June 30, 2010
IS IT TIME TO CRANK UP THE PRINTING PRESSES…AGAIN?
The stock market isn't a happy camper. Yesterday's 3% drop in the S&P 500 was a sign that the deflationary worries that revived in May are still considered a real and present danger, including the possibility that the disease may affect the mother of all headline pricing series: GDP. No wonder that with a renewed worry over the D risk, government bonds are hot once more, with rising demand pushing the yield on the benchmark 10-year Note under 3% yesterday for the first time since April 2009.
Much of the discussion is now focused on whether talk of fiscal austerity is to blame for new surge in risk aversion. It's premature to emphasize budget cutting when the economic rebound is tenuous and the labor market has yet to show convincing sounds of durable and sustained growth. This argument can't be dismissed, but the more immediate threat seems to reside in monetary policy.
The annual pace of change has fallen sharply recently for various measures of the money stock in the U.S., from M1 to M2 and MZM. Seasonally adjusted M1, for instance, rose by 3.0% over the past year, based on weekly data through June 14. That's down from nearly 20% a year ago. MZM money supply has suffered an even sharper retreat and was is now in negative territory to the tune of -2.4% vs. the year-earlier reading midway through this month, as the chart below shows.
Is the money supply retreat relevant? Yes, or so a fair reading of economic history strongly suggests. Indeed, it's now been half a century since the publication of Milton Friedman and Anna Schwartz's monumental work A Monetary History of the United States, 1867-1960, which reordered the notion of cause and effect in analyzing the business cycle generally and the Great Depression in particular. The crucial factor is the evidence that the U.S. money stock fell by one-third during 1929-1933—at a time when it should have been rising, or at least holding steady, to offset the deflationary forces ravaging the economy. Summarizing the central bank's colossal error in the 1930s in Capitalism and Freedom, Friedman wrote:
Had the money stock been kept from declining, as it clearly could and should have been, the contraction [in the early 1930s] would have been both shorter and far milder. It might still have been relatively severe by historical standards. But it is literally inconceivable that money income could have declined by over one-half and prices by over one-third in the course of four years if there had been no decline in the stock of money. I know of no severe depression in any country or any time that was not accompanied by a sharp decline in the stock of money and equally of no sharp decline in the stock of money that was not accompanied by a severe depression.
The current Fed chairman Ben Bernanke knows this, of course. As one of the leading authorities on the monetary history of the Great Depression, Bernanke is ideally suited to fight the D risk in the here and now. And to be fair, Bernanke has applied some of those lessons, albeit in fits and starts, in recent monetary policy decisions. Today's economic threat generally is still a fraction of what it was in the early 1930s, and that's largely because macroeconomic wisdom has progressed in some respects. We've learned a lot over the decades, despite what you read. Even Friedman's great insights are just the tip of the iceberg by current standards.
The fact that the target Fed funds rate has been virtually zero for almost 2 years is one sign that the Fed has made at least a partial effort to atone for the institutional sins of the thirties. But as economists like Scott Sumner have been arguing persuasively for some time, monetary policy can and should do more (see here, for instance). In other words, the fact that nominal Fed funds is just about nil isn't necessarily a sign that the central bank is doing all it can to battle the risk of deflation.
Until May, the case that the Fed should do anything more was muted, thanks to the rebound in the appetite for risk. But now there's reason to wonder if Bernanke and company are misreading the economic tea leaves with a misguided monetary policy--a mistake that isn't obvious by looking at the nominal Fed funds rate alone. One recommendation is that the Fed should target a higher inflation target. Yet Bernanke has gone on the record saying that he rejected such a course. In a Wall Street Journal Q&A last December with various bloggers and economists, Brad Delong asked Bernanke: Why haven’t you adopted a [higher] 3% per year inflation target? The Fed head's response:
The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.
In short, Bernanke's worried about inflation, or at least he was in December. Is he still worried? It seems so, based on the rapid fall in the annual pace of change in the money stock. To be sure, worrying about inflation isn't a trivial concern, given the inflationary bias of fiat money. It'd be foolish to stop worrying inflation as a general principle. But inflation isn't a pressing concern at the moment, as we discussed yesterday. Yes, inflation will eventually become a concern, and perhaps a big concern, and sooner than the crowd expects, given the mounting debt on the government's balance sheet. And so we need to be ever vigiliant. But that's not the burning issue today, and it probably won't be for the near-term future. Deflation, by contrast, is a real and present danger. It may be a false danger, but it'd be unwise to ignore it at this point, given all the various warning signs bubbling elsewhere in the economy.
The Fed must fight the enemy at its door, rather than focus on the enemy that may attack in the future. And, yes, at some point, the focus will shift from deflation to inflation, at which point the central bank must act aggressively to mop up the excess liquidity. As always, there's a danger that the Fed may mishandle that priority when it arrives. Meantime, it seems to be mishandling the danger du jour.
Is deflation really the priority today? This is economics, and so there's always doubt. The good news is that monetary policy can be adjusted rapidly, in contrast to fiscal policy, which suffers from a number of setbacks that at this point make it look materially less desirable. The idea of waiting for Congress to debate the merits of a new fiscal stimulus, for starters, runs the risk of doing nothing for several months while the economic risk festers. And then there's the debate about fiscal vs. monetary stimulus generally. But we'll leave that topic for later. For now, cranking up the printing presses is practical and compelling today.
Why isn't Bernanke's Fed doing so? Perhaps there's political pressure, or perhaps he has information that suggests deflation isn't the risk that it appears to be. But the clock is ticking and the stakes are rising. If the money stock's rate of change keeps falling, the D risk looks set to rise.
June 29, 2010
ANOTHER DIP IN THE INFLATION FORECAST
The Treasury market’s 10-year inflation forecast is slipping…again. That’s no surprise, given the renewed concerns of late on the deflation front (see here and here, for instance). Unsurprising, perhaps, but still troubling.
The inflation outlook dipped to 1.88% yesterday, based on the spread between the nominal and inflation-indexed yields on 10-year Treasuries, according to government numbers. It’s unclear if this is an accurate warning sign that deflationary winds are set to blow stronger, but considering the economic climate of late it’d be short-sighted to dismiss the trend.
As the chart below reminds, the market’s estimate of the inflation outlook slipped below 2% late last month, and it’s remained under that level ever since, save for a few brief but so far fleeting flirtations on the other side. Lower inflation is generally a good thing, of course, but until the economic signals are stronger—particularly in the labor market—the possibility of falling inflation at this point is a sign of trouble.
The jury’s still out on what comes next, but we'll know more in short order. On Thursday, we learn of the latest for the ISM Manufacturing Index, weekly jobless claims and construction spending. A more telling stat arrives on Friday, with the update on the jobs report for June. The headline number on jobs is expected to be negative, but the positive spin is that the trend in private payrolls is expected to show gains. Nothing less is required to counter the weakening outlook on inflation. Indeed, the jobs picture for May was disappointing and the hour is late for convincing the crowd that the labor market has some degree of sustainable upside momentum.
Meantime, the warning signs on monetary policy are becoming too obvious to ignore, according to some analysts. "We're heading towards a double-dip recession," Chris Whalen, head of Institutional Risk Analytics and a former official at the Federal Reserve, told The Telegraph last week. "The party is over from fiscal support. These hard-money men are fighting the last war: they don't recognize that money velocity has slowed and we are going into deflation. The only default option left is to crank up the printing presses again."
Economist Scott Sumner argues that "the Fed suffers from the same sort of paralysis as it did in the Great Depression." It's hard to argue otherwise when looking at the annual rate of change in MZM money supply (M2 money supply less small-denomination time deposits plus institutional money funds). As the chart below shows (courtesy of the St. Louis Fed), the annual rate of change for MZM has turned negative recently for the first time since 1995. Unfortunately, we're not in 1995 anymore.
June 28, 2010
SPENDING & INCOME RISE IN MAY, BUT ECONOMIC RISK IS STILL LURKING
The markets tanked last month, signaling trouble ahead. Yet consumer spending and income rose in May, the government reported this morning. Were the bears wrong? Maybe, but that's not yet obvious, despite the gains in today's economics stats.
As always, the burning question is whether Mr. Market's expectations writ large are accurate, or just the latest incarnation of speculative fever gone haywire? No matter your answer, there's always doubt. Nonetheless, the recent selling that's taken a toll on asset prices lately is a legitimate signal that the dangers are rising for the economic recovery. How much of a danger is open to debate, of course. And on the surface, it's a bit easier to argue that the selling was overdone, based on today's income and spending report for May.
Disposable personal income rose by a solid 0.4% last month, according to the U.S. Bureau of Economic Analysis. Personal consumption expenditures advanced by half as much, although on a monthly basis May's progress on these twin fronts contradicts the bearish sentiment in the stock market of late. Was it all a false warning? No, at least it's premature to declare the new new deflationary threat is dead and buried. Indeed, today's monthly numbers in spending and income mask the larger trend taking its toll on income.
As the chart below highlights, the rolling 12-month percentage change in disposable personal income (DPI) suffered its biggest percentage downshift last month since this time last year, when the fallout from the Great Recession was still blowing through the numbers and the Great Reflation had yet to kick in. The year-over-year pace of growth in nominal DPI was 1.7% last month, down from a 3% annual rate of increase in April. The good news is that DPI is still rising on an annual basis, but no one can dismiss the downshift last month given the recent uptick in risk aversion. And since the broader trend is the more reliable signal for the economy vs. monthly numbers, there's reason to wonder what's coming.
Perhaps it's all statistical noise, of course. No doubt the crowd will pay more attention to the news that consumer spending broadly defined rose last month by more than the consensus outlook anticipated. “The U.S. consumer remains resilient,” Sal Guatieri, a senior economist at BMO Capital Markets, told Bloomberg News. “As long as jobs are coming back people will continue to spend.”
On that point we can all agree, bear and bull alike: jobs are (still) the key. Keeping the pace of income growth positive depends on the labor market. On that note, what would convince us that the sharp drop in the annual pace of DPI's growth is a one-time event with no larger significance for the economic recovery? A strong employment report for June (scheduled for release this Friday) would go a long way in soothing our anxiety. Unfortunately, the outlook isn't promising, based on current forecasts. Nonfarm payrolls are set to fall by 100,000 for June, according to the consensus outllook among economists, according to Briefing.com.
Forecasts can be wrong, of course. But not always. Meantime, there's a lot of economic territory between now and Friday. It's going to be a long week.
June 25, 2010
EMERGING MARKET EQUITY ALLOCATIONS
"The rapid growth of emerging economies has led to a shift in economic power," the OECD reported earlier this month, offering quantitative support for what everyone already knows. "Forecasts based on analysis by late economist Angus Maddison suggest that the aggregate economic weight of developing and emerging economies is about to surpass that of the countries that currently make up the advanced world." The economic and financial turmoil of late is accelerating the trend, according to analysis from the OECD.
In 2000, non-member OECD economies (generally those nations outside the rich developed world) represented a 40% share of the global economy, based on purchasing power parity. This year, the share has risen to 49%, and it's projected to reach 57% by 2030.
