April 30, 2010
FIRST QUARTER US GDP RISES 3.2%
The U.S. economy expanded at a robust pace in this year’s first quarter, the Bureau of Economic Analysis reported this morning. Real GDP increased by 3.2% on an annualized basis in the first three months of 2010. That’s considerably lower than the 5.6% surge in the previous quarter. But no one expected the powerful momentum in Q4 2009 to continue. The question was (and remains): How much will the economy slow after the initial snapback from the Great Recession? With fiscal and monetary stimulus destined to fade, the economy faces a transition. For now, growth still has the upper hand. The latest numbers, albeit the first of three estimates, suggest that the expansion has a foothold. Encouraging as that is, there’s still some concern about the quarters ahead. The risk that the rebound will stall is lower these days, but not yet low enough to dismiss the idea completely.
"We're still running on the fumes of stimulus in the U.S. economy," Diane Swonk, chief economist at Mesirow Financial, advised via the LA Times. "It's a recovery, but by any standard is still a muted recovery. But we're thankful to have what we've got,"
For the moment, however, there’s reason to celebrate today’s numbers. Let’s start by looking at the broad trend. As our first chart below shows, GDP’s 3.2% rise in the first three months of this year marks the third consecutive quarterly increase. That’s a notable downshift from the previous quarter, but by any other comparison the economy started the year on a strong note. What’s more, the rebound was broad based: consumer spending, investment and exports all posted healthy gains in Q1.
In fact, Joe Sixpack’s affinity for spending accelerated in the first quarter. The 3.6% jump in personal consumption expenditures in Q1 is the strongest quarterly rise in three years.
Within the consumer spending category, the strongest segment was in durable goods, which posted a real 11.3% jump in Q1, sharply higher over the meager 0.4% rise in Q4 2009. Considering that durable goods are the most cyclical sensitive of all the spending categories, the strong showing in the January-March period is encouraging for thinking that consumers are willing and able to spend. In an economy that draws some 70% of GDP from retail consumption, that’s no trivial point at this critical stage of the economic rebound.
But while the upward momentum in the consumer sector was unmistakable in Q1, there was a downshift in corporate investment. Gross private domestic investment (GDPI) grew in the first three months of this year, but at a considerably slower rate compared to last year’s Q4, as our next chart below shows. Granted, the 14.8% rise in GDPI is healthy. The question is whether the slowdown has legs? In other words, is the business sector set to turn cautious in the months and quarters ahead? If so, the consumer must shoulder more of the burden for keeping the rebound bubbling. Of course, that's less than a fail-safe proposition, given the existing headwinds on household balance sheets, thanks to the crushing losses in residential real estate and heightened debt levels built up during the pre-2008 boom.
Adding to the anxiety about corporate America’s prospects is the slowdown in exports in Q1. Although the value of net exports was comfortably in the black, the 5.8% rise was well below Q4 2010’s stellar 22.8% gain. Much has been made recently of the necessity of keeping America’s export machine humming as a critical element in maintaining the economic recovery. As such, the sharp deceleration in exports in Q1, while not unexpected, raises questions about what comes next.
Overall, it’s hard to complain. Surely the GDP report could have been a lot worse. The issue isn’t about Q1. As broad economic reports go, today’s news is encouraging. As such, the only remaining issue is whether the trend is sustainable. On that question there are several hazards lurking. The first is the labor market. Without a sustained increase in job creation, the Q1 numbers are almost surely headed for lesser levels in future reports.
There’s also the issue of whether today’s good news is still drawing strength from the so-called restocking effect. In the wake of the deepest recession since the 1930s, a certain amount of rebounding was destiny, and at an extraordinarily strong pace. Consumers and corporations went overboard in 2008 and early 2009 in cutting back on spending and investing. Understandably so, given the dire outlook in the months following the financial crisis in the fall of 2008. When it became clear that the system wouldn’t collapse, the economy responded accordingly. Was this a temporary readjustment? Or can growth continue without government stimulus and unusually strong cyclical resilience that was virtually assured in the wake of the Great Recession?
The answer increasingly depends on the labor market. There are reasons to be optimistic, as the previous payroll report suggests. Next Friday’s update on April’s labor market will undoubtedly be closely watched. In essence, the crowd will want to know if the cheer surrounding today’s GDP report is warranted. The next big clue arrives a week from today.
“It was a very strong quarter for the consumer,” said Nigel Gault, chief U.S. economist at IHS Global Insight, via Bloomberg BusinessWeek. “The important thing in the coming months is seeing employment starting to come back to give some income support.”
April 29, 2010
MARKOWITZ ON MPT
Harry Markowitz, who more or less invented modern portfolio theory with his 1952 paper “Portfolio Selection,” talks finance in a new Q&A published by the Journal of Financial Planning. Asked if he thought MPT was fatally wounded from the dramatic market volatility of recent years, he said, No: still alive and kicking. "In fact, it proved itself in the crisis rather than disproved itself," he asserted.
He then goes on to explain why modern finance is relevant…
Let me give you an example. There's a simplified model of covariance, a simplified model of portfolio theory that Bill Sharpe published in 1963 that said, "Things go up and down, you know, just assume that things go up and down together because they go up and down with the market. But, the amount that they go up varies from one asset class to another, depending on their beta."
So, the way they measure these things, the S&P 500 has a beta of one but the bonds have a much lower beta and emerging markets has a much higher beta. So, in 2008, the S&P 500 went down 38½ percent. Corporate bonds went down about 5 percent. Emerging markets went down about 60 percent. So, as things went up and down, roughly in proportion to their beta and people who had done a risk- return analysis and picked a portfolio high on the efficient frontier with a high beta, they got hammered a lot. But, on the average, over the long run, they should do better than the guys who are lower on the frontier, who got hammered less.
So, there was a risk-return tradeoff and things worked out, in accord to the beta of your portfolio. Things worked out as one would have anticipated.
He also noted that asset allocation—"top-down analysis"—has come a long way since his groundbreaking paper was first published. "People who have no more ability to pick stocks than I have are now able to do a risk-return analysis at an asset class level, and they get you on the right part of the [efficient] frontier. Then, they implement it in terms of mutual funds or ETFs. That was a stroke of genius."
PONDERING THE POSSIBILITIES OF REBOUND & RETREAT FOR JOBS
Will the Federal Reserve rethink its decision yesterday to keep Fed funds at just above zero after this morning’s news of a fall in new claims for unemployment last week? Not likely. Initial claims slipped by just 11,000. That’s welcome, of course, but if you’ve been following the soap opera with this data series you know that we’ll need to see something more dramatic before the central bank changes its monetary tune of standing pat.
As of last week, initial claims totaled 448,000, a.k.a. distinctly uninspiring relative to the range for the year so far, as we've been discussing for some time. Until we see evidence to the contrary, it seems reasonable to think that the much-anticipated recovery in the labor market is still betwixt and between the end of the recession and the start of rebound.
Presumably the Fed thinks as much, based on yesterday's FOMC statement:
Information received since the Federal Open Market Committee met in March suggests that economic activity has continued to strengthen and that the labor market is beginning to improve. Growth in household spending has picked up recently but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software has risen significantly; however, investment in nonresidential structures is declining and employers remain reluctant to add to payrolls.
In short, "pace of economic recovery is likely to be moderate for a time," Bernanke and company advised. So too, it seems, will be the growth in the labor market. But perhaps we're overly pessimistic. There's no law that says that clues about the future trend must be telegraphed well in advance in such metrics as initial jobless claims. Yes, this data series has a history of calling the end of recessions well ahead of the fact. But expecting that initial claims will remain a timely predictor at every point in the business cycle is expecting too much. Every predictor fails at some point, which why there's so much opportunity for opining and disagreement in the dismal science. That fact of life also makes punditry difficult (and at times embarrassing) for those of us trying to see around corners. Is this one of those times? Might employment be poised to surge?
The notion that it might draws support from the rationale that job destruction was unusually steep in the Great Recession, which suggests that job creation will be uncommonly strong. The same reasoning was applied in reverse for evaluating the last several recessions, which were surprisingly mild. So too was the subsequent jump in the labor market. In the 2001 recession, job losses were relatively low in the grand history of the business cycle. As a result, the subsequent recovery in the labor market was also tepid.
If that's a valid analysis for 2001, the same thinking implies that something more than mediocrity awaits in the labor market's rebound for 2010 and beyond. Why, then, haven't we seen any signs of a rebound worthy of the name? Keeping our optimist goggles on, the answer is that the longer we go without seeing a rebound in jobs, the stronger the eventual recovery will be. This is a persuasive argument…unless it's wrong. At some point it's time to accept defeat and look for another theory. But not yet.
How will we know the difference? The numbers will tell us, of course, but the truth may end up being a surprise.
You can see what you want to see in the initial jobless claims figures, for good or ill. So it goes when the trend is sitting on the fence. Meantime, nonfarm payrolls are telling us that the recovery has started. But the relatively strong gain in the March jobs report suffers from isolation. Until (and if) a few statistical siblings of comparable strength arrive, the game is still too close to call. A fresh reading on how close arrives next week with the April update on payrolls. Till then, the debate rolls on about whether recent history is dropping useful clues... or setting us up for defeat.
April 28, 2010
ASSET ALLOCATION FUNDS: POPULAR BUT COMPLICATED
The rising popularity and expanding menu of multi-asset class funds suggests that investors are eager and willing to farm out the asset allocation decision to professionals. Morningstar Principia lists over 1,700 mutual funds and ETFs that engage in some form of multi-asset class investing under one strategic roof. These products are branded under several labels, such as global asset allocation or target date funds. There’s the old standby term balanced fund as well. But no matter what you call them, they all share a common link: managing asset allocation. Some investors think owning these funds relieves them of the chore of making strategic investment decisions, but that’s only partly true.
Asset allocation, of course, is a critical factor in multi-asset class portfolios. There’s plenty of debate about exactly how much influence asset allocation harbors, and what it means for investing. A widely read paper from a few years back, for instance, asks if asset allocation explains 40%, 90% or 100% of portfolio performance? The answer? All three. It depends on how you define the question.
But if there’s one thing most strategists agree on, ignoring asset allocation is asking for trouble. As Morgan Stanley's David Darst advises in his 2008 book The Art of Asset Allocation, "Asset allocation is the most important factor in the performance equation of a multi-asset portfolio."
It's also true that designing and managing a productive asset allocation takes time and effort, which inspires owning funds that take responsibility for this critical task. But with 1,700-plus funds at your disposal, the question arises: How to pick a product (or products) that are appropriate for your investment objectives, risk tolerance, etc.?
As with asset allocation, there’s no simple answer. There is, of course, a useful benchmark to start the analysis: the market portfolio. As I discuss at some length in my book Dynamic Asset Allocation, a broad, passively allocated portfolio that owns all the major asset classes according to market values is the optimal portfolio for the average investor for the long haul. The challenge is figuring out how (and if) your asset allocation should differ from this default mix. In addition, you need to develop a strategy for managing a customized asset allocation through time. It’s no wonder that many investors opt to let someone else do the heavy lifting.
But giving someone else responsibility to run your asset allocation strategy creates a new set of challenges, starting with the all-important issue of choosing a fund. That's effectively a decision of choosing an asset allocation policy, of which there are countless options. Making an informed choice is tougher than it sounds, and not only because there’s a large and growing list of funds focused on asset allocation. Indeed, as consultant Ron Surz (president of Target Date Solutions) is fond of noting, multi-asset class target date funds are complicated and fraught with hazards, as he explains in an essay on the topic.
In general, there are two basic ways (excluding leverage) to add value with asset allocation relative to the market portfolio, which is the benchmark for all multi-asset class strategies. One is focusing on dynamically managing the asset class mix. In pure form, this approach makes no attempt to choose the securities (or active funds) within an asset class. Instead, the goal is managing the asset classes by adjusting the weight of the broad components based on passive benchmarks. Using index mutual funds and ETFs is ideally suited to this approach, and it’s the preference for managing the model portfolios of The Beta Investment Report. Although this is no silver bullet, it does have the virtue of clarity. In other words, if you succeed or fail in trying to add value using only conventional index funds, there's no mystery in identifying the source of the results.
Another strategy calls for picking securities (and/or actively managed funds) within each asset class in an effort to beat the various benchmarks. Quite often this is combined in some degree with the first strategy noted above. The net result, the manager is actively managing the asset allocation and choosing securities/funds.
The problem is that it’s difficult to do so many things simultaneously and still add value that's cost effective relative to the benchmark—the market portfolio of all the major asset classes weighted passively. Let’s put some numbers behind this statement. First, we'll define the market portfolio as it’s used on the pages of The Beta Investment Report. The Global Market Index (GMI) is passively weighted among global stocks, bonds, REITs and commodities, which are based on 11 broad subcategories (cash makes it an even dozen), all of which we update and analyze monthly in the newsletter and in brief on these digital pages, including this overview from earlier this month.
GMI earned an annualized total return of 4.8% over the last five years through March 31, 2010. As we discuss in detail in the next issue of the newsletter (May 2010), replicating GMI with ETFs reduces this paper return to an annual 4.3%. Managing money in the real world carries a price tag, of course, although the price can vary, depending on who's running the show. Indeed, the 1,700 multi-asset class funds in Morningstar's database have expense ratios ranging from as low as 13 basis points up to nearly 500 basis points. By comparison, our ETF-based version of our proprietary GMI benchmark has a weighted average expense ratio of just 35 basis points.
Does a higher expense ratio bring a higher return? Sometimes, but not always. There are a bit more than 1,000 multi-asset class funds with track records of five years or more, according to Morningstar. Of those, the range of annualized five-year total returns peaked at 14.5% and bottomed out at negative 4.7%. In other words, roughly one-quarter of those 1,000 funds beat our ETF-based version of GMI over the past five years. That means that 75% of the funds delivered trailing performance.
