February 27, 2010
NO ONE LISTENED, BUT EVERYONE SHOULD READ IT
Harry Markopolos spent nearly a decade telling the Securities and Exchange Commission that Bernie Madoff's returns were too good to be true. The SEC more or less ignored Markopolos, a securities analyst and forensic accountant. The greatest Ponzi scheme in history, as a result, rolled on for years, ultimately stealing billions of dollars from investors, large and small, before it all came crashing down in 2008.
Markopolos has written a first-rate memoir of his lonely one-man investigation into Madoff's $65 billion fraud: No One Would Listen: A True Financial Thriller. In addition to being a compelling whodunnit (even though Markopolos knew who did it), this new book is a fascinating look into the important business of separating the wheat from the chaff when it comes to analyzing investment returns.
In the case of Madoff's reportedly stellar results, there was no there there, Markopolos discovered starting in the early 1990s. Recalling the first time he looked at the apparent results of Madoff's investing strategy, Markopolos recounts,
I glanced at the numbers. I’d spent countless thousands of hours preparing for this moment. And I knew immediately that the numbers made no sense. I just knew it. Numbers exist in relationships, and after you’ve studied as many of them as I had it was clear something was out of whack. I began shaking my head. I knew what a split-strike strategy was capable of producing, but this particular one was so poorly designed and contained so many glaring errors that I didn’t see how it could be functional, much less profitable. At the bottom of the page, a chart of Madoff's return stream rose steadily at a 45-degree angle, which simply doesn’t exist in finance. Within five minutes I told Frank,“There’s no way this is real. This is bogus.”
As I continued examining the numbers, the problems with them began popping out as clearly as a red wagon in a field of snow. There was a stunning lack of financial sophistication. Anyone who understood the math of the market would have seen these problems immediately. A few minutes later I laid the papers down on my desk. “This is a fraud, Frank,” I told him. “You’re an options guy. You know there’s no way in hell this guy’s getting these returns from this strategy. He’s either got to be front-running or it’s a Ponzi scheme. But whatever it is, it’s total bullshit.”
And that’s when we began chasing Bernie Madoff.
With that, the book is off and running. As compelling as this story is as a tale of financial sleuthing, it's also an indictment of how the SEC was asleep at the switch, or "comatose," as Markopolos complains in an interview this weekend with The New York TImes. "It was a trip through the twilight zone," he says of his nine-year effort at trying (and failing) to alert the SEC to the impossibility of the returns that Madoff was reporting. "They didn't respond to heat and light, much less evidence of wrongdoing," he tells the TImes' Deborah Solomon. There's a small army of investors who are poorer as a result.
We all need to understand what happened and why it happened. That alone is reason enough to read Markopolos' book. The fact that it's a dramatic page-turner only sweetens the deal. Truth is stranger than fiction in the genre of financial crimes and misdemeanors. In the case of No One Would Listen, it's also fascinating and enlightening.
February 26, 2010
MORE TROUBLES WITH BUBBLES
There’s been quite a bit of talk about a bond bubble recently. "Are bonds in a bubble?" inquires The Wall Street Journal. SmartMoney doesn't even ask but instead declares in a headline: "The New Bond Bubble." Meanwhile, a prominent forex trader warns today in Asia Times that "a nasty popping of the bond-market bubble lies in wait for investors."
Now we all know that interest rates are low—really low. In fact, they've almost never been lower. And there's some reason for thinking that they'll stay low for an "extended period." Reasonable minds can agree that the path of least resistance in the long sweep forward is probably up for the price of money. We've discussed this possibility (probability) before…several times. Two years ago this month, for instance, we noted that bonds appeared to be in a bubble. And the evidence, it seemed, was fairly compelling, courtesy of 26 years of generally falling interest rates.
Of course, as we all now know, bonds weren't in a bubble in early 2008, even though it appeared otherwise at the time. Or maybe the bubble was overtaken (sustained?) by events on the ground later in the year. Semantics in finance is an interesting topic, but it doesn't help much for managing money. In any case, bonds prices were poised for huge gains in the year or so ahead from the vantage of early 2008. Based on commentary and track records through much of 2009, however, it seems that most investors missed the great bond rally of 2008-2009. Predicting, as they say, is very tough—especially about the future.
Two years on, bonds still appear to be in a bubble, and an even bigger one than the apparent bubble of early 2008. But as we discussed yesterday, we should be cautious about drawing definitive conclusions from bubble analysis. For one thing, defining these states of financial affairs is a slippery beast. One man's bubble, it seems, may be another man's bull market based on fundamentals.
Should we ignore the market and economic signals as dispensed? No, although we need some perspective on how to use this information in the cause of prudently managing asset allocation. For starters, let's not jump to conclusions or make dramatic portfolio changes based on the analysis du jour. It's clear that the asset mix should be managed dynamically, although exactly how and to what degree is debatable. Even the smartest analyst in the world understands only a portion of the asset pricing rules that determine expected return. The error term is always lurking and strategic-minded investors should always factor in this risk in projecting risk premiums.
As for the current bond market, the case for thinking in bubble terms may be emotionally satisfying, but what does that imply about investors who hold bonds? Are they irrational? Maybe not. Yes, interest rates are low, but so is inflation. As our chart below shows, inflation expectations are once again on the decline, albeit only slightly so far. That seems like a rational reaction to whiff of deflation in the latest update of consumer prices.
The critical question is deciding if a new round of deflation is coming. If it is, bond returns are likely to be stellar once again, the bubble risk notwithstanding. If the deflation risk turns out to be a false alarm, however, bonds may be headed for a tumble. Yes, that and 50 cents gets you a cup of coffee, but that's how it goes. The future's uncertain. Meanwhile, investment decisions must be made in real time using lots of imperfect information, including the gray area of figuring out if the markets are correctly discounting future risk. Since know one knows all the risks that loom, or when they'll arrive or interact, mistakes will be made. Count on it.
A recurring driver of mistakes is blindly assuming that the past will extend into the future. That's especially likely (and hazardous) when trends run on for decades, as they sometimes do. That was/is certainly the case with inflation. "We have now arrived at the end of a roughly half-century economic cycle dominated by inflation, for good and ill," Robert Samuelson wrote in 2008's The Great Inflation and Its Aftermath: The Past and Future of American Affluence. "Its rise and fall constitute one of the great upheavals of our time, though one largely forgotten and misunderstood."
True enough, but as those words were written, inflation was fading from the economic scene amid the financial crisis and the deepening of the Great Recession. The case for inflation today remains questionable for the foreseeable future. Yes, higher inflation is coming, but it's the timing that has everyone guessing.
Meantime, it hardly seems irrational to own a 10-year Treasury that yields 3.64% (as of February 25) when the market's forecast for inflation over the next 10 years is a modest 2.13%, as per our chart above, and the annual pace of headline consumer price inflation is currently at a low 2.6%. Are Treasury buyers underestimating inflation's potential in the years ahead? Or maybe the market's outlook for pricing pressure is too low. We might be able to answer intelligently if we knew what's coming, and how the infinite array of economic, financial and political variables will interact in the months and years ahead. Since we don't, we need to guess. Ideally, we'll make a guess based on enlightened analysis. But since we can't be sure, we'll have to hedge our bets.
We can do so by limiting how much we commit to bonds. And if our bond allocation happens to earn more than we expect over the next year or so, perhaps we should rebalance our asset allocation by redeploying the fixed-income gains to other asset classes that haven't done as well. We can also deploy what financial economists have told us over the decades in terms of lessons for portfolio management, such as focusing on risk management for estimating returns rather than trying to predict asset class performance directly.
Are investors making irrational decisions about bonds these days? Maybe, but there's no reason you have to suspend your capacity for rational analysis about what may be coming. If someone else wants to label that irrational, that's his problem.
February 25, 2010
THE TROUBLE WITH DEFINING BUBBLES
What's the difference between a bubble vs. a legitimate rise in prices? Fundamentals, or so the story goes.
Paul Krugman speaks for many when he writes that the boom in housing early in the decade was a bubble. But something similar in crude oil wasn't a bubble, he opines:
"Oil prices did spike to triple-digit levels in early 2008, then drop sharply. But think about the fact that right now, with the world economy still seriously depressed, oil is at $80 a barrel. This suggests to me that high oil prices are largely caused by fundamentals."
He doesn't detail what he means by "fundamentals," but let's assume he's referring to the source of the higher oil prices as a function of higher demand. But surely that was part of the housing boom equation too. Ah, but the housing boom was supported by an innovative financial sector, along with low interest rates and government policy that promoted home buying. Oil does have Opec, of course, but that's another story.
If you're looking for a hard and clear definition of bubbles vs. bull markets driven by fundamentals, you'll have a long wait. Yes, some analysts use models to decide that a given market is in bubble territory, or undervalued. This is popular in the stock market using price-earnings ratio, for instance. Of course, buying and selling solely on p/e is no short cut to riches. In fact, you probably won't earn much more than average by trading exclusively on p/e, even if it's helpful at times. We need to look at othe metrics, as well as monitor the business cycle, the ultimate driver of risk premia. When the stock market's at a "high" p/e, it may be tempting to call it in bubble territory. Reasonable, perhaps, but hard to prove. Meantime, how long do we have to wait for a price correction before we can say a bubble diagnosis was accurate?
Any measure of a bubble depends on a model. If it doesn't yield an outsized return, is the model broken? Or maybe the market's inclined to stay in bubble territory. Hard to tell in real time.
Perhaps, then, bubbles should be thought of as a twist on Justice Potter Stewart's famous observation about pornography: difficult to define, "but I know it when I see it."
IS THIS REALLY JUST AN EXPENSIVE GAME OF MUSICAL CHAIRS?
The fiscal debacle in Greece is at least partly connected to minimizing (hiding?) deficits. In 2000 and 2000, Greece borrowed billions via currency swaps. But the fix was only temporary and the red ink has come back to haunt the country. (Gee, where have we heard this one before?)
Now the Fed is reportedly investigating the associated transactions, which were engineered by Goldman Sachs and other banks. Exactly where this leads is anyone's guess, but the not-so-subtle implication is that Wall Street had a hand in undermining the fiscal stability of Greece. Or perhaps it's more accurate to say that the big banks helped feed a country's addiction to debt.
Banks are facilitators, of course. They provide monies to borrowers, one way or another. But sometimes the facilitator crosses the line. Figuring out where that line lies is never easy, although hindsight is 20/20.
What makes the situation with Greece particularly troubling is that the country really couldn't afford to borrow the billions that the banks helped it tap. (Yes, that sounds familiar.) What's more, the borrowing was done on the sly. While it all appears to be on the level in terms of the regulatory rules of the European Union, it's not known if that standard will hold up under what's sure to be intense scrutiny in the months ahead.
In any case, Greece's red ink is fast becoming a political topic in Washington. "I’m coming to the conviction that many times these devices are used to avoid regulatory constraints,” Senator Reed (D-Rhode Island) tells the New York Times. “In the case of Greece it might have been strictly legal, but clearly the intent was to avoid the budget limitations and budget restrictions of joining the European Community.”
Meanwhile, Fed Chairman Ben Bernanke via BusinessWeek advises that "using these instruments in a way that intentionally destabilizes a company or a country is -- is counterproductive, and I’m sure the SEC will be looking into that. We’ll certainly be evaluating what we can learn from the activities of the holding companies.”
Sounds like the start of yet another round of hearings in Washington, with a front-row seat reserved for at least one large financial institution with offices in lower Manhattan.
As for the international perspective, it's unclear how many other countries might be on the hook for similar transactions, but there may be a few more. Rest assured, the tide will eventually go out and all will be clear soon enough. Meantime, one might wonder if a lot of this is really just a game of musical chairs. If so, the music has stopped and there's more than a few sovereigns looking for seats.
Brian Love of Reuters recently wrote that Greece's problems with debt "mark a new phase in global financial crisis." The full ramifications of that statement have only just started to leak out.
CAN WE BELIEVE THE RISING TREND IN DURABLE GOODS ORDERS?
The labor market may be facing new challenges, but new orders for durable goods rose again last month. This leading indicator of future economic activity increased 3.0% in January, the Census Bureau reports this morning. That’s good news, of course, although we’re in no mood to celebrate, given the apparent reversal of fortunes in jobless claims, as we discussed in our previous post.
Nonetheless, as our chart below shows, new orders for durable goods have made some progress in bouncing off the lows from early 2009. We can debate the source of the rebound, ranging from the natural tendency of an economy to right itself after a shock to the various efforts by the government to juice spending. More importantly, it's debatable if this and other leading indicators are as valuable this time around as forward-looking metrics of the broad economic trend. But if we ignore all that for a moment, the rebound so far in this series is encouraging.
As Pimco’s Tony Crescenzi explained a few years back, it’s the trend in such measures that provide clues about the future. “Persistent strength in durable goods orders should be taken as a sign that both consumers and businesses are confident enough in the economy to engage in spending on big-ticket items,” he advises in The Strategic Bond Investor : Strategies and Tools to Unlock the Power of the Bond Market.
The broad trend for durable goods orders is unmistakably up in recent months. The question is whether the rise can persist if—if—the labor market is set to move sideways, or worse, in the foreseeable future? This debate is all more potent if we recognize that January’s strong rise in durable goods orders was largely driven by civilian aircraft orders, which are quite volatile from month to month. Alas, excluding transportation reveals that new orders for durable goods actually fell last month, slipping 0.2% from December’s level.
Yes, the overall durable goods trend is encouraging. But even if we take this at face value, we can't ignore that it’s a jobless recovery so far. As long as that qualification remains, the bullish aura surrounding leading indicators is suspect.