But economic weight doesn't translate into market influence, at least not yet as measured by relative market capitalizations. At the end of last month, emerging market equities represented about 12% of global market cap, according to figures published by Standard & Poor's. That's up sharply from a decade ago, when emerging markets were a mere 1% of global equity capitalization. But 12% still falls short of the commensurate economic influence of so-called emerging markets.
Some of this mismatch is related to the varied evolution of each country's capital markets, which is dependent on local customs, preferences, and so on. For instance, China's equity market cap is still just 1% of its economy, based on purchasing power parity GDP estimates via the CIA World Factbook and S&P market data. By comparison, the U.S. stock market is valued at roughly 84% of its GDP.
In fact, emerging markets generally tend to post relatively low market caps vs. their economies while developed nations have richly valued stock markets in comparison with their GDPs. If the OECD forecast is correct for continued growth in emerging markets' relative share of global GDP, the trend implies that rebalancing of market cap in the world's equity markets will also roll on.
What does this mean for investing? One message is that global equity allocations should, at the very least, hold a dedicated stake in emerging market stocks as a strategic matter. Thanks to the proliferation of ETFs and mutual funds in this space, tapping this slice of the world's capital markets is inexpensive and precise. For instance, one of the leading broad-market indexing choices listed in a recent review of these funds in The Beta Investment Report highlighted Vanguard Emerging Markets (VWO).
Earlier this week, I wrote about the power of a broadly diversified, multi-asset class market strategy over the long haul. As it turns out, passively buying all the major asset classes and letting it run has done a decent if unspectacular job of turning a profit. Over the past decade, for instance, my newsletter's proprietary Global Market Index has returned about 3.6% a year. Not bad for the so-called dumb money compared with, say, a roughly flat return for U.S. stocks over the same stretch. In Monday's post I also noted that an updated view of modern portfolio suggests that we should intelligently customize the unmanaged market portfolio in the quest for earning a better return, lowering risk without sacrificing performance, or some of each. Holding an above-market-weight allocation to emerging markets is one possibility, and arguably a compelling one, in part based on the analysis above.
How much should we hold in emerging markets? If you had no view on this corner of the equity market you could argue that a 12% weight in these stocks within an overall equity allocation is neutral, as per the analysis above. Materially altering that allocation (up or down) is risky, perhaps productively so. The same can be said for many other factors that collectively make up the broadly defined market portfolio.
For many investors, however, this is putting the cart before the horse. A neutral weighting for emerging markets is 12% of a broad equity allocation at present. Yet many investors hold far less than that share, if any. Will that change? Probably, which is part of the reason why holding a market-weight allocation, if not more so, is compelling. As Ben Graham famously observed, in the short run the market's a voting machine; in the long run, it's a weighing machine. In other words, economic reality dictates prices eventually, but not always immediately. Or, if you prefer, the market's efficient in the long run, but provides opportunity (degrees of inefficiency relative to a long-term equilibrium perspective) in the short term. Emerging markets are but one of the possibilities in a world brimming with betas (or asset pricing anomalies, as some like to say).
Over time, more investors around the world will hold more emerging market equities. No guarantees, of course. But unless you're wildly pessimistic on the long-term growth trend in the developing world overall, the writing on the proverbial investment wall looks rather conspicious. What's the catch? Short-term volatility can be vicious. There's still no free lunch, but for those with nerves of steel, a disciplined investment strategy and a capacity for exploiting contrarian-based trends, there's still plenty of opportunity. Par for the course.
June 24, 2010
GOOD NEWS, BAD NEWS & STILL WAITING...
Last week’s new jobless claims dropped by a strong 19,000 to a seasonally adjusted 457,000, the Labor Department reported today. That’s a welcome change, but it’s too early to say if this is the start of a new round of declines or just more statistical noise of bouncing around in a range. If recent history is a guide, prepare yourself for the latter.
New weekly filings for unemployment benefits have been meandering between 450,000 and 500,000 so far this year. The implication: the recovery in the labor market has hit a rough patch. Recent economic news doesn’t offer much reason to think that’s a material change for the better coming in the immediate future. For example, yesterday we learned that new home sales crumbled by a third in May to a record low annual pace of 300,000. "We’re going to see a home-sales air pocket after the end of the tax-credit stimulus," said Richard DeKaser, the founding economist at Woodley Park Research told Bloomberg News. "That means housing will be a drag on third-quarter economic growth."
New orders for durable goods also fell last month, slumping 1.1% in May, the Census Bureau reported this morning. The drop follows five consecutive monthly increases, which suggests that a correction was due. As for the cause of last month's decline, it was lead by a drop in orders for commercial aviation. But that's a volatile sector and if we ignore aviation, durable goods orders advanced in May by nearly 1%.
Nonetheless, there are still concerns about the strength of the economic recovery. “In the last month or so, we’ve seen a little bit of softening or cooling in the pace," Michelle Girard, senior economist at RBS, told Fox Business News. "We’re rising, but the numbers don’t show us rising as quickly. But it’s a far cry from losing some upward momentum to double-dipping. I think that’s where people have gone too far."
Maybe. Next week promises to be a test of optimism with the arrival of updates on personal income and spending on Monday, followed by Friday's employment report for June. The May jobs report was largely a disappointment. A repeat performance would raise serious doubts about what comes next. On the other hand, a surprisingly strong report might be enough to convince the crowd that the double dip risk was overblown. Place your bets…
June 23, 2010
THE FINER POINTS OF BEING WRONG
Most interviews with money managers are all about success and how wonderful the ABC Fund's performance has been over the years. But once in a while you find a discussion on the opposite end of the spectrum, and maybe that's a good thing if you can learn more from mistakes than from victories. In any case, author Kathryn Schulz--no stranger to analyzing mistakes via her book Being Wrong: Adventures in the Margin of Error--interviews Victor Niederhoffer on trades that went bad, decisions that derailed and unsatisfactory results of one kind or another. Neiderhoffer, of course, is a trader known as much for being a former partner with George Soros as he is for blowing up his funds. Victor's also the author of one of the all-time great reads on the subject of speculating in markets and in life (and, no, it's not just for traders): The Education of a Speculator. Schulz's Q&A with Niederhoffer is a fascinating discussion of "The Wrong Stuff." Definitely worth a read. Then again, maybe I'm wrong.
June 22, 2010
MINIMIZING THE THREAT OF "LUCK"
Carl Richards, a financial planner who blogs for The New York Times, laments the fact that equity investing has been distinctly unimpressive over the past decade plus. Earning a risk premium in the stock market "is a function of pure luck," writes the founder of Prasada Capital.
It's easy to understand why investors might be frustrated. The S&P 500's annualized total return for the 10 years through the end of May 2010 is slightly negative: -0.82% a year, according to Morningstar Principia software.
Looking at such uninspiring results motivates Richards to write: "This is why so many of us who have been investing for 15 years feel as if we are about back where we started, even if we did everything right (assets allocated, properly diversified, didn’t bail out at the bottom and so on)."
But let's not be hasty in drawing hard and fast conclusions about asset allocation and strategic-minded investing. Let's start by recognizing that the S&P 500 does in fact post a positive annualized return of 6.8% over the past 15 years. A $10,000 investment in the S&P on June 1, 1995 would have grown to nearly 27,000 by the end of last month, based on Principia calculations. Back to where we started? Hardly.
If you've been investing for 15 years and "did everything right" and still don't have much, if anything to show for it, you're obviously doing something wrong. It's not hard to imagine what that might be. If a know-nothing strategy of buying and holding an S&P 500 index fund can generate a tidy gain over 15 years, it takes real effort to throw that away. What are the possible reasons for missing out on the S&P's rise? All the usual suspects come to mind, including going off the deep end in picking individual stocks and excessive trading in and out of the index.
But what about the last 10 years? A slightly negative return for stocks over a healthy stretch of time is a tough fact to swallow. How should we think about that dismal performance? Is there something strange going on in the land of equities? Not really. Annualized 10-year returns for the S&P 500 over various holding periods since the 1930s have ranged from nearly 20% down to roughly flat to slight losses, according to Ibbotson Associates. Granted, most of the time the return is in the 5-15% range, but history reminds that outliers do arrive. Expecting otherwise requires ignoring the historical record.
In any case, most investors should hold a portfolio comprised of multiple asset classes. The full range of investable assets for the average investor includes stocks, bonds, REITs and commodities. The first cut in breaking these broad asset definitions into a finer array of buckets might look something like this:
In fact, passively holding the broad array of asset classes weighted by market value would have delivered a 3.7% annualized total return over the past decade, based on the Global Market Index (GMI), the proprietary benchmark of The Beta Investment Report. Simply rebalancing the mix in the table above back to the passive weights on an annual basis would have boosted GMI's return to 4.6% over the past 10 years. Unusual? No, not at all. A number of studies over the years suggest that a basic rebalancing strategy of multiple asset classes can add 50 to 100 basis points of return vs. the identical portfolio that's otherwise unmanaged. It's not a sure thing, of course, but there's no convincing evidence that suggests you shouldn't expect a rebalancing bonus over the long haul.
The point is that every investor should start thinking about strategy by considering two simple techniques that require no skill or forecasting prowess: 1) diversifying across asset classes using index funds and/or broadly invested actively managed funds; and 2) rebalancing the mix on a regular basis. There are no guarantees that these techniques will always and forever deliver positive returns, much less stellar returns. And in the short term, anything's possible, including steep losses and equally steep gains. But history suggests that asset allocation and rebalancing are a powerful mix when used prudently.
Are there other things you can do to juice return, lessen risk, or tap a bit of both? Yes, but the choices beyond steps one and two entail more risk and some degree of skill is required, and perhaps luck as well. Deciding if you want (or need) to move beyond steps one and two requires careful thought and more than a little research.
By contrast, the first two steps are no-brainers. They're hardly a short cut to easy money, but asset allocation and rebalancing are powerful tools for minimizing the odds of saying you're sorry a decade down the line.
June 21, 2010
A DEATH EXAGGERATED
Is modern portfolio theory (MPT) dead? Yes, according to many pundits and strategists. There have always been skeptics of modern finance, although membership in this club has risen sharply in recent years, thanks to the surge in market volatility and the steep losses posted by the major asset classes during late-2008 and early 2009. A popular argument is that multi-asset class diversification didn’t spare investors from unusually big declines, ergo, MPT failed. By that standard, the case for abandoning conventional asset pricing theory looks compelling. There’s just one problem: It’s wrong.
MPT never promised to limit losses, short-term or otherwise. Yet it’s become popular to assume that modern finance will offer investors a silver bullet by delivering tidy returns for little or no risk. No theory or trading system can assure that, but somehow those unreasonable expectations have crept into thinking about MPT.
Untangling the misinformation about standard finance is complicated, a topic worthy of a book and ongoing analysis when managing money. Meantime, let’s consider one piece of the misinformation pie: MPT failed to save investors from the hefty losses in late-2008 and early 2009.