To be fair, there's a wide variety of strategies practiced in those 1,000 funds and so comparing the results to our benchmark may be a stretch in some cases. Indeed, these funds collectively are doing virtually everything under the sun. Some are quite tame bordering on passive while others are trading broad sectors and asset classes quite furiously. In any case, GMI makes no assumptions and instead owns and holds everything in weights according to market values. As such, it's a fully transparent and uncomplicated strategy that's available to everyone because it requires no expertise or trading skill. And at a cost of 35 basis points, it's one of the least expense ways to dive into a broad asset allocation strategy.
Should you do something else? Perhaps. In fact, almost everyone does. But deciding how to do something else by way of picking from the prepackaged asset allocation fund choices isn't easy. In fact, it's fraught with a number of hazards. That doesn't mean you should avoid these funds. There are, in fact, some good choices. Finding them, however, takes time, effort and a bit of skill in separating the strategic wheat from the chaff.
April 27, 2010
Everybody talks about bubbles, but what should we do about it? Before we can answer intelligently, we need to put bubbles in context. In other words, how should we think about bubbles? There's no simple answer, in part because the hyperbole surrounding the concept is thicker than honey in a beehive.
We can start by considering the argument that bubbles are something strange, something odd, something out of the ordinary. Prices that run up too far and too fast are bubbles, we’re told. The details are debatable, but presumably we all know what a bubble looks like, at least in hindsight, even if we’re reluctant to define it with surgical precision in advance.
Economist Robert Shiller in Irrational Exuberance describes a previous bubble in the stock market as “a situation in which temporarily high prices are sustained largely by investors’ enthusiasm rather than by consistent estimation of real value.”
That sounds like a rare event, although GMO's chief strategist says he's found lots of bubbles in financial history. In a video interview with the Financial Times last week, he reported that his firm identified 34 bubbles in a variety of asset classes over the years. He noted that 32 of them had since fallen back to pre-bubble levels, and that the remaining two that have yet to correct—the housing markets in the U.K. and Australia—are at risk of succumbing to the historical trend. Meanwhile, Grantham says commodities and emerging markets may constitute new bubbles in progress.
Grantham is one of the unofficial gurus on bubbleology and so we take him at his word: i.e, bubbles aren't exactly rare. In fact, they seem downright routine. Ergo, prices go up, prices go down, albeit with varying degrees of volatility within a given time period.
The concept was famously encapsulated by J.P. Morgan more than a century ago, as recounted in Jean Strouse's magnificent biography of "Jupiter," Morgan: American Financier: "Asked to predict what the stock market would do, [Morgan] replied, "It will fluctuate."
And so it shall, along with every other market. A market whose prices do not fluctuate is an unhealthy market. But how much fluctuation is too much? Or too little? The answer depends on your expectations and plans when venturing into Mr. Market's field of dreams.
For traders, there's never enough price volatility. As outlined in Edwin Lefevre's Reminiscences of a Stock Operator , the classic treatise on trading psychology, the fictional Larry Livingston (a thinly veiled front for Jesse Livermore, the famous trader of the early 20th century) tells us:
The tape does not concern itself with the why and wherefore. It doesn't go into explanations… The reason for what a certain stock does today may not be known for two or three days, or weeks, or months. But what the dickens does that matter? Your business with the tape is now--not tomorrow. The reason can wait. But you must act instantly or be left.
Such ideas are anathema to strategic-minded investors, or so-called fundamental investors who look for "value," i.e., assets trading at prices below some estimate of worth. The poster boy for fundamental investing is, of course, Ben Graham, who co-authored the bible for this approach in Security Analysis. To a value investor's sensibilities, the act of trading a la Jesse Livermore is misguided, to say the least. Wall Street Journal columnist Jason Zweig laments the view that traders are a lot that, by definition, trade first and ask questions later. In a recent article that reviews the pros and cons of financial disclosure, Zweig provides a glimpse of Graham's perspective on the subject:
Benjamin Graham, perhaps the most astute analyst Wall Street has ever produced, was once asked whether he thought disclosure was adequate. Graham replied that the quantity of disclosure "makes me ill." He added, "I don't know if there is any solution … I suppose [a prospectus] would have to say in big red-letter words, THIS [SECURITY] IS NOT WORTH WHAT IT IS SELLING FOR. I don't know if that would make any difference either … somebody [would just say], 'What the hell, it is going up anyway.'"
Traders, it seems, are irrational, or so it seems if you're a value investor. The feeling is usually mutual. If so, we've located a key source of why bubbles exist, which are premised on the idea of irrationality, which is a slippery concept depending on who you're talking to. Nonetheless, the bubble itself is widely seen as prima facie evidence of irrational decision making, or so argues the behavioral school of economics. But if bubbles are always and forever irrational, what does that say about the fairly routine arrival of bubbles? Could bubbles simply be part of the normal fluctuation in prices? In a world populated with short-term traders and long-term value investors (a.k.a. "the market"), are bubbles simply inevitable events that reflect disagreement over prices? If so, are these market debates always irrational? Or just natural?
Some economists suggest that bubbles might actually be rational at times. Summarizing one paper in this theoretical corner, Economics 2.0: What the Best Minds in Economics Can Teach You About Business and Life considers the alternative perspective on bubble study via the challenge tied to a lack of time consistency. "The estimation of what will be tomorrow's estimate on long-term price development is not necessarily consistent with today's estimation of long-term price directions," the book explains.
As example, Economics 2.0 asks the reader to imagine a point when most investors believe the market is overvalued. Yet most investors have not yet sold out of the market, perhaps because they expect further price increases, and so they buy more. "The same will occur tomorrow,
with the effect that my daily predictions for the next day's average market assessment will not be in line with my long-term forecast of the average market assessment. The discrepancy grows wider with each day, as observant investors have an incentive to "ride the bubble."
Obviously, the trend evolving this way will be prone to an abrupt reversal. Bits of innocuous public information can bring about a change in direction, for rational investors—rightfully—attach greater significance to publicly available information than to their own, private information. Only public information is meaningful for the formation of investors' average market assessment.
Yet both types of information are unreliable. For instance, an upward blip in the U.S. core inflation may be no more than a slight aberration. If financial markets function akin to Keynes's beauty contests, however, this bit of commonly available information can have very significant consequences. All investors will notice the upward move in inflation rates—and all will know that everyone else sees it, too. As a result, many investors might expect others to sell—and begin to exit their own positions as well. What caused exaggeration on the way up is now likely to cause exaggeration on the way down.
To fully understand the challenge of bubbles, one needs to consider the markets in real time. Indeed, Grantham suggests that commodities and emerging markets may be bubbles. He may be right (or wrong). To be fair, he anticipated the tech bubble that burst in 2000-2002, along with the 2008 reversal of fortunes. Other strategists offered warnings as well. But more than a few value investors went broke in the late-1990s waiting for the bubble to burst. Bubbles exist, but that doesn't mean they can be profitably exploited in real time. Identifying bubble watchers who will be right and timely, in advance, may be just as difficult as identifying the next bubble and when it's set to burst.
We may or may not be in a bubble in one or more markets as we write. If we were sure that a bubble existed, we'd go to 100% cash, wait for the correction and buy anew. In fact, there's a case for embracing this strategy, albeit modestly, in recognition that a) we're never sure if the bubble's a bubble; and b) the timing of the bubble's rise and fall is unknown.
In fact, using the word bubble to describe price changes can get us in to trouble. There's a perception that profits come easier in bubbles, either by riding them up or stepping aside when the risk a collapse seems imminent. So be it. Sometimes such analysis is timely, sometimes not. But prices will continue to fluctuate, sometimes violently. This is nothing new.
Perhaps, then, the $64,000 question is: How many bubbles do we need to see in a given time frame before we think of these events as part of the normal market fluctuation? Everyone is likely to have a different answer, which is probably why bubbles will remain a permanent fixture on the economic scene. That's not entirely bad news, as The Road from Ruin: How to Revive Capitalism and Put America Back on Top opines. Why? Bubbles tend to be linked with innovation, this new book argues.
There's a "strong correlation between bubbles and genuinely exciting advances, whether in technology or finance," according to The Road From Ruin. It's not clear, however, that bubbles can be prevented without killing the innovation. Yes, reasonable efforts to keep bubbles under control are warranted, although hammering out the details isn't easy. That's partly because no one's really sure how to prevent bubbles productively without cutting off the economy's nose to spite its face. As economist Russ Roberts has written, "We should face the evidence that we are no better today at predicting tomorrow than we were yesterday. Eighty years after the Great Depression we still argue about what caused it and why it ended." As a result, "We have the same problems in economics. The economy is a complex system, our data are imperfect and our models inevitably fail to account for all the interactions."
Meantime, because the proposed solutions du jour are ultimately political affairs, the danger of making things worse can't be dismissed.
In any case, "we may have to accept some occasional bubbles as a fact of life, human nature being what it is," advises The Road From Ruin, co-authored by Matthew Bishop of The Economist and Michael Green, a London-based consultant and writer. That's not as bad as it sounds, the book argues:
…the really nasty economic consequences tend to result not from bubbles per se but from the wrong reaction when bubbles burst, or when government actions, rather than restraining a bubble, have the effect of blowing air into it. Alas, both of these are common errors.
April 26, 2010
THE CASE FOR CAUTIOUS OPTIMISM
“The global economy seems to be recovering,” the chairman of the IMF’s Financial Committee meeting said at press conference over the weekend. "The worst is definitely behind us," advised Youssef Boutros-Ghali, who's also the Egyptian finance minister in his day job.
But most bouts of macro optimism come with caveats these days, and Boutros-Ghali's cheerful commentary was no exception. "We are not out of the woods yet," he added. "We see a strengthening of economic recovery, but we also see an unevenness in this recovery, unevenness within countries, and unevenness between countries."
Earlier in the week, the IMF revised up its global growth forecast to 4.2% for 2010 from January's estimate of 3.9%. Leading the expansion: emerging market economies, Boutros-Ghali emphasized in his Saturday chat with the press. The IMF projects that emerging nations will grow by more than 6% this year and next.
By comparison, economic growth in mature economies is expected to be relatively modest at roughly 2% to 2.5%. Not too shabby on its face. The problem is that the advanced economies need something better than average for an extended period in the wake of the Great Recession. As the IMF's chief economist, Olivier Blanchard, explained on the IMF's blog a few days ago: The 2%-plus outlook for growth in advanced economies
...is just not enough to make up for the ground lost during the recession. Output for these countries is now 7% below its pre-crisis trend, and this “output gap” is expected to remain large for many years to come. Associated with this prolonged output gap is persistent high unemployment. We forecast the unemployment rate in advanced economies to reach 8.4% in 2010, and to only decline to 8.0% in 2011.
The main factor behind this weak performance and this prolonged output gap is weak private demand. In the United States, consumers, who were the drivers of the economy before the crisis, are being more prudent. In Europe, where banks play a central role in financial intermediation, the weak banking sector limits credit supply. In Japan, deflation has reappeared, leading to higher real interest rates, and putting in danger an already weak recovery.
But while there's a risk of growth that's not quite up to the challenge in the developed world, some analysts think the hazards of a fresh round of economic contraction have diminished. "In the United States, there is a growing consensus that the risk of a double dip recession has abated which is positively impacting markets," the Blackstone Group said in a statement this past week.
In fact, it's easy to find forecasts of modest growth for U.S. GDP for the year ahead. BMO Capital, for instance, projects the U.S. economy will expand by roughly 2.5% to 3.0% at an annual pace in the coming quarters. MFC Global Investment Management expects even stronger results, albeit with that annoying caveat again:
We forecast a robust economic recovery, as job growth will drive incomes and consumer spending, which in turn fuel a resurgence of business investment. The process of rebuilding inventories, which pushed GDP growth to almost 6% in Q4 2009, is not over yet. In addition, more than half of last year’s stimulus package is still to come, while a synchronized global expansion is boosting exports.
But this is not the whole story. Another wave of mortgage defaults and foreclosures threatens renewed declines in home prices, while commercial real estate seems on the verge of a major slump. More losses for banks would only make a constrained lending environment even worse, potentially limiting the normal growth of spending.
Meantime, the always cautious, circumspect and widely followed Jeremy Grantham, chief strategist of GMO, writes in his latest quarterly letter to clients:
The economy is limping back into action, but faces some tough long-term headwinds that I collectively call “seven lean years.” Mortgage defaults in housing, steady repayments of consumer debt, and refi nancings in commercial real estate and private equity, are all problems that linger, as do many others, on what is becoming a long, boring list. We may get very lucky and have a strong broad-based economic recovery.
Boring but no less relevant. The next several months are sure to be a test of the economy’s capacity from transitioning from crisis mode to something resembling stable-growth mode. The outcome will likely be determined by the prevailing winds in the labor and housing markets, both of which were crushed by the economic turmoil in recent years. In both cases, there are nascent signs of stabilization, which may be a prelude to a bonafide recovery.
One reason for thinking so comes from a new survey of U.S. companies, which are becoming more confident that the economy will grow, which inspires plans for more hiring and less firing. As the National Association for Business Economics reports today:
Job creation increased for the first time in the past two years of this NABE survey. The percentage of firms increasing payrolls rose to 22% from 13% in the January survey. The percentage of firms cutting jobs moved lower—from 28% in January to 13% in April. The share of respondents expecting their firms to add employees over the coming six months rose to 37%, up from 29% in the previous survey.
Cautious optimism seems to be the sentiment of the moment. Even assuming that's accurate, what does it mean for the market? Have stocks fully priced in the expected recovery? "If the economic recovery is slow and if unemployment drops slowly," writes Grantham, "then [Fed chairman] Bernanke will certainly keep rates very low, as he has promised in as clear a way as language permits. In that case, stocks and general speculation will very probably rise from levels that are already overpriced."
