time. GDP's Q3 report tells us so in no uncertain terms.
Indeed, it's no small trick to elevate consumer spending in the wake of the deepest economic recession since the Great Depression. And yet the numbers in our table below show that Joe Sixpack has been pulling out his wallet and spending across the board. This is no free lunch, of course, and so there'll be a price to pay for juicing consumer spending at a time of mounting debts and default. But the bigger risk, albeit temporary risk, was allowing spending generally to seize up. We've avoided that trap, at least for the moment, although we fear that we've traded an large acute problem for a modest chronic one that lingers.
In short, there are caveats lurking behind today's sunny GDP report. Many caveats. For now, we'll simply note one. The jump in durable goods, for instance, was assisted in no small way by the government's cash-for-clunkers stimulus program that boosted (or seemed to boost) auto purchases in recent months. That was a one-shot deal, of course, and it's not clear that the additional spending generated by the plan didn't simply transfer future spending activity into the present. Indeed, a report by Edmunds.com, via The Christian Science Monitor, charges that the cash-for-clunkers program gave money to consumers who would have bought a car regardless of the government's efforts.
The fact that the Fed has been effectively giving money away for much of the past year, combined with various fiscal stimulus efforts, insured that liquidity would be spilling over into every nook and cranny of the economy. Some of this liquidity was destined to show up as new consumption. If you print it, they'll spend it, at least some of it.
Helping the process along has been the snapback effect. Early in 2009, the economy was going to do one of two things: collapse or bounce back. The Fed's efforts helped tip the scale by more than a little to the latter, and we continue to see the effects. Indeed, the clues leading up to today's news of GDP's Q3 rise have been bubbling for some time, as we've been noting for months, including here.
But the snapback effect has limited reach, as do the government's various stimulus efforts. The true judge of the post-apocalyptic world of last autumn can't be judged—shouldn't be judged—by the Q3 GDP report alone. Yes, we've learned the lesson of how to manage monetary affairs in the immediate aftermath of a severe financial crises/recessions. But the lessons, and the solutions, for the period beyond that early post-crash period remain much more of a gray area with less-obvious policy responses, if any.
We're now moving into uncharted territory. Yes, we've arguably laid a foundation to provide the economy with a fighting chance of maintaining stability. Fostering growth, on the other hand, remains a challenge of some magnitude, with no easy answers, as the ongoing slump in the labor market reminds. Part of the problem is that there are so few periods to study in recent history. Japan in the 1990s and the U.S. in the 1930s are the main precedents, and neither offers compelling insights beyond the immediate snapback period.
Regardless, the U.S. economy faces a number of challenges, few of which are of the garden variety, starting with debt. Another is the labor market, which was showing signs of strain well before last year's debacle. As we pointed out earlier this month, the labor market rebound following recessions over the past 25 years has been increasingly mild. Given the context this time around, there's little reason to think the trend will abate. If anything, it seems likely to accelerate.
So, yes, let's cheer today's GDP report. But let's reserve judgment on whether we won the war or merely survived the first battle.
October 28, 2009
THE CHALLENGE AHEAD
Today's update on new orders for durable goods reminds that the slash-and-burn of the Great Recession is over, replaced by the tedious business of rebuilding what's been lost.
Once again, the news is encouraging, if only because the deep pain of the recent past fades as an imminent threat. And so the crowd can look with somewhat less-anxious eyes to the 1.0% rise in new durable goods orders and find a measure of comfort. As our chart below shows, the orders are rising off the bottom that formed in the first half of this year. But as anyone can also see, the work of rebuilding what's been lost has only just begun and climbing this hill will take time, in part because the recovery is susceptible to the usual hazards that loom in every post-crash period. True for durable goods, and for many other measures of economic activity.
But let's revel in the good news, if only for a minute. That includes recognizing that orders rose at a healthy clip even after subtracting the standard noisemakers: transportation and defense. That tells us that the advance was broad based. And so it was, save for a few minor holdouts.
At the same time, it may be dawning on the crowd that the recovery, while looking intact for the moment, is set to be increasingly boring. The excitement of the past six months or so is on track for the dull business of looking forward, finding challenges and formulating responses. That's quite different from weighing the data du jour, looking backward and cheering that we've sidestepped a larger disaster.
The future, to put it bluntly, looks rather tedious from our perch. Rebuilding and reviving the economy from here on out will take real work that doesn't lend itself to big headlines and late-night meetings on Wall Street and in Washington's halls of power. We're no longer in imminent danger of collapse but we're not poised for robust growth either. Changing this future will only come with time. There are no new TARPs waiting in the wings to spirit us back to the good old days. The government has pulled all the rabbits out of its hat, and with some progress to show for it. But there are no more obvious strings to pull to jump-start recovery beyond the soothing elixir of time and letting economic nature take its course. The angel of darkness is no longer hovering, but salvation isn't yet at hand, at least not salvation worthy of the name that's likely to satisfy the crowd's hunger for quick results.
The main impediment to a deeper, richer rebound remains the labor market, which continues to retreat. October's nonfarm payrolls report isn't due for more than a week, but the consensus forecast warns of another dip of 175,000. That's light by the standards of earlier this year, but a long way from supporting the hope that's embedded in the rising price of risk these last several months.