That sounds like a reasonable complaint, but a careful reading of MPT reminds that no such promise was ever made. In fact, MPT is a body of research that provides an investing framework that offers to minimize if not eliminate one type of risk: idiosyncratic risk. This is the risk tied to picking individual securities. That risk can be harnessed for boosting return, of course. But it’s also the source of unusually big losses at times. The Warren Buffetts of the world needn’t worry about idiosyncratic risk, but for the rest of us it’s rash to dismiss it out of hand.
In the long run, idiosyncratic risk isn’t likely to generate a risk premium, at least not for the average investor. In the short run, of course, this risk can be harnessed for profit, but that’s a lot harder than it sounds, especially after adjusting for taxes and trading costs, as numerous studies remind. That not-so-subtle implication: avoid idiosyncratic risk. What you're left with is the market risk, which does generate a risk premium over time. A cost-effective way to earn a market risk premium is with conventionally designed index funds and ETFs. And if we consider a formal interpretation of MPT, the concept should be applied across all the major asset classes. In short, a simple, investable proxy of the “market” portfolio should be hold stocks, bonds, REITs, commodities weighted by relative values of those markets. Over time, this benchmark will earn a modest risk premium, according to MPT. Here’s one way to slice and dice the market portfolio, although minds will differ as to the best approach for defining the crucial components.
What do you get when you buy the market portfolio? Part of the answer is emphasizing what you don’t get: idiosyncratic risk. That leaves us with systematic risk, or the market’s beta risk. MPT forecasts that the market portfolio is the best mix of risky assets in risk-adjusted terms for the average investor over the long haul. In fact, that seems to be the case, based on my analysis of markets as published in The Beta Investment Report. Numbers don't lie. Alas, this information isn't widely published, certainly not in the usual suspects of financial journalism. Instead, the media likes to look at, say, the S&P 500 by itself over the last year or two, or even ten, and draw sweeping conclusions about MPT based solely on that massively misinformed perspective.
And since even properly defined systematic risk can be volatile in the short run, a naive review of MPT convinces many that the theory's worthless. But there is a grain of truth here. If you’re investment horizon is measured in days, weeks or even months, MPT’s not going to help you. No one who understands MPT ever claimed otherwise.
But over the medium- and long run periods, MPT’s still quite valuable. It’s still no short cut to big gains with little or no risk. But as a model for helping us think about designing and managing portfolios, MPT is still useful, if not essential. Yes, it’s an evolving theory, as I explain in my book, Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor. Financial economists have uncovered a number of risk factors beyond the broadly defined market beta that offer opportunities for enhancing the market portfolio’s risk-adjusted performance. On the surface, these opportunities look like evidence of MPT failures, although the risk-based explanations are compelling counterpoints.
One quick example is related to the research that shows that the market beta doesn’t fully account for risk and return. But the smoking guns on this front aren’t as cut and dry as the critics would have you believe. For instance, some researchers make a case for dismissing market beta as a robust tool for explaining return. A number of these studies are based on crunching the numbers on a monthly basis. But analyzing the connection between risk and return via beta over longer time frames shows a stronger linkage—strong enough to give pause before throwing out MPT entirely.
The conventional interpretation of MPT that’s widely embraced in the media is based on finance research through the mid-1960s. By that standard, buying and holding the market portfolio and letting it ride is the embedded wisdom. But research over the last several decades tell us that risk and return are more complicated, which implies doing something other than holding the unmanaged market portfolio. In the long run, the broad market portfolio is still likely to perform as theory predicts and generate middling to slightly above middling returns for relatively little risk compared with the various efforts to beat this index.
At the same time, let's recognize that MPT has evolved, even if it’s easier to claim that this theory is dead. What does an updated view of MPT tell us to do? In the coming days and weeks, I’ll take a closer look at some examples.
June 18, 2010
ONE ANALYST'S TAKE ON THE RECESSION RISK
The risk of recession is rising, warned Lakshman Achuthan, managing director Economic Cycle Research Institute, in an interview today. But it's not yet clear if the risk is the real deal or an idle threat.
What's clear is that the rate of growth in the economy is slowing, according to ECRI's weekly leading index, which slumped 5.7% last week and 3.7% the previous week. The downturn is pronounced and pervasive, Achuthan explained today on Yahoo Finance's Tech Ticker. What's missing to seal the deal in terms of making a clear forecast of recession is persistence in the trend, added the co-author of Beating the Business Cycle. It'll take a few months of watching ECRI's leading index to determine if there's a new recession ahead vs. a slowdown in growth. Of course, the clues may be obvious by then to even a casual observer.
In the meantime, there's only speculation, along with a reasonable range of opinion about what's coming, he advised. Although ECRI's brand of leading index has a good forecasting record, it's not perfect, he admitted. The future, in short, is still uncertain. So it goes with all economic forecasting techniques that have the thankless task of divining the future with yesterday's numbers.
As for the latest reports, the fact that economic growth is slowing isn't all that surprising. As we've been discussing on these pages for some time, a downshift was probably inevitable. Yes, we've had a "V" recovery, but it couldn't last, at least not at the pace over the past year. Unfortunately, the labor market has only recently joined the expansion, and only marginally. A downturn in the overall growth rate may threaten the nascent rebound in jobs. But as troubling as that will be if growth continues to slow, an outright recession would compound the problem.
But we're getting ahead of ourselves. The recession risk, although higher today than it was a month or two back, still isn't so severe that the threat is now destined to go viral. Nonetheless, the markets are predicting a higher risk of trouble ahead, as last month's selling suggested.
How worried should we be? As usual, Achuthan brings some much-needed perspective on the current reading of the business cycle. Let's go to the videotape…
(RE)CONSIDERING INVESTMENT NEWSLETTERS
Dow Jones sent me an email this morning inviting yours truly to partake of the enlightened analysis in The Hulbert Financial Digest, a newsletter edited by Market Hulbert that evaluates other investment newsletters. No doubt thousands received similar invites. But while it was one more marketing effort, the email was intriguing for what it says about published efforts at trying to beat the market.
"More than 80% of advisory letters fail to beat the market over the long term," the email advised, and goes on to note:
If you followed the advice of the bottom five worst-performing letters, you'd have lost almost your entire portfolio.
Because advisory letters only promote their successes, you never hear about their long-term failures!
Cut Through the Hype!
On the other hand, if you took the advice of the top 5 best performing advisory letters over the last 10 years, you'd have profited between 298% and 506%. Compare that to the Wilshire 5000 which returned 104% for the same period.
Now that's a rather dramatic bit of numbers. Indeed, 80% of investment newsletters trail the market over the long haul, and the worst ones destroy capital at a disturbingly high rate. (The "market" here is defined as a broad measure of U.S. equities, or so it appears based on the email copy.) On the other hand, a handful of letters analyzed—five, to be exact—beat the market by an impressive degree. The email doesn't say what percentage those high five are of the total universe, but it's reasonable to assume they're in the top 20% (or maybe top 5%?) based on the claim that 80% fall short of the market's performance.
Let's consider these stats for a minute. The news that 80% of investment newsletters leave you worse off than a broad market doesn't inspire confidence that there's a lot of active management talent in this corner of financial analysis. There are many studies documenting that beating the market over the long run is difficult, but an 80% failure rate is a bit high compared with how actively managed mutual funds fare against a relevant index. The implication: investment newsletters suffer from an unusually high degree of inferior analysis.
Why, then, should anyone even consider subscribing to an investment newsletter? Aren't the odds stacked against us before we even begin? If we were talking about anything other than investing, wouldn't an 80% failure rate convince you to look to alternatives? Imagine, for a moment, that the failure rate of bridges was 80%. Would you be willing to take a chance and drive over one? Imagine similar failure rates for routine surgery, aviation, food poisoning. But apparently in money management, an 80% failure doesn't scare off folks, or so it seems, once you recognize that financial newsletter publishing is a thriving business. If we include Internet-based pubs, the supply of published financial advice with an eye on beating Mr. Market totals something more than the population of New York City and less than the stars in the universe.
The riposte, of course, is that an intelligent analyst can cut through the noise and help you identify the winners. Really? If so, that surely would be worth something. In fact, it would be worth a lot. Indeed, the ability to identify winning newsletters that outperform the market by wide margins is such a skill as to suggest that you'd keep this information to yourself in a bid to become wealthy. That raises the question: Why can anyone buy this extremely valuable information for, say, $100 a year?
In the interest of full disclosure (while warning of the shameless plug to follow), I'm in the newsletter game too. I edit The Beta Investment Report, a monthly publication that, like countless counterparts, focuses on investing. And like every other financial newsletter, The Beta Investment Report claims to offer information of some value in the quest to make intelligent investing decisions. But where my newsletter parts company with most if not all investment newsletters is in the underlying philosophy. The Beta Investment Report isn't trying to beat the market per se. Rather, the goal is to analyze the capital and commodity markets, review new research and generally crunch the numbers and interpret the trends in order to fully exploit the power of broad, unmanaged index mutual funds and ETFs over medium- and long-term horizons in the context of a multi-asset class portfolio.
This is harder than it sounds, but it's a productive way to invest. The analysis starts by considering a broad, unmanaged mix of everything. In other words, the foundation of the newsletter's focus is monitoring the risk and return profile of investing in the broad asset classes, initially weighted by market value and thereafter let loose to meander untouched. The newsletter's proprietary Global Market Index (GMI), in other words, is a true passive benchmark for almost everyone. Theoretically speaking, it's the optimal investment portfolio for the average investor over the infinite future.
GMI's no silver bullet, but it does pretty well. For the past 10 years through May 31, 2010, for instance, this index posts an annualized total return 3.7%. That's hardly impressive, but then that's no surprise, considering that U.S. stocks were basically flat over that period while U.S. bonds overall in the investment grade space returned an annualized 6.5%.
What's in GMI? You can see the list here, which is updated every month on these pages. In the newsletter, of course, I go into greater detail. Some of the analysis in recent issues has analyzed how a simple rebalancing strategy of GMI has boosted returns a bit. Related analysis looks at the best ETFs and index mutual funds to use for building portfolios and how close attention to product selection can limit the total cost of replicating an investable version of GMI to around 50 basis points.
Yes, there's much more to discuss. For investors with a relatively high risk tolerance, for instance, the opportunity to make targeted allocations to risk factors beyond GMI broad holdings are reviewed as well. Adjusting Mr. Market's asset allocation to hold higher (or lower) weights in certain asset classes can be productive at times too. Ditto for targeting narrowly defined sources of priced risk that appear to offer unusually high expected returns. And on and on. There's no shortage of strategic-minded topics to discuss, and so there's never a problem filling the pages of The Beta Investment Report. But starting with the context of the unmanaged market portfolio via GMI is critical.
In sum, keeping a close eye on the various asset classes and focusing on low-risk areas of managing asset allocation that have a high success rate are the first lines of attack (or maybe it's defense) in trying to win the money game. In the investment journey that stretches out over the metaphorical 1,000 miles ahead, The Beta Investment Report concentrates on the first hundred yards or so—terrain that's widely overlooked, ignored or summarily dismissed. Ignored or not, there's a lot of meat on this bone. The kinds of questions that we seek to answer include: How can we capture the lion's share of the broad market portfolio's return with the least amount of risk? What are some low-risk techniques for trying to boost this passive benchmark return? What are the best funds that target a given asset class? What is new research in financial economics telling us that boost our strategic intelligence?