The margin for error, in other words, is getting uncomfortably thin. That doesn't mean equities won't climb higher. But the potential fallout from any negative surprises isn't getting any smaller.
April 23, 2010
IT'S NOT OVER TILL IT'S OVER
Three out of four isn’t too shabby. New orders for durable goods fell last month, the first decline in the last four months. Even if we maintain that success ratio, rebuilding the business of durable goods manufacturing is going to take time. Therein lies the symbolic challenge for the broad economy. Recovery is underway, but it’s still unclear if it’s sustainable at a sufficiently high pace to make a dent in the damage of the past two years. In any case, we've still got a long way to go.
Then again, it’s pointless to look at absolute dollar levels from the old peaks. New orders for durable goods, for instance, were routinely running in the low $200 billion range every month before the Great Recession hit. Now we’re still struggling to reach $180 billion. But it’s the strength of the trend that matters now.
If we ignore the volatile transportation sector, new durable goods orders rose a strong 2.8% last month. Of course, if we leave off defense-related business (i.e., Uncle Sam’s orders), we’re down by 1.2% in March.
No matter; if we look at the various sectors that make up the full mix of durable goods orders there are gains and losses to consider. Overall, there’s economic bubbling in the country, and some of it’s showing up in the cyclically sensitive corner of durable goods. New orders for machinery and computers/electronics, for instance, boasted tidy gains in March.
The fact that orders overall slipped in March isn’t suprising after the near-7% rise over the three months through February. Durable goods orders are a volatile lot in the short term. It’s the long run trend that’s crucial. On that front, the news remains encouraging. Durable goods have bounced higher by around 10% from the recession lows of a year ago. A similar story describes recent history for a number of other key economic metrics. We can see the positive change in a number of broad economic gauges. As one example, the Aruoba-Diebold-Scotti business conditions index, published by the Philadelphia Federal Reserve, shows a dramatic surge over the past year.
The uncertainty about whether the rebound is sustainable is partly tied to wondering what will happen as the government’s monetary and fiscal stimulus fades. Economist Nouriel Roubini and colleagues, for instance, advise:
We remain concerned that global growth will slow over the course of 2010. Inventory restocking and continued stimulus suggest many countries will report stronger growth in H1 2010, but as these factors wane and aggressive job growth fails to materialize, growth in many advanced economies--starting with the U.S.--is expected to decelerate in the second half of 2010. Private investment and consumption will struggle to post strong gains after the effects of stimulus policies start fading. The end of destocking has propped up growth, particularly in Asia, but there are already signs that the growth momentum has slowed, particularly in Europe. The effect of inventory restocking may fade out by the middle to latter part of 2010.
No one knows if this risk will plant the seeds of something more than a speed bump on the road to recovery. But every time we see a dip in the economic report du jour in the months head, Roubini’s warning will come to mind. The forces of recovery seem likely to win, but it's too soon to make definitive predictions.
April 22, 2010
JOBLESS CLAIMS FALL, BUT THE THREAT OF GOING NOWHERE FAST STILL LOOMS
Initial jobless claims dropped last week—the first since the drop at the end of March. But the question remains: Is the broader trend stuck in neutral?
New filings for jobless benefits slipped by 24,000 for the week through April 17 on a seasonally adjusted basis, the government reports. But we’re still wondering if the end of job destruction will soon bring job creation on a sustained and meaningful basis. If there’s a clue in the recent trend in initial claims, it’s not obvious in the data. As our chart below shows, new filings have been moving sideways in the mid- to upper-400,000 range for much of the year so far.
It’s not out of the ordinary for claims to move sideways for a spell after recessions. Eventually, the downtrend resumes as the economy recovers. But given the severity of the recent economic contraction and the sluggish rebound in payroll growth (so far), we're a touch cautious on expecting salvation in the near future. Deciding if this is merely a pause that refreshes, or one that signals an extended bout of sluggish labor market activity, remains to be seen.
Speaking of the future, the next monthly employment report is scheduled for release on May 7. The crucial question: Was the March rise in nonfarm payrolls a sign of things to come? Or will we be hornswoggled by the April update?
Till then, there are two more weekly jobless claims updates to ponder. Meanwhile, economist Evelina Tainer offers some guidance for thinking about jobless claims, starting with the caveat of managing expectations when it comes to the update du jour. "Do not fall into the trap of assuming that a decline in the number of reported initial jobless claims automatically means an increase in non-farm payrolls," she writes in Using Economic Indicators to Improve Investment Analysis. "Jobless claims are the direct result of layoffs. Just because fewer persons were laid off, does not mean employers increased hiring."
April 21, 2010
NEW MONEY, SAME OLD CHALLENGES
Nothing really changes in the money game, although the face of the currency gets a makeover every so often, as the redesigned $100 bill attests. "In order to protect your money and keep counterfeiting low, the United States government continues to enhance the security of its currency," the Treasury's "New Money" web site reports. The latest roll-out is the new C note, which "incorporates the best technology available to ensure we’re staying ahead of counterfeiters,” said Secretary of the Treasury Tim Geithner in the accompanying press release issued today. Colorful, isn't it? Of course, there's still no technology that will prevent currencies, freshly designed or not, from losing their purchasing power. That age-old challenge still requires some very old-fashioned ideas.
THE IMF ISSUES A RED INK WARNING
We’ve heard it before, but the IMF is telling us again: there’s a lot of debt sloshing around in the global economy, and more is on the way. The question before the house: At what point will ballooning deficits reach the financial tipping point? Whatever the answer, we seem to be moving closer to that hazardous peak. That doesn't mean we're destined to reach it, but the alarm bells are now ringing loud and clear.
“The global financial system and the world economy are slowly regaining their health, thanks in large part to unprecedented interventions by governments,” the IMF advises in its newly published Global Financial Stability Report. “But the sharp rise in government debt during the economic crisis from already elevated levels helped create… the newest threat to the financial system: growing sovereign risk.”
A chart from the report summarizes the trend. The ratio of sovereign debt to GDP in the G7 countries is approaching 120%, which is near a 60-year high. "Some sovereigns have also been vulnerable to refinancing pressures that could telescope medium-term solvency concerns into short-term funding challenges," the IMF advises.
Sovereign risk has been a topical subject of late, including on these digital pages, such as a look earlier this month at new red ink commentary from the Bank for International Settlements. In broad terms, the IMF essay doesn't really bring anything new to the table, although it certainly adds a powerful voice to the mounting list of alarms issued from economists and other observers of the macro scene.
The core issue, the IMF asserts, is that "the biggest threats have moved from the private to the public sectors in advanced economies. Governments not only took on many of the bad assets from private institutions but due to the recession face continuing heavy borrowing needs for the next few years."
In another graphic from its report, the IMF contrasts recent trends for several macroeconomic risks. As the chart below shows, the IMF counsels that sovereign credit risk has worsened since last October—in sharp contrast to the otherwise improving state of the macroeconomic environment.
The good news is that the "the world economy is recovering from the global crisis better than expected," the IMF advised in another report, which was published today. That's no small trend in generating the cash flow needed to pay down the world's rising debt load. "In its latest World Economic Outlook (WEO), the IMF said among the advanced economies, the United States is off to a better start than Europe and Japan," according to a statement. "Among emerging and developing economies, emerging Asia is leading the recovery, while many emerging European and some Commonwealth of Independent States economies are lagging behind." The new WEO projects that world economic growth this year will 4.2%, up from the predicted 3.9% in January. And the U.S. will grow by 3.1% in 2010, up from the 2.7% forecast from earlier this year, according to the IMF. But even amid this encouraging outlook, the statement added that "sovereign risks in advanced economies could undermine financial stability gains and extend the crisis." The forces of light and dark are headed for battle.
"When investing abroad, it's always important to look at the country's sovereign rating," writes Randy Epping in The 21st Century Economy--A Beginner's Guide. "Usually, a sovereign government is almost always a better credit risk than a company in that country. This is because the government, in theory, will always be the last to go bankrupt." But perhaps This Time is Different.
THE KEY QUESTION IN THE GOLDMAN SACHS CASE
The SEC's case against Goldman Sachs, in which the investment banks is charged with fraud, raises a sea of questions, ranging from: What defense will the company use? How will the case affect Goldman's business and reputation? What will the legal precedent be for dealing with clients? But the at the core of what promises to be a legal thicket is a rather simple narrative that demands a simple answer. James Stewart in today's Wall Street Journal explains:
Goldman hasn't disputed the basic facts in the SEC's narrative: (1) that the company allowed its client Mr. Paulson, who famously made billions betting that subprime mortgages would default, to play a role in the selection of a portfolio of the worst imaginable subprime mortgages that would be packaged into a collateralized debt obligation, and (2) that the bank failed to disclose to clients to whom it sold those CDOs that it had, in effect, let the fox into the henhouse. Goldman claims its sophisticated clients wouldn't have cared about such information or considered it important, but if that's the case, why did Goldman conceal it? Goldman collected millions of dollars in fees from Mr. Paulson, who bet against the doomed securities, and from the clients who invested in them.
April 20, 2010
A QUICK LOOK AT THE STOCK MARKET'S FUTURE
In yesterday’s post we discussed the idea of valuing the stock market like a bond, which is inspired by the academic research and the historical record. Today, we apply the concept to the real world by plugging in some numbers in an effort to develop a bit of perspective on estimating the long-run return for the stock market. It's an imperfect art, to be sure, and one that ultimately requires far more detail than we can provide here. But every journey starts with a first step.
Let’s begin by considering the current dividend yield for U.S. stocks, defined by the S&P 500. The market’s yield last month was 1.9%, the lowest since December 2007, the start of the recession. As we noted yesterday, there’s a long line of research showing that current yield is linked with the future long-run return for the stock market. The rule of thumb is that higher yields imply higher expected return, and vice versa. Accordingly, expectations about future returns for equities should be lower today than, say, March 2009, when the market's yield was quite a bit higher at 3.6%.
Burton Malkiel calls the clues thrown off by dividend yield a “dividend jackpot,” overstating the case for effect only slightly. As he explains in A Random Walk Down Wall Street, “investors have earned higher total rates of return from the stock market when the initial dividend yield of the market portfolio was relatively high, and relatively low future rates of return when stocks were purchased at low dividend yields."
But how much is "high," and how little is "low." To put a number on these vagaries, we need to run additional analysis. The possibilities, of course, are endless and we'll only scratch the surface (just barely) here. A simple way to begin is with the dividend growth model. In its basic form, assuming a constant rate of change for dividends, this model advises that the expected return on stocks is calculated as the current dividend yield plus the long-term rate of growth on dividends. Some finance textbooks, such as The Cost of Capital: Intermediate Theory, explain this as "inferring" the expected return for stocks from dividends.
Adding last month's 1.9% yield to the 5.1% historical rate of growth in dividends for the past 60 years produces an expected return of 7.0% (1.9% + 5.1%). That's hardly the last word on developing estimates for the stock market's expected return, but it's a good place to start. But it's only a beginning. We might, for instance, attempt to estimate the outlook for dividend growth for, say, the next 10 years rather than simply extrapolating the historical trend.
Once again, there are many models to consider. One simple approach is assuming that the growth in dividends will match economic growth. That means we need an estimate for economic growth. For the past 60 years through the end of 2009, U.S. GDP has risen at an annualized 6.8% rate in nominal terms. That's almost certainly too high for, say, the decade ahead. Suffice to say, the outlook for the U.S. economy in 2010, for any number of reasons, is quite a bit more modest than it was in, say, 1950.
As one possibility for developing a more realistic basis for projecting economic growth, let's take the Congressional Budget Office's current forecast for U.S. GDP through 2020. That works out to an annualized nominal rise of roughly 4.3%. Adding the current stock market dividend yield of 1.9% to that economic outlook gives us expected return for equities of 6.2%. By comparison, the long-term historical return on U.S. stocks since 1926 is substantially higher at 9.8%, according to the 2010 Ibbotson SBBI Classic Yearbook.
Ultimately, there are no easy answers in forecasting expected returns, for stocks or any other asset class. The future's uncertain—always. But investing requires making assumptions, including assumptions about future returns. History is a guide, but we need more. Indeed, one of the key lesson in financial economics, along with real-world experience, is that investment results are highly dependent on when you invest. That means that we should think carefully about the current economic and financial climate, including asset valuations, and how that compares with our forecasts of the future.
It's tempting to think that there are short cuts. But if we're going to develop compelling intuition about prospective return, we must forecast continually and intelligently, by drawing on a variety of resources. Dividend-based forecasting is just one example, but no one should assume it's the only one.
Yes, it's all adds up to a lot of work, but that's not surprising. If it was easy, the crowd would load up on risky assets and reap the rewards, and in the process bid up prices to the point that expected risk premiums are zero, if not negative. The reality, of course, is quite different. There's an eternal debate about expected return. What's more, expected returns are constantly changing. That implies that investors need to be constantly vigilant in developing expectations.
In short, making informed estimates about returns is a process rather than a one-time guess.
April 19, 2010
VALUING THE STOCK MARKET AS A BOND
No one should confuse stocks with bonds, but there's a case for valuing equities as if they were fixed-income securities. There are several caveats, of course, but that's always true with financial analysis. The question is whether there's anything to learn when it comes to analyzing stocks as would-be bonds? Yes, although it's not a silver bullet, nor is it helpful for short-term trading. And to the extent we do so, this valuation approach should be used simultaneously with other techniques. That said, there's something to be said for taking a page from the world of fixed-income when assessing the stock market.