Better days are coming, but the gains will be incremental, occasionally retreating and ceaselessly shadowed by doubts, innuendo and plenty of volatility and surprises—good and bad. In short, the economy's going to give investors a run for their money, but not necessarily in the way we've come to expect these past 12 months or so. Big, dramatic swings with monster-size catalysts are a thing of the past. Patience is in; bold decisions with quick results (up or down) are fading. Subtle challenges and precious nuance await. It was all or nothing early in 2009. No longer. We're headed for an era of a thousand risks, each one subtle but lacking the power of life and death.
The implication for strategic-minded investors is that managing asset allocation will get tougher. A year ago you had one or two decisions that were of the make-or-break variety. That was an anomaly. We're sailing back to seas with finer shades of gray. Some of that—perhaps a lot of that is related to the nuance that awaits in the business cycle.
The bottom line: opportunities will retreat for beating an expansive definition of the market portfolio, as defined and analyzed on the pages of The Beta Investment Report. You'll have to work harder, be smarter, all things equal, compared with the past year or so. All of which is likely to stoke the marketing machines advising otherwise. Beware the risk that comes dressed as the seer promising the moon.
October 26, 2009
THE DATA DUMP FOR THE WEEK AHEAD
The next round of economic releases is about to commence, ushering in the next phase of the post-apocalyptic financial crisis. Although we're likely to see a fresh batch of encouraging numbers, there's plenty of reason to remain humble on expecting salvation is imminent for one simple reason: the labor market continues to bleed.
"While job losses will likely end early next year, robust job gains may still be several quarters away," according to Christina Romer, the chair of President Obama's Council of Economic Advisers, in testimony to Congress last week.
That's a fairly stark assessment considering that it comes via the usual political spin that passes for debate in Washington. A cynic might argue that if the White House is preparing the nation for many more months of job destruction, the truth may be even harsher. Meantime, the next clue comes on November 6, with the monthly update on employment from the government.
Hope isn't lost, of course. An Intuit payroll survey taken in late-September, for instance, offers reason for optimism over the next 12 months. More than 40% of respondents said they plan to hire new employees over the next year. But a year is a long time in a recession that's the longest since the 1930s.
In short, talk is cheap and so the world waits for numbers. There'll be no shortage this week, starting with tomorrow's update on consumer sentiment, followed by Wednesday's double-barreled release of durable goods orders and new home sales. Thursday, of course, brings word of the government's first estimate of third-quarter GDP. Most observers are looking for a rise, although this sets up the markets for more than a trivial amount of disappointment if the actual number falls into the red. But for the moment, the crowd's looking for a healthy jump of 3.2%, according to the consensus outlook via Briefing.com.
Friday wraps up the week with the personal income and spending report for September. The consensus forecast calls for no change in income on the month and a rather hefty 0.5% drop in consumer spending, according to Econoday.com via Bloomberg. If so, those numbers threaten to take the shine off any rise in the previous day's GDP report.
But let's not forget that it's still all about the labor market at this point. Yes, we're likely to see more evidence this week that the recession has technically ended. But let's hold the applause until we see what the Bureau of Labor Statistics' October labor report brings, scheduled for release on November 6. Indeed, equating a gain in GDP with the start of a net positive change in jobs on a national basis is still premature. The consensus forecast for jobs, according to Briefing.com, is another loss, with nonfarm payrolls shrinking by 175,000 this month. If so, that'll be the smallest monthly loss in more than a year. Alas, trying to put a happy face on another negative number by speaking in relative terms is wearing thin after nearly two straight years of monthly job declines.
The question before the house is what the distinction means vis-a-vis an expanding economy and a still-shrinking labor market? Something tells us that we're about to find out.
October 22, 2009
A LITTLE CONTEXT GOES A LONG WAY
Twenty-first-century investing is all about predicting. But developing intuition about markets, asset classes and how they interact is too often overlooked if not ignored outright. That's a mistake for strategic-minded investing, albeit a mistake that's understandable in the crowd's rush for quick and easy profits.
It's hard to miss all the self-proclaimed seers running around espousing magic formulas and the three most-important investment gauges that insure big gains. Rarely do you hear of the dark side of these easy rules, such as the possibility that maybe, just possibly they're byproducts of data snooping, survivorship bias and other gremlins that harass seemingly flawless assumptions.
It's no surprise that limitations, blemishes and in some cases blatant fallacies are minimized/ignored in the three-minute talking-head interview or the personal finance column at your favorite financial publication. To be fair, some of this is simply an issue of time. Journalists and investment strategists can't deliver a full accounting of prudent investing practices and concepts every time they opine on the subject du jour. As such, it's easy to get a distorted view of investing by looking at any one post from, say, the CapitalSpectator.com and embracing it in isolation to my broader asset allocation analysis as outlined in my book and in my monthly newsletter.
The point is that investing requires (demands) constant vigilance on the critical issue of maintaining strategic perspective. It's tempting to cherry pick a few tidbits of the analytical pie in the belief that a few simple rules and/or market metrics will dispense triumph. Too often they lead to something less.