There are other ways of investing, of course, and some do quite well by moving far afield of the market portfolio. But many end up with high-priced mediocrity, or worse. That's why most investors should start by considering the broad market portfolio, moving beyond it carefully, and selectively. The first priority: First do no harm. Winning by first ensuring that you don't lose is a critical issue in money management, as Charlie Ellis famously explained in his book Winning the Loser's Game. Yes, that's counterintuitive. But this is finance, after all, and much of what appears to be clear and obvious is ambiguous if not misleading. No wonder that providing context and looking for clarity in the broader scheme is helpful. A radical idea, perhaps, but it works. The numbers speak for themselves.
June 17, 2010
THE TRENDLESS TREND IN JOBLESS CLAIMS
Today’s update on weekly jobless claims is more of the same. New filings for unemployment benefits continue to bounce around in the seasonally adjusted weekly range of 450,000-500,000. That’s been true all year, and today’s report doesn’t change anything. The longer this goes on, the stronger the case for thinking that the rebound in the labor market is going to be sluggish—perhaps more so than even the generally muted expectations of a month ago.
As for the number du jour, new claims rose by 12,000 last week to a seasonally adjusted 472,000, the Labor Department reported today. That’s obviously a change in the wrong direction, but we’ve been here before and we may be here for a while yet. As our chart below shows, the trend for jobless claims has been trendless since last November. The sideways action isn’t unprecedented in post-recession periods, but the potential for trouble this time is substantially higher, given the unusually steep losses in nonfarm payrolls over the past two years.
"We need faster growth in employment, and we’re not at that point yet," Michael Englund, chief economist at Action Economics LLC, told Bloomberg News in advance of today’s report. "Whether we have adequate economic growth to bring down the unemployment rate significantly remains to be seen."
Indeed. Economic data rolls out with a substantial lag, and it takes months to see signs of a robust trend, for good or ill. The labor market news of late has been mixed, at best. Today’s jobless claims suggest it’s best not to expect much more, if that, in the weeks ahead. The meandering of jobless claims signals that it may be time to downgrade expectations for growth in nonfarm payrolls. The May employment report said more or less the same thing.
And on the subject of downgrading expectations, don’t expect much of anything tomorrow in the way of fresh statistical meat. Friday’s scheduled lineup of economic updates is nil. Into this numerical abyss comes tomorrow's quadruple witching for the markets. The absence of economic news and the potential for lots of unwinding in derivatives approaches. It’s a perfect metaphor for the road ahead. Lots of noise, light and heat, but nothing really changes much.
"We're going to see a lot of back and forth action," predicts Brian Belski, chief investment strategist at Oppenheimer and Co. via CNBC.com. "It's a trader's paradise."
Is a new recession brewing? No, or at least I don't see the odds as particularly high for a double-dip contraction. Not today, anyway. But the risk isn't zero. It's still quite low, or so I estimate, but it may be rising, in part because the deflationary winds are blowing harder these days. But this is economics, and so no one's really sure what's coming. That doesn't stop anyone from making forecasts, of course. And if there was ever a moment for keeping an open mind, this is it. Here's a sampling of recent commentary on what the economic pundits are saying about the business cycle, pro and con...
...the case for a second dip still seems pretty overwhelming to me. I take comfort in the knowledge that I tend to have a pessimistic bias, and in the fact that sophisticated quantitative models are generally putting the odds of a second dip quite low. On the other hand, successfully forecasting recessions has not been a strong point of quantitative models.
--Andy Harless, chief economist, Atlantic Asset Management
The Chances of a "Double-Dip" are Essentially Nil...
Early in the recovery many forecasters, concerned that the nascent expansion was fueled only by temporary inventory dynamics and short-lived fiscal stimulus, fretted over the possibility of a double-dip recession. Now, with the emergence of the sovereign debt crisis in Europe, that concern has re-surfaced. Certainly we recognize that the debt crisis imparts some downside risk to our baseline forecast for GDP growth. However, based on current, high-frequency data — most of which is financial in nature and so is not subject to revision — we believe the chance of a double-dip recession is small.
One way we assess these odds is with a simple but empirically useful “recession probability model” in which the probability of experiencing a recession month within the coming year is a weighted sum of the probability that the economy already is in recession and the probability that a recession will begin within a year. The former probability is estimated as a function of the term slope of interest rates, stock prices, payroll employment, personal income, and industrial production. The latter is estimated as a function of the term slope, stock prices, credit spreads, bank lending conditions, oil prices, and the unemployment rate. Currently this model, updated through May’s data, estimates that the probability of another recession month occurring within the coming year is zero.
I wish I could believe in this Macroeconomic Advisers claim that there is a zero chance of a double-dip recession. But when they say that this probability "is estimated as a function of the term slope of interest rates, stock prices, payroll employment, personal income, and industrial production" I immediately lose all confidence. When short-term interest rates are up against the zero lower bound, a positive term spread tells you nothing...
--Paul Krugman, NY Times
The U.S. economy is slowly healing and will avoid a relapse into recession, the American Bankers Association's economic advisory committee said on Wednesday.
The US economics team at financial firm Morgan Stanley says in their latest research report that recent gains in the nation's economy point to a remote chance of a so-called double dip — where recent upticks in economic activity are only temporary — citing low mortgage rates as a key driver in drawing this conclusion.
June 16, 2010
HOUSING STARTS, BUILDING PERMITS & WHOLESALE PRICES RETREAT IN MAY
The markets told us that there were problems in May, and as the economic data rolls in there’s no reason to think otherwise. Today's numbers on housing starts and new building permits certainly suggest that the economic recovery struggled last month. The question is whether the change is temporary, or the sign of more trouble ahead?
At the very least, it's clear that the housing market hit a speed bump in May. New housing starts dropped 10% in May on a seasonally adjusted annualized basis, the government reported this morning. Building permits also fell last month by nearly 6%. The year-over-year trend is still positive, but the pace of expansion has slowed considerably in both cases. Another month or two of setbacks and housing starts and permits could be posting declines vs. the year-earlier figures. If that happens (and it's not obvious that it will), the dip into negative territory on an annual basis would be a disturbing sign for the forces of expansion.
Adding to the anxiety in the numbers du jour is today's update on wholesale prices, which dropped in May—the second straight monthly decline and the third so far this year. Deflationary winds generally appear to be blowing harder these days, if only marginally, as we've been discussing (see here and here, for instance). Today's producer price report won't soothe those concerns.
"We’re still in disinflationary territory and probably will be for a while," Julia Coronado, a senior economist at BNP Paribas in New York, told Bloomberg News ahead of today's reports. "If anything, the Fed is going to be erring on the side of more easing rather than tightening."
To be fair, the weakness in housing last month was to some extent expected, considering that the federal subsidy for new home buyers recently expired. And if we look at core wholesale prices (excluding food and energy), producer prices actually rose 0.2% last month. In addition, wholesale prices overall on a 12-month basis remain firmly higher, advancing more than 5% for the year through May. In addition, the Federal Reserve reported this morning that industrial production rose by 1.2% last month--the strongest monthly gain since last August. Even better, the cyclically sensitive durable goods sector was a key reason for the growth. May had its problems, but it was far from a complete wash-out.
And if we focus on the longer-term trend, it's still clear that upside momentum has the upper hand. The broader year-over-year trends, in fact, are superior gauges of economic activity. Monthly numbers, by contrast, are subject to any number of one-time events and statistical noise. Looking at the annual pace minimizes such distractions. On that basis, housing and wholesale prices are still in recovery mode. Ditto for industrial production, which rose by nearly 8% for the year through May.
Even so, the warning signs last month are unmistakable, particulary for housing. There's no doubt that the economic recovery had a rough time in May. We should prepared for additional confirmation as the remaining economic reports for last month arrive. This news is already factored into market prices, as suggested by last month's sharp drop in the broad indices for the major asset classes. The greater challenge is deciding if May was a blip, or the start of something more ominous.
No one should discount the possibility that the economic recovery faces stronger headwinds. But based on a broad review of the economic reports, including our broad economic index published and analyzed in The Beta Investment Report, we still think economic growth will prevail. Expansionary momentum is slowing, but that's not surprising. The powerful rebound of last year was destined to slow.
The bigger problem is that the growth looks set to remain subpar for an extended period. The low-grade pace of expansion ultimately threatens another round of economic contraction, although that risk looks minimal for the rest of this year.
Nonetheless, the great hazard that we've been talking about since last year is upon us. The post-snapback period in the economy is history, replaced by the harder work of keeping the rebound in positive territory. The numbers in May remind that the task ahead isn't going to be easy. Indeed, there's chatter bubbling that the Fed will soon pare its economic growth forecast for the U.S.
June 15, 2010
STILL WORRYING ABOUT DEFLATION
If a wave of deflationary threatens the global economy’s rebound, will Japan be the canary in the coal mine. Probably. It’s certainly a high risk country, in part because it’s already loaded to the gills with debt from efforts at fighting deflation over the past 20 years. There are no guarantees in macroeconomic analysis, but if Japan’s already cheerless outlook takes a turn for the worse, it may signal that deflationary winds are set to blow harder in the rest of the world.
Gross public debt in the Land of the Rising Sun is at 200% of the Japanese economy--the highest in the developed world. "It is difficult to continue our fiscal policies by heavily relying on the issuance of government bonds," Japan’s prime minister, Naoto Kan, said last week. "Like the confusion in the eurozone triggered by Greece, there is a risk of collapse if we leave the increase of the public debt untouched and then lose the trust of the bond markets," the former finance minister advised.
The FT's Martin Wolf argues that Japan could easily inflate away its debt problem…if it chooses to. But it's not obvious that Japan is willing to embrace higher inflation as a way out of its debt problems. In fact, some economists say that Japan's long-running on-again/off-again troubles with deflation, and weak economic growth, are self-inflicted. Scott Sumner, for example, laid out the case this way:
The evidence is absolutely overwhelming that the BOJ didn’t want even 2% inflation. The BOJ behaved exactly like a central bank who wanted to keep CPI inflation at 0% or slightly below, and they have succeeded in that objective better than almost any other central bank in the world. Here’s the evidence:
1. They twice tightened monetary policy (in 2000 and 2006) when Japan did not have any inflation. They did this by raising interest rates. What does that tell you?
2. The monetary injections of 2002-03 were temporary, and withdrawn in 2006, despite the fact that there was no inflation. Temporary currency injections are not stimulative.
3. They let the yen appreciate sharply from about 115 to 85 to the dollar, despite falling prices in Japan.
4. They continually refuse to set a positive inflation target, as the Fed and ECB have either implicitly or explicitly done.
5. They refuse to do level targeting, which is known to be very helpful during deflation. This would force them to make up for past deflationary mistakes.
When will people stop talking about the BOJ as some sort of helpless victim of deflation who did all they could, and recognize that they are an extremely reactionary central bank, much more so that the Fed or ECB?