This is hardly a new revelation. Financial economists and money managers have been telling us no less over the decades, albeit with varying twists. The latest comes by way of a new essay published at VOX, a research web site run by the Centre for Economic Policy Research. The dividend price ratio performs "very well" in predicting long-term equity market returns, advises "Demographics and stock market fluctuations."
As an example, the paper's authors show how the dividend-price ratio for the U.S. stock market is related to subsequent 10-year returns. As it turns out, the relationship, while not perfect, is surprisingly robust, as one of the paper's charts illustrates (see graph below).
The chart above suggests that high dividend price ratios are associated with relatively high stock market returns in the years ahead. Meanwhile, low yields tend to precede low returns.
In fact, this is a widely discussed relationship in finance. Dividends alone aren't a magic metric. More broadly, dividend yield is providing information also found in other fundamental measures. The research shows that a number of statistics offer comparable help in forecasting returns. Dividends are one, but earnings and book value are useful too. The bibliography on the general topic would be quite lengthy if we listed all the papers and books that discuss the details. A few examples: Robert Shiller's Irrational Exuberance and Andrew Smithers' Wall Street Revalued. And in my own book, Dynamic Asset Allocation, I review some of the research published over the years that finds a connection with current market valuations and expected return.
That includes Professor John Cochrane, who's been one of the leading academics shedding light on the link between dividends and expected returns. In a 2008 paper published in the Review of Financial Studies—"The Dog That Did Not Bark: A Defense of Return Predictability"—he writes, "If returns are not predictable, dividend growth must be predictable, to generate the observed variation in divided yields. I find that the absence of dividend growth predictability gives stronger evidence than does the presence of return predictability."
Cochrane has also observed that "stocks are a bit like bonds." By that he means that when the price-to-dividend ratio falls, expected return (as well as dividend yield) rises.
How is this connected with valuing bonds? Think of a 10-year Treasury Note trading today at a 4% yield. If you buy this Note and hold it till maturity, you'll receive a 4% return. But let's say you decide to wait a week before buying. During the interim, traders have bid up the price of the bond so that it's now yielding less--3.9%. At that point you say, too expensive, and so you wait. During that time, we learn that the inflation outlook has deteriorated and the market reacts by revaluing bonds at lower prices. The 10-year Treasury's price falls sharply and so its yield has jumped to 4.1%. At that point, you decide to buy and lock in a 4.1% return for the remaining life of the Note.
The same relationship between current yield and expected return applies to the stock market, albeit with some caveats. The first is that there's quite a bit more risk surrounding dividends with equities vs. payouts from bonds. In addition, equities have the equivalent of infinite maturities. As a result, we must be far more skeptical about current yield when it comes to stocks vs. bonds. Nonetheless, some of uncertainty goes away if we're buying a broad basket of stocks vs. individual companies.
Another risk-management tool is building equity return forecasts from a variety of sources. The research literature is also quite clear on the value of forecasting return using a mix of variables. Indeed, the Vox essay noted above reports that combining dividend yield with demographic data may offer a richer forecast than dividends alone.
As we wrote last month, the case for so-called combination forecasts is compelling. That is, using a diversified mix of return predictors is superior to relying on one. That's just common sense, of course, although financial economics is beginning to flesh out the details on a more formal basis.
Dividend yield is certainly a worthy factor to consider in the dark art of forecasting return. It's far from foolproof. What's more, the power of its embedded outlook waxes and wanes through time. That implies that we need to find complimentary predictors that can minimize the inherent hazards of peering into the future. Investing success, in short, is built one brick (and return predictor) at a time.
There are no guarantees in predicting returns, but that doesn't preclude the possibility of reducing the magnitude of the nefarious error term. The devil, of course, is in the details...and in the particulars of the forecast.
April 17, 2010
WHY THE GOLDMAN & PAULSON SAGA SOUNDS FAMILIAR
Yesterday's news that the SEC charged Goldman Sachs with "defrauding investors" for selling a subprime mortgage product is eerie because much of the process that created it was profiled in last year's widely reviewed book The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History, by The Wall Street Journal's Gregory Zuckerman.
At the center of the SEC's complaint is a Goldman product loaded with dicey synthetic collateralized debt obligations, or CDOs. It was sold to institutional investors and, suffice to say, a losing proposition. The question is whether the losses were preordained with Goldman's knowledge, in which case the investors were sucker-punched. Or, to quote the phrase that's become widely used in the last 24 hours in describing the fund, was the product "designed to fail"?
The flip side of the failure, intentional or not, is that hedge fund honcho John Paulson profited in spades from the fund's implosion in what Zuckerman coins as the "the greatest trade ever." In fact, Paulson helped design the product that a) failed and b) created enormous profits for him. Was there a connection between the two? To be precise, did a) preordain b)? The SEC seems to think so. Nonetheless, there's a fine line between trying to outlaw failure and regulating against creating products that are intentionally designed to stumble in order to create profits for insiders. Clearly, the ability to fail must be and should be preserved in the financial system, but only if it's part of promoting a legitimate and fair-minded embrace of risk and capital formation. It's not clear that this is what was happening with the Goldman and Paulson deal, although perhaps we'll learn otherwise as the case unfolds in the days and weeks ahead.
Meantime, "What makes it feel like dirty pool," writes Joe Nocera in The New York Times, "is the allegation that Paulson & Company and Goldman Sachs were actively involved in choosing the bonds that would be bet on — knowing they were going to be short."
How we got to this point is outlined in Zuckerman's book. Paulson reportedly had been looking for an investment bank that would be willing to cobble together a fund of CDOs with a bearish aura before he came across Goldman. At one point Paulson was in contact with Scott Eichel of Bear Stearns about the proposed idea. Zuckerman writes that "Paulson would want especially ugly mortgages for the CDOs, like a bettor asking a football owner to bench a star quarterback to improve the odds of his wager against the team." Paulson, in other words, would be shorting the mortgage components of the fund. The problem was that someone would need to take the other side of the trade by owning the fund. Zuckerman goes on to report,
"On the one hand, we'd be selling the deals" to investors, without telling them that a bearish hedge fund was the impetus for the transaction, Eichel told a colleague; on the other, Bear Stearns would be helping Paulson wager against the deals.
"We had three meetings with John, we were working on a trade together," says Eichel. "He had a bearish view and was very open about what he wanted to do, he was more up front than most of them.
"But it didn't pass the ethics standards; it was a reputation issue, and it didn't pass our moral compass. We didn’t think we should sell deals that someone was shorting on the other side," Eichel says.
For his part, Paulson says that investment banks like Bear Stearns didn't need to worry about including only risky debt for the CDOs because "it was a negotiation; we threw out some names, they threw out some names, but the bankers ultimately picked the collateral. We didn't create any securities, we never sold the securities to investors….We always thought they were bad loans."
Besides, every time he bought subprime-mortgage protection, someone had to be found to sell it to him, Paulson notes, so these big CDOs were no different.
Indeed, other bankers, including those at Deutsche Bank and Goldman Sachs, didn't see anything wrong with Paulson's request and agreed to work with his team. Paulson & Co. eventually bet against a handful of CDOs with a value of about $5 billion.
The rest, as they say is history... still unfolding in real time.
April 16, 2010
GOLDMAN TAKES A HIT...
Wall Street is a shadow of its former self, and not just because of the financial trauma in late-2008. Technology has long been reducing the relevance of big-city financial centers. Much of what passed as standard operating behavior among previous generations of bankers and money managers working in the financial canyons of New York, London and other cities can now be accomplished in the hinterlands, and probably at a lower cost. But if the writing has been on the wall for some time, it may be accelerating with today’s news that the SEC has charged Goldman Sachs with a rather large fraud in regards to its dealings with the subprime mortgage market. (Goldman denies the charges and claims the government's case is unfounded.)
Here's how Bloomberg News explains the charges:
Goldman Sachs created and sold CDOs tied to subprime mortgages in early 2007, as the U.S. housing market faltered, without disclosing that hedge fund Paulson & Co. helped pick the underlying securities and bet against the vehicles, the Securities and Exchange Commission said today. Billionaire John Paulson’s firm earned $1 billion on the trade and wasn’t accused of wrongdoing. The SEC also sued Fabrice Tourre, a Goldman Sachs vice president who helped create the CDOs, known as Abacus.
“The product was new and complex but the deception and conflicts are old and simple,” SEC Enforcement Director Robert Khuzami said. “Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party.”
And the core of the SEC's charge, in the agency's own words via its complaint:
In sum, GS&Co arranged a transaction at Paulson’s request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson’s role in the portfolio selection process or its adverse economic interests.
Lisa Endlich told us a decade ago that the Goldman partnership that has for so long endured and triumphed had a “culture of success” via her 2000 book Goldman Sachs . A decade hence, Michael Lewis, among others, paints a less-flattering profile of Goldman Sachs and its Wall Street counterparts in The Big Short: Inside the Doomsday Machine on the subject of subprime mortgages. As for a more general cultural indictment, and one of the more memorable phrases to come out of the financial crisis, Matt Taibbi's in last year's Rolling Stone piece calls Goldman the "great vampire squid wrapped around the face of humanity."
One pundit wonders if we've gone too far. "Are we really to believe that Goldman is the worst offender?" asks Dennis O'Brien at the Huffington Post. "Or are they a convenient scapegoat? Politically, nothing could be a safer bet than attacking Goldman."
In any case, this is now officially the golden age for attacking the world's leading investment bank. Rightly or wrongly, Goldman is on the ropes like never before. One might wonder if the firm will survive after reading today’s news. Given the sharp drop in the price of Goldman shares, as we write, the thought has crossed the minds of a few traders.
Meantime, if any one was wondering if the SEC was willing to bare its teeth in the wake of Harry Markopolos’ indictment of the government’s financial industry watchdog, today’s revelation seems to suggest an answer. If the SEC is in fact a new and more aggressive agency, that represents no less than a complete transformation from the institution that Markopolos encountered when he tried for a decade to warn the government that Bernie Madoff was running history’s biggest Ponzi scheme. To no avail. The old SEC, he writes in No One Would Listen, was unable or willing to do much of anything to act on behalf of investors’ best interest—even when the evidence of an ongoing fraud was handed to the institution on a silver platter…several times.
Today’s SEC looks different, or so the latest news suggests. What are the ramifications of the government’s case? Here’s a sampling of the first round of reactions from the punditocracy this afternoon…
"The news about Goldman Sachs is still very fresh and we do not know all the details but from 30,000 feet the notion that the worst financial crisis in 80 years could tidily wrap up in a year or two is ludicrous."
--Roger Nusbaum, Random Roger
"Finally the chickens are coming home to roost on the greatest short scam of the last decade."
--Jon Taplin, TPM Café
"Three cheers for the SEC!"
--Paul R. La Monica, CNNMoney.com
"Certainly under the leadership of a new chairman and enforcement director, the SEC’s Obama years have marked a hard switch from the posture of the Bush SEC. In 2009, the regulator opened twice as many investigations as in 2008, with fines up 35 percent. The new assertiveness helped cool talk on the Hill that the SEC should be merged with the CFTC and pushed into a giant super-regulator."
--James Pethokoukis, Reuters
"Road blocks for financial regulation have taken a hit today."
--Thomas Villalta, co-portfolio manager of the Jones Villalta Opportunity Fund, via AP
"This is just one SEC filing [i.e., the charges against Goldman]. My guess is that more will be forthcoming."
--Annie Lowrey, Washington Independent
"Finally. Finally. There may be some accountability on Wall Street. This is only a civil suit. Many of these big bankers should probably be in jail, so I'm holding out for criminal charges. But, the SEC showed it has some teeth. This is a good start."
--Joe Sudbay, America Blog
"I’m no lawyer, but here’s my guess as to what is likely to occur: Goldman will deny any wrongdoing, claiming that everything was disclosed to the accredited investors (pension funds, foreign banks and other institutional investors) who purchased Abacus. And even if the SEC’s claim is sort of correct–that it wasn’t disclosed that Paulson was cherry-picking the bad stuff–Goldman will settle for some seemingly large, but ultimately not earth-shattering amount and go on its way. Remember that only Moby Dick and Ishmael survived…"
--Jill Schlesinger, MoneyWatch.com
"Going back to the transaction that instigated this suit, Goldman created and marketed the CDO for $15 million. A substantial sum of money to be sure, but something that could have easily been foregone by the banking titan. In the halcyon days of the housing bubble, Goldman’s bonuses to top producers were factors of that sum.
"It’s unlikely that Goldman Sachs would have walked into litigation where the SEC seeks disgorgement of profits, fines and an injunction over a relatively measly $15 million. The sale of shares in the CDO could have resulted in greater upside for Goldman, but this is just one of dozens, if not hundreds, of similar deals being made on Wall Street at the time.
"A number of reasons for this action come to mind. First, collateral estoppel. If the SEC can get favorable rulings or a fat settlement out of Goldman, it can use them as leverage in future suits against the bank and other financial entities. The specter of a potential lawsuit will chasten other banks and potentially even bring them to the table to avoid future litigation, especially as this mornings news has already sunk Goldman’s stock price (ticker symbol GS) 10%. For executives and employees with much of their compensation tied up in stock options, as was the case at Bear Stearns, the fallout from this event poses a significant risk. There is the rage of populism, which spilled over at yesterday’s nationwide Tea Parties. Though these people cannot quite articulate what Wall Street and, specifically, Goldman Sachs do, they’re mad as hell to see the financial sector enriched as the traditional economy crumbles. Though the SEC has more independence than other agencies, the Commission’s actions are ultimately imputed back to the President, and it’s good press to go after The Great Satan of high finance."
--J. DeVoy, The Legal Satyricon
A RECOVERY IN HOUSING?