ANOTHER WARNING SIGN IN JOBLESS CLAIMS
Last week’s rise in new filings for jobless claims adds another data point to the case for thinking that the downtrend has hit a wall in this critical measure of the labor market's trend.
In the week ending Feb. 20, seasonally adjusted initial claims rose to 496,000 from 474,000 in the previous week, the Labor Department reports. That’s the highest since last November. Even more discouraging is the heightened risk that the general decline in new filings is over, at least temporarily. If so, the recovery in the labor market, which has yet to begin in terms of net job creation, may be facing a new headwind.
One reason for thinking so comes from our chart below, which seems to saying that the downward momentum in this measure has evaporated.
Today's news of anothe rise in jobless claims isn’t a total surprise. We’ve been reading the statistical tea leaves for weeks (here and here, for instance) and wondering if something had changed in the formerly sinking number of new claims for jobless benefits. Today’s number only raises the stakes.
It's possible that there are technical reasons for the rise. Maybe February is a quirk. Although the numbers in our chart above are seasonally adjusted, there may be one-time variables that make recent readings anomalous. But it's getting harder to think so as the upward trend rolls on.
At the very least, the labor market is at a critical juncture. The massive monthly losses in nonfarm payrolls have more or less faded. But net job creation in the private sector on a sustainable basis remains MIA. The recent trend in new jobless claims doesn’t offer much reason to think that there’s an imminent change for the better in the next round of data.
February 24, 2010
IS THE ECONOMY HEADED FOR A SLOWDOWN?
Yesterday's sharp downturn in the Conference Board's consumer confidence index for February has rattled investors, but the shift in sentiment isn't surprising. With the labor market still weak, it's only reasonable to expect that there'll be a price to pay in Joe Sixpack's outlook.
As the Conference Board's Lynn Franco said in the accompanying press release, consumers "remain extremely pessimistic about their income prospects. This combination of earnings and job anxieties is likely to continue to curb spending."
Of course, there's no obvious damage unfolding in the government's tally of retail sales, at least based on the latest reading for January. And, of course, last year's fourth-quarter GDP report for the U.S. economy was quite favorable. But as we've been discussing for some time, it's important to distinguish between the economic and financial activity of the past year or so vs. the outlook from here on out. The rebound in the economy and capital markets since last spring that was fueled by the gee-we-dodged-a-bullet syndrome has probably run its course. It's been clear for many months that the economic system wasn't going to collapse after all, at least not based on the acute financial-crisis factors that arrived in late-2008. There are debt/deflation issues to worry about going forward, a la Greece. But the previous worry is no longer a concern, as suggested by the sharp rise in formerly depressed prices in almost everything over the previous 12 months.
But that's so 2009. Expecting the reflation trade to roll on indefinitely is naïve. There may be future gains in markets in the months ahead, but if so the source of the underlying bullishness will have to come from something other than comparing today vs. 2008. The hard business of generating economic growth has now moved to the forefront of challenge du jour. As the dip in consumer confidence suggests, this challenge will be far tougher than the reflation trend of the recent past suggests.
No matter how you slice it, it's all about the labor market for the foreseeable future—and how the ongoing struggle to mint new jobs will impact spending. The next clue comes tomorrow, when the Labor Department updates the latest initial jobless claims. The burning question is whether our recent anxiety regarding this data series was warranted or not. Tomorrow will also bring news of the pace of new orders for durable goods last month. Since this corner of the economy is quite sensitive to cyclical fluctuations, the trend here is relevant for peering into the future.
Meantime, a worrisome sign for employment arrived in yesterday's update on monthly mass layoffs, defined as 50 or more job cuts at a company. Unfortunately, there was a slight rise in mass layoff actions last month, the Labor Department reported: 1,761 in January on a seasonally adjusted basis, up from 1,726 in December. That's a relatively mild 2% increase on a monthly basis. In addition, mass layoffs are still far below the nearly 3,000-a-month level from last March. But while the trend has been encouraging, at least up to now, this measure of the labor market's health overall is still well above what would be considered healthy. But for the moment, there's some concern that the trend of recovery may be faltering.
In short, the fact that the layoffs turned up last month on a seasonally adjusted basis for the first time since August is discouraging. As economist Richard Yamarone notes in The Trader's Guide to Key Economic Indicators, "increases in the number of layoff announcements usually portend a softer payroll picture…"
One month a trend does not make, of course, and so we can't yet declare that the labor market has hit a wall. And even if layoffs aren't yet in full recovery mode, that setback can be offset with net gains in nonfarm payrolls. So far, however, there's no sign of such an offset.
The hour is growing late for waiting. All eyes on the next round of job-market data.
February 23, 2010
WHAT'S THE CRITICAL FACTOR IN PORTFOLIO RETURN?
If you could only make one decision in your investment strategy, what would it be? Would you concentrate on picking the best securities? The best ETFs or mutual funds? Would you focus exclusively on trying to time your asset allocation/rebalancing choices? Or maybe you'd spend a lot of time deciding if Asian stocks would beat European equities in the foreseeable future. Or how about managing the risk, however defined, like a hawk? In any case, the question is simply this: Which variable in the money game is likely to have the most influence on the end result of performance?
Depending on the investor, answers are likely to be all over the map. And perhaps that's reasonable, since we left out a critical piece of information for answering intelligently: time horizon.
What's the single-most important investment decision driving return? We can't respond shrewdly unless we know the length of time we'll be investing. If we're managing money with an end point of, say, next year, or even a few years down the road, the critical variable may be different (is likely to be different) than if you're investing for results 20 years on.
This isn't terribly surprising, although the time horizon distinction is often minimized, if not ignored in discussions of everything from security selection to asset allocation. Part of the problem is that in theory we're all long-term investors but we're destined to make the journey on a tick-by-tick, daily basis. Even the self-proclaimed day trader has a horizon beyond the next 24 hours. A 35-year-old who trades furiously during the day still wants a comfortable retirement 40 years hence. Perhaps the only investors with truly short, or shorter time horizons are older folks, although even that's debatable, depending on your estimate for longevity.
In any case, back to our question: What's the single-most important variable that influences portfolio return? If we're investing with an eye on maximizing return 20 years from now, the answer is one of basic asset allocation: stocks vs. bonds vs. cash. Assuming some reasonable level of diversification in stocks and bonds, choosing individual securities will have a minimal impact, if any. And it probably won't matter much if you overweight U.S. stocks vs. foreign stocks, or vice versa.
Consider, for instance, a few statistics. For the period 1970-2008, the annualized total return for domestic stocks (S&P 500) was 9.5% vs. 9.7% for foreign stocks (MSCI EAFE), according to the Ibbotson SBBI Classic Yearbook. Not a huge difference for that 38-year stretch. The future's always uncertain, of course, but generally over long periods it's likely that regional differences in equity beta will be minimal relative to the global stock market beta.
In the shorter term, however, it's a different story. Looking at returns by decade for the S&P 500 and MSCI EAFE shows a wider array of results. For the 10 years through 2008, EAFE gained an annualized 1.2% vs. a 1.4% annualized loss for the S&P 500. In the 1990s, the relative performance tables were turned, with a much bigger divergence. U.S. stocks earned an annualized 18.2% for the decade through the end of 1999, more than double the annualized rise for MSCI EAFE, which gained 7.3% during the 1990s on an annual basis. (For a slightly more technical analysis of this trend, see William Bernstein's 1997 treatment of this topic.)
Meantime, we can also show that bond returns over time tend to be quite modest relative to stocks. Again, no big surprise. What's more, assuming reasonable diversification, your choices on short vs. long term bonds, or domestic vs. foreign, probably isn't going to matter so much. Yes, there's the foreign currency factor to consider, particularly when it comes to bonds. But over time, the capacity for forex to add or subtract from equity and bond returns tends to be a wash (i.e., the expected return for currencies proper is zero). In the short run, however, lots of forex volatility, and therefore lots of risk, which may or may not be helpful, depending on the investor and the strategy.
What's the lesson in all of this? Your overall stock/bond/cash allocation is where the action will be over the long haul. But there's a glitch. Although we're all long-term investors, at least in theory, the long-run future arrives one day at a time. In fact, almost no one builds a portfolio today and lets it roll on, unattended, over the next 20 years. That's true even for foundations, which theoretically have an infinite time horizon. Actually, a passive strategy that's broadly diversified would probably fare quite well over time, assuming we chose a reasonable mix of stocks and bonds, such as 60% equities/40% fixed income.
But the set-it-and-forget mentality is hard to do. We're all constantly buffeted by the daily barrage of headlines and other mental matters that compel us to act. For those with discipline and an above-average level of financial analytical abilities, short-term trading can be productive. But adding value over the long haul is rare by way of short term trading, especially after deducting for taxes, commissions and other frictions. In other words, most of us will end up with middling results. The problem is that everyone thinks they're above average when it comes to money.
So what's the big-picture message here? First, don't lose sight of the fact that in the long run, your overall stock/bond/cash mix will perform the heavy lifting for generating performance results, for good or ill. (We might add in REITs and commodities, if we're inclined to embrace a bit more nuance for matters of portfolio design). But getting from here to there is complicated, which is to say that you'll be faced with numerous tactical decisions. There'll be opportunities to add as well as subtract value from your end result, and so we must proceed cautiously on a day-to-day basis.
The good news is that there are some things to do that are likely to add some value, even if you're no financial wizard, starting with rebalancing and owning multiple asset classes. Beyond these two factors, however, things get messy, at least for most investors, and that includes the issue of time horizon. In effect, we're all short term traders with a long-term horizon. This is the original sin that comes prepackaged with investing. We can't escape it, but neither can we fully solve for it.
Balancing the short and long term is a key element in the art of investing—the intertemporal risk for asset allocation, as it's known in the literature. Robert Merton formally identified this risk in the early 1970s in a series of seminal papers and financial economists have been grappling with the related challenges ever since. So, too, have investors, for that matter, even if they don't recognize the risk on those terms.
Yes, we've picked up a few clues in the game of managing money for the long run while juggling short-term risk. We know, for instance, that expected returns vary, and so reversion to the mean is likely, even though the reasons are hotly debated (i.e., market efficiency vs. irrational investing decisions). But there's still no hard and fast solution beyond some general rules of thumb, such as own a broad mix of stocks and bonds, perhaps with some cash and so-called alternative betas. There's also compelling evidence that active management won't help much over the long sweep of time.
The debate, however, is a Wild West show for the short term. Or, as J.P. Morgan, once said, prices fluctuate, proving, if nothing else, that there's at least one concept in finance that's universally accepted.
February 22, 2010
CAN INVESTMENT MISTAKES BE RATIONAL DECISIONS?
There’s a furious debate these days over the efficient market hypothesis and whether recent events support or spurn its implications. Among the criticisms: investors are irrational, meaning that they're prone to chase trends mindlessly. In turn, this leads to speculative manias and crushing selloffs.
It all sounds reasonable on the surface, but the details are tangled. Suffice to say, definitive, all-or-nothing explanations, one way or the other, are far more elusive than a casual discussion on the matter suggests. That includes the issue of distinguishing irrational behavior from genuine but otherwise rational mistakes and miscalculation. Even proponents of EMH concede that the market isn't perfect, at least on an ex-post basis. All's clear in hindsight; it's the ex-ante challenge that's slippery.
Or as Warren Buffett likes to say, it's only obvious who's swimming naked after the tide goes out. Speaking of Buffett—widely hailed as the uber-investor par excellence—Investopedia's Financial Edge published a story last week that reviews "Buffett's Biggest Mistakes." It comes as no shock to learn that the master is fallible. He may be the world's greatest investor, but he's only human.
That brings up the subject of irrational behavior, or what appears to be so. No one would call Buffett an irrational investor. That implies that he's making rational investment decisions. Perhaps he's an anomaly in an otherwise irrational world. But here's the thing. If a rational investor can make mistakes when it comes to valuing securities (e.g., paying too much, selling too early), how does one distinguish that from similarly flawed decisions by so-called irrational investors?
Yes, it's easy to say, Well, he's Warren Buffett, ergo, his investment decisions are rational. But what about the average mutual fund manager? Or the guy down the street trading from his bedroom? Could you tell if one's irrational and the other's rational? Clearly, it's no quick clue to simply declare that someone paid too much, or sold too early. We need something more than that. But what?
Alas, there are no easy answers, if any. There are no econometric tools that separate rational investors who make mistakes from irrational types who stumble. On the other hand, there's no shortage of subjective opinion, rules of thumb, and a truckload of hyperbole.
Meanwhile, the market may collectively be irrational at times, if not continually. Or maybe not. Could the market (and individual investors) be making rational decisions that are sometimes wrong? Or is it a matter of degree? Does irrational behavior equate with making really big mistakes, vs. relatively modest ones? Okay, how do we define big and modest? Is that determined solely by, say, price relative to earnings? Is a 15 p/e too high? Or is it 16? And do we need to adjust that for inflation, interest rates, the outlook for economic growth, the possibility of war, etc.? Or does the mere presence of mistakes (defined after the fact, of course) constitute irrational investing, regardless of valuation?
As you can see, deciding if the EMH is reasonable or not isn't quite so easy. At least not if you have to write down the rules. Then again, there are those pesky index funds, which generally perform as EMH predicts. But even that's debatable, as we'll discuss in a future post. It's not an entirely persuasive argument, but that doesn't slow the debate.
If you're looking for quick, definitive answers, debating EMH isn't likely to offer satisfaction. By comparison, you'll probably have better luck with religion or politics.