Why is this important? Because if you recognize that a regime of level targeting can prevent deflation, even during a financial crisis, then you also recognize that it can prevent a severe demand-side recession in the wake of a financial crisis. And you will also see the current fall in inflation to levels far below “price stability” as a failure of monetary policy, not some sort of inevitable side-effect of a recession that was caused by financial distress.
Is Japan's reluctance to go the full nine yards with monetary stimulus the result of a cultural bias? Political? Economic? Perhaps part of the answer can be found in reviewing America's debate over monetary policy. Although the deflationary threat seems to be running a bit higher these days, some economists are calling for a tightening of monetary policy. But this risks repeating the Fed's monetary mistakes of the 1930s, others respond. "The attitude on display from quite a few economists [calling for higher rates] bears a distinct resemblance to Depression-era liquidationism," writes Paul Krugman.
What does the Fed think? James Bullard, president of the St. Louis Fed and a voting member of the FOMC, today said that "the global economy is now in the middle of a powerful recovery led by Asia." Meanwhile, he worres about the red ink on the U.S. balance sheet, defined as "high deficits and a growing debt-to-GDP ratio." But a double-dip recession risk looks low, while inflationary troubles down the road are looking stronger, he advised. Bullard continued:
The U.S. has exemplary credibility in international financial markets, built up over many years. Now that the U.S. economy is about to achieve recovery in GDP terms, it is time for fiscal consolidation in the U.S. Irresponsibly high deficit and debt levels are not helping the U.S. economy and could damage future prospects through a loss of credibility internationally. A substantial and credible fiscal adjustment could set up the U.S. for a sustained period of growth, as it did in the 1990s.
It sounds like one FOMC member is leaning toward higher rates. What does the market think of all this? If we look at the inflation forecast based on the spread between the 10-year nominal and inflation-linked Treasuries, the jury's still out on whether the deflation worries of May were a blip or the start of a new threat. The market's inflation forecast is still hovering at just under 2%--the lowest since late-2009.
In the stock market, last month's sharp correction has, at least for the moment, been put on hold. The S&P 500 has been moving sideway for the last several weeks.
What might change the market's outlook, one way or another? More economic numbers, of course. The May data are still rolling in. Tomorrow we learn how housing starts and industrial production fared in May, followed by an update on Thursday on last month's consumer price inflation. Next week brings word of durable goods orders for May.
Meanwhile, the latest numbers on manufacturing in the New York region suggest there's more strength in the economy than some thought. “The manufacturing recovery is continuing at a pretty rapid pace into the middle of the year,” Zach Pandl, an economist at Nomura Securities tells Bloomberg News. “So far, we have seen no signs of spillover from Europe to the U.S.”
In fact, it's going to take a few months to make an informed decision. Till then, it's debatable if deflation is the new new threat. Economists have learned a lot in recent decades about what works and what doesn't in macro policy. Maybe. But there's still the old problem of uncertainty. Enlightened economic policy still relies heavily on waiting for the numbers...and forecasts about the future.
That said, history suggests it's best at times like these to lean on the side of promoting more inflation rather than less. When and if higher inflation rears its ugly head, which it undoubtedly will one day, the central bank can quickly and effectively deal with the threat. If—if—it's willing and able. That's a big if, of course. But it's hardly a solution to let deflation build a head of steam. Decisions, decisions...
June 14, 2010
THE MARKET PORTFOLIO & YOUR "PERSONAL BETA"
Moshe Milevsky, a professor at York University, recommends thinking strategically about your “personal beta” for managing risk. That begins by evaluating your human capital, he advises in today's Wall Street Journal. "It's a measure of your future earnings, a product of what you've invested in yourself." Good advice. In fact, evaluating your career risk is job one when considering how to modify the broad market portfolio. But even before you do that, you need a good definition of the market, and the usual suspects just won't do.
I spend a lot of time studying an expansive definition of the passively allocated market portfolio. It's hardly a silver bullet, but it's a critical part of developing an investment strategy and surveying market opportunity and risk. Surprisingly, it's routinely ignored by most investors. Maybe that's because it's hard to find good measures of the market portfolio, which is why I decided a while back to calculate it myself. In each monthly issue of The Beta Investment Report I review the broad market's performance, asset mix, risk allocation, etc. Why? Because over the long haul, a robust definition of all the major asset classes, weighted by their passive market cap weights, is the optimal investment portfolio for the average investor. Many investors will outperform this benchmark, but many will trail it. And if you factor in taxes and trading costs, perhaps the majority of investors will fall short of the broad market portfolio benchmark over time.
Decades of financial economics predict no less, as outlined in my book Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor. Theory, of course, doesn't pay the bills. Is there any reason to think that academic deciphering of asset pricing has any relevance in the real world? Yes, based on my analysis on the proprietary index published in The Beta Investment Report.
For instance, over the past decade, the Global Market Index (a passively weighted measured of all the major asset classes) posted a roughly 3.4% annualized total return. (For a list of the underlying indices used in the calculations, see the benchmarks noted here.)
That's more or less middling, if not disappointing. But in other periods, the market portfolio has done better. Returns can and do fluctuate. As for the past 10 years, times were tough on two of the index's biggest components: equities in the U.S. and foreign developed nations--both trailed the market portfolio. On the other hand, the last 10 years also delivered stellar returns in REITs and emerging market stocks and bonds.
The point is that a mindless indexing strategy of owning everything in its market-weighted proportions delivered a modest return over the past decade. Could you have done better? Sure, but you could have also done worse, perhaps a lot worse. In fact, many investors suffered for taking radical asset allocation bets, believing that a given manager could easily beat the market, etc.
The central challenge for strategic-minded investing is deciding how to modify the market portfolio. The possibilities are, of course, endless. We could, for instance, alter Mr. Market's asset allocation, or manage it dynamically, or use actively managed funds as replacements for the various index components, and so on. In fact, there's a case for some prudent modifications, if only because individual investors are something other than average and the market's aren't always and forever a pure random walk.
But we should proceed cautiously in changing the market's allocation. In other words, we need to pick our poisons carefully. History suggests that the path of least resistance does otherwise. A fair amount of the modification's to the passive asset allocation ends up delivering self-inflicted wounds. Owning U.S. equities in isolation over the past 10 years, for instance, hasn't worked out that well. Of course, if we go back a decade to the year 2000, expectations were sky high in thinking that stocks would bring big, easy gains.
The debate about what to do, and when to do it, is a career unto itself when it comes to considering the possibilities for modifying the market portfolio. All the more so if we factor in the confusing messages that bubble forth from Wall Street. To be blunt, much of what passes for productive advice is misguided, misleading or just plain dangerous.
Fortunately, there's a great place to start, as Milevsky's article suggests. In effect, he tells us to "think smarter about risk." That's also the advice embedded in decades of financial econoimcs research, i.e., successful investing is primarily a task of managing risk as opposed to chasing return.
As one example, imagine that you work for an oil company. Your career is tied up with the fortunes of energy. In effect, you're personal beta is long energy, perhaps in a big way. If the energy business does well, you'll do well, and vice versa. That suggests lightening up on the allocation to energy stocks in your investment portfolio, if not avoiding energy companies altogether. In fact, you might even consider shorting energy firms.
Thanks to ETFs and index mutual funds, customizing Mr. Market's portfolio is easy, efficient and inexpensive. Some of the customization is a no-brainer. But some of it's speculative, and other decisions are downright foolish. Knowing how to spot the difference is the first step in boosting the odds that you'll end up with something more than Mr. Market's returns over the next 10 years.
June 11, 2010
RETAIL SALES DROP IN MAY
Retail sales dropped 1.2% last month on a seasonally adjusted basis, the Census Bureau reported today. That’s the biggest monthly decline since last September’s 2.2% fall and the first retreat since December’s mild 0.2% loss. The latest drop in retail expenditures, coming at a time of rising deflationary worries, suggests that the worst fears about the economic recovery are confirmed. But while it’s too soon to dismiss such concerns, today’s retail sales update for May isn't the smoking gun it appears to be.
Indeed, monthly retail sales figures bounce around a lot and so we should be cautious in reading too much into any one number. Consider a bit of perspective. Over the past five years, monthly percentage changes in this series has ranged from roughly a 3% rise down to a 3% fall. Meanwhile, the first four months of this year logged consecutive gains. As a string of non-stop monthly advances go in retail sales, that’s about as good as it gets. In other words, we were due for a pullback. That doesn’t mean all’s well, but at the moment it’s hard to determine if the broad economic trend is getting worse simply by looking at retail sales for May.
Consider the 12-month rolling percentage change in retail sales, a superior gauge of the underlying trend vs. the monthly numbers. Like many economic statistics over the past year, the annual pace of retail sales has rebounded sharply, as the chart below shows. In April, retail sales were higher by more than 8% over the past 12 months. But that rate of improvement is unsustainable, even under the best of economic conditions. A downshift was always inevitable, and more of the same is surely coming. As of last month, the annual pace slowed to a gain of less than 7%. That’s still high by historical standards, which implies that we'll see a further slowdown.
If this was a “normal” economic recovery we might leave it there and move on to the next topic. But the business cycle is far from normal at this point. We’re referring, of course, to the labor market, the last great unknown in an otherwise encouraging economic recovery, at least in terms of the shift in trend over the past year.
The marginal change in retail sales relies on the general trend in the labor market over time. And much of the news on the change of trend in the job market has been positive over the past year. Nonfarm payrolls have gone from shedding hundreds of thousands of jobs every month to eking out small gains. An impressive rebound. From the depths of hell to the subpar normality in a year. As employment recoveries go, the change has been striking, particularly since it’s come over a relatively short span. As such, the improvement in retail sales over the past year is more or less tracking the change in the labor market and other economic metrics. No big surprise there.
But as we’ve discussed many times over the past year, the big challenge was less about rebounding off of depression lows. Rather, the critical question: How will the economy fare this time once the danger of outright economic implosion had passed? It’s passed, and we’re now knee-deep with the tougher task of keeping the positive momentum going and avoiding a double-dip recession.
The risk of slipping back into outright economic contraction still looks low, but much depends on how the numbers play out over the summer. Are we concerned that retail sales are headed for a prolonged slowdown? Yes, or at least we’re a bit more anxious today after reading the latest numbers. But it's important to point out that last month's retreat was led by a record 9.3% tumble for spending in the building materials and garden equipment industry. It's probably no coincidence that a homebuyer tax credit recently ended, and so sales for this group were negatively affected with a one-time demand reversal tied to the end of a government stimulus effort.
The downturn in private-sector job creation in May is more worrisome. Clearly, May was a tough month, as the markets recognized via a sharp round of selling. It's becoming clear why May was the worst month for the broad asset classes in more than a year. We still don't have a full picture of May's economic numbers, but as the reports in the coming weeks arrive, we're expecting the numbers to look soft.
The bigger mystery is whether the trend in June, July and August will confirm or deny the events of May. Over time, government stimulus will wind down. Will private sector demand be able to fill the gap, or at least keep the trend from turning negative? No one has a crystal ball and so the best we can do is guess. For what it's worth, we're still modestly optimistic that the economy will muddle through. Today's retail sales numbers don’t materially change this view. But that’s cold comfort. There are other demons lurking that could pose trouble in the weeks and months ahead. Yes, it's going to be a long summer.