With each new data point, it’s clear that the economy is no longer contracting. The signs have been bubbling for months, and today’s update on new housing starts and building permits offers another round of statistical support. But while it’s tempting to conclude that the economy’s poised for a robust, sustained run of growth, that’s still premature. As we’ve been discussing for much of the past year, the time gap between the end of economic contraction and economic growth is likely to be longer this time. In turn, that means that the recovery is vulernable to a fresh bout of weakness once the initial bounce fades. That's not fate, of course, but neither is it far beyond the pale of possibilities, given the breadth and depth of the Great Recession's lingering complications.
But first the good news of the day. Housing starts rose 1.6% last month over February and are higher by 20% compared with a year ago, the Census Bureau reports. An even stronger rebound describes the trend in new building permits issued for March, which climbed 7.5% over the previous month and are up more than 34% vs. a year ago. The permits trend is especially encouraging because it’s a forward-looking indicator that tells us that confidence is returning for investing in housing construction.
In fact, housing overall is thought to offer valuable clues about future consumption and its relationship to the economy. “Why is the level of single-family housing starts such an excellent barometer of the health of the consumer sector?” asks Richard Yamarone in The Trader's Guide to Key Economic Indicators. "Simply put, when people are concerned about their economic situation, they may still spend on other products, but they won’t even consider buying homes," he advises. On the other hand, if housing is doing well, homeowners are likely to spend more at the margins.
No wonder, since housing generally dominates household balance sheets and so it casts a long shadow over consumer sentiment. The fact that housing seems to be stable if not growing is a rather large bit of good news. These days, we’re looking for a recovery in the housing market, which was crushed, not only in the Great Recession but in a long bear market for housing that preceded the overall economy’s descent that started in December 2007.
After reading today’s housing report, it appears that all’s well, or at least better. The market’s recovering, and that suggests that consumers will resume their old habits of spending. Certainly the trend in retail sales of late suggests as much. Retail spending rose a strong 1.6% last month, the government reported earlier in the week. That’s the third straight month of higher sales. That implies that consumer spending is rebounding, a critical factor in the U.S. economy, which is based largely on consumption.
But before we make definitive declarations that all’s well, let’s consider the broad risk factor for the cycle. The main issue is recognizing that the economy is still bouncing back from a very deep fall. That’s encouraging if not inevitable in the grand scheme of cycles. No one should be surprised that the mother of all monetary and fiscal stimulus programs in the history of the United States has delivered a reaction—a positive reaction—in economic activity. Indeed, our broad economic indices published in The Beta Investment Report have been signaling recovery for some time, as the chart below shows.
The question is whether the initial rebound has legs? In other words, how much of the recovery so far is due to government intervention vs. a self-sustaining recovery in the private sector? The answer is always obscure, of course, but it’s a safe bet that a bit of both are relevant at the moment. Meantime, let’s also note that government support for housing is winding down, along with the likelihood that other government props will fade in the coming months.
That doesn’t mean that the economy’s headed for a fresh round of contraction. Nonetheless, it’s unclear just how much growth is coming in an economy that has stabilized but still suffers on a number of levels. The housing market is looking better, and today's numbers help minimize the fear that housing is the "other big problem." But optimism shines brightest only in terms of comparisons with the recent past, which is about as ugly as housing can get without completely imploding. We wonder how year-over-year comparisons will look in 2011, when the year-earlier baseline is much higher.
"Some of the worries about the housing market have been alleviated by this report," Cary Leahey, an economist at Decision Economics, tells Reuters today. We agree. But as our first chart above reminds, we’ve only just recently begun the healing process. If it continues, and the labor market shows sustainable growth, and inflation stays moderate, and the eventual increase in interest rates doesn’t derail the still-fragile state of consumer sentiment, the future looks encouraging. There’s a lot of “ifs” to step over. We’re beginning to walk, but we’re still a long way from running.
April 15, 2010
JOBLESS CLAIMS JUMP
The economy continues to recover in a number of key areas, but it’s still not obvious that the labor market has joined the party. Yes, the latest nonfarm payrolls report was encouraging, but today’s labor market news on new filings for unemployment benefits leaves us wondering (again) if the recent end of job destruction will quickly bring job creation.
Initial jobless claims jumped sharply last week to 484,000, the Labor Department reported this morning. That’s the highest since late-February. As always, the standard caveat is relevant here: initial claims are volatile and so any one reading should be taken with a grain of salt. That said, it’s getting harder to dismiss the trend this year for this series: treading water.
As our chart below shows, last year’s progress, which cut jobless claims to roughly 450,000 by the end of 2009 from more than 600,000 earlier, seems to have stalled. For most of 2010, jobless claims have been stuck in the 450,000-to-500,000 range. That’s a problem since it suggests that the labor market isn’t creating enough new jobs to soak up ongoing job losses. Yes, jobless claims have a history of stalling in post-recession recoveries. In that respect, perhaps there's nothing abnormal here. But that doesn't change the fact that the job losses over the past two years are unusually high, and so the pressure to mint new jobs quickly is urgent to keep the current recovery going.
In broad terms, the recession is technically over. But it’s not clear that the economy is poised to create new jobs on a scale that’s needed to address the 8 million-plus jobs lost since January 2008.
Using the history of the business cycle in the U.S. as a guide, jobless claims dipped to a trough of under 300,000 after past recessions in the last generation. To be sure, the fall in jobless claims takes time. After the 2001 recession, for instance, jobless claims (based on a four-week moving average) finally slipped under 300,000 in…2006!
On the other hand, job losses in the 2001 recession were comparatively mild vs. recent history. Nonfarm payrolls shrunk by a bit more than 2.5 million thanks to the contraction of 2001. How quickly did the labor market recover that time? Nonfarm payrolls returned to the old peak in 2004, or slightly more than two years after the recession officially ended in November 2001.
As for the current cycle, let’s assume that the recession ended last June. By the standards of the relatively mild 2001 recession, we won’t see a return to the old peak in nonfarm payrolls until June 2011, or a bit more than a year away. Don't hold your breath. That possibility, of course, is highly improbable. As it now stands, the labor market is light by 8 million jobs relative to the previous peak in nonfarm payrolls. What’s more, the labor market has only just started to show signs of creating jobs on a net basis. The prospect of creating 8 million jobs in a year the equivalent of playing the lottery as a plan for paying off your mortgage.
We’re looking at a much longer recovery period for the labor market than any recessions since the 1930s. That’s old news, of course. But as today’s initial jobless claims suggests, we may need to be even more patient than we thought.
April 14, 2010
INFLATION? DEFLATION? OR SOME OF EACH?
Today’s update on consumer prices for March suggests that inflation remains tame. Is it too tame?
Some analysts think so. In fact, worries over deflation are again popping up in economic discussions. Didn’t we thrash the deflation beast last year? Maybe not. One reason for thinking that inflation is the bigger threat in the years ahead is the massive reflation program that’s been job one at the Federal Reserve, aided and abetted by the profligacy of fiscal policy.
Does the ambitious government’s ambitious efforts in money printing since 2008 threaten higher inflation? Not necessarily, opines Paul Davidson, editor of the Journal of Post Keynesian Economics. In his latest book The Keynes Solution, Davidson argues that merely printing money in and of itself isn’t a sure path to higher inflation. Drawing on Keynes, he minimizes the potential threat of inflation and warns against “knee-jerk” reactions for predicting pricing pressures.
Based on today’s CPI report, at least, there are no official signs of rising inflation at present. Consumer prices rose just 0.1% last month, the government reports. That’s up ever so modestly from February’s report of flat prices. For the 12 months through March 2010, CPI advanced by just 2.2%. That's up from the outright deflation in the year-over-year numbers posted for much of 2009. But is deflation again a growing concern? Some analysts think so.
There is a “near-term risk of flipping to deflation given our view that developed economies have not fully healed and consumers are not yet ready to stand on their own two feet,” advises Mihir Worah, manager of the $18 billion Pimco Real Return Fund. As he explained on Pimco’s web site, “to the extent central banks continue their quantitative easing programs then clearly they are once again truncating the deflationary tail and we can anticipate a successful reflation of the economy. But any meaningful inflation should still be a couple of years away.” Asked if the rise of sovereign debt around the world threatens higher inflation or deflation, he responds:
The answer to this depends on the timeframe and on the country in question. In general, there are essentially three ways out for countries that cannot service their debt: The first is to grow their way out of it, the second is to default on their debt, and the third is to inflate their way out of it. Which option is selected is really country- and region-specific.
Countries such as the U.K. and the U.S., which have their own fiscal issues, clearly aren’t going to default on their debt. They issue debt in their own currency and control their own monetary policy. Hence, in the longer term, inflation is a likely solution to deal with their inability to grow their way out of persistent deficits. However, in the eurozone, you’re faced with a very different situation where countries like Greece cannot issue debt in their own currency. They cannot debase their currency, which makes their economy more competitive, and so it is unlikely that they can grow their way out of it. So the only possible outcome (other than an outright default) is fiscal belt-tightening and reduction of input (labor costs) in order to make the goods and services they produce more competitive – and this is deflationary. We are already seeing signs of this. Countries in Europe with the worst fiscal situations that have started the tightening process, like Ireland and Spain, are already showing strong signs of deflation and we expect to see deflation in Greece as well.
To summarize, countries that cannot grow their way out of the problem and do not have their own currency that they can debase are more likely to see deflation. Meanwhile, you should expect to see the opposite effect in countries like the U.S. and U.K., which issue debt in their own currencies.
Worrying about deflation has also crossed the minds over other analysts recently. "We're looking at an economy that's dangerously close to deflation," Ethan Harris, chief economist at Bank of America Merrill Lynch, tells The Wall Street Journal. The D word is also popping up in various spots around the blogosphere. “The Europeans are heading right into the den of a deflationary trap,” according to Roseman Eruptions. “At a time when most of the world is still supporting an economic recovery plan to boost growth following the darkest days of the credit crisis, the Europeans seem bent on fighting inflation.”
Nonetheless, with all the liquidity sloshing around the world, it’s too soon to dismiss inflation as a real if not necessarily present danger. "I don't think we should be complacent about inflation risk,” Fed governor Kevin Warsh said last week. "Inflation expectations will be anchored until they are not."
In fact, some investment strategists are anything but pessimistic about the prospects for the global economy. Ed Yardeni and his research team at Yardeni.com, for instance, advise in a note to clients today that the outlook for a robust rebound—a “V-shaped recovery”—appears to be in the offing. “That’s what industrial commodity prices are predicting again,” they write. “The CRB Raw Industrials Spot Price Index, which is one of our favorite indicators of global economic activity, is rallying again, more than reversing the loss posted earlier this year.” The note goes on to explain,
In a sign the global economy is emerging from its downturn, the value and volume of world trade, along with global production, are up from 2009 lows, and trending higher. The value of trade has turned down, but remains on uptrend. Renewed strength in commodity prices suggests the global recovery remains on track.
At the moment, it seems that we can’t dismiss deflation or inflation as a potential hazard. In the long run, inflation is surely the bigger problem. But in the course of getting from here to there, the road may run through a fresh tussle with deflation. What’s a strategic-minded investor to do? The default approach is considering both sides of the pricing equation and hedging against these twin demons of potential risk. Unless you have an unusually high degree of confidence about the future, it seems prudent to guard against deflation in the near term and inflation further on down the road.
In short, it’s still too early to abandon allocations to Treasuries or to commodities, each of which represent a hedge on inflation and deflation risks, respectively. There are other hedges, of course. One can argue that equities will benefit from inflation as a long-term proposition by way of earnings growth above the rate of general inflation. The precise degree of how to structure such a dual allocation is debatable, of course. But the general concept seems well founded, at least for the moment.
The larger point is that we seem to live in bifurcated world with respect to the outlook on pricing trends. Or as the ETF Database advises, “Forget The Inflation/Deflation Debate: The Real Threat Is Biflation.”
April 13, 2010
DEBATING THE DATING OF THE BUSINESS CYCLE
Is the recession over? No, or at least not officially, according to the National Bureau of Economic Research, the non-profit group that makes the official pronouncements on business cycle dates. In a statement yesterday, NBER said it was too soon to mark the end of the contraction that began in December 2007.
"Although most indicators have turned up," the NBER explained, "the committee decided that the determination of the trough date on the basis of current data would be premature." The press release went on to say,
Many indicators are quite preliminary at this time and will be revised in coming months. The committee acts only on the basis of actual indicators and does not rely on forecasts in making its determination of the dates of peaks and troughs in economic activity. The committee did review data relating to the date of the peak, previously determined to have occurred in December 2007, marking the onset of the recent recession. The committee reaffirmed that peak date.
But one panel member on NBER's Business Cycle Dating Committee thinks otherwise. Economist Robert Gordon, who teaches at Northwestern, says that "it is obvious that the recession is over," according to Bloomberg BusinessWeek. The U.S. "is enjoying strong upward momentum that is evident every day in the announcement of retail sales, service-sector production, and almost everything else."
So, why the delay in declaring the finale to the recession? In a word, caution. "The committee is very careful to guard against surprises," the chairman of the Business Cycle Dating Committee told The Wall Street Journal. "We wait until the numbers come in even if we have a fair level of certainty about what they're going to be," explained Stanford University economist Robert Hall.
Meantime, Ken Goldstein, an economist at the Conference Board, summed up the thinking of some in the dismal science: "While we, the professional egghead economists, feel we are in a recovery and that there is only a small chance we are wrong, consumers are still saving and not spending, as if they think this thing is not completely over."
So, is it over? Probably, although that doesn't mean the danger's gone. It's too early to rule out the possibility of a fresh round of weakness in the economy later this year, as we discussed here. Regardless of what's coming, the clues that suggested the recession was over have been bubbling for nearly a year. As early as June 2009, for instance, we considered the case for thinking that the economic contraction was at or near an end.