GDP VS. MARKET CAP FOR EQUITY MARKET ASSET ALLOCATION
In the hierarchy of investment decisions, asset allocation is at or near the top of the list of variables that are strategically relevant for diversified portfolios. There are a number of studies telling us so, starting with the influential Brinson study from 1986—"Determinants of Portfolio Performance"—and its 1991 update. The basic message: asset allocation matters.
Deciding how much it matters, why it matters, and under what conditions has spawned a fierce debate over the years, along with a small library of research analyzing the details. A paper a few years back from Ibbotson Associates (now a part of Morningstar) captured the spirit of the discussion with this title: "Does Asset Allocation Policy Explain 40, 90 or 100 Percent of Performance?" The answer? All three accurately summarize asset allocation's influence, but it very much depends on how you define the question.
As the Ibbotson paper explains, "asset allocation explains about 90 percent of the variability of a fund's return over time but it explains only about 40 percent of the variation of returns among funds. Furthermore, on average across funds, asset allocation policy explains a little more than 100 percent of the level of returns."
Although the Ibbotson research helps clarify the dispute over how and why asset matters, it's hardly the last word on the subject. Indeed, navigating the nuances of asset allocation research, and drawing practical conclusions, has is almost a full-time job in the 21st century. Clearly, this has become a broad and deep discipline in its own right, with the no shortage of reference material to consider. Skeptical? Type in "asset allocation" at Social Science Research Network's home page and behold the result.
Asset allocation as a formal topic of inquiry has come a long way since the 1986 Brinson study launched the discipline, and it's still evolving. Rapidly, in many directions. There are no easy answers, but at least we know where to start. Among the standard works that deserve a spot on every strategic-minded investor's bookshelf:
• Asset Allocation: Balancing Financial Risk
• The Art of Asset Allocation: Principles and Investment Strategies for Any Market, Second Edition
• The Four Pillars of Investing: Lessons for Building a Winning Portfolio
• All About Asset Allocation
As valuable as these books are, they only scratch the surface. Indeed, a number of niches in asset allocation are worth exploring, such as tactical interpretations. Mebane Faber's The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets is a recent contribution to this niche. And yours truly reviews some of academic literature in Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor.
Meanwhile, the discussion over GDP vs. market-cap weighting systems is another aspect of the debate over what constitutes an effective passive definition of structuring a portfolio. A new research briefing from MSCIBarra revisits the subject by considering the differences in weighting an international equity portfolio by the size of each country's economy vs. the market capitalization of its stock market. This is a familiar topic for MSCI, which has long published a series of equity indices weighted by GDP. How have the two methodologies fared? The GDP methodology has recently posted a considerable edge over its market-cap equivalent on a broad basis that targets all the world's stock markets, including the U.S. For the five years through February 19, 2009, the MSCI ACWI GDP Weighted Index earned a 2.8% annualized total return--comfortably above the slight 0.3% annualized rise for the conventional MSCI ACWI, which is market-cap weighted.
It's tempting to declare GDP weighting as the winner, now and forever more. But investors should be wary of assuming the past will repeat. It may, but we need something more than blind extrapolation of the past as a compelling argument. Indeed, one of the reasons for the GDP weighting's edge is that the strategy holds larger portions of emerging market stocks, which grab a bigger slice of assets in GDP-oriented indices vs. market-cap benchmarks. As such, one's views on emerging markets are critical to assessing GDP weighting.
Notably, China's large and growing economy is under represented in a market-cap index because its stock market is relatively small compared with its GDP footprint. At the opposite end of the extreme, the U.S. market is over represented via market cap because American stocks are highly valued relative to the economy. As our chart below shows, China's stock market capitalization represents less than 10% of its GDP value. By that standard, the U.S. is over represented because its stock market capitalization trades at a premium to the dollar value of the economy.
Presumably, such gaps will close in the years ahead. If so, the trend implies a bullish tailwind for China equities and a headwind for U.S. stocks.
But GDP is but one alternative weighting scheme, as a recent article by Rob Arnott and two co-authors reminds. It's not always clear that an investor should assume that any one methodology will be superior in the years and decades ahead. "Our research shows that a combination of cap weight, economic scale and minimum variance creates a compelling risk/return profile," Arnott and company write.
But there are several issues to consider. One is that passive indexes based on something other than market cap may incur higher management costs vs. a standard market cap indexing strategy. There are other details to review as well if we're to understand why expected risk premiums might be higher for one weighting system vs. another. Overall, one can persuasively argue that higher expected returns come only by assuming different risks relative to the market cap portfolio, which is arguably the true passive definition for equities. Becoming comfortable with those risks in terms of their economic interpretation is essential before diving into alternative indexing systems.
It's no surprise to learn that different portfolio construction techniques provide different return expectations. But these expectations, after adjusting for risk, may not be so surprising (or enticing) after all. Indeed, modern finance has identified an array of betas to consider, such as small-cap value. Is this a free lunch? No, absolutely not. Does small-cap value offer a higher expected return vs. the standard equity beta? Yes, or so it seems. But understanding why it offers a higher expected return is critical before overweighting the beta. No less is true for GDP weighting, or any other strategy that claims to capture a higher risk premium.
There are no short cuts to minting risk premiums in the money game, but there are lots of betas to consider. Choose wisely, but do your homework first.
February 19, 2010
THE WEATHER FACTOR
"Everybody talks about the weather but nobody does anything about it," goes the famous quip (written, by the way, by Charles Dudley Warner and quoted by Mark Twain in a lecture). The connection between the weather and the economy is popular among the chattering classes these days. There's some who think that the winter storms from earlier this month have suppressed business and consumer activity to a degree and so March will bring a stronger bit of growth than we'd otherwise see. In turn, that implies that we shouldn't get too uptight about data dispatches for this month, as we did yesterday with regards to weekly jobless claims.
Ryan Sweet of Economy.com writes that because "the severe storms that hit the Northeast will have a noticeable effect on February data, most of the lost activity will be made up for in March."
Bill Cheney, chief economist at John Hancock Financial Services, tells Bloomberg News via BusinessWeek: "Almost certainly we will see bad-looking numbers for February and good-looking numbers for March and we probably won’t be able to tell what the underlying trend is."
Harm Bandholz, an economist for UniCredit Bank, thinks there'll be a tailwind for economic reports next month. Why? In a word, snow, as he said last week, according to MarketWatch.com. "The two blizzards that struck the East Coast this week will perceptibly weigh on major economic data releases for the month of February." If Mother Nature is kind, next month should bring some better trends as March rebounds from the winter of February's discontent.
But it's no always clear that severe winter weather deters all economic activity. The Wall Street Journal last week ran a story that advised that retail sales remained strong last month despite frigid temps. Perhaps that's because it's always balmy for Joe Sixpack when he's sitting in his living room and making purchases via the Internet. "Retail sales increased a larger-than-expected 0.5% last month, more than recovering a 0.1% loss of December," the Journal advised. "The latest retail data suggest real gross domestic product is on a solid track, even though February's storms cut into business activity."
Blaming the weather for labor market weakness is hardly a new innovation. As the National Post reported earlier this month:
National Bank chief economist and strategist Stefane Marion points out that when a blizzard shut down the eastern coast of the United States back in January of 1996, roughly 200,000 jobs were reported lost on the month. That’s a significant deviation from the average monthly creation of 150,000 observed prior to the blizzard.
Jobs rebounded very strongly in February with more than 600,000 gained, then reverted to trend the following month.
Mr. Marion also expects to see a loss of roughly 200,000 this time around, with the first sizeable increase in headcounts likely to come in March 2010.
"Those storms will drive initial jobless claims lower next week as workers find the trek into state offices more difficult to make, if they’re open," Scotia Capital said in a note to clients, noting that affected states comprise about 10% of total jobless claims.
Diane Swonk, chief economist Mesirow Financial, also sees a silver lining after the dark storm clouds of February, explaining earlier this week via AOL's Daily Finance that "the storms will distort the unemployment data as everyone who works hourly and could not show up for work during the week lost wages, and did not show up on the payroll survey..."
Yes, everyone's talking about the weather, but deciding what it all means for the numbers will take time. Meantime, meteorological-based hope springs eternal...or at least until March.
A WHIFF OF DEFLATION IN THE CPI REPORT
Headline inflation last month rose a modest 0.2%, the Bureau of Labor Statistics reported today. That’s been the pace each and every month since last September. Over the past year, inflation was a mild 2.6%. On the surface, it’s all quite humdrum. But wait—what’s this? There’s an outlier in the core inflation trend for January: CPI less food and energy slipped by 0.1%.
The last time core CPI went negative on a monthly basis was 1982. Meantime, flat readings are more frequent, including last November’s zero reading for CPI ex-food and energy. The question, of course, is whether this is an early warning sign that the deflationary winds are starting to blow stronger (again)? For the moment, it’s too soon to tell. One month of modestly negative core consumer inflation is hardly a definitive sign of anything.
Nonetheless, it’s hard to overlook the fact that negative monthly readings for this data series are extraordinarily rare. For the sake of economic stability, let’s hope it stays that way. Yes, a little deflation every now and then wouldn’t hurt. Indeed, consumers have reason to hope for deflation, which most folks see as a sale imposed from on high. But from a macroeconomic policy perspective, deflation is about as welcome as the barbarians in Rome. That is if we're talking of persistent deflation. The good news is that we're quite a long way from that sad state of affairs. Nonetheless, when we see negative signs in core CPI, we're inclined to stop and reflect.
Simply put, we thought deflation was so 2009. Wasn’t that battle already won? Perhaps not. If this was a “normal” business cycle, it’d be easy to dismiss what amounts to a small and statistically insignificant bout of deflation. But we’re still suffering the aftershocks of the Great Recession. And as This Time is Different: Eight Centuries of Financial Folly reminds, business cycle contractions brought on by a financial crisis are an especially pernicious strain of decline. Debt, in short, tends to be unusually hefty in these cases, which is no small catalyst for deflationary pressures.
The recent history of Greece and its pile of red ink remind that the risk of deflation, while far lower today than a year ago, isn’t quite nil. Nor are the spillover effects benign across international borders.
Still, there’s reason to think that today’s core CPI number is a blip, or so yesterday’s wholesale price report for January suggests via Morgan Stanley’s David Greenlaw.
We tend to agree, in part because monetary stimulus is still aggressive, at least in nominal terms. The Fed continues to chase inflation, and to some extent it’s been successful. But as today’s consumer price report reminds, there may yet be some backtracking on the road to reflating.
February 18, 2010
THE FIRST OF MANY RATE HIKES BY THE FED
We knew it was coming, but we didn't know when. Now we know. After the stock market closed today in New York, the Federal Reserve announced it was raising its discount rate to 0.75% from 0.50%. This is the rate that the Fed charges on short-term loans to banks. Think of it as a down payment on the future.
Yes, the hike is both small and primarily symbolic. Lending through the Fed's discount window is relatively slight in the 21st century. It's hardly surprising that Bernanke and company chose to ease back into monetary tightening quietly. Nonetheless, a similar rise is probably near for the Fed funds rate, which is the central bank's primary benchmark for adjusting the price of money. Currently, the target Fed funds is in a range of zero to 0.25%.
The burning question this evening: How will the markets react in the morning? The initial reaction in Asia is modest selling. Japan's Nikkei 225, for instance, is off by around 0.7% as we write.
It looks like the era of the Great Easing is over in America. This is merely the first installment. Although the economy's far too weak to warrant a rapid return to normal policy, today's minor adjustment is a signal of things to come. The long road back to a normal monetary policy has started and there's likely to be a few bumps on this journey.
"The Fed’s action came as a surprise and enhanced speculation that it will withdraw stimulus ahead of major peers," Tomokazu Matsufuji, at SBI Liquidity Market Co. in Tokyo, tells Bloomberg News. "This will drive the dollar higher."
Meantime, Chris Rupkey at Bank of Tokyo-Mitsubishi UFJ tells the LA Times this evening: "The Fed can talk all day about how the discount rate hike is technical and not a policy move, but the market sees it as a shot across the bow." He went on to opine: "Today they raised the discount rate, and not tomorrow or the next day, but soon, they will be lifting the fed funds rate target as well, as the economy is starting to regain momentum."
Finally, a few excerpts from a speech given earlier tonight by Dennis Lockhart, president of the Federal Reserve Bank of Atlanta. He spoke after the Fed announced it would increase the discount rate:
Earlier today, the Fed announced an increase in the primary credit rate. The primary credit rate—also called the discount rate—is the rate at which the 12 Federal Reserve Banks across the country provide temporary liquidity to healthy banks. How should today's announcement be interpreted? I would not interpret this action as a tightening of monetary policy or even a sign that a tightening is imminent. Rather, this action should be viewed as a normalization step.
..the public and markets should not misinterpret today's move. Monetary policy—as evidenced by the fed funds rate target—remains accommodative. This stance is necessary to support a recovery that is in an early stage and, in my view, still fragile.
WHERE ARE THE CUSTOMER'S RETURNS?
Fred Schwed's classic Where Are the Customers' Yachts: or A Good Hard Look at Wall Street (Wiley Investment Classics) asks the perennially relevant question when it comes to investment advice. A 21st century corollary might inquire: Where are the customer's returns? More precisely, why do the customer's returns so often trail the benchmarks?
There are many answers, of course, ranging from high fees to poor decisions to thinking that beating the market is easy. Whatever the reason, it’s no secret that the average investor needs help in earning a decent rate of return on his investments. It all looks easy from the vantage of history, but real-world results tend suggest otherwise.