June 10, 2010
JOBLESS CLAIMS CONTINUE TO MOVE SIDEWAYS
New filings for jobless benefits dropped a bit last week, the Labor Department reported today. But the trend is still stuck in a rut. For most of this year, initial weekly jobless claims on a seasonally adjusted basis have been in a range of roughly 450,000 to 500,000. Last week’s tally of 456,000 is a slight improvement over the previous week’s 459,000, but there’s still no sign in the data that a dramatic decline is imminent for this series.
Why are new claims treading water this year? An insufficient rebound in the labor market. And considering the tepid momentum in private-sector job creation in May, it’s not obvious that a dramatic change for the better is just around the corner.
The optimistic spin is that progress in lowering initial jobless claims sometimes pauses after a recession. After the 2001 downturn, new jobless claims fell to around 400,000 in early 2002, moving sideways for the next several years, and even reversing course by rising for a time in early 2003. Keep in mind too that job growth in the wake of the 2001 recession was unusually weak. After the 1990-91 recession, jobless claims also meandered for a time. But the meandering was brief and the pace of job creation was better. Jobless claims dropped sharply to pre-recession levels in 1992, or roughly 18 months after the recession’s official end, as per the National Bureau of Economic Research.
Let’s assume that the Great Recession ended in June 2009. By that standard, the trend in jobless claims doesn’t look all that disturbing. Meanwhile, despite all the anxiety over the pace of job creation, let’s recognize that the net job growth in nonfarm payrolls has snapped back dramatically. Over the past year or so, the economy has gone from shedding jobs at nearly 800,000 a month at one point to modest gains in recent months. That’s a stellar recovery in a short amount of time, and it was all but anticipated by last year’s sharp drop in jobless claims.
The primary challenge is building on the recovery to date. As we’ve been discussing for some time, the main threat isn’t a double-dip recession. We can’t rule that out, but the bigger problem for now is overcoming the rising odds that the economic recovery remains lukewarm.
One more clue for thinking so arrived in yesterday’s monthly update for the Livingston Survey, the oldest continuous review survey of forecasts from dismal scientists. "Projections for the unemployment rate have been revised downward throughout 2010, but it is still expected to remain above 9 percent into the middle of 2011," advised the accompanying press release.
Yes, that’s just one more prediction, and it should be viewed with the usual degree of suspicion. Meanwhile, it’s still possible that future labor market news will be considerably brighter. That's not beyond the pale, given the rebound in the labor market from massive losses to modest gains over a 12-month stretch. But for the moment, at least, the jobless claims numbers offer minimal incentive for thinking we’re on the cusp of a job creation renaissance.
"The labor market is not as healthy as it should be at this stage of the recovery," John Herrmann, senior fixed- income strategist at State Street Global Markets, tells Bloomberg BusinessWeek. "Hiring isn’t ramping up and this means there are downside risks to growth, income and consumption."
June 9, 2010
THEY POP BUBBLES, DON’T THEY?
They’re everywhere. In that market, in this country. The bubble detectors are out and about and productivity is up. If you don’t see the bubbles, well, you’re just not looking hard enough…or reading the right columnists.
A few examples of recent vintage…
"The bond market is a bubble," says Robert Froehlich, senior managing director of the Hartford Financial Services Group. "And it's getting ready to burst."
"The next bubble -- and this is the lesson of what this Greek drama was all about -- is sovereign debt." (John Hathaway, Manager, Tocqueville Gold Fund)
…gold is in a nascent bubble.
The Gold Bubble blog
The Australian dollar faces a "bumpy and volatile ride" because of the risk that China’s property bubble may deflate, HSBC Plc said…
The notion of a bubble implies that returns are predictable, and in a timely manner. Simply claiming that a given market is destined to correct, fall, crash or implode at some indeterminate point in the future isn’t enough. Even a broken watch is right twice a day. Is there a statute of limitations on predicting the end of a bubble? No, but there should be.
It's no great surprise to learn that bubbleologists prefer to shy away from precise or even semi-vague predictions tied to a specific point in the future. I don’t blame them. After all, who wants to look foolish by claiming that the bubble in market X will pop in 13 months and four days. A preferable formulation is something along the lines of: We think valuations are overextended and the risk of a correction is high.
Of course, some commentators aren’t shy about throwing caution to the wind and invoking the "B" word directly. George Soros went out on a limb in January and opined that gold was in "the ultimate bubble." And Warren Buffett wrote in Berkshire Hathaway's 2008 annual report that the U.S. Treasury market was a "bubble" in late-2008. But bubble logic isn't always, well, logical.
Gold, of course, is up about $100 since January, reaching a new all-time high yesterday. As for Treasuries, they didn't do so badly. As one example, the iShares Barclays 7-10 Year Treasury ETF (IEF) posted a 10.4% total return for the year as of yesterday's prices, according to Morningstar. For the past three years, IEF's annualized gain is 9.5%.
Bubbles, it seems, are a slippery lot. Yes, sometimes the pricking of bubbles arrives more or less as expected, but not always. But if you believe in bubbles--more to the point, the ability to profit from them--the opening quotations offer ample opportunity for making a tidy bundle. You'll also have plenty to read from like-minded analysts, such as When Bubbles Burst: Surviving the Financial Fallout and Bubbles, Booms, and Busts: The Rise and Fall of Financial Assets.
Bubble talk has lots of appeal at times, and with the benefit of hindsight some of the chatter turns out to be accurate. Focusing on the bubble forecasts that turned out right suggests that it's productive to look for bubbles on a regular basis. So why aren't more people getting rich from identifying bubbles in advance? Maybe the question should be: Is anyone profiting from bubble predictions? Yes, someone is. Maybe lots of them. But is there any way to objectively document the good fortune? Meanwhile, since we're asking questions, how might you distinguish bubble profits from an otherwise talented investment strategy? Or maybe they're one and the same. Meantime, how should we think about the bubble forecasts that went bad? There's plenty of those as well. Does their existence imply that we should ignore bubble predictions?
Bubbles, it seems, are complicated. Sure, bubbles exist, but they're not always obvious ex ante, even if they're clear as a bell ex post. Or as Charles Kindleberger wrote in his classic Manias, Panics, And Crashes, financial crises are "a hardy perennial."
But as investors should we ignore bubble talk? No, not necessarily, although not all bubble predictions (or bubbleologists) are created equal. There's plenty of research that tells us that when fundamental valuation metrics on the stock market (dividend yield, price-earnings ratio, etc.) go to extremes, future returns have a tendency to suffer or benefit accordingly. Timing is still critical, and it opens the door for debate. Still, financial economists have found quite a bit of evidence that risk premia aren't randomly distributed, which means that there's varying degrees of predictability for asset classes through time. But just don't bet the farm on it.
As the old saw reminds, Predicting is difficult…especially about the future.
June 8, 2010
MONETARY THEORY IN ONE PARAGRAPH....
Don't try this at home, at least not without a dismal scientist as a chaperone. But if you could only read one paragraph about monetary policy (I know, I know), here's a possibility to consider. It comes courtesy of Scott Sumner's The Money Illusion. I'm reasonably sure that excerpting the following and trying to pass it off as a silver bullet for understanding, defining or otherwise explaining the fundamental laws of monetary policy is hopelessly misguided. Still, it's hard not to admire one economist's view of how the ebb and flow of money supply influences prices and market preferences (even if my editing runs the risk of running off the literary road into reductio ad absurdum). Enough...judge for yourself. For unexpurgated context, here's the full essay. Meantime, here's the laconic excerpt...
I want you to imagine that everyone understands and believes in the QTM. Imagine you live in a country where a typical 3 bedroom ranch house sells for $200,000. Also assume the money supply has been stable for years. Now the Fed suddenly doubles the money supply. What will happen to the price of that house? Keynesians will say “nothing”; prices are sticky. If they are right, I plan to buy up as many houses as I can, right after the money supply doubles. And then sell them again when the house prices double later on. But I actually think it more likely that the sellers will also understand this implication of the doubled money supply, and won’t hand me a $200,000 profit on a silver platter. They’ll immediately demand higher prices. The Keynesians are right that in the real world many prices rise more slowly, but in any case they do eventually rise.
IS THE DEFLATION RISK DEFUSED?
The jump in deflationary risk last month is still a real and present danger, if only marginally. But given the market reaction of late, it would be shortsighted to dismiss the threat. Yet there are reasons for optimism. One is that the inflation forecast in the Treasury market has stopped falling. Two, the money supply growth rate is no longer dropping like a rock.
It’s unclear if the inflation outlook will remain steady, fall or rise in the weeks and months ahead. Ditto for the rate of change in the money supply. But for the moment, there’s been a pause in downward trend in both measures, suggesting that the deflationary threat, for the moment, isn’t getting any worse. It’s open to debate if it’s getting any better, but first things first.
As our first chart below shows, the market’s inflation outlook (based on the yield spread between nominal and inflation-indexed 10-year Treasuries) has stabilized at just under 2%. That’s down from around 2.45% in late April. The drop in the inflation outlook in May coincided (not surprisingly) with a sharp decline in asset prices. Although equities and commodities have yet to recover those losses, and have fallen further so far in June, Mr. Market is no longer anticipating that the D risk is getting worse per se. That’s hardly the same thing as saying that the recent anxiety over deflation was wrong. It may be, but it'll take time to know for sure. Meantime, the markets seem to be taking a wait-and-see approach after the recent repricing. Prices have been discounted a bit to reflect the higher D risk. The question is whether future economic reports will confirm or deny.
One reason for thinking positively is that the U.S. money supply is no longer falling at the steepest pace since the Great Depression, as it was in recent months. As the second chart below shows, M1 money supply (seasonally adjusted) rose by 3.4% in the week through May 24 vs. a year earlier. That’s well off the cyclical highs of 10% to 12% that prevailed in early 2009. But the pace now appears to have stabilized at roughly 3%-4%. A similar stability has recently arrived in the broader M2 money supply trend.
Is this a sign that the Fed is responding to the recent rise in deflationary risk? Perhaps, although the trend bears watching over the summer. Pressure is mounting for the Fed to raise interest rates and generally begin the process of implementing an exit strategy to mop up the massive liquidity injections of the past two years. For instance, consider last week’s comments from Dennis Lockhart, president of the Atlanta Fed. Although he’s not currently a voting member of the Fed’s FOMC group that sets interest rates, Lockhart speaks for many when he says…
I continue to support the current stance of interest rate policy. But the time is approaching when it will be appropriate to consider recalibrating interest rate policy. I do not believe that time has yet arrived. The conditions that require a change of policy are not yet at hand. However, as the economy continues to improve and financial markets find firmer ground, extraordinarily low policy rates will not be needed to promote recovery and will become inconsistent with maintaining price stability.
The implication is that the policy rate may have to begin to rise even while unemployment is considerably higher than before the recession. I'm very concerned about unemployment, and certainly employment trends should be a critical consideration in setting policy. But I accept that good policy, even in circumstances of unacceptable levels of unemployment, may incorporate higher interest rates.