Investing, after all, is complicated. Financial economics has uncovered many insights into the inner workings of the black box known as asset pricing, but we're still a long way from fully understanding the process. There are some tantalizing clues, however. But in order to take full advantage of the lessons distilled by way of studying economic cycles, asset class relationships and asset pricing, we need to develop some intuition and context about the capital and commodity markets and how they compare with one another and the larger economy through time.
As a quick example, investors need to develop informed expectations about return and risk for each of the major asset classes, or at the very least domestic stocks, domestic bonds, and the aggregate equivalents for foreign markets. That begins by studying history and incorporating what we know about the behavior of prices relative to risk.
Take a simple dynamic like stock market return relative to stock market volatility. How should we think about this relationship? It's temping to extrapolate a raw reading of history and call this a forecast, but that's naïve. The relationship isn't stable. By looking at, say, three-year snapshots of this relationship, however, we can develop a deeper understanding of risk and return. In turn, this can help us formulate an enlightened view of the future.
But we can't stop there. We should also apply an overlay of current valuation, for instance. Another variable is integrating these signals with the business cycle. And if we're strategically oriented in our investing decisions, we'll apply a similar analysis of other asset classes and combine the insights for designing asset allocation. Even so, this only scratches the surfac of the necessary work.
If you're looking for rules of thumb, here's one: Forecasting returns directly is short sighted. A more durable approach is inferring equilibrium-based risk premiums via studying volatility, correlation and other risk parameters and then comparing that with our tactical expectations. This takes time and effort, of course, which is why such topics aren't popular fodder for the three-minute interview.
The bottom line: be wary of easy solutions that purport to offer investment success for little or no effort. If it was really that easy, middling investment results (and worse) wouldn't be so common.
October 21, 2009
Yesterday's news on housing starts wasn't great, but neither was it bad. Perhaps we might label it a mildly positive yawn. More of the same is coming, we predict, in a range of economic indicators.
It's fun to forecast extremes. It makes the headlines; people pay attention when you scream the world is coming to an end, or that the next great bull market will commence on Friday at 2:39 p.m. But projecting middling results rarely taps the zeitgeist du jour. Popular or not, that's the future we see coming for some period in the U.S. Oh, sure, there will be volatility, surprises here and there, and even some mayhem in the economy and the capital markets at times. But for the most part, the future looks rather boring, at least compared with what's passed over past 12 to 18 months.
Boring constitutes progress these days, but it also creates a challenge and a new world order that, we suspect, the crowd isn't quite prepared to deal with. Having fallen out of its chair, the U.S. economy—still the world's largest, last we checked—is struggling to return to its former elevations of expansionary glory. The central bank, bless its heart, has been doing all it can to assist in the reflation game. And it's clear that the Fed has had some effect, with more of the same on tap for some time. No wonder, then, that prices in the stock market, to take the obvious example, are up sharply this year.
But printing money, as necessary as that's been for sidestepping a deeper economic collapse, only get you so far. We may be nearing the point where the monetary medicine has run its course. The marginal gains, in short, may be set to diminish. That doesn't mean we're headed for the ditch again, although the mass of debt weighing on the U.S. economy, both in government and on household balance sheets, inspires us to wonder. In any case, until a deeper, more fundamental rebound in the economy takes hold, the possibility of treading water in the months and quarters ahead should be considered as something more than a distant possibility.
The key challenge remains the labor market, which still shows limited capacity signs of expansion. Monetary policy is a blunt instrument for repairing this critical corner of the economy. And since the U.S. economy remains heavily dependent on consumer spending, it's dangerous to ignore the current problem in minting new jobs. Indeed, in December it'll be two years since American capitalism hit an iceberg and job destruction took hold. Almost no one thinks potent, sustained growth in the labor market is imminent, and so the very real possibility that we'll be licking our wounds on this front for many months to come raises its ugly head.
That raises the issue of expectations. The rousing run higher in equities may have elevated hope that something similar is coming in the broader economy. But we're inclined to err on the side of caution. The stock market, we believe, has recently become decoupled from the economy, which continues to confront a host of headwinds, the likes of which haven't been seen in generations.
That's not to say that recovery momentum is dead. Far from it. The seeds for restoring economic health have been sown to some extent, but the process has only just started. But it'll be a bumpy ride. Yes, the worst is over, but the season of middling to mildly frustrating trends await.
Ours is an age that requires instant gratification. But speedy satisfaction will likely remain on a lengthy holiday.
October 19, 2009
THE FIRST STEP IS A GOOD PLACE TO START
Is the stock market overvalued? Wolfgang Münchau says it is in today's FT. He cites some persuasive evidence, based on analysis by smart people: Professor Robert Shiller and Andrew Smithers. The U.S. stock market is overvalued by more than a third, we're told.
Our own work suggests that caution looks increasingly prudent when it comes to risk exposures in asset allocation. But we're not sure. To be precise, we're not sure that a given quantitative profile of the market dispenses timely information about what returns will be in the immediate future. And neither does anyone else.