This is hardly news, but it’s an ongoing feature in the struggle to make a buck in the capital markets. The latest smoking gun comes by way of Morningstar, which calculates asset-weighted investor returns. This study reflects what the average investor actually earned in various mutual fund categories vs. the average for the respective fund category. Unsurprisingly, the average investor tends to earn less than the average fund. Consider a few examples from Morningstar’s latest tally:
● The average investor in U.S equity funds earned 0.22% for the 10 years through the end of 2009, well below the 1.59% gain for the average fund in this category.
● For international equity funds, the average investor earned 2.64% vs. 3.15% for the average international stock fund for the decade through this past December 31.
Is it any wonder, then, that 401(k) investors can benefit from professional advice? This says as much about the quality of the advice as it does the poor investing decisions that so often pass as standard operating procedure for the man in the street. Yes, we must be careful of "advice," which can sometimes be a cure that's worse than the afflication. But simple recommendations, such as embracing broad-minded asset allocation, can do wonders for investors who are clueless as the to basics.
On that note, consider a study published last month by Hewitt Associates and Financial Engines that 401(k) participants who availed themselves of target-date funds, managed accounts and/or online advice earned higher returns—i.e., “help.” The study—“Help in Defined Contribution Plans: Is It Working and for Whom?”—advises: “On average, the median annual return for Help Particpants was almost 2% (186 basis points) higher than for Non-Help Participants, net of fees.”
The research goes on to report that “non-help participants often have inappropriate risk levels and/or inefficient allocations, both of which can significantly affect portfolio performance.”
No one should be surprised by any of this, although one can only guess how much of these types of studies promote thinking and investing strategically. The good news: the basic building blocks of shifting the investment odds in your favor isn't rocket science. Owning multiple asset classes and engaging in some simple rebalancing from time to time offers a surprisingly durable risk-reward profile over time, as we’ve discussed. But what’s easy and obvious (at least to some) in the money game is rarely embraced by the masses. Documenting the supporting evidence is fairly uncomplicated. Explaining why this is so is something else altogether.
ANOTHER JUMP IN JOBLESS CLAIMS
It’s still touch and go with weekly jobless claims, and it probably will be for some time. We’re in a transition phase, or so it seems. The question is what will be the outcome? As we write, we’re inclined to think the odds are evenly split between a resumption in the near future of the general decline that’s been in force vs. a change for the worse.
We’ve been writing about what appears to be a pivotal test for the labor market. After nearly a year of a decline in jobless claims, we’ve been wondering if the favorable winds have shifted in the early weeks of 2010, as we discussed here and here, for instance. Depending on the week, our concerns look inspired or naive.
Today’s update reports a hefty rise of 31,000 new filings for unemployment claims for the week ending February 13 (this and all jobs numbers reported here are seasonally adjusted figures). As our chart below shows, the uptick looks discouraging at this point, more so than usual. Relative to the linear trend over the past year, it’s getting harder to dismiss the idea that the recovery wind for the labor market has run out of steam.
It’s still too early to say for sure what’s going on with jobless claims, which are a valuable resource for anticipating the larger economic trend. For one thing, this data series is notoriously volatile from week to week. As such, the latest data point is still well within the range that would be consistent with on ongoing decline. At the same time, it’s also true that the trend may be setting us up for a period of sideways action, with jobless claims stuck in a range of, say, 450,000 to 500,000 for an extended period. If so, that spells trouble for expecting a robust rise in nonfarm payrolls any time soon. Our outlook for net job growth has been muted for some time and perhaps we'll have to further reduce our expectations, depending on the numbers that arrive in the coming weeks.
Meantime, we’re not encouraged by the latest update on so-called continuing claims for jobless benefits, which is the tally for those who’ve been previously collecting unemployment checks. The trend on this measure has also stalled, as our second chart below illustrates. The latest number puts the continuing claims total at 4.563 million for the week through February 6. That’s unchanged from the previous week and about 2 million higher than what would prevail in a healthy economy. We're still a long way from home.
Progress, in short, remains in some peril in the formerly recovering labor market. The problem, of course, is that the recovery so far has been virtually all about slowing the bleeding. The second phase of net job creation has yet to begin, and based on today’s numbers there’s reason to wonder if the day of salvation is further down the road than we thought a few months back.
February 17, 2010
SEARCHING FOR ECONOMIC PERSPECTIVE AMID A SEA OF NUMBERS
There’s no shortage of economic data in the 21st century. Perspective, however, isn't always easy to come by. The digital age is a wonder for dispensing statistics, but the central challenge of digesting the endless reports, surveys, numbers and trends requires assistance.
Fortunately, there are productive tools available for mining intelligence from the river of numerical supply. Here are few worth considering in the struggle to figure what’s really going on with the business cycle.
• The St. Louis Fed offers a useful big picture review of global economic data. You can even choose to receive email updates when new information is posted.
• The Philadelphia Fed publishes several resources for tracking the business cycle in the U.S., including the Aruoba-Diebold-Scotti business conditions index and the Livingston Survey, which is reportedly the "oldest continuous survey of economists expectations."
• If you're searching for Washington's economic data du jour, take a look at the Economics and Statistics Administration's overview site to help parse through the various reports published by Bureau of Economic Analysis and the U.S. Census Bureau.
• For an overview of the U.S. Labor Department's output, its summary page is a time saver.
• The IMF's data and statistics resources offer yet another treasure trove of statistical delight for monitoring economic and financial trends around the world.
• Another rich array of economic data on a country-by-country basis is available via the OECD.
• The United Nations also maintains an extensive database on national economic statistics.
Finally, our own analysis includes a monthly look at the major economic measures for the U.S. Each month in The Beta Investment Report, we review the latest numbers in search of perspective on the business cycle. As a sample, here's an excerpt from the February 2009 issue:
HOUSING & INDUSTRIAL PRODUCTION CONTINUE TO RECOVER
The staying power of the current rebound remains an open question, but the data du jour at least confirm that a recovery is underway. It’s a precarious rebound, but the economy must walk before it can run.
Both housing starts and industrial production posted higher levels last month. The annualized pace of new housing permits issued slipped, however, falling by 4.9% last month vs. December—the first decline since October and the biggest percentage drop since March 2009’s 7.1% tumble.
As our chart below shows, the housing market is a pale shadow of its former pre-recession profile. The rebounding of late is certainly encouraging, but we shouldn’t kid ourselves that anything approaching a normal recovery is imminent in this sector. Short of a complete collapse in the economy, the housing market was destined to show signs of life after three years of virtual non-stop contraction. What's unclear is what happens after the initial snapback fades.
As our chart above reminds, much has changed in the housing market, and not for the better. The rebound so far, if we can call it that, is still a marginal event with limited relevance to the broad economic trend. The main positive is that the housing market is no longer in freefall.
Industrial production, by contrast, is closer to what we might think of as recovering. As the second chart below shows, a broad measure of industrial activity in the U.S. shows that growth has been a constant since last July. But like housing, industrial activity is still in a deep hole relative to the days before the Great Recession.
Looking backward is encouraging, but the real test of the recovery awaits in the months and quarters ahead. Having stepped away from the brink, the economy has stabilized and started showing signs of life again. Industrial production and housing are but two examples. But the labor market has yet to offer signs that it too is set to join the party. Although job destruction is almost surely behind us, it remains to be seen how strong the job creation phase of the recovery will be. The answer will cast a long shadow on how the economy fares in the years ahead.
The natural forces of recovery are in force, supported by monetary and fiscal stimulus. But the headwind of debt, both in government and on household balance sheets, remains a potent force in keeping growth lower than it would be. The true test of just how problematic these negative forces will be is about to begin. For what it’s worth, we’re mildly optimistic that the expansion will continue. So too are a number of economists. The U.S. economy will grow at an annual rate of 2.7 percent over each of the next five quarters, according to 42 forecasters surveyed by the Federal Reserve Bank of Philadelphia.
Sounds good, but getting from here to there requires crossing a fair amount of treacherous economic ground. This rebound is likely to be far more prone to setback than any post-recession period since the 1930s. We already knew that, of course. The uncertainty is discovering exactly what that means over the coming months and quarters.
February 16, 2010
THE TROUBLE WITH MACROECONOMICS
Hyman Minsky is a popular guy these days. An economist who studied under Joseph Schumpeter, Minsky has become the dismal scientist of choice in the wake of the Great Recession as the man who told us so.
Robert Barbera in The Cost of Capitalism: Understanding Market Mayhem and Stabilizing our Economic Future identifies a key theme in Minsky's oeuvre by explaining that the "renegade financial economist…insisted that finance was always the key force for mayhem in capitalist economies." Barbera goes on to observe that Minsky advanced two ideas that were central to his view of the economic world:
First, the persistence of benign real economy circumstance invites belief in its permanence. Second, growing confidence invites riskier finance. Minsky combined these two insights and asserted that boom and bust cycles were inescapable in a free market economy—even if central bankers were able to tame big swings for inflation.
John Cassidy is no less effusive in profiling Minsky. In last year's How Markets Fail: The Logic of Economic Calamities, Cassidy writes:
From the early 1960s until shortly before his death in 1996, Minsky advanced the view that free market capitalism is inherently unstable, and that the primary source of this instability is the irresponsible actions of bankers, traders, and other financial types. Should the government fail to regulate the financial sector effectively, Minsky warned, it would be subject to periodic blowups, some of which could plunge the entire economy into lengthy recessions.
There is much to admire in Minsky's sober-eyed view of business cycles, even if some of it is self-evident. The idea that stability breeds instability, as he preached, is just another way of saying that business cycles persist. At times, these cycles "have have the potential to spin out of control," as Minsky wrote in the early 1990s.
Recognizing the challenge of macroeconomics is one thing; solving the challenge is something else. Surely there are broad principles upon which all (or at least most) students of economic theory can agree, with the first being that an unfettered, totally free and unregulated market system can't dispense economic nirvana at all times under all conditions. To quote Minsky again from the above paper, the various economic seizures throughout history "are evidence supporting the view that the economy does not always conform to the classic precepts of Smith and Walras: they implied that the economy can best be understood by assuming that it is constantly an equilibrium seeking and sustaining system."
Perfection does not exist, in economics, investing or anything else. But what does that imply? For some, the temptation to regulate the markets is the obvious response. Indeed, it is now the cause celebre to argue over the details of how to embrace so-called financial reform. For all the rhetoric and popularity of invoking Minsky of late, success won't be anywhere near as easy as the Monday morning quarterbacking suggests.
For one thing, financial markets are already regulated, and they have been for decades. Yes, there's a furious debate over the details, including when, how and if regulation in recent years has failed and what should be done about it. But it's naïve to expect that some obvious piece of new financial regulation can be enacted and, voilà, Minsky's ghost will rest easy for all of eternity. Washington has been tinkering with regulation for decades and it's not always clear that progress is inevitable. Countless numbers of economists of all stripes have weighed in. The system has leaned toward relatively light regulation to heavy handed regulation to something in between since the government took up the cause in the 1930s. It should be lost on no one that despite the best (and worst) efforts of regulators, the business cycle is not yet tamed.
In the grand scheme of macroeconomics lies the basic conundrum of deciding how to integrate government's hand with the principles of free markets. We've known since at least Bagehot's Lombard Street. A Description of the Money Market, first published in 1873, that the banking system requires a lender of last resort from time to time.
We've also learned that seemingly easy solutions to what are ultimately complex economic paradigms can give temporary relief but perhaps at the cost of delaying the inevitable, and paying through the nose for the procrastination. Liaquat Ahamed's magnificent tome from last year—Lords of Finance: The Bankers Who Broke the World--spells out this pitfall as practiced during the 1920s and early 1930s by way of embracing the gold standard as the all-season answer to the surviving the business cycle. But as Ahamed's book reminds, nothing works all of the time. Every solution in economics has a glitch. Everything fails at times. Should we expect the approaching solutions to the crisis du jour to fare any better?
As we await for an answer, the crowd wants blood. The popular idea that the market has failed is intuitively appealing. But is that really how we should explain price fluctuations? Clearly, investors, business people, government regulators, and the rest of the human species are prone to error. It's not always obvious in advance what distinguishes enlightened decisions from folly. In the end, the market will instill discipline by lowering or raising prices to reflect new information. Still, delusion at times is possible if not inevitable. Bidding up the price of houses and stocks above "fair value" isn't beyond the pale. The trick is defining fair value and estimating when the market will reprice assets to move closer to this idealized state of valuation. Unfortunately, markets don't come with instructions, leaving mere mortals to reverse engineer the laws in real time, and at times with great difficulty.
Among the various trends du jour in Washington is one of forcing the Federal Reserve to prick "bubbles" in order to sidestep the troubles of the last several years the next time out. But it's not obvious how this should be done in real time, even if the general concept is appealing. Stating a general case for pricking bubbles won't suffice. Details, man, give us details. When? Under what conditions? Perhaps this mandate is warranted, but writing the rules in advance will be torture. And in the end, there's still likely to be mistakes. Pricking too early, or too late. Pricking bubbles that seemed to exist but didn't. And on and on.
Meantime, didn't Minsky tell us that the business cycle is endemic to capitalism? If so, are we simply chasing our own tails by assuming that the business cycle can be tamed to a degree that satisfies the quest for stable growth without the nasty side effects?
Barbera is correct when he identifies a crucial change in the nature of business cycles over the past 30 years. A sharp rise in wages and inflation didn't precede the great cyclical episodes since the early 1990s. That's in contrast to recessions in previous years. "From 1945 to 1985," he writes, "there was no recession caused by the instability of investment prompted by financial speculation—and since 1985 there has been no recession that has not been caused by these factors."
The trouble, Barbera argues, is that central bankers were fighting the proverbial last war in the last two decades, i.e., keeping inflation at bay without paying heed to financial bubbles. "Surging asset prices and increasingly dubious finance define excess in the modern day cycle," he explains.