Meanwhile, Kansas City Fed President Hoenig, who is a voting member of the FOMC, suggested earlier this month that the Fed should begin preparing to raise interest rates to 1% by the summer’s end, up from the current zero-to-0.25% target Fed funds rate that now prevails.
The worry, of course, is that the Fed has opened the door for higher inflation in the years ahead. The great question is whether the risk of deflation is the bigger threat at the moment? If so, does that require delaying the exit strategy--or temporarily accelerating the monetary stimulus? The market’s view appears to be slightly biased toward more quantitative easing, or at least delaying the inevitable exit strategy. But the market’s not necessarily making decisions at the central bank. It remains to be seen if that’s good news or not.
June 7, 2010
ANOTHER FINE MESS
How did we get into this mess? More precisely, how did the United States, a bastion of financial insight and innovation, manage to wind up between the economic rock and the hard place at the opening of the second decade of the 21st century?
The short answer: poor decisions. From Wall Street to Washington, in real estate and banking, in livingrooms and boardrooms, choices were made and the consequences are on display. The most conspicuous blowback of the ignoble preferences of recent vintage: debt. Lots of it, which we’ll be living with for quite some time.
It’s not the first time that the U.S. has managed to find itself in a river of red ink. It’s our destiny at the moment, and it’s our history too…from the beginning. “The United States was born in debt,” reminds John Steele Gordon in Hamilton's Blessing: The Extraordinary Life and Times of Our National Debt. Debt was hardly an innovation in the 18th century, although few countries, before or since, have tried to do so much with so little capital. “The American War of Independence was unique,” observes Jason Goodwin in Greenback: The Almighty Dollar and the Invention of America. “Never before had a nation gone to war without money to pay for it. Had the revolutionary Continental Congress managed to gather up all the gold and silver in the country, it wouldn’t have covered the cost of a year’s fighting.”
Old habits, apparently, die hard. The U.S., along with a growing slice of the world’s economy, is attempting once again to do more with less. Why, one might wonder, do we seem to relive the same old trials and tribulations? Perhaps it's because finance in America is somehow different, as Alexis de Tocqueville opined in Democracy in America , a timeless treatise from the late-1830s by a French political philosopher and historian who explores the finer points of what makes the republic tick. “Tocqueville conceded that there was nothing unique about American character traits,” writes Jack Cashill in his entertaining Popes and Bankers: A Cultural History of Credit and Debt, from Aristotle to AIG, published earlier this year. “He had known of people in other countries who were hardworking, restless, ambitious, religious, egalitarian, and individualistic. He had not known, however, nor had the world seen, a whole nation of such people.” Cashill cites what may be Tocqueville’s most insightful observation of the American psyche as it relates to finance:
Although Tocqueville did not dwell on the question of credit, he understood why Americans would available themselves of it. “When an immense field for competition is thrown open to all,” [Toqueville] continues, “when wealth is amassed or dissipated in the shortest possible space of time amid the turmoil of democracy, visions of sudden and easy fortunes, of great possessions easily won and lost, of chance under all its forms haunt the mind.” Under these circumstances, “The present looms large…and men seek only to think about tomorrow.”
Dreaming about making a fortune needs no explanation, of course, and so much of what makes America great (or much of what drives its enemies mad) is related to the possibilities surrounding the business of wealth creation. But the flip side is no less potent. It’s hardly surprising to find that a nation that has been so focused (some say obsessed) with earning a buck is also a nation with a strong preference for spendin it. In order to understand America, one has to understand the consumer. On that point, Cashill digs up a quote that comes as close as any to dissecting the connection between consumption and the American economy. One Edward Rumely, a consultant to Henry Ford. had a revolutionary thought in 1916: “Because of certain facts of human nature, there are always more people who will buy when they can pay for a thing gradually in the course of the next six months, than there are people with cash in their pockets to buy outright.”
Credit and debt are America’s history, but so too is this pair closely entwined with world history. Cashill traces the concept of usury—the charging of interest on loans—through the history of kings and philosophers, bankers and playwrights, economists and politicians, revealing that the only enduring truism is finance is that human nature is unchanging when it comes to money. But the book has yet to be written that answers the bigger question raised by Cashill and many other pundits of the economic scene: Why can’t we learn from the past?
It’s been done before in aviation, medicine, engineering, to name a few industries where progress is something other than wishful thinking. Finance, however, is different.
“The ethics surrounding credit and debit…find expression in the oldest written records, those of the Greeks and the Hebrews,” Cashill writes. “But the real history predates that, as the Mesopotamians kept records of borrowing and lending on stone tablets. And yet even when the terms of a loan were literally ‘written in stone,’ people sought to evade them…”
Not much has changed by the standards of the 21st century, although the details are forever in flux and the computer has replaced the stone. The details, of course, are more interesting, and quite a bit more complex. The last few decades have excelled in offering individuals, institutions and governments an array of possibilities for amassing a sizable bit of red ink.
Innovation is alive and well in finance, which is to say that usury has come a long way since it was banned in the Book of Exodus. Deciding if finance has progressed, on the other hand, well, that’s still an open debate.
June 5, 2010
SATURDAY LINK LIST: 6.5.2010
Yesterday's disappointing news on the pace of private-sector job creation sent the stock market tumbling. The S&P 500 lost more than 3.4% on the day and capital flowed into Treasuries, pushing the yield on the 10-year down to 3.2%. The risk-aversion trade is alive and kicking...again. That didn't stop President Obama from declaring on Friday that "the economy is getting stronger by the day." Mr. Market thought otherwise. But all's not lost, explained one dismal scientist, who argues that the crowd simply needs an attitude adjustment. “Nothing in [the May employment report] suggests that the recovery is in trouble — the markets need to get a grip,” Bernard Baumohl, chief global economist at the Economic Outlook Group, said via The New York Times. Nonetheless, optimism is in short supply in the wake of the latest labor market update. Here's a sampling of the chatter on the jobs front from various corners of the punditocracy…
"The May numbers are now a sobering reminder of the depth and severity of the labor market decline of the past two years and the lingering obstacles to growth," said Sophia Koropeckyj at Moody's Economy.com.
While today's jobs report shows gains, it's a significant setback following four consecutive months of accelerating growth. The private sector added only 41,000 jobs, as May's employment increase was driven by temporary Census hiring. Continued slower growth would mean we've passed an unprecedented early peak in the rate of employment growth following a recession, which wouldn't be good news for the recovery's strength. Manufacturing jobs gains are at best tepid, and a lack of significant growth in construction, financial services, and information show several sectors aren't yet on the recovery path.
Statement from Bart van Ark, chief economist of The Conference Board
"We're in a slow and steady jobs recovery, emphasis on slow," said Harry Griendling, chief executive of DoubleStar Inc., a West Chester employment consultant. "None of this is surprising, and I don't understand why the stock market reacts like it did today. I think it's emotional."
"We do not yet have the makings of a double-dip [recession]," economist Nigel Gault wrote Friday in an analysis for IHS Global Insight of Lexington, Mass. "We still believe that private sector job creation will gradually improve over the rest of the year."
Christian Science Monitor
It is time to stop searching for the right letter to describe the recovery. It isn’t a V and it won’t be a W, it is a hyphen – flat, low growth indicative of an economy in the process of deleveraging. There is no other interpretation for an add of only 41,000 private jobs plus the downward revision to the April jobs numbers. The median number of weeks out of work climbed to record 23 weeks and of those unemployed 46% have been out of work for more than 26 weeks. And the data from Labor is that much more suspect – in the worst recession since the 1930s the birth/death add in the 12 months ending in May added 427,000 jobs against a reported decline of 831,000 jobs. Without the adjustment the number of jobs lost would have been 51% bigger. The percent of firms surveyed that are hiring plus one-half of those standing still dropped to 54.1% from 66.7% last month. Judging from still elevated jobless claims, the slowdown in new job listings posted on the internet, and the fading impact of government stimulus, it is difficult to see how job growth strengthens from here in a politically acceptable time frame to the levels that cut into unemployment.
Steve Blitz Morning Notes
Today’s jobs report shows a labor market that has turned the corner and is creating jobs but one with a long way to go toward a full recovery from the devastating job losses of 2008-09. The percentage of the population with a job is generally moving in the right direction but remains at a very depressed level. Unemployment is still very high, and jobs are still hard to find. Under these circumstances, policymakers should have no qualms about passing a robust jobs bill — indeed, they would be derelict not to. Unemployed workers struggling to find a job need the help, and based on current forecasts of relatively weak economic growth for the rest of the year, the economic recovery could really use an additional boost.
Statement from Chad Stone, chief economist, Center on Budget and Policy Priorities
June 4, 2010
PRIVATE SECTOR JOB CREATION SLUMPS IN MAY
Don’t let the top-line number fool you. The employment report for May was discouraging. Although total nonfarm payrolls rose by 431,000 last month—the biggest monthly gain in a decade—it was heavily padded with the government’s temporary hiring of Census workers. Stripping out the government factor reveals a tepid rise in private-sector nonfarm payrolls of just 41,000, a dramatic fall from April's 218,000 gain in private-sector jobs. In other words, job creation in real economy is struggling…again. In fact, it looks like it hit a wall in May.
A bit of historical perspective is in order on the difference between total nonfarm and private nonfarm payrolls. The chart below graphs the monthly percentage change in each over the past three years. The message is that private-sector job creation (red line), which had been recovering with a fair degree of strength in recent months, tumbled last month.
It’s not unusual to see temporary setbacks in job creation, and so we should be cautious in reading too much into any one month's number. But there’s just no getting around the fact that, for the moment, private-sector job creation has come to a virtual standstill after four straight months of improvement. At this late stage, bad news on the employment front carries extra psychological baggage. Indeed, positive expectations jumped substantially in the wake of the April employment report, which boasted the biggest monthly gain in total nonfarm payrolls in four years. A month later, there’s reason to wonder if the momentum in job creation is faltering.
"Hiring looks soft," Michael Feroli, chief U.S. economist at JPMorgan Chase, told Bloomberg News today after the employment report was released. "It does raise some red flags that businesses are still pretty cautious."
The concern is less about job loss vs. job creation. The only significant decline in private-sector jobs last month was reported in the construction industry, which shed 35,000 positions. The real trouble is that the gains elsewhere in the private sector were slight last month.
The numbers for May are all the more troubling when you consider that private-sector employment vs. the total nonfarm payroll total (which includes government hiring) has been realtively weak for some time, as our second chart below shows. The numbers in May mean that the private-sector trend is that much deeper in the hole.
We've been arguing for some time that the period between the end of the recession and a recovery worthy of the name would be unusually long, primarily because the labor market is at risk of subpar performance. The stalled trend in initial jobless claims has been suggesting as much for months. As we wrote in April, for instance, "the threat of going nowhere fast still looms."
Is a new recession looming? No, although it's tempting to think so, given the run of discouraging news of late. But it looks like the bigger risk at the moment is still the same hazard we've been discussing throughout this year: a lengthy stretch of sluggish growth. The Great Recession is over, but the Great Recovery has yet to arrive.