It's tempting to thinking otherwise, but the future is always unclear. The good news is that the ambiguity oscillates with degrees of vagueness. But that alone isn't enough. The challenge for investing is finding context and structure for managing asset allocation through thick and thin; through times when the future looks reasonably clear as well as during periods when the near term outlook for risk and return is murky.
The good news is that more than half a century of financial economics provides us with the tools and concepts for thinking clearly and productively about designing and managing asset allocation for the long haul, which arrives one day at a time. Different investors will come to different conclusions, but everyone should begin at a common point: the market portfolio.
By market portfolio we're talking of all the major asset classes weighted passively. This boils down to a global mix of stocks, bonds, REITs and commodities. Those four constitute the "major" asset classes in the sense that all are readily available at low cost through ETFs and index mutual funds or, if you're so inclined, actively managed funds. For most investors, these markets (and their various subgroups) constitute the lion's share of the investment choices, and so this is where much of the heavy lifting in the money game takes place.
Weighting all these asset classes by their respective market values gives us a robust benchmark to begin our analysis. Too many investors are convinced that the market decisions in the aggregate tell us nothing; but this is shortsighted. The market portfolio isn't a crystal ball, but neither is it chopped liver. We shouldn't be so naive to think the market portfolio constitutes a short cut to quick success, but neither should we dismiss the collective judgments of all the world's investors.
The first step is recognizing that the market portfolio, flawed though it is, is a valuable resource. Unfortunately, finding a good benchmark that represents all the world's investable assets isn’t easy. Indeed, much of the financial industry pays no attention to this benchmark. No wonder, then, that such a benchmark is generally unavailable, which is why we calculate our own homegrown version. Indeed, indexing a broad-minded definition of the market portfolio is at the core of our asset allocation work in The Beta Investment Report. And for good reason. Everyone needs a neutral benchmark as a starting point to consider the choices. We need to know how this benchmark has performed, and how its risk profile has changed over time. In short, we must study the market portfolio. We're not necessarily going to own it per se, but we need to recognize that in the very long term the market portfolio will deliver average returns and risk relative to the wide variety of money management strategies.
Much of the analysis in my newsletter centers on building a market portfolio index and using this benchmark as a guide for adjusting Mr. Market's asset allocation. As a general treatment, The Beta Investment Report maintains three model portfolio: high risk, medium risk and low risk. All three offer variations on the market portfolio, which is our proprietary Global Market Index. How do we manage these portfolios? It starts with estimating equilibrium returns and risk for the benchmark, a.k.a. the market portfolio.
Projecting the long run return for the market portfolio is essential as a building block for designing and managing asset allocation. The truth is that you'll go blind looking for analytics and data on this critical index. But while much of Wall Street is obsessed with trying to figure out where this or that asset class (or security) is going over the next month, The Beta Investment Report concentrates on forecasting the equilibrium return for the market portfolio. It's hard to overemphasize the power of routinely analyzing this benchmark. At the same time, it's probably the most under-utilized piece of analysis in all of money management. But if we have any hope of gaining strategic insight in the all-important business of asset allocation, we need to have a broad benchmark of the market portfolio and become intimate with its risk and return profile.
It's important to point out that finance theory advises against trying to forecast equilibrium returns directly. A more reliable approach is calculating implied returns by looking at volatility and correlations between the asset classes. In effect, we're reverse engineering the market's prospective return by studying its risk parameters, which offer more reliable insights compared with studying returns directly.
With expected equilibrium returns in hand, the real work begins. At this point, we can start to integrate our views about individual asset classes and whether they're likely to generate higher or lower returns relative to their long run equilibrium performance estimates. If we're fairly confident in our forecast, we'll change the weight of the asset class in our model portfolios up or down, depending on the forecast, relative to the market portfolio weight. But the pesky problem of always have doubts about the future keeps us from straying too far from the market portfolio's asset allocation.
For some investors who are highly confident in their outlook, the resulting portfolio will look radically different from the market portfolio. At the other extreme is an investor who has no particular view, which implies holding the market portfolio as offered. Our model portfolios in The Beta Investment Portfolio generally fall in the middle of these extremes, albeit with three variations of risk.
The real benefit of analyzing portfolio choices in this way provides valuable context and perspective for understanding our particular worldview. Simply going through the process of estimating equilibrium returns, and reflecting on what that implies for the market portfolio and individual asset classes, is an education of immense powerf.
Alas, too much of what passes as investment advice starts at the opposite end of the spectrum. It's tempting to dive into the debate about whether the stock market, or any other market, is overvalued or undervalued. But that courts disaster if the analysis lacks broader context for assessing risk and thinking about asset allocation.
There are no short cuts in designing and managing a portfolio strategy that satisfies in the long run. Fortunately, there's a productive starting point. The bad news is that too few investors are paying attention.
October 15, 2009
INITIAL JOBLESS CLAIMS DIP AGAIN
The trend remains our friend in the land of initial jobless claims. The absolute level is still reflecting pain in the labor market, but there's no denying that the general ebb and flow of new filings for unemployment benefits is favorable.
As our chart below shows, new filings dropped again last week, falling to a seasonally adjusted 514,000, below the previous week's 524,000, the Labor Department reports. That puts the latest number at the lowest level since the week ended January 3, 2009.