Maybe so, although one might wonder if that will remain true in the years ahead. Are we doomed to always fight the last war? There's a reason why so many smart economists thought the Great Moderation was durable in the 1990s and early 2000s: It was, at least until it wasn't.
In fact, we're always fighting the last war for the simple reason that the future is uncertain. Despite more than two centuries of central banking, the best and brightest are still trying to figure out how to optimize the management of the economic cycle. The first 8 million books and research papers were only a prelude to the real insight that's surely lying just around the corner.
To be sure, there are some very definite things we should be doing now that we weren't doing before, such as putting a lid on the capacity of financial institutions to sell insurance contracts (i.e., certain derivatives) without an appropriate level of collateral to offset the associated liabilities. In fact, coming up with a laundry list of things we should have done is easy, as it always is after the fact. We've been doing no less since the 1930s. So why isn't there more progress to show for all our efforts at trying to tame of the cycle? And just how much should we try?
One can argue that the Greenspan/Bernanke approach to central banking was all about moderating the business cycle. It seemed to work, until it didn't. How much confidence should we have that tomorrow's solution will bring salvation? The jury's always out on that one, but for our money we're forever skeptical. The same wetware that brings us to each mess is also asked to get us out. The human mind is capable of many things, but finding perfect solutions to the business cycle is hopelessly elusive. That doesn't mean we shouldn’t try. But we must also beware that the apparent answers have consequences too.
The seemingly productive goal of minimizing recessions may have long-run costs. As James Grant outlined in The Trouble With Prosperity: The Loss of Fear, the Rise of Speculation, and the Risk to American Savings, "…the attempted suppression of the business cycle has hurt economies through the industrialized world."
Not everyone agrees, of course. But this is economics and so definitive proof is always lacking, one way or the other. Economics, in other words, is all about juggling risk. Sometimes we do well, sometimes not. On that note, Grant quotes Clement Juglar, father of business cycle theory: "Where economic growth is slow and calm, crises are less noticeable and very short; where it is rapid or feverish, violent and deep depressions upset all business for a time. It is necessary to choose one or the other of those conditions, and the latter, in spite of the risks which accompany it, still appears the more favorable."
There are many poisons to pick, of course. But having tried the others, the free market poison is still the least worst of all the alternatives. Can we improve it? Perhaps, but it's not going to be easy. It's not even clear that well-intentioned efforts at a solution in the coming months and years will be successful, or that the reported solutions won't end up causing more pain. Nonetheless, the great experiment in macroecononmics rolls on! Just be careful if some wide-eyed pundit tells you it'll be different the next time, or that enduring progress is just one more piece of legislation away.
February 12, 2010
FROM RUSSIA WITH CAVEATS
Is it me or is there a growing supply of video feed available gratis on the strategic and tactical investment topics du jour? In any case, the Russia Forum 2010 from last week offers some intriguing commentary by Marc Faber, Nassim Taleb and others (hat tip to Mebane Faber). Faber's set-up question: How would you invest $100 million today for the next 12 months?
RETAIL SALES & EASY GAINS
Today’s update on retail sales for January shows that the annual change in consumer spending has returned to pre-crisis levels in terms of 12-month rolling changes. In fact, the 4.7% increase in retail sales over its year-ago level as of last month is quite a bit better compared with the trend in early 2008. But like so many other measures of economic and financial activity, the return to levels that pre-date that financial crisis that swept through the markets and the global economy starting in September 2008 is only half the battle, and arguably the lesser part.
On a monthly basis, January’s 0.5% rise in retail sales (seasonally adjusted) is middling relative to recent history. Of course, any news of higher spending is welcome in the current climate, i.e., the ongoing weakness in the labor market. It could easily have been a lot worse.
Looking at the rolling 12-month change is more encouraging, as our chart below shows. But it’s not terribly surprising to find that the annual pace of retail sales have rebounded from the depths of the late-2008/early 2009 crisis. Recognizing that the risk of seizure in the world’s financial system has fallen dramatically, consumers are spending again in something closer to the normal trend.
One reason is the natural bias in the business cycle for recovery after decline. The economy was either going to implode or it wasn’t. Since it’s been obvious for months that the worst fears of late-2008/early 2009 were excessive, a number of metrics have recovered in sympathy with this updated information. From industrial production to the stock market to consumer sentiment readings, there’s been a clear and significant rebound. Even inflation expectations, as per the Treasury market’s expectation, have returned to pre-September 2008 levels.
The fact that retail sales have joined this bandwagon is no surprise. All the more so if we consider that monetary policy and fiscal stimulus have been juicing the natural forces of recovery.
But as we’ve been discussing for some time, there are two stages in the post-crisis world. The first stage is one of the snap-back period, when the end-of-the-world expectations are replaced by more temperate outlooks that reflects the world as it now appears. The immediate beneficiaries of this first phase are those measures of economic and financial activity that are relatively easy to repair. Dropping interest rates to zero and sending checks to consumers, businesses and other entities dispense some obvious and fairly predictable responses. In other words, the easy and quick solutions have been applied, and with degree of success.
The tougher challenges, however, remain, starting with the labor market, which has yet to show convincing signs of recovery. More generally, maintaining robust growth from here on out in everything from retail sales to industrial production promises to be a much bigger challenge than is typical in post-recession periods of recent decades.
Bottom line: the actute portion of the crisis is over but it’s been replaced by the post-crisis challenge, which is one of generating and maintaining growth. High levels of debt on the government and household balance sheets threaten to make the second stage far more precarious than the recent snap-back numbers suggest.
Alas, there are no easy solutions for what awaits. That doesn't mean that the future is doomed. But the tailwind that's been blowing over the past year is no longer a hurricane. It's been downgraded to a tropical storm and in the near future it's likely to downshift to a strong breeze. Evolution is constant in the business cycle, and the next phase isn't likely to be all that helpful.
HISTORY LESSONS ON DEBT, DEFAULT & INFLATION
The Wall Street Journal today has an interesting look at the troubles associated with red ink. Among the resources cited is new research from Morgan Stanley with a clever title that asks: The Return of Debtflation?
It's a revealing look into the history and the implications of sovereign debt and the related risk. You can read the full report, complete with graphs, here. Meanwhile, here's the summary, which packs a punch on its own:
US public debt as a share of GDP is now higher than at any other time in history except after World War 2 - and rising: our US colleagues expect public debt to GDP to increase to 87% by 2020. How policymakers will deal with this fact will likely be one of the main drivers across markets going forward. So what are the implications of high public sector debt for fiscal sustainability and inflation? To answer this question, we look at how the US economy escaped high debt following World War 2. We then quantify the inflation risks inherent in today's US fiscal position by asking what would happen if policymakers were to deal with the current debt overhang in the same way.
Stabilisation of public debt to GDP at current levels would require average inflation rates between 4-6% over the coming decade - even under much lower budget deficits than currently in place. On our numbers, even with budget deficits that are much lower than the current (and projected) levels, average inflation over the next ten years would have to be substantially above 2% to keep debt in check. Even a balanced budget would require 3% average inflation over the next decade. With an average deficit as low as 3% of GDP, debt stabilisation would require average inflation above 6%. Note that in the current fiscal year (FY) we expect a deficit of 9% of GDP, projected to decline to 5.2% of GDP by 2020. Suppose the government were to reduce the deficit to 5.2% from 2011 onwards - rather than by 2020. Stabilising the debt at current levels would then require an inflation rate of 9% on average over the next 10 years. What level of deficit would be consistent with achieving a 2% inflation target, on average, over the next 10 years? A 1% of GDP budget surplus.
It is clear that inflation risks of this magnitude are not in the price: currently, markets are anticipating inflation to be below 2.5% over the next 10 years, on average. Should we be worried about ‘debtflation' - the Fed engineering inflation to keep the debt in check? A forward-looking central bank may prefer to create a little controlled inflation now to the pressure of inflating a lot later on. And the idea of controlled inflation has influential advocates in policy circles. Former IMF Chief Economist Kenneth Rogoff has suggested the Fed announce a 4-6% inflation target for a limited period. Coincidence?
February 11, 2010
A TIMELY FALL IN JOBLESS CLAIMS
This morning's update on initial jobless claims is a timely bit of good news. In fact, the markets probably couldn't wait another week for this. For starters, the decline of 43,000 in new filings for jobless benefits last week is the biggest weekly drop since last summer. Even better, this fall comes at time of heightened anxiety for this data series and so the latest turn for the better is welcome for all the usual reasons, and more.
In recent weeks we've been concerned that the encouraging trend in jobless claims since March 2009 might have run its course, as we discussed here and here. Today's news offers a reprieve, at least for the moment. As the chart below reminds, the falling trend in jobless claims appears to be intact after all, or so the number du jour implies. Had the report leaned the other way, well, let's just say that we probably dodged a bullet, or maybe a freight train.
Nonetheless, the tension between the forces of recovery and the headwinds of stagnation haven't gone away. We're not going to repeat here all the various ill winds blowing other than to note that our basic concern about slow job growth is still very much on the docket, as we noted here. Indeed, while the latest report on new jobless claims offers a fresh round of optimism, the bigger picture remains clouded, to say the least.
What are the prospects for sunny skies? That's going to take a while. As we reminded last month, the three Ds of debt, deleveraging and default are clear and present dangers. The question is one of whether the markets will tolerate the long time horizon that's required for processing all the red ink. For the moment, the crowd is willing to see the glass half full, but it's not obvious that this goodwill will run on indefinitely. For a rather chilling perspective on the D trio and the implications, see Niall Ferguson's piece in today's FT.
So, yes, today's jobless claims numbers deserve a collective sigh. We dodged a bullet—again. But the larger macro risks are still with us. It's mid-February on the calendar, but it's still going to be a long year.
THE STRANGE WORLD OF INVESTMENT ADVICE
Jason Zweig's latest investing column in The Wall Street Journal is disturbing, but not necessarily for the reasons he outlines.
Consider this passage: "…many investors who followed the best advice were punished the worst. Someone who held a total-stock-market index fund lost more than 58% from October 2007 through March 2009 and remains 31% behind even after last year's recovery. " Zweig goes on to note that "these people can't blame themselves; they did as they had been told."
My first reaction is to question who was handing out "best advice" that recommended owning a stock-index fund in isolation? Okay, let's be generous and assume that the equity index fund was owned along with other funds that targeted other asset classes. Even then, analyzing an equity index fund alone, rather than in concert with the entire portfolio, offers a distorted view of portfolio strategy. So too does using a short time frame for assessing success or failure. If you're day trading, presumably you understand the risks. But if you're a medium-to-long-term investor, reviewing recent history as the last word on portfolio strategy is a bit like trying to figure out the value of a car by looking only at the tires. It's certainly easy, but not very productive if we're looking for strategic-minded intelligence.
If we step back and consider what financial economics has taught us over the decades, the first rule is to own a broad mix of asset classes. The starting point is simply to own everything, in its market-cap weight. We calculate such a benchmark--the Global Market Index--for our monthly newsletter, The Beta Investment Report, which focuses on asset allocation design and management using ETFs and index mutual funds. As we discussed earlier in the week, this know-nothing portfolio has generated a modest gain over the past 10 years: a 3.9% annualized total return vs. a slight annualized loss for the S&P 500 (-0.8%). In addition, a mindless rebalancing of the multi-asset class portfolio at the end of each year raised the 3.9% annualized total return by around 90 basis points.
In other words, an investor who diversified broadly, across all the major asset classes, and simply rebalanced every December 31 back to initial weights, would have earned a modest return over the past 10 years. What's more, this isn't rocket science, nor is the concept particularly new.
As I explain in my new book, Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor, financial economics has been dispensing prudent advice for portfolio strategy for decades. Even better, there's a constant stream of new intelligence on asset pricing and portfolio design. When you boil it all down, the first step is owning a broad mix of asset classes—i.e., asset allocation. Step two, rebalance the mix. Yes, there's lots of nuance in those steps. Fair-minded people can debate certain details in the real-world oversight of portfolios. Indeed, there's also sorts of issues to consider, much of which comes down to deciding how you differ from the average investor. But as a basic proposition, this pair of rules is a pretty good starting point for designing an investment strategy.
Should we deviate from rules one and two? Should we employ additional rules? Perhaps, but you'll need a compelling reason, a bit of skill and a deep understanding of asset pricing and how markets can deviate from equilibrium. It would help if you're smarter than the average investor. A more plausible reason to do something different than simply own the broad, passively managed market portfolio is that you have a different risk tolerance and investment objective than the average investor.
But it all starts with steps one and two: asset allocation and rebalancing. This constitutes the foundation of the "best advice" that decades of financial economics has dispensed. If we were talking of medicine or aviation, the advice would be widely embraced. But this is finance and so what constitutes prudent counsel is regularly ignored or dismissed.
Does this mean that broad-minded asset allocation and routine rebalancing is a guarantee of investment success? No, of course not, particularly in the short term. If you absolutely must have a guaranteed income over the short and even long term, you probably shouldn't own the market portfolio. At the very least, it should be a small part of your investable assets. On the other hand, if you tolerate some risk, can live with volatility in the short run, and you need to earn something more than the risk-free rate in the years ahead, the basic framework for tackling the challenge is clear.
There are no perfect solutions in the quest to earn a risk premium, but some choices are better than others.
February 10, 2010
BERNANKE SPEAKS OF EXITS & THINGS...
The snow didn't stop Ben. Blizzard or not, there were no stormy surprses in Fed Chairman Bernanke's testimony today in Congress. Yes, the central bank was contemplating an exit strategy, but nothing was imminent.