Officially speaking, however, it still ain't over till the NBER says it's over. Does it matter? Probably not, although that's debatable too. At least one economist thinks there may be a risk in the absence of the rhetoric that everyone wants to hear. "By not calling an end to the recession," warned MarketWatch.com's chief economist Irwin Kellner, "the NBER might inadvertently cause economic policy to remain too easy too long."
April 12, 2010
HOUSING: THE OTHER BIG PROBLEM
The hefty 8-million jobs lost during the Great Recession won’t easily or quickly return, as Robert Reich reminds in today's Wall Street Journal. But at least there’s hope that the March gains in the labor market signal that recovery has begun. Maybe. Even if that's true, questions still abound for the other elephant weighing on the economy—housing.
If the the long journey of job growth is set to begin, will housing be a help or a hindrance? The answer matters because housing is such a large and influential factor for household balance sheets. “Housing is a mainstay of the U.S. economy, consistently accounting for more than one fifth of the gross domestic product (GDP),” writes Alex Schwartz, chairman of the New School’s Department of Urban Policy Analysis and Management, in his book Housing Policy in the United States.
Unsurprisingly, the research literature finds a strong link between housing and economic growth. Common sense suggests no less. “A healthy pickup in housing starts depicts an economy that is robust…,” notes economist economist Bernard Baumohl in The Secrets of Economic Indicators.
Based on what we know today, however, the signals are mixed. Indeed, housing starts appear to be bottoming out, but it’s not yet obvious that growth on a sustainable basis is near. Economist Robert Shiller weighs the pros and cons in yesterday’s New York Times, explaining,
The most obvious reason for hope is that, unlike stock prices, home prices tend to show a great deal of momentum. Correcting for seasonal effects, home prices as measured by the S.&P./Case-Shiller 10-City Home Price Index increased each month from June 1995 to April 2006, then decreased almost every month to May 2009. Since then, they have risen through January, the latest month for which data is available.
So, because home prices have been climbing of late, isn’t it plausible that they’ll keep doing so?
If only it were that simple.
Home price booms and busts do end, sometimes quite suddenly, as was the case for the boom of 1995 to 2006 and the bust of 2006 to 2009. Today, we need to worry about strong headwinds, as the government begins to withdraw its support of a still-troubled lending industry and as foreclosures are dumping millions of homes onto the market.
Worrying about repairing the housing market is old news, of course. Back in January, for instance, The Washington Post ran a story that advised: “Housing recovery could take a decade, economists warn.”
Nonetheless, we should be careful about generalizing, which only goes so far when it comes to housing. Real estate markets, in other words, tend to be local beasts and so speaking in broad terms minimizes the wide disparity in activity from region to region. Those areas that witnessed the greatest boom during the glory days are likely to suffer the longest. As HousingWire reported last week,
Housing markets that experienced the greatest inflation in house prices — including certain metro areas in sand states California, Florida, Arizona and Nevada — will not see a return of peak-level home prices before 2025, according to financial services technology provider Fiserv.
But if some areas are under above-average market strain, it's no surprise to learn that other regions are expected to fare relatively better. Housing prices for Columbus, Ohio, for instance, are expected to stop falling within a year and return to the 2006 peak sometime in 2014, advises Columbus Business First. And Dallas-Fort Worth housing starts "soared in the first quarter from a year earlier, signaling recovery in the local home-building industry," reports the Star-Telegram.
Perhaps the burning question these days is whether the economy drives the housing market--or is it the other way around? Hanley Wood Market Intelligence, a real estate consultancy, explains that "the rate of GDP growth is very important to the housing market, not only because it measures the strength of the economy, but also because the variance from what is considered to be the long-term achievable growth rate influences Federal Reserve policy, which directly affects mortgage rates."
But the connection these days doesn't inspire David Rosenberg, chief economist and strategist at Gluskin Sheff via Time:
Housing is a sector that is receiving tremendous support from the government — at all levels, whether it's through FHA financing or home-buyer tax credits, or the fact that the Federal Reserve for the first time ever took a trillion dollars of housing loans onto its balance sheet. And yet with all of that, whatever recovery we're seeing in the housing market is extremely feeble. I mean we just came off a month where new home sales were at a record low. When you look at housing starts, take a look at a 50-year chart of housing starts — it's extremely difficult to see any recovery taking place at all. At best we're forming a bottom in housing, and that's after massive government aid.
Housing will, of course, recover at some point, but when? Members of the Fed's interest-rate-setting FOMC seem inclined to err on the side of caution. In last month's meeting, the FOMC lowered its outlook for GDP growth, in part because of sideways activity in housing construction. "Indeed, housing sales and starts had flattened out at depressed levels, suggesting that previous improvements in those indicators may have largely reflected transitory effects from the first-time homebuyer tax credit rather than a fundamental strengthening of housing activity, according to FOMC minutes from March. Expectations on foreclosures, meantime, isn't all that encouraging either, as the minutes relate:
[FOMC] Participants indicated that the pace of foreclosures was likely to remain quite high; indeed, recent data on the incidence of seriously delinquent mortgages pointed to the possibility that the foreclosure rate could move higher over coming quarters. Moreover, the prospect of further additions to the already very large inventory of vacant homes posed downside risks to home prices.
What will it take to convince the Fed, and everyone else, that a recovery worthy of the name is taking root in housing? Encouraging numbers, of course. For the moment, we're a bit light on this front. But there's always a fresh batch of statistics on the way, providing another opportunity to blow away the real estate blues. That includes this Friday's update on housing starts for March. The consensus forecast calls for a modest rise of 25,000 to 610,000, according to Briefing.com.
April 10, 2010
DEBATING THE ECONOMIC RECOVERY: IS IT REAL?
Since the Labor Department released the March employment report, which delivered the first substantial gain in nonfarm payrolls since the recession began in December 2007, the debate about the strength of the economic recovery has gone into overdrive. A selective sampling of the conversation...
• Harvard’s Jeff Frankels asserts that the recession is history. “The last piece has fallen into place, with the BLS announcement that employment rose in March.”
• And there are corroborating signs of growth from various corners. A few of the more obscure examples include favorable news in food processing, the local view from Kansas City, and the case for arguing that the slump has ended for tech spending.
But there's also plenty of dissent...
• Recovery? What recovery? Retail analyst Howard Davidowitz of Davidowitz & Co. thinks not. Not even close, warns this bear’s bear. Among the obstacles: debt, and lots of it.
• If the recovery’s less than it appears, why has oil been so strong recently? The bullish view is that higher energy prices of late imply a strong recovery.
• Not so fast, warns the Federal Reserve’s vice chairman. "Home sales, which seemed for a time last year to be starting to slowly recover, have stalled recently, and housing starts are only a little above last year's low," says the Fed’s Don Kohn.
• Eric Janszen writes in the Harvard Business Review: “Welcome to the False Recovery”
• But let's not be hasty, suggests economics professor Mark Perry, who offers 10 reasons the economic recovery is real"
• Finally, Kudlow and company debate the case for and against the odds of a strong “V" shaped rebound:
April 9, 2010
BACK TO THE FUTURE OF ASSET ALLOCATION
The FT's Gillian Tett reported yesterday that the "Harvard model" of investing is under the microscope at the Government Investment Corporation of Singapore (GIC), a sovereign wealth fund. The internal debate at the fund carries " fascinating implications for investors round the world."
As Tett explains:
The issue at stake revolves around the so-called Harvard or Yale investment model. During most of its recent history, the GIC – like many other sovereign wealth funds round the world – has looked at these huge university endowment funds with envy and admiration. For the Harvard or Yale model seemed to offer an exciting vision for any long-term investment group that wanted to do more than act like a stodgy, old-fashioned pension fund. After all, for 20 years, groups such as Yale earned solid returns, by pioneering a distinctive investment style. This essentially championed the idea of diversifying into illiquid and alternative asset classes, such as private equity, alongside mainstream securities.
But the bloom has fallen from the rose. The soaring successes of Harvard, Yale and other endowments that ventured far afield from conventional pension fund strategies has stumbled recently. Tett quotes Tony Tan, deputy chairman of the GIC, who says: “The whole idea of the endowment model has been very influential [before]. But any reasonable investor would [now] want to take another look at this.”
The Harvard and Yale models weren't always on the defensive. In happier times, the portfolio strategies of a few choice endowments were things of wonder. What's changed? Returns, of course, and that's mostly due to a shift in the trend for betas.
A few years ago, for instance, Yale's endowment manager David Swensen was celebrated as the new guru du jour. He wrote several books that were widely praised as offering the insights from a financial seer: Pioneering Portfolio Management and Unconventional Success.
In fact, Swensen's books are quite valuable and worthy of study. At the core of his books are recommendations to focus on a familiar concept: asset allocation. And for good reason, since a fair degree of success or failure flows from strategic decisions, even if the noise of markets in the short term sometimes suggests otherwise.
Earlier in the 21st century, when Yale's portfolio was reporting returns of 20% to 30% a year, Swensen was considered a genius. Now that Yale and other formerly high-flying endowments are struggling, like most other investors, their so-called models are questioned. That's unfair in the sense that no one has a secret strategy for asset allocation. Portfolio strategies designed and managed by mere mortals are destined to stumble at times. Why? The future's uncertain, which means that it's impossible to consistently hold the ideal asset allocation.
Yet Tett's article implies that there's something inherently inferior about the Yale and Harvard models. That may be true, but it's not obvious from reading her article. As one example, she writes that the Oxford University endowment fund's one-year losses through June 2009 were less than half as steep as Harvard's and Yale's. That's hardly definitive proof of anything, although it looks like compelling evidence of something on its face. Indeed, by the same reasoning, one could conclude from a few years back that Swensen's strategy was superior to Oxford's because the former had superior 12-month trailing returns. That too would be short-sighted.
The larger point in all this is (once again) that asset allocation matters, and that evaluating the merits of any given asset allocation strategy requires a fair amount of effort beyond look at recent returns. Swensen's previous run of stellar results was largely due to broad portfolio decisions made years earlier, namely, allocating a hefty chunk of Yale's investments to private equity and hedge fund investments. As it happened, those investments were made early in a period of soaring returns for so-called "alternative" funds. Was it luck? Or skill? Or some of each? Whatever the answer, it's not conspicuous by looking at 12-month total returns in one period.
But let's also recognize that Swensen and his team's particular fund choices were crucial in allocating assets to alternatives. In contrast to the conventional betas of stocks and bonds, fund selection is critical when it comes to buying hedge funds and private equity vehicles. Indeed, it made a world of difference if your hedge fund investments were in Bernie Madoff vs. John Paulson.
By contrast, the stakes tend to be lower in choosing products to represent conventional betas. As one example: You can spend a lot of time and effort trying to figure out which large-cap stock manager will beat the S&P 500 over the next 10 years. But it's no obvious that this is the best way to channel your analytical resources. All the more so if you own a multi-asset class portfolio. Just don't try that with hedge funds. If you allocate assets to this realm, you'll need to do lots of homework. That's no surprise, since even a modest allocation to hedge funds has the potential to radically alter portfolio results (for good or ill). In short, risk and return are related, all the more so with hedge fund allocations.
Meantime, for all the light and heat in Tett's story today about assessing the wisdom inherent in the Yale and Harvard models, the primary message is still the same one we've heard for years: focus on asset allocation and choose wisely. If you have the talents of a David Swensen, perhaps you should allocate a portion of assets to alternative products. But that's assuming you have the skills to analyze the funds, which can be devilishly opaque. Even if you have the right stuff, you'll still need access to the underlying data and inner workings of the portfolios. Swensen and his team had both, but relatively few investors can count on that advantage. The best hedge fund managers are largely closed to all but a select few institutions and wealthy individuals.
That means that for most investors, and perhaps most institutions, focusing on conventional betas is the only game in town. Fortunately, there's enough action here to keep investors of all types happy. Depending on how you choose to slice and dice the conventional markets of stocks, bonds, commodities and REITs, there are at least half dozen basic choices or as many as 20 to 30. Accordingly, there's a wide array of returns and risk in so-called plain vanilla index fund choices, as we routinely report on these pages in our monthly updates of asset class returns and in our newsletter.
Should you own something more than conventional betas? Maybe, but it's not clear that this is a short cut to superior results. And even if you have the analytical skills of a David Swensen, you'll still need to make informed decisions on your portfolio's overall asset allocation. Choosing the "right" funds or securities doesn't matter all that much if the associated market is crumbling.
You can start by considering the true benchmark, the market portfolio, which is the passive mix of all the world's major asset classes that are available in ETFs and index mutual funds. Each month in The Beta Investment Report, I crunch the numbers on this benchmark and consider the opportunities for second-guessing Mr. Market's portfolio. As it turns out, beating this benchmark isn't easy. For the past 10 years through the end of March 2010, for instance, our proprietary Global Market Index cited in the newsletter posted a 3.7% annualized total return vs. a slight loss for U.S. stocks (Russell 3000) and a 6.3% gain for U.S. bonds (Barclays Aggregate).
Can you do better? Of course, but you can also do a lot worse. Ultimately, the answer still revolves around what you do with asset allocation. It's not always the elephant in the room, but over time it surely casts a long shadow on results. That implies that we should spend more than a trivial amount of time understanding the big-picture forces driving portfolio results and how asset classes interact in terms of risk and return. The literature on this topic is broad and deep, as I've discuss in my book, Dynamic Asset Allocation.
On that note, here's how not to proceed: analyze the most recent returns of several large endowments and draw conclusions about what works, and what doesn't by favoring the winner. Ah, if it were only that easy!
April 8, 2010
NEW JOBLESS CLAIMS RISE; CONTINUING CLAIMS FALL
New filings for jobless benefits jumped by 18,000 last week to a seasonally adjusted 460,000. Weekly numbers for this series are notoriously volatile, but the trend so far this year is distinctly unimpressive. Measured from the week through this past January 2, initial claims have generally moved sideways this year through last week. That's in contrast to the strong downside trend that prevailed for most of last year.