Confirming the trend is the decline in continuing claims, which dropped below the six-million mark in the week through October 3 for the first time since March.
All of which is encouraging and lends more support to our earlier calls that the recession is technically over. But that invites our standard caveat: sustained growth in the labor market is still far from imminent. Even the optimists don't expect much good news on this front until next year. “We will probably have more sustained growth in the labor market starting in early 2010," Maxwell Clarke, chief U.S. economist at IDEAglobal in New York, tells Bloomberg News. "From there we will find a peak in the unemployment rate and ultimately create jobs.”
Part of the problem is that consumption may revive in fits and starts. For an economy that relies heavily on consumer spending, that challenge threatens to remain a thorn in the recovery's side for the foreseeable future. Indeed, yesterday's update on retail sales offers little reason to think otherwise. The Commerce Department reports that retail sales last month slid 1.5% on a seasonally adjusted basis. Of course, if we exclude auto purchases, which were artificially boosted in recent months by the government's cash-for-clunkers program, retail sales inched higher in September by 0.5%. That encourages some observers, including Bruce Shalett of Wynston Hill Capital in New York, who tells Reuters: "While the consumer may be more prudent in the way they spend money, the data would indicate they are certainly spending money. The consumer is participating in the recovery."
The stock market seems to be buying into that outlook, or so the rally of late suggests: The media's obsession with reporting that the Dow Jones Industrials closing above 10,000 for the first time in more than a year being the obvious example.
But until the labor market starts showing stronger signs of revival, we remain wary of declaring that consumption is set to return to the golden days of yore.
Inflation, meanwhile, still doesn't seem to be a problem, which bodes well for keeping interest rates just above zero. The liquidity-injection train rolls on! But let's also recognize that the deflationary scare is now history, or so it appears. The last time CPI dipped on a monthly basis was March. Last month's inflation report is hardly worrisome—CPI rose just 0.2% in September. But the future will struggle with the question of how long the Fed can/should continue to pump money into the economy as if the world was coming to an end? Finding the sweet spot between juicing the labor market, consumer spending and at the same time keeping a lid on future inflationary pressures promises is the new new thing in central banking.
What does all this imply for investing? For our money, we're increasingly cautious...again. Asset allocation decisions are tougher these days compared with early in 2009, when the price of risk looked unusually attractive. That doesn't mean it's time to run for cover. But for the moment, we're of a mind to consider our Global Market Index's passive weights as a guide for structuring portfolios. Until more convincing signals (or valuations) arrive, we're inclined to settle for a neutral asset allocation. Or, to borrow Warren Buffett's metaphor, we're not tempted to swing at every pitch these days.
October 13, 2009
THE FOREST, THE TREES & ASSET ALLOCATION
Jason Zweig, one of the best financial journalists in the business, asks in his latest Wall Street Journal column: Can you make the risk of stocks go away just by owning them long enough?
This is a popular question and one that has been the focus of entire books, such as Jeremy Siegel's Stocks for the Long Run. It's also a useful question, but it's important to recognize that it's only one question for strategic-minded investors.
The reason, as Bob Litterman explained in Modern Investment Management, can be condensed to a single sentence: "The simplest and most practical insight from modern portfolio theory is that investors should avoid concentrated risk."
As fundamental truisms in portfolio theory and practice go, this one's at the top of the list for most investors. It's also among the most neglected rules in money management. Sure, most investors own some form of diversified funds. But too many people define their investment options narrowly, which can lead to trouble.
Consider again the topic of whether it's prudent to own stocks for the long run. In fact, that's a poor way to analyze the investment challenge. Instead, investors should begin by asking: Should I own the market portfolio?
A practical definition of the market portfolio is all the world's stocks, bonds, REITs and commodities, weighted by their respective market values. In theory, this is the optimal portfolio for the average investor with an infinite time horizon. The question is how we should change the asset allocation of the market portfolio to match our risk tolerance, expectations and financial situation? In addition, we must decide how (or if) to manage the asset allocation through time. Should we own all the asset classes? If not, why not? Should we employ a mechanical rebalancing system that reinstalls the previous asset allocation? Or should we use a form of tactical asset allocation premised on predicting risk premiums? How about a bit of both?
Such questions constitute the lion's share of relevant subjects for analysis in money management. Curiously, strategic analysis of this sort is rare.
The world is awash in analyzing securities and asset classes in isolation. But if you're looking for strategic perspective on the portfolio level, the choices are surprisingly slim. In an attempt to fill the gap a bit, I launched The Beta Investment Report early this year. I also wrote a book on the fine points of considering how to customize the market portfolio (Dynamic Asset Allocation: Modern Portfolio Theory Updated For The Smart Investor, which will be published by Bloomberg Press in February). To be sure, using the market portfolio as a benchmark is no short cut to easy success. You still have to keep a close eye on the markets and make decisions about the future. But as a starting point, the market portfolio is a robust beginning. All the more so these days since index mutual funds, ETFs and other products allow us to build a reasonable proxy for the market portfolio.