"We have been working to ensure that we have the tools to reverse, at the appropriate time, the currently very high degree of monetary stimulus," he said, according to prepared remarks. "We have full confidence that, when the time comes, we will be ready to do so."
How might such an exit strategy unfold? Bernanke considered one scenario:
One possible sequence would involve the Federal Reserve continuing to test its tools for draining reserves on a limited basis, in order to further ensure preparedness and to give market participants a period of time to become familiar with their operation. As the time for the removal of policy accommodation draws near, those operations could be scaled up to drain more significant volumes of reserve balances to provide tighter control over short-term interest rates. The actual firming of policy would then be implemented through an increase in the interest rate paid on reserves. If economic and financial developments were to require a more rapid exit from the current highly accommodative policy, however, the Federal Reserve could increase the interest rate paid on reserves at about the same time it commences significant draining operations.
Nonetheless, he emphasized: "I currently do not anticipate that the Federal Reserve will sell any of its security holdings in the near term, at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery."
Many commenters take Bernanke at his word. Calculated Risk, for instance, writes today in the wake of Ben's testimony: "It is unlikely that the Fed will raise the Fed Funds rate any time soon (very unlikely this year, and maybe not in 2011)."
But not everyone is so sure that low rates have long legs (still). Wall Street vet Larry Doyle opines that Bernanke today "just sent a very clear sign that he is getting ready to start tightening monetary policy."
As for Fed funds futures this afternoon, the market's still expecting more of the same for the foreseeable future: a 0%-0.25% Fed funds target rate.
The more things change...
REGULATION VS. REGULATION
Is the goal of avoiding the risk of "too big to fail" in regulating banks by keeping them smaller too improbable to work? Yes, according to Avinash Persaud of Intelligence Capital, a financial advisory firm. In a new essay posted today on Vox, he argues that policymakers should instead focus on making "the financial system less sensitive to the error in the markets’ estimate of risk..."
He goes on to write,
In the US, perhaps reflecting a greater belief in markets and a stronger mistrust of regulation, the emphasis has been on finding market-friendly ways to contain the spillover of bank failure. US policy debates are occupied with concerns that banks should not be “too big to fail”; that private investors, not taxpayers, should hold “contingent capital” which carry implicit or explicit conversion into equity in a crash, and that improvements must be made to the functioning of “over-the-counter” markets through greater use of centralised trading, clearing, and settlement. These proposals are less about modifying capital requirements and more about prohibition and taxation and are micro-prudential in nature. Banks would not be allowed to do “risky” things (the “Volcker Plan”) and large balance sheets will be taxed to repay the bailout funds (“the Obama Levy”).
A better approach starts by first recognizing that error in banking is "strongly correlated to the boom-bust cycle." In other words, there's only so much that regulation can do, even if it's enlightened regulation. The business cycle isn't going away, no matter how many laws Congress enacts. Meantime, policymakers need to emphasize efforts on reducing "the sensitivity of the financial system to the errors of estimating risk" by limiting "the flow of risks to institutions with a structural capacity for holding that risk, and not a statistical capacity."
"Bank balance sheets bloated by leverage are systemically dangerous," he continues, "and regulatory or fiscal policy should address this through liquidity buffers and leverage ratios.
But given how contagious crises are, it is likely that what is “too big to fail” is actually small. Any list of institutions that were “too big to fail” conjured up in 2006 would not have included Northern Rock, Bradford & Bingley, IKB, Bear Sterns or even Lehman Brothers. Banks lend to banks. While some are more illiquid than others, they are intrinsically illiquid institutions. It does not take a large failure to lead to panic. High-yielding deposits can fly out of the website almost as quickly as money market funds can withdraw. In a crisis almost everyone is “too big to fail”.
Moreover, we can have as large a boom and subsequent crash, with the same economic misery, in a world of only small banks. Some will recall the 1973-1975 Secondary Banking Crisis in the UK, in which 30 relatively small financial institutions had to be supported by the Bank of England following the preceding property boom. The 1973-1975 crisis rivals, and on some measures exceeds, the impact on the UK of the current financial crisis. It was one of the reasons that developed country regulators began to take a more benign view of large banks snapping up smaller ones. The fashionable argument of the day was that small, competitive, financial institutions were inefficient and had little “franchise value” and so they would under invest in their own longevity – by having less conservative lending practices – than larger, more profitable banks.
Crashes follow booms. Booms are fuelled by some new dawn – normally the arrival of new technology – that makes bankers feel that the world is a brighter place, risks have fallen, and that they are therefore justified in lending and leveraging more. This behaviour is even more acute in the modern age of “risk-sensitive” regulation than in the old-fashioned world of credit and concentration limits and lending rules of thumb. The systemic effect of having one large bank engaged in rapid lending growth is no different than having several small banks do so. It may even be easier to resolve a crisis with one large bank.
"It's naive to think 'too big to fail' is going to go away," Gil Schwartz, a partner at Schwartz & Ballen LLP, tells American Banker via Financial-Planning.com. Regulatory reform "may change the nature of the problem, but I don't think it will ever go away. It will always lurk in the shadows that an institution is too big to fail and the government won't let it fail."
Someone should tell the folks in Washington.
STAG + INFLATION?
No one's talking about stagflation these days, and for good reason. Inflation expectations remain quite low in the U.S., although the outlook for prices has been rising over the past year, albeit from a depressed state. As such, the stag part of the equation--a stagnant economy--seems more likely, although one might think otherwise in the wake of the latest GDP report, which superficially looked quite strong. But there may be less to the top-line rise in GDP than it appears, as we discussed.
As for the prospects of stagflation--higher inflation and relatively low economic growth--the Bank of England offers a reason to reconsider the possibilities. The BoE's outlook for the range of GDP growth " is as wide as ever but, importantly, it’s sliding down the scale," FT Alphaville notes today, citing the the Old Lady of Threadneedle Street's latest Inflation Report. "Whereas the central bank was once forecasting economic growth in the region of 0 to 7 per cent, it’s now forecasting something like negative 1 per cent to 6 per cent." Inflation expectations, on the other hand, are unchanged.
That's hardly the end of the world, given the relatively low outlook for inflation generally. But the combination of falling expectations for GDP without the same for pricing pressures is a trend we can do without. Unfortunately, others see the possibilities of stagflation too. Hong Kong may be facing low growth and higher inflation, warns Hang Seng Bank. Meanwhile, economist John Cochrane of University of Chicago recently said: "My biggest worry is stagflation. That is where I am much more pessimistic than everybody else."
February 9, 2010
DOES INDEXING MAKE SENSE IN "INEFFICIENT" MARKETS?
Since the first index fund was launched in the early 1970s, the concept of passive investing has come a long way in terms of earning respect. For broad U.S. equity mandates in particular, finding supporters of active management is getting tougher in the 21st century. And among those managers who claim to mint alpha relative to broadly defined benchmarks, such as the Russell 3000 and MSCI U.S. Broad Market Index, many track records look a lot less impressive after adjusting for size (market cap) and style (value).
But the case for indexing isn't nearly so persuasive in other asset classes, or so the skeptics argue. In emerging markets, for instance, the argument is that equity trading is less efficient compared to the U.S. and so the opportunities for minting alpha are higher.
Does this claim stand up to scrutiny? No, according to Paul Lohrey, Vanguard's chief investment officer for Europe. In a recent essay, he asserts that "the idea that investors in this asset class [emerging market stocks] are better off with actively managed portfolios should be challenged. Taken as a group, active managers fail to consistently add value to emerging market portfolios after expenses. In fact, over the past ten years, 81% of actively managed emerging market funds have underperformed the FTSE All-World Emerging Index."
Of course, you'd expect someone from Vanguard to make such a claim. Indexing, after all, is the company's bread and butter. That inspires looking at the numbers again, and courtesy of Morningstar's Principia software, the task is quite easy.
There are 91 mutual funds and ETFs in Morningtar's diversified emerging market equity category with three years of history through last month (our screen ignores various share classes for a given mutual fund). For the trailing 3 years through January 31, 2010, the annualized total returns range from a high of 8.1% down to a loss of 23.5%, the latter being a victim of leverage.
By contrast, a popular index in this space (MSCI Emerging Markets) posted a 3.5% annualized total return through last month. How many emerging market funds beat the index over the past 36 months? Twenty, or about 22% of the pool of funds with track records stretching back at least 3 years.
Perhaps three years isn't a fair sampling of the historical record. Okay, let's look at the trailing 10 years through the end of January. Over that run, MSCI Emerging Markets' annualized total return is 9.1%. Meantime, there are 56 funds in Principia's database with records at least that long. The range of returns for those 56 portfolios runs from a high of 14.8% to a low of 2.1%. As it turns out, 22 funds beat MSCI EM over the past decade, which means that nearly 40% earned benchmark-beating returns.
That's better, but it still doesn't make a strong case for thinking that generating alpha is easy or sommon in emerging markets. What's more, similar results apply to the other major asset classes too. A relevant index that's designed as a proxy for a broadly defined asset class tends to capture middling results if not slightly better than middling over time, depending on how much active managers in the space are charging.
You could, of course, spend a lot of time analyzing the expanding universe of actively managed funds. There's no guarantee that you'll hit pay dirt, although you're sure to create a hefty workload. You'll also pay more, perhaps much more, regardless of whether you earn more or not. All of these caveats are compounded if you plan on owning a multi-asset class portfolio, in which case you'll have to pick superior managers across the array of capital and commodity markets.
Can it be done? Sure. But the real question is this: How much confidence do you have that you'll be able to identify investment talent, in advance and in enough of your investments to rationalize paying the extra costs of active management, which can add up to as much as 100 to 200 basis points. Yes, some investors are able to pull this off, but the majority don't. The tragedy is that the average investor often ends up with middling results at actively managed prices.
Maybe, just maybe, your time and effort is better spent at evaluating the betas and the overall asset allocation and deciding how and when to overweight/underweight via the lowest-cost index funds and ETFs. Yes, this is hard too. But you've got to make these strategic decisions even if you own active managers.
In fact, if you're halfway successful in managing the asset allocation, the heavy lifting is already done. Superior choices in picking active managers can add incremental return in a multi-asset class portfolio, but not much. Unless you're willing to make extreme strategic bets in the asset allocation, favoring active management probably won't change your portfolio results other than to create a performance drag. That is, unless you're in the top decile of the population when it comes to figuring out who'll beat the index and who won't.
REBALANCING & THE GLOBAL MARKET INDEX
There are countless investment strategies, but arguably there's only one true benchmark: the market portfolio, defined as a passive allocation to all the major asset classes, initially weighted by the relative dollar values and thereafter left to the whim of market fluctuation.
This benchmark isn't necessarily appropriate for everyone as an investment strategy, although it's easy and inexpensive to build, thanks to the proliferation of index funds, ETFs and ETNs. Yes, it's a mindless measure of the risk and return profile from a broad-minded definition of markets. And yet the results over time, although middling (as you'd expect), look pretty good these days.
Our definition of the market portfolio is a passive allocation to a global mix of equities, bonds, REITs and commodities. Our proprietary Global Market Index (GMI) fits the bill and is the benchmark for The Beta Investment Report. GMI is no silver bullet and it's been known to lose money at times. But it offers a reasonable proxy for owning everything and questioning nothing. How has this know-nothing strategy fared? For the 10 years through the end of January 2010, GMI's posted an annualized 3.9% total return. That compares with a small annualized loss for the S&P 500 (-0.8%). Meantime, U.S. bonds overall have done better over the past 10 years via the Barclays U.S. Aggregate Bond Index, which is up 6.5% an annualized basis.
There are 11 components to GMI, and we update the results monthly (plus the return for cash) on these pages, including the latest installment here. There are alternative ways of profiling the markets, but this is a good place to start to tackle the burning issue in portfolio strategy: Deciding if it's timely to overweight this or that asset class and to what degree.
Delivering some insight on an ongoing basis is the raison d'etre of our subscriber-only newsletter (The Beta Investment Report). Then again, not every strategic-minded portfolio decision requires deep analysis. Some techniques for adding value are simple and require no particular talent or knowledge per se. That inspires looking to GMI and asking what can we do to enhance risk-adjusted performance with little or no effort? One answer is rebalancing, which we're defining as reacting to previous market changes. Tactical asset allocation, by contrast, is rebalancing based on forecasting. That's another issue entirely.
As for monitoring and measuring rebalancing's payoff, if any, we recently launched a companion index to GMI that is identical to the original except that it's rebalanced every December 31 back to GMI's initial asset allocation as of December 31, 1997, when the index was launched. How have the two benchmarks fared? The graph below compares results from the close of 1997 through the end of last month—a bit more than 12 years of history.
As you can see, the rebalanced version of the index (GMI-R) has outperformed its unmanaged counterpart (GMI). On an annualized basis, that works out to around a 90-basis-point bonus for rebalancing. That's not surprising. A number of researchers, including author and financial planner William Bernstein, have found that rebalancing can add 50 to 100 basis points of incremental return for a diversified portfolio.
Of course, it'd be foolish to expect a rebalancing bonus to arrive each and every month like clockwork. Nor should we automatically assume that we'll earn more from rebalancing over longer periods, even a few years. Ideally, the rebalancing bonus will reveal itself over a full business cycle or two. But there are no guarantees. This is finance, after all. But as techniques for adding value go, rebalancing is among the relatively worthy choices to consider, either alone or in concert with other applications.
On that note, it's possible to earn a richer rebalancing bonus if we do something more than simply rebalance mindlessly at the end of every year, as is GMI-R's methodology. As I outline in my book, Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor, there are a number of techniques to consider for enhancing a naïve rebalancing strategy. For example, one could adopt of more opportunistic approach to rebalancing by focusing on those times when asset allocation changes to your portfolio are extreme. Watching performance momentum, relative return spreads, dividend yields (along with dozens of other metrics) have been shown to be useful at times as well.