A month ago, we considered the possibility that the trend in new jobless claims had stalled. Looking at today's numbers offers no obvious reason for dismissing that concern. Nonetheless, hope still has the upper hand, according to one dismal scientist quoted in today's news reports. "The trend [for initial jobless claims] is still down,” Jonathan Basile, an economist at Credit Suisse, tells Bloomberg News. "I would look for continued gradual improvement as we go forward."
Perhaps, although it takes an extra dose of faith today in thinking so. How might we muster extra faith? We can start by looking at weekly continuing jobless claims. Although this number is reported with a weekly lag relative to initial claims, today's continuing claims news is encouraging. As our second chart below shows, continuing claims dropped to 4.55 million for the week through March 27. That's a relatively steep drop by recent standards, bringing the total to the lowest level since December 2008.
Good news, to be sure. But continuing claims are still quite high—too high to assume that the labor market is in full-bore recovery. And as the latest uptick in initial claims suggests, job creation is still touch and go at this point. The healing process has begun, but the numbers strongly suggest that the mending will be long and slow, and subject to setbacks.
As Fed Chairman Ben Bernanke said yesterday, "We are far from being out of the woods. Many Americans are still grappling with unemployment or foreclosure or both." Hiring is still "very weak." Arguing otherwise with convincing statistical support is going to take months, perhaps well into next year. The best we can say for sure at this point is that it's not getting worse in terms of the labor market. But that news is less satisfying with each passing week.
April 7, 2010
A FRESH LOOK AT THE RED INK CHALLENGE
It's all about debt from here on out, and probably will be for many years. That's old news, of course, but it's still relevant, as we've been discussing, including here and here. A new research paper from the Bank for International Settlements is the latest contribution to the literature that rings the warning bells.
"The future of public debt: prospects and implications" (published last month) lays out the basic challenge, explaining:
The financial crisis that erupted in mid-2008 led to an explosion of public debt in many advanced economies. Governments were forced to recapitalise banks, take over a large part of the debts of failing financial institutions, and introduce large stimulus programmes to revive demand. According to the OECD, total industrialised country public sector debt is now expected to exceed 100% of GDP in 2011 – something that has never happened before in peacetime.
Is this reason for concern? So far, the paper's authors report, bond markets have shown a high tolerance for future liabilities in the new age of red ink. But the fixed-income market is "notoriously short-sighted," they warn. "We take a longer and less benign view of current developments, arguing that the aftermath of the financial crisis is poised to bring a simmering fiscal problem in industrial economies to boiling point." In other words, "the question is when markets will start putting pressure on governments, not if."
The central issue, according to the paper:
…the fiscal problems currently faced by industrial countries need to be tackled relatively soon and resolutely. Failure to do so will raise the chance of an unexpected and abrupt rise in government bond yields at medium and long maturities, which would put the nascent economic recovery at risk. It will also complicate the task of central banks in controlling inflation in the immediate.
The rise in government debt is, by itself, reason for concern. But the problem is compounded by expectations that we're facing an era of higher spending related to aging populations. The study explains:
…the current expansionary fiscal policy has coincided with rising, and largely unfunded, age-related spending (pension and health care costs). Driven by the countries’ demographic profiles, the ratio of old-age population to working-age population is projected to rise sharply. Interestingly, this rise is concentrated in countries such as Japan, Spain, Italy and Greece, which are already laden with relatively high debts.
In addition, the full hazards have been muted in recent years thanks to low interest rates and low inflation. Under those conditions, the burden is considerably eased for financing and refinancing debts. But the times they are a changing. In particular, real (inflation-adjusted) interest rates have been rising lately, as the chart from the study below shows.
"Real borrowing rates rose through 2009, and are poised to continue increasing with the reversal of the current zero interest rate policy," the authors predict. "It is essential that governments not be lulled into complacency by the ease with which they have financed their deficits thus far," they write. "In the aftermath of the financial crisis, the path of future output is likely to be permanently below where we thought it would be just several years ago. As a result, government revenues will be lower and expenditures higher, making consolidation even more difficult. But, unless action is taken to place fiscal policy on a sustainable footing, these costs could easily rise sharply and suddenly."
THE COMPLICATIONS OF REBALANCING
The lessons tied to rebalancing a portfolio's asset allocation should be simple, but they aren't. Like every other investing topic, this one too comes with baggage. Although there's a large body of research suggesting that rebalancing is productive, not everyone agrees. Some of this is about the details, although the basic question of whether rebalancing is worthwhile in concept is debated as well.
Vanguard founder John Bogle, for instance, raised doubts about rebalancing in The Little Book of Common Sense Investing. In essence, he advised that failing to rebalance never costs more than 50 basis points. Meanwhile, not rebalancing may sometimes add 200 to 300 basis points to a portfolio's return.
Maybe, although the choice of asset classes casts a long shadow over results. Bogle looked at several subgroups of equities and a broad domestic bond index and found that a buy-and-hold/avoid rebalancing strategy worked well. He crunched the numbers over the past 20 years. It's not obvious that the next 20 will offer a comparable result in terms of returns.
In any case, our own research in The Beta Investment Report shows that owning a broad mix of all the major asset classes, and rebalancing that mix once a year, adds 50 to 100 basis points to total return over time. That's in line with what some researchers find, such as William Bernstein. In his latest book The Investor's Manifesto, for instance, he reports that there's a "rebalancing bonus" of up to 100 basis points for a broadly diversified portfolio over the long term.
But there's no guarantee. The ideal mix of factors that generate success with rebalancing are hard to control, namely, returns. But you can improve the odds of earning a rebalancing bonus by focusing on what you can control. That starts with owning a broad mix of asset classes. Because the returns of asset classes post lower correlations over time compared to subgroups within an asset class, the odds are better for earning a rebalancing bonus.
Some investors confuse this point by pointing out that that return differences between, say, foreign and domestic stocks, can vary quite a bit at times. That implies that that there's just as much opportunity in rebalancing within equities as there is across asset classes. But that's not true. The critical issue is whether returns are highly correlated or not. Within equities, returns are in fact highly correlated. It matters less if one equity group posts dramatically different returns than another vs. the degree of correlation between the two return series. Overall, equity performance tends to move similarly over time, even if the changes exhibit a wide variety.
By contrast, correlation of returns between stocks and bonds, or commodities and bonds, REITs and bonds, etc., tend to be lower as a general proposition. Therein lies the foundation for expecting a rebalancing bonus. There's more to the story, of course, as we explain in some detail in our book Dynamic Asset Allocation. But the basics begin with correlation.
Of course, there's also the question of timing and magnitude. That is, how often should you rebalance, and under what conditions? The answers are complicated and well short of definitive. Sure, you can enhance the rebalancing bonus by adjusting the timing and magnitude. But you can also give up return if you misjudge the markets. There's a fair amount of subjectivity on these topics in terms of what's likely to work, or not.
This much, at least, is clear: If you own fewer asset classes, you'll have to rely more on timing and magnitude to generate a rebalancing bonus. In turn, success with adjusting timing and magnitude requires more skill vs. a naive, mechanical rebalancing strategy across broad asset classes.
April 6, 2010
It’s now clear that the Great Recession is not (was not) the Great Depression 2.0. A deeper crisis appears to have been averted. That’s not to say that all's well. But given the dire expectations of late-2008 and early 2009, the view from early April 2010 looks like a gift from heaven. The question is whether this is a free lunch? Or, as we expect, there's a price to pay, even if the price isn't obvious yet, in either the details or magnitude.
Of course, we know that there'll be lots of debt to deal with. We've known that for some time. But it seems as though the market, so far, has accepted this price. In fact, the market doesn't appear extraordinarily upset, to the extent that we can glean such sentiments from things like bond prices and the associated yields.
Given what we know so far, the global economy has made a remarkable rebound over the past 18 months or so. Remarkable relative to what was expected not so long ago. Using global industrial production as a proxy for world economic activity, economists Barry Eichengreen and Kevin O’Rourke attribute the recovery to proactive monetary and fiscal policy responses that flooded the economic system with liquidity. This is in direct contrast to the early stages of the Great Depression in the 1930s, they advise.
"Global industrial production now shows clear signs of recovering," Eichengreen and Kevin O’Rourke report last month. They go on to write:
This is a sharp divergence from experience in the Great Depression, when the decline in industrial production continued fully for three years. The question now is whether final demand for this increased production will materialise or whether consumer spending, especially in the US, will remain weak, causing the increase in production to go into inventories, leading firms to cut back subsequently, and resulting in a double dip recession.
There's one more reason for thinking positively in anticipating that demand will eventually catch up with supply: Last week's encouraging update on nonfarm payrolls for the U.S. The government advised that last month witnessed the biggest net creation of jobs since the Great Recession began.
The global economy (the U.S. in particular) is still a long way from the halcyon days of, say, 2006, when all seemed right with the world. But it's obvious that there's reason to be hopeful. Does the business cycle always tell us so?
The financial journalist and historian James Grant made a case for answering "yes" last September, when the outlook was quite a bit less optimistic compared with the vantage of April 2010. As Grant reminded, "it has been a generation since a business cycle downturn exacted the collective pain that this one has done. Knocked for a loop, we forget a truism. With regard to the recession that precedes the recovery, worse is subsequently better. The deeper the slump, the zippier the recovery."
Grant went on to cite a bit of U.S. cyclical history:
Growth snapped back following the depressions of 1893-94, 1907-08, 1920-21 and 1929-33. If ugly downturns made for torpid recoveries, as today's economists suggest, the economic history of this country would have to be rewritten. Amity Shlaes, in her "The Forgotten Man," a history of the Depression, shows what the New Deal failed to achieve in the way of long-term economic stimulus. However, in the first full year of the administration of Franklin D. Roosevelt (and the first full year of recovery from the Great Depression), inflation-adjusted gross national product spurted by 17.3%. Many were caught short. Among his first acts in office, Roosevelt had closed the banks. He had excoriated the bankers, devalued the dollar, called in the people's gold and instituted, through the National Industrial Recovery Act, a program of coerced reflation.
"At the business trough in 1933," Mr. [Michael] Darda [chief economist of MKM Parnters] points out, "the unemployment rate stood at 25% (if there had been a 'U6' version of labor underutilization then, it likely would have been about 44% vs. 16.8% today. . . ). At the same time, the consumption share of GDP was above 80% in 1933 and the household savings rate was negative. Yet, in the four years that followed, the economy expanded at a 9.5% annual average rate while the unemployment rate dropped 10.6 percentage points." Not even this mighty leap restored the 27% of 1929 GNP that the Depression had devoured. But the economy's lurch to the upside in the politically inhospitable mid-1930s should serve to blunt the force of the line of argument that the 2009-10 recovery is doomed because private enterprise is no longer practiced in the 50 states.
But if there's a stronger case for expecting a "zippier" recovery these days, that happy outlook is not yet the consensus view. Just a few weeks ago, Lee McPheters, economics professor at the W. P. Carey School of Business, observed:
Since 1948, the average growth in real output following a year of decline in GDP is 5.6 percent. But it seems unlikely there will be a corresponding Great Recovery following the Great Recession of 2008-2009.
The prevailing view among economy watchers is that the recovery will be "u" shaped rather than "v" shaped, meaning that real growth of Gross Domestic Product will be modest compared to past upturns and unemployment will remain as a persistent problem.
The March revision of the W. P. Carey economic forecast reflects this somber assessment. While 3.0 percent growth of real GDP for this year and next is not a "gloom and doom" outlook, it is consistent with expectations that consumers will remain cautious, business will be slow to expand plant, equipment and hiring in the face of excess capacity, and state and local governments will remain strapped for funds.
Declaring final truisms about the business cycle is always subject to the economic report du jour. Indeed, the only thing for sure in economics is what appears valid today, which is hopelessly bound up with the last batch of numbers in front of us. The world economy shifts and shakes based on, well, everything and anything. Depending on the day, it appears that we've isolated the key drivers. And to some extent we have...until it's no longer relevant.
But surely we've learned a few things over the decades. We know, for instance, that raising interest rates and letting banks fall like dominoes is something less than intelligent during an international financial crisis. It's the course of action after the worst of the danger has passed that's the central challenge.
The larger topic of debate is whether there's a cost to all our efforts at managing the business cycle. Have we simply traded the acute for the chronic in the last round of prescriptions? Some analysts warn that we're facing the problem of managing hefty debts and rising inflation in the years ahead with no easy solutions. Does that mean we're fated for stagflation? Or can we avoid this trap even as we sidestep the risk of Great Depression 2.0? So far, it looks like we've dodged a bullet. Then again, we're only halfway through this process. Perhaps the biggest risk is hubris at this point. It ain't over till it's over.
Or until the labor market starts expanding again on a sustained basis. "I personally put lots of emphasis on employment," Robert Hall, who leads National Bureau of Economic Research’s Business Cycle Dating Committee, told Bloomberg News last week. "“I think the odds favor a continuing expansion in employment, but I don’t have great confidence."
April 5, 2010
THE 10-YEAR TREASURY TOUCHES 4%
The benchmark 10-year Treasury touched 4% today. That’s the highest yield since October 31, 2008, according to Treasury data.
It marks a minor milestone, although it’s hardly a surprise, as we discussed in today’s previous post. In the wake of last week’s robust gain for March nonfarm payrolls, the market's focus has turned to interest rates, exit strategies and the supply and demand trends for government bonds. "The market is acknowledging an economy that's producing jobs and may be gaining momentum," Derrick Wulf, portfolio manager with Dwight Asset Management, tells Reuters.