The default strategy is owning everything in a passive asset allocation and letting it ride. How has this choice fared over the past 10 years? As you might expect, the results are middling, based on my newsletter's proprietary Global Market Index (GMI). For the decade through the end of last month, GMI's annualized total return is 4.5%. By comparison ,the best asset class performance is emerging market bonds, advancing by an annualized 12% over those years; the bottom performer is U.S. stocks, rising by roughly 0.7%, based on the Russell 3000.
We can spend all of our time debating if stocks are worthy of buy-and-hold investing for the long run. But if we do, we're missing the financial forest for the trees.
October 9, 2009
ONE WAY OUT
Maybe it was Australia's decision to hike rates last week, the first monetary tightening among the G20 nations since the financial crisis began. Or perhaps it's just the recognition of economic fate. Whatever the catalyst, Fed chief Ben Bernanke is now talking openly of the "exit strategy."
"My colleagues at the Federal Reserve and I believe that accommodative policies will likely be warranted for an extended period," Bernanke said yesterday, based on prepared remarks published by the Fed. "At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road."
The Fed's exit strategy has been a topical subject on The Capital Spectator since May, when we wrote that "there will come a day when the great countercyclical monetary operations of the Fed should cease and desist." Such chatter was widely unpopular in the spring, even if the issue at hand was always a question of timing. But a lot has happened since May and apparently it's now safe to talk in respectable circles about the day when Bernanke and company will begin reversing the Great Easing.
At the moment, however, there's no imminent sign of higher rates. Based on implied rates in Fed funds futures, the odds of a rate hike look slim until early next year. But the days of cheap money, for good or ill, are numbered.
That doesn't necessarily spell trouble for the capital markets or the global economy, although the change in the monetary weather that awaits represents a secular shift of considerable magnitude. Consider the chart below, which graphs more than 50 years of monthly 10-year Treasury yields through last month. No one can say with certainty that yields won't go lower in the foreseeable future, or perhaps even dip into negative territory, as recently occurred in Sweden, when the Riksbank became the first central bank to go negative by dropping one of its key rates below 0% in July. But we're not holding our breath in anticipation of a repeat performance in the U.S. or Europe.
A more likely outlook at this juncture is that low rates stay low for a time, a view embraced by Bernanke via his reference to keeping monetary policy "accommodative" for an "extended period." But extensions eventually run out and no one should doubt that the clock is ticking. Short of an extraordinary turn for the worse in the global economy, which looks unlikely at the moment, the case for higher rates starting in the first half of 2010 looks better than even.
To some extent the change, when it comes, will be good news. The Fed will only begin elevating the price of money when it believes the economy can weather the adjustment. But the new game plan will also mark a new era for interest rate trends: up. And this time, the momentum isn't likely to be temporary.
The implications aren't necessarily dire, but neither are they irrelevant. Low and falling rates have contributed to rising asset prices and otherwise offered cover for ill-advised financial decisions over the past three decades. Yes, other factors have been instrumental in the bull markets of the past several decades too, but falling yields have been integral to the story. The assistance has come erratically, sometimes fading altogether for a time. Secular trends in the price of money are a bumpy affair.
What's different now, in looking ahead into medium and long-term horizons, is the likely absence of low and falling rates as a general proposition. True, the markets have known periods of rising rates over the last 30 years, but they were short-lived episodes. Nor do we mean to suggest that the future is sure to bring steadily rising rates, ascending to the old highs of the early 1980s. But markets can no longer count on a broad, extended retreat in the price of money. The shift will change the profile of investing, perhaps only in subtle ways. Nonetheless, it seems likely that the margin for error in owning various types of risk will shrink, if only slightly.
Investing, in other words, will be tougher in the generation ahead vs. the last 30 years. Rising interest rates won't be the only reason, but the trend promises to be a first among equals.
October 8, 2009
INITIAL JOBLESS CLAIMS DIP AGAIN, BUT DON'T CHEER YET
This morning's update on new filings for unemployment benefits suggests that the improving trend since the spring for this series remains intact. Initial claims for jobless benefits dropped 33,000 for the week through October 3, the Labor Department reports. That cuts initial claims to the lowest level since this past January, as our chart below shows.
More good news comes in the way of continuing claims, which dropped to 6.04 million, the lowest since April.
Good news, to be sure, in terms of the general trend. The bad news is that both of these numbers are still elevated in absolute terms to an extent that reflects broad economic weakness. And signs of a quick turnaround are still scant. Repeating our long-running mantra, the labor market's recovery will be unusually slow in the months and quarters ahead and so we must be cautious in expecting too much too soon in terms of an economic recovery worthy of the name on Main Street as well as Wall Street. For an economy that's heavily dependent on consumer spending, which in turn relies on a robust labor market, the U.S. faces a headwind of some magnitude.
That said, the recovery process, albeit a weak and tentative version, remains in play. The general decline in initial jobless claims has been one clue telling us so for months. As we discussed back in March, this metric is worth watching for its predictive powers as it relates to the finale of recessions, according to the economic history. So far, it's hard to argue otherwise.
The good news, however, may already be baked into equity market prices, as we suggested yesterday. Meanwhile, there is the great unknown about the future path for the labor market proper, which promises (threatens) to be the overwhelming subject going forward, even if the crowd isn't yet fully focused on this fate.