Keeping an eye on the various signals that may be productive for managing asset allocation is the premise behind The Beta Investment Report. In a world that's obsessed with finding short cuts to quick profits, the motivation for the newsletter is monitoring the major asset classes for clues that can improve risk-adjusted performance of broadly diversified portfolios over the medium-to-long-term horizon using index funds and exchange-traded securities. In short, we're trying to bring a little strategic perspective to the care and feeding of betas.
Nonetheless, we can't lose sight of the fact that over the long haul, higher return generally arrives only by embracing additional risk. In the end, we're all risk managers. Then again, not all risk-management techniques are created equal. Rebalancing, for instance, is a technique that almost everyone can employ productively. Assuming, of course, you have a broadly diversified portfolio across the major asset classes.
Asset allocation and rebalancing, in sum, constitute the first two steps on the thousand-mile journey of investing.
February 8, 2010
ENTER THE EXIT STRATEGY
Fed Chairman Ben Bernanke will be chatting up the central bank’s exit strategy later this week when he testifies before the House Financial Services Committee on February 10. To say that there are political and economic risks hovering over the subject is to understate the potential hazards.
There are risks to tightening too early, which some worry would repeat the mistakes of 1936-1937, when reserve requirements were tightened and the economy slipped into recession. At the same time, it'd be foolish to discount the potential for higher inflation in the years ahead in the wake of the extraordinary monetary stimulus over the past year or so. Regardless of the economic reality, the political pressure to keep rates low is intense, given the weak labor market.
In late-January, Carnegie Mellon Professor Alan Meltzer bluntly responded to Bernanke’s commentary on the details of an exit strategy by opining that the Fed chairman’s plan is destined to fail. Meltzer, author of a sweeping two-volume history of the Fed (A History of the Federal Reserve, Volume 1: 1913-1951 and A History of the Federal Reserve, Volume 2, 1970-1986), said that Bernanke's plan to prevent future inflation is "incomplete." As Meltzer explains, "The Fed recently began to pay interest to banks on the reserves they hold in their vaults. Using this new tool, it claims the ability to get banks to keep the money instead of lending it out, thus containing the money supply and inflation. I don't believe this will work, and no one else should."
Will Ben respond to the criticism and soothe Meltzer's concerns? Stay tuned. For the moment, however, the stakes are low, or so the market outlook for inflation suggests. The Treasury market's 10-year inflation forecast is a modest 2.27%, based on the spread between the nominal and inflation-indexed 10-year Treasuries as of Friday's close.
That's roughly in line with the inflation outlook just before all hell broke loose in September 2008, when Lehman Brothers failed and the financial troubles at the time exploded into a crisis. Among the fallout from the chain of events that month was the heightened risk of deflation. Judging by the market's forecast these days, the deflation risk has faded. Yet the inflation risk at the moment looks tame.
No wonder that the Fed funds futures market anticipates no imminent change in short term rates. If we look out a year, the futures market expects the Fed to raise interest rates, but just barely. The February 2011 contract is currently priced for a roughly 0.75% Fed funds. That's up from the current 0-0.25% target range, but as changes in rate expectations go, that's rather subdued.
Will Ben's testimony on Thursday give us reason to rethink the future of inflation and interest rates?
February 5, 2010
THE PUNDITS & THE LABOR MARKET
Today's employment report was, well, discouraging. Or was it? The range of opinion was unusually wide, or so it seems.
The reported facts, at least, are clear. Quoting from the Labor Department's press release, "The unemployment rate fell from 10.0 to 9.7% in January, and nonfarm payroll employment was essentially unchanged (-20,000), the U.S. Bureau of Labor Statistics reported today. Employment fell in construction and in transportation and warehousing, while temporary help services and retail trade added jobs."
But that's just the beginning. Or is it the end? You decide. Here's a sampling of the commentary on today's numbers that, for one reason or another, caught our attention...
● “The question is, what is the rate of improvement going to be? Very slow. We don’t see companies going crazy on the hiring.”
Joshua Shapiro, chief United States economist at MFR Inc.
New York Times
● "Today's employment report from the Bureau of Labor Statistics, showing that unemployment fell to 9.7 percent in January, provides fresh evidence that the labor market has stabilized and our nation has turned a corner."
Rep. Carolyn Maloney, congresswoman (D-NY)
● "The Bureau of Labor Statistics (BLS) employment report for January contains mixed signals about the job market’s emergence from the 2008-2009 recession. The household survey showed a sizeable drop in the unemployment rate – down 0.3 percentage points from December 2009 and down 0.4 percentage points since the peak unemployment rate in October. The fall in unemployment cannot be explained by a rise in the number of discouraged workers or any further decline in the labor force participation rate. On the contrary, the household survey shows a rise in the participation rate. The reason unemployment fell is that the number of Americans who report being employed rose substantially. This is heartening news."
Gary Burtless, Senior Fellow, economic studies
● "The drop in the unemployment rate, from 10% to 9.7%, is grabbing a lot of attention, but I'd suggest that's not providing the most accurate picture of the labour market. Looking instead at the establishment data, we see that the employment picture was more or less flat in January (payrolls officially fell by 20,000), but that labour markets are struggling to climb out of a much deeper hole than was initially realised..."
The Economist.com blog
● "The latest unemployment rate of 9.7 percent is an unexpected jolt of good news. That's down from 10 percent in December and even lower than the 9.8 percent the Obama administration projects for the end of this year. That encouraging number raises an obvious question: Is it an aberration or a positive indication that we are indeed coming out of the recession in the only way that matters to most people, the ability to readily find work? Buried in the numbers there is reason to hope."
Dale McFeatters, Scripps Howard News Service
● "Today's report contained the much-awaited annual benchmark adjustment that added 930,000 lost jobs which had not been counted between April 2008 and March 2009. Since the start of the recession in December 2007, payroll employment has fallen by 8.4 million. Before today's adjustment, job losses had totaled 7.2 million. The adjustment happens every year, but this year's is especially large. A number of economists blame the BLS's birth-death model for the problem. This is a 10-year-old formula for calculating the number of jobs created as businesses are born and die. The trouble is that it doesn't seem to work very well in a recession. And while we now know how many lost jobs it didn't count nearly a year ago, we won't know until a year from now how many jobs the birth-death model will have miscalculated from April 2009 until March 2010. We do know the the model 'created' nearly a million jobs in the nine months ending in December. How many of them are real?"
● "...much of the job growth in the past has been in the public sector and through gimmicks such as the so-called 'cash for clunkers,' and this is unsustainable as a foundation for long-term economic growth. While private industry appears to be replenishing depleted inventories, many manufacturers are skittish about significantly increasing production to meet rising consumer demand that may not be there. This is still a very risk-averse economic environment."
Samuel R. Staley, director of Urban & Land Use Policy at the Reason Foundation
● "With the unemployment rate falling from 10.0 to 9.7 the employment report implies that the economy is in a transition phase. The period of widespread layoff and job cuts is over. So if you still have a job the odds of your losing it have roughly returned to normal. This change is reflected in the improvement in personal confidence. But firms have not yet begin widespread hiring. So if you are still looking for a job it is going to be rough."
CFA INSTITUTE REVIEWS MY BOOK
Martin Fridson of Fridson Investment Advisors reviews my new book, Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor, via the CFA Institute.
JANUARY'S EMPLOYMENT REPORT: ANOTHER DISAPPOINTMENT
Always a bridesmaid, never a bride. That about sums up the struggle in nonfarm payrolls to reach the tipping point of growth (or at least zero).
This morning's update for January tells us that the economy is still losing jobs. In the optimistic words of the Labor Department's press release, last month's 20,000 decline in nonfarm payrolls amounts to a labor market that's "essentially unchanged" for January. Yes, we recognize the statistical reasoning for saying so. A decline of 20,000 jobs in a labor force of nearly 130 million is statistically insignificant—a decline of less than two-hundredths of one percent. But the scribes at the Labor Department have chosen their words poorly for the press release du jour. The economy has now lost over 8 million jobs since the recession began in December 2007, and the losses continue. The red ink is relatively slight, to be sure, but continuing nonetheless. Calling another loss of jobs--any loss of jobs--as a status of "essentially unchanged" at this late date is not only unecessary, it appears to trivialize what is clearly the deepest and longest-running dent in the labor market since the Great Depression.
But enough of complaining about poor manners and ill-advised rhetoric. As for the numbers dispensed today, there's some good news in the sense that the Labor Department revised upward the November nonfarm payrolls count: the month had a net gain of 64,000 jobs, much better than the rise of 4,000 previously reported. Unfortunately, the revision for the rest of the year is uniformly worse off than originally reported. Bottom line: the Labor Department tells us that the economy was lighter by more than 600,000 nonfarm jobs than originally estimated.
At this point the details don't matter and revisions are of little relevance save for the academics who'll be studying the numbers in the years ahead. For now, the only issue is reaching the point of nirvana, that glorious realm where the trend in nonfarm payrolls is something other than a loss. We're not there yet, the "essentially unchanged" status notwithstanding.
Yes, we're close. Zero and above zero seem to be well within the economy's grasp. But with each near miss, the disappointment builds and so the case for arguing that the "essentially unchanged" status will linger well into 2010 becomes a bit more persuasive. Next month, is all we're left with. Maybe, maybe not.
The longer this drags on, the higher the odds that we're facing an even weaker post-recession job recovery than previously anticipated. And that's saying something. We've been opining for some time now that the labor market's "recovery" is likely to be weak this time (for example, see our posts here and here). Perhaps even weaker than we thought.
In fact, we expect zero to arrive, more or less, in the months ahead. The problem is still that there's some doubt about the capacity for generating numbers of substance above zilch on a sustainable basis.
February 4, 2010
WHAT ARE THE LEADING INVESTMENT TRENDS FOR 2010?
Mercer, the consultancy, has some thoughts. Ten, to be exact...
1. Superannuation legislation will force change in the way we look at retirement and how retirement savings are invested
2. A weaker global banking system will create opportunities for private credit
3. Emerging market growth will outstrip developed markets, but equity markets may have priced this in
4. Environmental, Social and Governance (ESG) factors will continue to rise on investors’ radar
5. Investors will critically examine their investment strategies in the context of evolving deflation/inflation risks
6. Dynamic Asset Allocation (medium-term asset allocation tilts) will be de rigueur to capture market mispricing in the medium-term
7. Investors will undertake more due-diligence on hedge fund strategies
8. The big “macro” moves may be behind us - time to become “micro”?
9. Super funds will question the role of illiquid assets in their portfolios
10. Diversification will remain key.
HEY, BUDDY...CAN YOU SPARE A LOAN?
Yields on short-term government securities vary from just above zero (10 basis points for 3-month T-bills) to around 1% (88 basis points for a 2-year Treasury). Those are extraordinarily low rates by the standards of recent decades. But don’t confuse that with borrowing costs, or the demand or ability to borrow.
Finding loans is tough. Commercial and industrial lending continues to fall. In last year’s fourth quarter, C&I loans were down more than 5%, even though top-line GDP climbed at an annualized real 5.7% rate.
For consumers, the state of borrowing isn’t encouraging either. The St. Louis Fed recently crunched some numbers on so-called consumer loan spreads, defined as "the amount they would earn on a weighted average of funds held in M2 (which is essentially cash on hand or in easily accessible bank accounts)." The bottom line: the cost of funds remains high for consumers. In fact, the credit card spread "is higher today than at any time in the past decade—even when the federal funds rate was as high as 6.5 percent in 2000:Q4," according to William Gavin at the St. Louis Fed.
On the other hand, perhaps this is something of a moot point. Joe Sixpack seems intent on saving more these days. The personal savings rate (measured as a % of disposable personal income) was 4.6% in last year's fourth quarter, more than double the level in 2008's third quarter. That's hardly a surprise, given the current economic backdrop and the general need to repair household balance sheets. But to the extent that economic recovery depends on a robust increase in consumer spending, there's reason to stay cautious (as if we needed another reason).
A CHANGE IN THE TREND?
Last week we pondered the possibility that an ill wind was blowing in what had been a fairly consistent decline in initial jobless claims. Today’s update on new filings for jobless benefits doesn't offering a soothing follow-up. If anything, we're more anxious.
Initial claims rose last week to 480,000, the highest since mid-December. Now before we go off the deep end, let's recognize that rising jobless claims in January and February is hardly unprecedented. Meanwhile, the general decline in this data series still looks intact and one can argue that the recent rise in claims is still within the bounds of statistical noise. But let's also recognize we're bumping up against the thin line of statistical noise vs. a turn for the worse in the generally improving trend of initial jobless claims. Exactly where and when one gives way to the other is debatable and inherently speculative in real time.
Good news in tomorrow's payroll report for January would certainly go a long way in easing our concerns about the recent rise in jobless claims. In short, we'd like to see at least some modest job growth on a net basis for nonfarm payrolls. Indeed, the hour is late—it's now well beyond two years since the recession began and monthly nonfarm jobs dipped into the red on a monthly.
Almost a year ago we wrote that a peak in jobless claims would bring a strong signal that the end of recession was near, at least on a top-down, GDP-measured basis. As it turned out, jobless claims peaked in March 2009 and the rest of the year was generally one of recovery on a number of broad economic metrics along with the stock market, which rallied dramatically from the spring of last year onward.
But now we have the possibility that the decline in initial jobless claims is stalling. It's too soon to say for sure, of course, but the possibility is suddenly no longer beyond the pale. Before we say any more, let's first have a look at tomorrow's payroll numbers.