June 3, 2010
POSITIVE NEWS FOR JOBS AHEAD OF FRIDAY'S EMPLOYMENT REPORT
Today brings two bits of good news on the employment front, laying the groundwork for thinking positively about tomorrow’s jobs report for May. New jobless claims fell last week, the Labor Department advised, and nonfarm payrolls rose in May, according to the ADP National Employment Report. Are these positive changes a sign of things to come in the official employment report? We’ll have an answer in less than 24 hours.
Meantime, there’s a bit of statistical optimism to ponder as we wait. Nonfarm private employment rose 55,000 last month, according to ADP. That’s the fourth consecutive increase this year, albeit a modest downshift in the pace from April’s 65,000 gain.
The latest jobless claims numbers also show a change in the right direction, although the trend here is less convincing. As we’ve been discussing for months, new filings for unemployment benefits have been stuck in a range this year. The latest data point represents an improvement—new claims dropped 10,000 to 453,000 last week. But as the chart below reminds, we’ve been here before. The question is whether we’ll be here again in the weeks and months ahead?
It’s not unprecedented for jobless claims to move sideways for a time in the wake of a recession’s end. But at this late date, the failure for new claims to resume a downward trend raises doubts about the strength of the labor market’s recovery. All the more reason to hope for a strong number tomorrow.
The case for wishful thinking is compelling, according to the consensus forecast among economists for tomorrow’s official jobs report from the government. Dismal scientists expect that nonfarm payrolls will rise by a strong 500,000, according to Briefing.com. If true, the surge would be the biggest monthly gain since 1997, and well above April 2010’s rise of 290,000. More importantly, a 500,000 advance in nonfarm payrolls would tell the world that the U.S. labor market still has the power to expand at something more than a tepid pace.
The danger is that high expectations may bring a big disappointment if the forecast proves overly rosy. But the ultimate insider, at least, is telling us to keep the faith. “We expect to see strong jobs growth in Friday's report," President Obama said yesterday. "This economy is getting stronger by the day."
CONSUMER SPENDING SOFT IN MAY, ACCORDING TO REPORT
A private-sector report on consumer spending advises that retail spending slipped last month. "Overall the environment in May has been relatively soft," Mike Berry, director of industry research for MasterCard Advisors SpendingPulse, tells Reuters. "It looks like the consumer is taking a pause."
The official government retail sales report for June is scheduled for publication next week, Friday, June 11. Last month, the Commerce Department reported that April retail sales rose in April, the seventh consecutive monthly increase. The data from MasterCard Advisors the trend won't reach number eight.
June 2, 2010
HARRY MARKOPOLOS & THE "NEW" SEC
When Bernie Madoff's Ponzi scheme imploded in December 2008, it unleashed two major scandals. One was simply an issue of money. Lots of losses because there were lots of victims. The tens of billions of dollars that went up in smoke rocked the financial world, thanks to the sheer size of the fraud and the fact that Madoff had snookered so many people (and institutions) for so long. The other great indignity (and arguably the bigger one) is that the world's biggest financial con survived for years under the nose of America's top regulatory agency: the Securities and Exchange Commission.
Harry Markopolos and a few colleagues continually warned the SEC about Madoff for nearly a decade. Markopolos recounts the details in his book No One Would Listen: A True Financial Thriller, a biting but engaging yarn about uncovering the Madoff fraud and the frustration of failing to convince the SEC to act on the information. As Markopolos writes,
It all began in 1999 when my friend Frank Casey first brought Madoff to my attention. I was confounded by the Wall Street mogul’s financial successes, and had to know more. I tried but couldn’t replicate his results. I later concluded it was impossible. One red flag led to another, until there were simply too many to ignore.
In May 2000, I turned over everything I knew to the SEC. Five times I reported my concerns, and no one would listen until it was far too late.
Madoff would end up being exposed, but not until December 2008, when his giant scam collapsed. What was the trigger? It wasn’t the SEC. Rather, it was the financial crisis in late-2008 that brought down Madoff. "You don't know who's swimming naked until the tide goes out," Warren Buffett once observed. In December 2008, the tide had finally gone out on Madoff. What if the economy and markets had continued to rise? Perhaps Madoff would still be in business today.
History turned out differently, of course. It's been 18 months since Bernie Madoff's multi-billion-dollar Ponzi scheme disintegrated. What have we learned? What's changed at the SEC? In search of some answers, I recently talked with Markopolos by phone. I asked what he thought of the "new" SEC, which has had a house cleaning of sorts. The Commission recently published a list of post-Madoff reforms, announcing that "the agency is continuing to reform and improve the way it operates."
"They're making evolutionary changes at a rapid pace," Markopolos says of the changes at the SEC. Those changes have arrived "much more rapidly than any government agency has made in the past." That's not surprising, of course, considering that the SEC "came close to being put out of business," according to Markopolos.
The threat of death is a great motivator. And certainly there have been leadership changes in the upper ranks. The SEC is also asking Congress for expanded powers to investigate, regulate and prosecute securities fraud. An encouraging start, but not nearly enough, explains Markopolos, a certified financial analyst (CFA) and certified fraud examiner (CFE). "They've replaced several people at the top, but now we need to go through the middle ranks. We need people who can spot fraud from across the trading floor."
In essence, the basic reform challenge for the SEC remains, he asserts, advising that the Commission is still overpopulated with lawyers. But uncovering securities fraud in the 21st century requires financially savvy investigators with a deep understanding of Wall Street. The SEC is "run by lawyers," Markopolos says. That's fine to a degree. But the guts of finding fraud amid complex derivatives trades, structured products and a host of other complicated strategies requires a high level of financial expertise. And on that front the SEC has yet to make convincing progress, he charges. "They need people with [financial] industry experience."
Markopolos also thinks that SEC investigators need financial incentives that are up to the task at hand. "There are only disincentives to fighting fraud" on Wall Street. "If you do big cases, you create waves." The solution, he believes, is to create a "bonus system" with a Wall Street-type compensation plan to reward the SEC sleuths searching for crimes. That will put investigators on an equal playing field with the fraudsters, who can earn millions of dollars from their scams.
I also asked Markopolos about the SEC's ongoing case against Goldman Sachs. As we discussed previously on these pages, the investment bank was charged in April with "defrauding investors" for selling a subprime mortgage product and failing to "disclose to investors vital information," according to the SEC's announcement. Was this an encouraging sign of the new and improved SEC?
Markopolos says he's impressed that the SEC went after the "biggest player" on the Street. "They showed aggressiveness." He also believes that Goldman is "guilty of bad ethics." Yet he also says that "it seems that the criminal violations were in the packaging of the subprime securities. Banks had to know these loans were toxic." By charging Goldman in the way it did—focusing on technical violations—the SEC is overlooking the bigger violation, he opines. "It's almost like they're letting the investment banks off the hook." The creation, financing and securitization of the securities was the "bigger crime," he asserts.
The SEC, in short, has a long way to go with its post-Madoff reforms, says Markopolos. Yes, the Commission has made a strong start. But the tougher changes still lie ahead, including firing a fair amount of the middle ranks in the Commission, hiring financially savvy investigators and giving them sufficiently large financial incentives to uncover securities fraud. "If they're not willing to fire anyone, people's confidence in government will go down," he says. Yes, new regulations are coming, he admits. "But if we get new regulations with the same old people, that'll be a crying shame."
June 1, 2010
A RATE HIKE CLOSE TO HOME
The Bank of Canada today announced that it was raising its overnight lending rate by 25 basis points to 50 basis points. The doubling of the price of money is the first hike in North American by a central bank since the Great Recession ended.
The bank explained:
The economy grew by a robust 6.1 per cent in the first quarter, led by housing and consumer spending. Employment growth has resumed. Going forward, household spending is expected to decelerate to a pace more consistent with income growth. The anticipated pickup in business investment will be important for a more balanced recovery.
Will the Federal Reserve soon follow? Don't count on it. Chicago Fed President Charles Evans downplayed the idea in a speech today. According to Bloomberg:
Evans told reporters in Seoul today that he “wouldn’t be surprised” if the Fed’s policy of keeping rates low “gets extended just a little bit.” Philadelphia Fed President Charles Plosser, who is attending the same event, said separately that “how the crisis in Europe ends up affecting the economy will dictate how we will respond.”
The Fed funds futures market seems to agree. Contracts are priced in anticipation of Fed funds remaining unchanaged at a zero-0.25% target rate through the end of the year.
Another reason for expecting rate hikes in the U.S. to come later rather than sooner comes by way of the rising greenback. AP reports:
The dollar surged to a fresh four-year high against the euro Tuesday as worries that European banks could still face large loan losses next year added to concerns about the continent's economic outlook.
Notice that American officials are no longer making statements about how the government supports a stronger dollar. That's because the buck is rising these days for all the wrong reasons: risk aversion. The dollar is still the world's reserve currency, for good or ill, and the world is piling in once more in search of the proverbial safe haven. A higher dollar at the moment is a signal that the world is worried about deflation, debt and slow growth. Those risks aren't new. The only difference is that investors are now demanding a higher risk premium (i.e., lower asset prices) as additional compensation for the potential fallout.
THE MAULING IN MAY
May was the worst month for the major asset classes since the dark days of February 2009. Virtually everything suffered with more than trivial losses. Treasuries were the exception, thanks to the revived rush to safety. In turn, that helped prop up broad investment-grade bond indices. Otherwise, the red ink last month is a sign that the big, easy gains in everything is over.
Stocks around the world led the decline, with foreign developed markets posting the biggest loss among the major asset classes. What changed the sentiment so sharply in May? A renewed fear of deflation was one catalyst. Investors are increasingly focusing on the growing burden of debt that weighs on the global economy, particularly in the mature countries of Europe, Japan and the U.S.
Making matters worse is the perception in some circles that the European Central Bank is still focused exclusively on fighting inflation. One pundit charges that the ECB's emphasis on inflation is fighting the "wrong war." As The New York Times reported over the weekend:
The central bank’s doubters grew louder after it made a big show of taking measures to cancel out the supposed inflationary impact of the government bond purchases it began on May 10 to help keep Greece and several other euro zone countries from defaulting on their debts.
“It’s nuts: how can they be concerned about the inflationary impact of this?” said Carl B. Weinberg, chief economist of High Frequency Economics in Valhalla, N.Y. “If I were the head of the E.C.B., I would be printing money to avert the decline in the money supply.”
It was inevitable that the surge in asset prices across the board would come to an end. That doesn’t mean that expected risk premiums are nil or negative. But the investment landscape ahead is set to become more complicated. In the spring of 2009, as it became clear that the global economy wasn't going to implode after all, the markets repriced assets accordingly. Markets are no longer trading in anticipation of another Great Depression. But in some respects the world has traded the acute for the chronic, and it's unclear how that will play out and what it means for pricing.
The simplicity of the past year is giving way to complication and nuance. That creates opportunity for tactical asset allocation maneuvers, but it also comes packaged with higher risk. Phase II of the post-Great Recession period is here.