In fact, this is hardly a new subject in the dismal science. As we write in this month's issue of The Beta Investment Report, the trend in job creation has been discouraging for 25 years:
Five years after the end of the 1981-82 downturn, nonfarm payrolls jumped by more than 16% (a gain of 14.6 million jobs). Five years after the end of the 1991 slump, payrolls were higher by 9.5% (a rise of 10.4 million). In the wake of the 2001 recession, nonfarm jobs advanced by less than 3% (or up by 3.8 million) after five years.
The fading power of the U.S. economy to generate new jobs in absolute and relative terms in post-recession periods over the past generation is well documented. Call us crazy, but there's nothing on the economic scene at the moment that suggests this trend is about to change for the better. In fact, it's likely to get worse.
Perhaps it's time to acquaint ourselves with the finer points of a jobless recovery. Let's hope not, but if that comes to pass, a round of rewriting the economic and financial yardsticks and rules of thumb as we know them may be looming.
Meantime, today's initial jobless claims tell us that the recovery in October 2009, whatever that ultimately means, is alive if not necessarily kicking. In fact, we're confident that the inflation-adjusted third-quarter GDP number will be modestly positive when the initial estimate is released on October 29. If so, that'll be the first expansion in real GDP since 2008's second quarter. Unfortunately, the practical implications in a revival of GDP this time threaten to be quite unsatisfying for the immediate future.
October 7, 2009
THE ALL-OR-NOTHING TRADE IS HISTORY
In case you were wondering, 2009 is on track to be among the best years in the annals of the stock market. There's still nearly three months of trading left, of course, and so we shouldn't write anything into stone just yet. But as we write, it doesn't get much better than this. In fact, we don't expect it to get any better and in relative terms, at least, it's likely to get quite a bit worse. Or perhaps we should say less stellar.
Whatever label is appropriate, there's just no way that equities can maintain the pace so far this year. As our chart below shows, it's been nothing less than extraordinarily profitable in the land of equities, here and abroad. The bullish momentum may roll on, of course. In the short term, anything's possible. But as a strategic matter, there's reason to wonder.
This much is clear: The trailing returns of recent vintage won't survive for the year or two ahead. No, that doesn't mean that we're headed for a new bear market, although no one can dismiss the idea entirely given the still-precarious nature of the economic revival. But equity performance is headed for a period of lesser results, if any, for the foreseeable future.
The gains this year have largely been a reaction to the recognition that the global economy dodged a bullet earlier this year. That doesn't mean that all's well, but no longer are we rushing to hell in a paper suit. When the financial crisis of late-2008 exploded, equities were quickly repriced in anticipation of the worst-case scenario. As it became clear over the course of 2009 that the worst case was no longer the likely case, risk was repriced again at something approximating "normal" levels.
The return to normal, if we can call it that, is more or less complete as far as equities are concerned on a strategic basis. There may be exceptions, but looking out across the world it's tough to make the case that equities are cheap. They're not necessarily expensive either, and therein lies the challenge: Deciding what valuation is appropriate for the months and years ahead, which promise to be anything but routine in terms of post-recession periods over the past several decades.
No, equity markets haven't returned to the previous highs yet, but the old peaks were over baked and beyond the pale in the current economic climate. What prevails now is roughly equilibrium, albeit an anxious variety. Markets are no longer pricing equities for a world of economic disaster. At the same time, Mr. Market is struggling with putting a price on what comes next.
Governments around the world are working overtime at the game of reflation. Judging by equity prices, they can point to a measure of success…so far. But the all-or-nothing trade is behind us. In late-2008 and early 2009, investors had but one question to ask and answer: Will the economy survive? If you got that right and invested accordingly, you made money, quite a bit of it in fact. Assessing risk and profiting from the analysis from here on out will be slightly more complicated.
October 6, 2009
RAISING INTEREST RATES DOWN UNDER: THE NEW NEW THING?
Someone had to be first. It turns out that it's Australia. The Reserve Bank of Australia raised its benchmark cash rate by 25 basis points to 3.25%. No longer are rates at a half-century low down under. And so the precedent has been set: the first central bank among the G20 nations has hiked rates.
"Economic conditions in Australia have been stronger than expected and measures of confidence have recovered," RBA advised in a press release accompanying the rate hike. "Overall, growth [for Australia] through 2010 looks likely to be close to trend." Nonetheless, the labor market in the country remains weak, the bank acknowledged. But as RBA reasoned, "With growth likely to be close to trend over the year ahead, inflation close to target and the risk of serious economic contraction in Australia now having passed, the Board’s view is that it is now prudent to begin gradually lessening the stimulus provided by monetary policy."
There will be more reports of rate hikes in the coming months and years. But it starts here. The question now is timing and magnitude. How soon will rates rise and by what degree? And when will the big central banks in the global economy follow suit? And, of course, there's the $64,000 question: What will be the impact on the global economy and markets?
Questions, questions, always more questions. The only constant: It's always a different set of questions.
But for now, a milestone has been reached. The Great Decline in rates is over. We've known that was coming for some time, of course. Now begins the inevitable sequel.