Meantime, today’s auction for inflation-linked Treasuries was reportedly met with strong demand. The implication: the market’s eager to hedge future inflation risk. Nonetheless, the Treasury market’s 10-year inflation forecast (nominal less inflation-linked Treasury yields) remains subdued. Based on today’s closing yields, the market predicts inflation will be an annualized 2.31% for the decade ahead. That’s slightly higher compared with recent weeks, although it’s below levels reached in February.
Speaking of inflation, the San Francisco Fed today advised that a weak housing market hasn’t distorted pricing signals overall. The bank advised today in its Economic Letter that low inflation overall reflects economic weakness. The bank’s report offers additional support for keeping interest rates low, explaining:
Weakness in the housing market has reduced the inflation rate of the housing components of core inflation. Yet, this very substantial decline in the rate of housing inflation has not been isolated. Rather, it is indicative of a much wider decrease in inflationary pressures observed since the peak of the financial crisis. Even if we take housing out of core PCEPI, inflation has come down substantially over the past 1½ years. As a consequence, there is little reason to reduce the emphasis on core inflation as the main gauge of underlying price pressures in the economy. Recent core inflation trends reflect substantial and widespread disinflationary pressures, which, as Liu and Rudebusch (2010) point out, is likely due to a large amount of slack in the economy.
The real question is whether the bond market will accept this explanation. The front line here is the pricing of long rates, over which the Fed has relatively little control. It's too soon to say if today's rise over 4% in the 10-year is indicative of a new round of skepticism in the fixed-income market or just statistical noise. But the subject, at least, is now on the table for "discussion."
THE FOCUS TURNS TO BONDS, INTEREST RATES & INFLATION
As the benchmark 10-year Treasury Note inches higher, closing in on 4%, the chatter about interest rates and inflation is heating up.
The subject is all the more topical in the wake of last week’s encouraging jobs report. If the economy is gaining “momentum,” as former Fed head Alan Greenspan said yesterday, it’s only natural to expect higher rates. But how much is too much? The economy may be improving, but there’s still a long road of mending ahead. Warranted or not, the price of money is rising. As our chart below shows, the 10-year yield is just under 4%. That’s the highest since last June.
Are even higher rates coming? Yes, according to some bond bears at the outer edges of current forecasts. “Treasury rates will soar,” Kazuhito Miyabe, who assists with managing foreign fixed income in Tokyo at Toyota Asset Management Co., tells Bloomberg BusinessWeek.
Is inflation also headed higher? Not likely, at least not in dramatic fashion for the foreseeable future. The market outlook for inflation, based on the spread between the nominal and inflation-indexed 10-year Treasuries, remains modest at around 2.25%. That’s up sharply from the near zero percent range of late-2008, when the market feared a deflationary implosion. The low-2% range of late is merely a return to levels that prevailed before the financial implosion of September 2008. Yes, inflation's likely to creep higher, but it's unlikely to surge in the short term.
Nonetheless, this is no time for complacency on the matter of pricing pressures. Inflation appears to be bubbling, if only modestly, around the world. From Brazil to Australia, central banks are starting to focus on inflation. Rate hikes are still rare, but that too will change as the year rolls on. Consider, for instance, that Mexico, Brazil and South Africa, to name a few countries, have officially raised their inflation projections.
For U.S. policy, debating if inflation is, or isn’t, a clear and present danger going forward is topical within the Fed. As The Wall Street Journal reports today,
The Federal Reserve's decisions to keep interest rates near zero and to flood the financial system with credit are sparking fears of an eventual outbreak of inflation.
But inside the Fed, an influential band of policy makers is fretting over the opposite: that the already-low rate of inflation is slowing further.
The presidents of the New York and San Francisco regional Fed banks, William Dudley and Janet Yellen, see the abating inflation rate as convincing evidence the economy still is burdened by excess capacity and needs to be sustained by the Fed.
Others, led by Philadelphia Fed President Charles Plosser, argue that current inflation measures are distorted by an epic decline in housing costs and could mask a buildup of inflationary pressures.
Expectations about future inflation may hinge on whether there’s a consumer-spending response to last week’s news of March’s robust round of job creation—the first significant increase since the Great Recession began in December 2007. Minting new jobs in substantial numbers is one thing. Will that lead to a material boost in consumer income and spending? Maybe, although we’ll need to see the March gain in jobs creation roll on through the spring and summer to make a convincing case.
Meantime, there are new hurdles looming, starting with this week’s Treasury sale of a hefty chunk of new government debt. Last week’s selling in the bond market, which drove yields higher, was an act of standing back to see what happens next, according to one strategist. “No one wants to stick his neck out before the auctions," George Goncalves, head of U.S. interest rate strategy at Nomura Securities in New York, told Reuters late last week.
April 3, 2010
PUT A FORK IN IT?
Bloomberg News reports:
The biggest increase in employment in three years makes it “pretty clear” the deepest U.S. recession since the 1930s has ended, said the head of the group charged with making the call.
“I personally put lots of emphasis on employment,” Robert Hall, who heads the National Bureau of Economic Research’s Business Cycle Dating Committee, said in an interview. “I would say ‘pretty clear’ is a good description” for whether the economic contraction has ended, he said.
Among the top indicators the group uses is payrolls, according to its Web site. The government revised the January and February job count up by a combined 62,000, putting the March gain at 224,000 after including the updated data.
Does Joe Stiglitz still think otherwise? Last September, he predicted the recession would end in 2012.
MORE CHATTER ABOUT THE MARCH JOBS REPORT
Yesterday's monthly update on the labor market received a lot of attention, as you'd expect, given that it was the first real month of substantial gain for payrolls since the recession began in December 2007. But for all the cheering, there's still plenty of sobering realities to consider, including a few observations that caught my attention over the last 24 hours:
Mark Zandi, chief economist of Moody's Analytics: The U.S. economy has "turned the corner," but it will still take up to five years to regain all the jobs lost since the economic collapse, economic guru Mark Zandi told ABC News today… Despite the boost in jobs, the unemployment rate remained steady at 9.7 percent and Zandi said that rate "isn't going to fall anytime soon." He said it will remain high for the next six to nine months.
Dave Altig, senior vice president and research director at the Atlanta Fed: …the pace of net job creation is still well below the levels required to appreciably improve the unemployment rate or to make a sizable step toward regaining the eight million-plus jobs lost since the beginning of the recession. Updating a calculation referenced in a speech by Atlanta Fed President Dennis Lockhart on Wednesday, at a pace of 162,000 jobs added per month and at the current labor force participation rate, unemployment this time next year would still be just north of 9 percent.
Heidi Shierholz, economist, Economic Policy Institute: While the unemployment rate held steady at 9.7% in March, the long-term unemployment situation deteriorated. In March, an additional 414,000 unemployed workers crossed the six-months-unemployed threshold, so that now there 6.5 million workers who have been unemployed for longer than six months. The average unemployment spell was 31.2 weeks, the median unemployment spell was 20 weeks, and 44.1% of all unemployed workers had been unemployed for over six months.
Finally, David Beckworth, assistant professor of economics at Texas State University, examines yesterday's jobs report by industry and offers some interesting graphical analysis here. He observes that "it is encouraging to see the four industries hit hardest during the recession--construction, durable goods manufacturing, professional & business services, and retail trade--had jobs gains in March and all but one of them have had job gains over the past three months as well." Meantime, he notes that "the financial activities sector continues to lose jobs and has done so over the past three months."
April 2, 2010
JOB GROWTH WORTHY OF THE NAME ARRIVES…FINALLY
The labor market at long last posted a month of job creation that’s immune to second guessing, or so it seems. Nonfarm payrolls rose by 162,000 in March, the Labor Department reported this morning. That’s the biggest monthly advance in three years and the first convincing evidence since the recession began more than two years ago that the job market is recovering.
The revised employment numbers show that the economy added 14,000 jobs in January and 64,000 last November. But March's six-digit increase is the first compelling news that the labor market is growing and that the underlying numerical details aren't merely statistical quirks.
That said, one encouraging report doesn’t wipe away a two-year run of the longest and deepest contraction in the labor market since the Great Depression. But there’s no denying that today’s net gain in nonfarm payrolls appears to mark the end of job destruction. Deciding if this is a preview of things to come, or not, remains to be seen.
Only time will tell if the economy can continue to mint new jobs at a comparable pace in the months and years to come. In fact, simply returning the country’s nonfarm employment to levels that prevailed before the Great Recession in a timely fashion requires substantially higher numbers of job creation than the 162,000 increase logged in March. As of last month, nonfarm payrolls are still lighter by 8.2 million compared with December 2007, when the economy entered recession, according to NBER.
It’ll take time to assess the labor market’s return to growth, or even if it has legs. But judging by today’s numbers, the economy appears to have turned a corner. Indeed, the job creation was spread across economic sectors, suggesting that the positive change reflected broad economic momentum. The services industry led the rise, posting an increase of 82,000. The cyclically sensitive goods-producing sector reported a lower but still handsome advance of 41,000.
"Labor markets have shifted to expansion mode," Aaron Smith, a senior economist at Moody’s Economy.com, told Bloomberg News. "Some of the increase was payback for weather but more encouraging is that the recovery in hiring is spreading quickly across industries."
As encouraging as today’s jobs report looks, it’s important to remember that the enthusiasm is partly or perhaps largely a byproduct of relativity. It’s been well over two years since we’ve seen net gains of this magnitude in the monthly employment reports. That makes today’s news unusual by the standards of recent history, not to mention welcome. But a rise of 162,000 in payrolls in the grand scheme of American economic history is middling. A number of economic projections advise that 100,000 new jobs a month is necessary simply to soak up the growth in the civilian labor pool. Add to that, say, the 200,000 new jobs a month needed to repair the damage over the past two years and a back-of-the-envelope calculation suggests that today’s update, encouraging as it is, is at a minimum about half as much as what’s needed on a sustained basis over the next several years.
Meantime, one month of modest improvement a trend does not make. There are several reasons to second-guess the latest payroll number. That starts with the fact that roughly a third of the gain in jobs last month is due to temporary hirings for the once-in-a-decade census review. And there’s also questions about whether February’s snowstorms delayed hiring by a month, delivering a one-time boost to March’s numbers. Also, let's not forget that the unemployment rate didn't budge last month, sticking to an unchanged 9.7% in March—despite the net job creation.
In any case, it could have been a lot worse. Still, it needs to be quite a bit better, and for years.
"We have had this massive disaster, but we’re at a place now where things are stabilizing," Heidi Shierholz, an economist at the Economic Policy Institute, tells The New York Times. "But it’s nowhere near the level of growth we need to start moving the dial."
April 1, 2010
INITIAL JOBLESS CLAIMS FALL AGAIN
After a rocky period in February, the downtrend in initial jobless claims seems to be back on track, as today's
update suggests. Are we setting ourselves up for disappointment? Perhaps not, although tomorrow's monthly report on nonfarm payrolls will shed some light on whether we're being fooled again.
Meantime, the Labor Department reports today that new filings for unemployment benefits slipped by 6,000 to settle at 439,000. That matches the tally for the week through February 6. Indeed, those twin dips represent the lowest points since jobless claims peaked at a high of 651,000 back in late March of 2009. It's been (mostly) downhill ever since, albeit with some bumps along the way, including February's temporary surge.
As encouraging as the latest report is, the same old problem continues to lurk: signs of net job growth are MIA. A decline in the numbers of newly unemployed is critical, albeit less so as the weeks and months pass by. The key period for this data series as a window on the future has passed.
The sharp decline in newly unemployed over the past year has been a powerful clue that the economy would soon stop contracting. That's almost certainly the case, and we expect that the National Bureau of Economic Research will eventually declare the Great Recession's end as sometime in the second half of 2009. That's easy to say now, of course. An early clue was the persistent decline last year in initial jobless claims.
But that's old news. We know that the economy is no longer in danger of a death spiral. That's been a topical point of discussion for much of the past six months or so. The elephant in the room remains the debate about when net job creation will commence. In other words, the burning question is when the news for the labor market is positive. That's separate and distinct from learning that the news is less negative. In search of an answer, we await tomorrow's employment report.
FIRST QUARTER RALLY
March was generally kind to risk exposures. The main exceptions were commodities overall, foreign government bonds in developed markets and investment-grade U.S. bonds. But the slippage in that trio was more than offset elsewhere in the capital markets. As a result, our passive benchmark of the major asset classes—the Global Market Index (GMI)—rose by handsome 3.4% last month. That's the highest monthly performance since last September's 3.5% gain.
For the year so far through the end of March, GMI is ahead by 2.3%. That's a respectable performance for a passive benchmark that owns everything and shuns preconceived notions other than setting asset allocation to relative market values and letting the ebb and flow of prices run their course. As such, it's a worthy benchmark for considering the full boat of investment choices.
By comparison, the universe of actively managed balanced mutual funds in this year's first quarter rose by 2.1% (world allocation funds) to as much as 4.4% (target date 2041-2045 funds), according to Morningstar.
As for the lagging asset classes in this year's first quarter, there are two: commodities and foreign developed-market government bonds. Some of the blame is the rebound in the U.S. greenback in 2010's first three months. The U.S. Dollar Index jumped 4.1% this year through the end of last month. Commodities and foreign bonds denominated in local currencies are sensitive to the meanderings of the buck, and so it's no surprise that that those two corners of the markets have been weak this year.
Otherwise, what's driving the price of risk higher? A bullish outlook on the U.S. economy is arguably at the top of the list. We've come a long way since late-2008/early 2009. But there's one rather large fly in this ointment: the labor market. As we've been discussing for some time, the employment numbers have yet to offer convincing evidence that net job creation on a sustainable basis is imminent.
Will tomorrow's update on payrolls for March from the Labor Department tell us different? Or, to put it in investment terms, will tomorrow's report on jobs validate the rally in risk so far this year? Tune in tomorrow morning for the answer...