February 3, 2010
MONETARY VS. FISCAL STIMULUS
Economist Scott Sumner makes the case that if we need more stimulus, it should be of the monetary variety rather than fiscal. That sounds about right, based on my analysis at 2009's close that if there's any evidence in favor of economically stimulating stimulus over the past year or so, the clues suggest that the monetary toolkit was the productive catalyst for averting a deeper contraction/crisis.
YOUR EDITOR ON THE RADIO...
I'll be discussing the finer points of portfolio strategy, strategic-minded investing and my new book (Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor) this coming Monday evening, February 8, on the Gabriel Wisdom Radio Show. The 60-minute show airs at 7 p.m. on the East Coast (4 p.m in the West). I'm scheduled for 7:30 eastern time. You can listen live via the link above or by way of the conventional channels with terrestrial radio (find your local station here.) In addition, the show will be archived here.
CLEAR GRASP OF THE OBVIOUS
Is it really necessary to remind folks not to spend the rent (or college) money on the slot machines? And if someone is actually engaging in such obsessive and self-destructive behavior, is a casual comment to do otherwise from a stranger on TV likely to make a difference? Apparently the President of the United States thinks so. Maybe he's right. In that case, let me remind everyone to be sensible and avoid the following: driving with your eyes closed, investing every last dime of your life savings in out-of-the-money options and expecting that politicians will focus (and speak) on the priorities du jour.
ADP REPORTS A (SMALL) JOB LOSS FOR JANUARY PAYROLLS
ADP’s estimate of nonfarm payrolls for January shows a 22,000 decline. That’s in contrast with the consensus view of economists, who collectively expect a small rise of 13,000 in the official jobs report from the U.S. Labor Department, which is scheduled for release on Friday.
The reported loss by ADP is an improvement over its revised job loss estimate of 61,000 for December. "Growth of overall private employment is on the verge of turning positive," according to Joel Prakken, chairman of Macroeconomic Advisers, ADP’s partner in compiling this data series, via MarketWatch.com.
The view that the economy is close to the point where payrolls will rise seems to be fairly widespread at the moment. For instance, John Canally, an economist at LPL Financial, responds to the ADP payroll news and tells CNNMoney.com: "We aren't doing a whole lot of hiring yet, but I think you can safely say the firing is starting to stop. And this shows that we're close to adding more jobs."
Meanwhile, John Challenger of Challenger, Gray & Christmas, an employment placement firm, explains today via Bloomberg News: "We are certainly starting 2010 on better footing than a year ago. It could be several months before hiring begins to accelerate but, in the meantime, employers are trying to hold on to the skilled workers they have counted on to get them through this downturn."
Onward to Friday morning at 8:30, when the number arrives…
THE TROUBLE WITH MICRO-CAP STOCK INVESTING
Microcap stocks soared last year, even by the inflated standards of the broad market. The CRSP Decile 10 Index (the smallest of the small in micro-cap land) surged more than 80% last year vs. a bit more than 26% for the S&P 500.
Why didn’t investors in funds targeting this slice of equities reap the lion’s share of the rewards? Rick Ferri of Portfolio Solutions explains the gap (hat tip to Mebane Faber’s World Beta blog). Ferri argues that microcap index funds “don't exist, because micro-caps are too small for index funds and ETFs to invest in.”
We’ll have more to say on the subject in the near future in terms of what it means for multi-asset class investing. Meanwhile, you can read Ferri’s article at Forbes.com.
JOBS, JOBS, JOBS
Friday's nonfarm payrolls promises (threatens?) to be a critical update on the labor market. Basically the question is, If not now, when?
The Great Recession is technically over, but the labor market has yet to show any sympathy. Nonfarm payrolls have been retreating for more than two years—each and every month. Although net job creation is always among the last to arrive after recessions, the depth and length of the current/recent job destruction now begs for some evidence that recovery is at least possible if not robust. Even if job growth begins now, there's some reason to wonder about its sustainability and duration. As we wrote last month, it's going to be a long year.
But the year arrives one data point at a time. The next major update arrives on Friday, when all eyes will focus on Friday's nonfarm payrolls report for January. What should we expect? Briefing.com reports that the consensus outlook calls for a small rise of 13,000 in nonfarm payrolls. If so, that would be a welcome change from December's 80,000 loss. Meanwhile, Briefing's in-house forecast is a negative 40,000 change in nonfarm payolls for January.
For some additional perspective, here are a few of the speculations making the rounds...
● Rick MacDonald, director of investment research and analysis, Action Economics, via
BusinessWeek, Feb. 2, 2010
Following the "sea of red" for employment reports for much of the last two years, U.S. nonfarm payrolls are set to move back into positive territory in 2010, and perhaps as early as January, with the Feb. 5 release of the month's employment report. We should see stronger gains over the coming months, led by hiring for the U.S. Census, though economists will be tracking the private payroll figures to gauge the sustainability of job growth into the second half of the year.
For the January report, we expect an unchanged payroll figure with a 0.1% rise in the jobless rate to 10.1%. The average workweek should be unchanged at 33.2 hours, while average hourly earnings should rise 0.2%.
● Reuters, Feb 1, 2010
The median forecast for nonfarm payrolls is for an increase of 5,000 after an unexpected 85,000 drop in December. Forecasts range from a decrease of 97,000 to an increase of 100,000. The unemployment rate is seen rising to 10.1 percent from 10 percent in December. Forecasts range from 9.8 percent to 10.2 percent…The weather is a wild card for January payrolls. Given a rise in job losses in weather-sensitive sectors such as construction and leisure in December, analysts believe below-normal temperatures contributed to the surprise 85,000 drop in payrolls that month.
● Wall Street Journal, Feb. 3, 2010.
"Further reduced employment levels could be seen, as the consensus expects, but bear in mind that we may be around a turning point for the labor market. Still, we should not expect a rapid decline," said Raphaelle Knight, analyst at Newedge Group.
● CNNMoney.com, Feb. 1, 2010
The big report of the day [Friday, Feb 5] is the January jobs report from the Labor Department. Employers are expected to have added 13,000 jobs to their payrolls in the month after cutting 85,000 in the previous month. The unemployment rate, generated by a separate survey, is expected to hold steady at 10%.
February 2, 2010
THE CHALLENGE OF CHOICE
Yesterday’s Wall Street Journal warned that a "a treacherous landscape of potential trading problems" harasses the world of ETFs. Most of these problems are associated with liquidity. Some have it, some don't. Identifying the haves, and the have-nots, is prudent way to start looking at ETFs. But the task is daunting, at least in the beginning of your search, because of the sheer number of products to review.
Sifting through the potential list of choices takes more time with each passing month. There are more than 900 ETFs, according to Morningstar Principia, and the list keeps growing. That’s good news--lots of choices. It’s also bad news because you have to sort through the list in search of investor friendly products. There are also hundreds of index mutual funds to consider, if you’re so inclined. Most of these choices aren’t worth your time for reasons including high expense ratios, insufficient liquidity, high tracking error and poor overall design, to name a few.
But that’s just the beginning. Reviewing the fund candidates is no trivial task, although it’s all a sideshow to the primary task of designing and managing a multi-asset class portfolio.
Yes, asset allocation is simple in concept, but the details are messy. Truth be told, it’s really a full-time job. It’s not always rocket science, but it’s always time consuming. Wouldn't it be nice if someone routinely analyzed the list of potential ETFs, ETNs and index mutual funds and identified the best choices? And wouldn't it also be useful if someone also routinely analyzed the major asset classes with an eye on offering strategic perspective on the asset allocation challenge? In fact, that's the raison d'etre for The Beta Investment Report.
Half the battle is simply paring the ever-growing list of index fund products by separating the wheat from the chaff. That takes time and vigilance, but the paring pays off if only by keeping your investments away from the dogs. Our short list of funds is about 200 products, comprised of index mutual funds, ETFs and ETNs that run across the major asset classes and several key subgroups. Keeping the list short by focusing on the high-quality funds doesn’t take a Ph.D., but it does require a constant focus on pruning, watching and reading the details of the fund literature.
The other side of the coin is monitoring the markets for clues about optimizing asset allocation. What's our philosophy here? Actually, we wrote a book on the topic: Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor, which is published this month by Bloomberg Press.
The shorter version of how we think: start by tracking the market portfolio, which we define as all the world’s major investable asset classes (stocks, bonds, REITs and commodities), each weighted by their respective market values. The asset allocation of this market portfolio is a robust starting point for considering your own investment portfolio. The basic question: How should you alter Mr. Market’s asset allocation to suit your own particular profile, based on risk tolerance, time horizon, investment goals, etc. In addition, we can intelligently rebalance the resulting asset mix. Also, there are opportunities for tactical asset allocation (i.e., making changes based on forward-looking analysis). This is less about "market timing" vs. prudently harnessing the insights dispensed by financial economics over the decades, particuarly since the 1980s. What are the factors to consider? It's actually a long list, but it includes an array of variables including volatility and correlation trends, dividend yields, p/e ratios, yield curve analysis, return spreads, yield spreads, estimating equilibrium risk premia. And, of course, watching the business cycle for some insight on whether the wind is blowing in your favor, or not.
More and more choices are a good thing when it comes to investing. But there are no free lunches. As the world of index fund products expands, so too does the workload for staying up to date by sorting through the full menu. Indeed, most of the products available aren't worthy of consideration. That's not always obvious. Meanwhile, it's important to stay focused by keeping your eyes on the prize: earning a sufficient risk premium to fund your particular set of future liabilities.
The implied value proposition in the 21st century is that investing is easier and more efficient than ever. That's true in theory. In practice, however, the details are complicated. Liquidity is a critical issue, as the Journal article suggests. But that's just the tip of the strategic iceberg.
TIDBITS FROM THE WORLD ECONOMIC FORUM
Did you attend Davos this year? No? Neither did I. Next year, perhaps. Then again, maybe we're not missing all that much by staying home. Why suffer airports and rubber chicken lunches in the digital age? Well, it's true you can't have a quiet chat with Mr. X over a scotch and soda via the web with the Swiss Alps in the background. On the other hand, everyone can afford the out-of-pocket expense for taking a peek as a long distance web voyeur.
A pair of video clips from the confab that caught our eye, along with some late-night reading material for those long, cold winter nights...
● The FT's Martin Wolf hosts a chatter festival with some movers and shakers on the "Global Economic Outlook"
● Looking past the damage: "After the Financial Crisis: Consequences and Lessons Learned
● "Global Risks 2010," which includes this bit of risk management eye candy...
February 1, 2010
A FORK IN THE ROAD...
The December update on personal income and spending isn’t terribly informative. Disposable personal income rose 0.4% in December, modestly above the monthly average rise during 2009 (0.3%). Meanwhile, personal consumption expenditures increased 0.2% in December, or slightly below average based on the monthly average for last year (0.3%). It all rounds out to a yawn in terms of what one month's numbers tell us. Par for the course.
Still, it’s a bit unnerving to learn that the pace of consumer spending growth in December is down substantially from the 0.6% and 0.7% levels for October and November, respectively. But that’s not terribly surprising, given the ongoing contraction in the labor market. Meantime, there's the general recognition that Joe Sixpack needs to save more than he has been doing over the past generation. That's not exactly an encouraging prescription for what ails the economy at the moment. But it is what it is. Balancing long-term needs with short-term fixes, it seems, is the general dilemma that await, and no one really has a persausive solution.
As for the statistic du jour, if we step back and look at the 12-month rolling change in personal income and spending, it appears that we’ve reached a critical point. As our chart below shows, the annual pace of change for income and spending has nearly returned to the levels that prevailed just before the onset of the recession in December 2007. There’s some debate as to how much of this rebound is due the liquidity injections of monetary policy vs. stimuluative fiscal policy vs. the natural recovery process endemic in the business cycle. Meantime, the pressing issue is whether the bounce in spending and income will continue to climb or at least remain stable at current levels.
Ultimately, the answer resides with the labor market. The next installment of insight on the jobs front arrives this Friday, when the update on nonfarm payrolls is released. From our vantage, the stakes look unusually high (even by recent standards) on the news of whether the labor market is growing or not. If nonfarm payrolls can’t at least show a small net increase at this point, well, let’s not even go there...yet. Suffice to repeat what we said about the trend in nonfarm payrolls: the hour is late.
THE AGE OF NUANCE
January was a rough month for risky assets. For the first time since the financial crisis raged in late-2008, the red ink that spilled was broad and deep across the broad asset classes on a calendar-month basis. Bonds generally held their own in January, but stocks, REITs and commodities suffered sizable retreats.
It was an orderly bout of selling, at least compared to what prevailed a year ago. The bigger question is whether the reversal of January is a sign that the great reflation in the capital and commodity markets in 2009 is over. The answer is probably “yes.” Does that mean that a new bear market is upon us? No, or at least we don’t expect one. But it’s time to anticipate something other than strong, sustained rallies in everything. The money game now appears destined for a more complicated era.
If the intense wave of selling in late-2008 and early 2009 was the perfect storm, the past year or so has been the perfect rebound. After selling off deeply, risky assets were priced for a world of economic collapse. By the spring of 2009, it became clear that the world would survive, which triggered a wave of buying to return the price of risk to something closer to normal. That process is probably complete. If so, the future will bring more months like January, where a mix of results prevails.
Of course, we've been anticipating no less. Back on October 1, for instance, we wrote that "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." And so it has, at least for January. The complication, we think, has legs.
Indeed, the economic outlook is now more complicated, which has spilled over into asset pricing. Absolutes, for good and ill, have dominated in the recent past. Goodbye to all that. The age of nuance has only just begun.