Risk, in short, is a perennial, albeit in an ever-changing state.
[Note: In the original post, we wrote that the Reserve Bank of Australia was the first central bank to raise interest rates. In fact, as one commenter pointed out, the honor goes to the Bank of Israel. We should have clarified our commentary by noting that the Reserve Bank of Australia was the first central bank of a large economy--i.e., a member of the G20 nations--to hike rates. The oversight has since been corrected in our post above. Sorry 'bout that. --JP]
October 2, 2009
NONFARM PAYROLLS: STILL SLIPPING AND SLIDING
The news that nonfarm payrolls shrunk again last month by 263,000 is bad news, but a little perspective may help minimize the pain.
But first, let's recognize that there's just no way to sugarcoat the fact that the economy has been losing jobs each and every month since January 2008. The question is whether the upward tick in job losses last month vs. August is a turn for the worse or just statistical noise on the way toward zero and, at some point, an expansion in the labor market?
We don't have a definitive answer, of course, but it's worth pointing out that the reversal in the recovery trend also occurred in the June jobs update, and on a grander scale. But that was temporary and it soon gave way to more progress, albeit in relative terms by way of fewer losses. It's also worth reminding that the reversal in June didn't stop investors from bidding up asset prices in the ensuing months. This time, however, we may not be so lucky.
What's different? For one thing, September closed with strong rallies in virtually everything, as we discussed briefly yesterday. All the major asset classes have delivered powerful rallies since March. The problem is that the economic news accompanying the change in investor sentiment hasn't been anywhere as stellar or consistent as the reflation in asset prices implied.
The stage, it seems, has been set for a correction of sorts, some of which unfolded in yesterday's bout of selling in the U.S. stock market, which suffered it's worst one-day retreat in months. The larger issue is related to whether the nascent signs of economic recovery that we've been discussing these past several months have any internal momentum sans the government stimulus efforts of late. Such questions have been overlooked in the summer during the rush to jump on board the recovery bandwagon. But autumn has a way of refocusing summer flings through a more sober analytical prism.
In fact, your editor has been refocusing for some time. In August, for instance, we opined that the road to recovery ahead was likely to be long and winding. "We're going to be hearing a lot about green shoots and recovery in the weeks and months ahead," we wrote at the time. "Yes, that's coming, but it's going to be quite a while before the trend has any significance on Main Street."
Regular readers of these digital pages will recall that we've been predicting the "technical end" of the recession for some time, probably in the second half of this year. One reason for thinking so is that our proprietary index of leading indicators published and analyzed regularly in The Beta Investment Report continue to lean in favor of recovery. But we've also been warning all along that there's likely to be a longer-than-usual lag between the recession's closure and the ensuing labor market's recovery. In fact, that opens the debate on whether a recession can really be over if the labor market isn't growing, but we'll leave that for another day.
Meantime, it's clear that the minting of new jobs is usually among the last of the major economic metrics to rebound after a recession. Given the depth of the Great Recession, the labor market's recovery will be that much slower and sluggish this time.
For some perspective, let's take a tour down memory lane. After the end of the vicious 1973-75 recession, the first month of gain in nonfarm payrolls came just two month's after the contraction's end. In the 1981-82 recession, nonfarm payrolls also posted a rise two months after the downturn's formal demise in November 1982, as per NBER. And in the wake of the milder 2001 recession, job growth returned three months after the recession's end.
Where does that leave us in the mess du jour? Let's be optimistic and say that the recession ended in September. The standards of recent downturns imply that we might see a gain in nonfarm payrolls before this year's out. But we must be cautious here for at least two reasons. One, it's not yet obvious that the recession's over. (If you're waiting for NBER to speak, don't hold your breath—the institution usually declares an end to recessions long after it's already obvious.) Two, the downturn this time around was/is extraordinarily steep and so we shouldn't expect that payrolls will rebound as quickly as they did in the past.
All of which leads back to the advice we've been dispensing for months: The recovery ahead, when it does arrive, will be meek and prone to setbacks courtesy of a frail labor market, a negative aura that's sure to reverberate throughout the consumer-dependent economy in the U.S. for some time. That's been a risk factor all along. The difference now is that maybe, just maybe, the crowd understands the challenge ahead.
October 1, 2009
THE RETURNS OF SEPTEMBER
It's becoming repetitive, but no one's complaining. September witnessed across-the-board gains in all the major asset classes. Again.
With some minor exceptions, the world's capital and commodity markets have been on a non-stop rebound since March. That's not exactly surprising, given the depth of the previous losses in almost everything. When you stretch returns to extremes in a short period, a reversal in the opposite direction is typical. Deciding how long it will last is the trick.
In sum, the good times can't last, at least not in terms of tidy gains as far as the eye can see. There's a reason that diversifying across asset classes has merit, even if it's not obvious these days. But correlations among the various subgroups of stocks, bonds, REITs and commodities are destined for a wider divergence. Designing and managing portfolios, as a result, will become more challenging in the years ahead.
But not today. For the moment, everyone's a winner regardless of asset allocation. Enjoy it while it lasts.