September 30, 2010
GUESSTIMATING FUTURE INFLATION
The Federal Reserve has been trying to juice inflation higher for some time, and it appears that it's had slight if precarious success over the past month. The market, at least, is pricing in slightly higher inflation for the decade ahead, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries. As of yesterday, this inflation forecast was 1.78%, up a bit from 1.52% at the close of August, when worries of deflation were raging.
Inflation expectations have been creeping higher recently, as the chart below shows, but it's less than convincing. In fact, it's easy to think that the recent pop is just a pause in a broader decline.
But even taking the recent rise in the inflation outlook at face value, can we believe the Treasury market's prediction? Is the uptick believable? Today's Heard on the Street column in the Wall Street Journal raises some doubts:
…the Fed is buying regular Treasurys as it tries to prime the economy and keep inflation from slipping even further below its target range. But that risks distorting inflation-expectation signals from Treasury Inflation Protected Securities, or TIPS. Investors, and the Fed itself, compare yields on Treasurys and TIPS to get a read on what investors expect inflation to be five or 10 years out.
To compensate, the Fed is also buying TIPS and, as the Journal notes, is "attempting to compensate one distortion with another." Is it working? Is the uptick in the inflation outlook credible? It's not clear, which inspires looking elsewhere.
One reason for thinking that the higher inflation outlook is more than statistical noise comes via the latest reading on the annual percentage change in the money stock. The annual pace of the MZM measure, for example, has popped up recently, rising ever so slightly on a year-over-year basis through September 13, 2010, as the second chart below shows. That's not much on its face, but it's a notable change from the summer, when money stock for a time was falling by more than 2% on an annual basis.
Higher inflation expectations and an increase in the annual pace of the money stock looks fairly convincing. But is any of this having an impact on investor expectations about inflation as it relates to worries about low nominal yields? Not really, at least not yet. The benchmark 10-year Treasury yield was roughly 2.52% yesterday, up slightly from the day before and from 2.47% at the end of August. But that's hardly an earthquake in market sentiment. In other words, not much has changed. We've had a few tremors, but the rumblings haven't added up to much so far.
Something will change, of course, and perhaps soon, but deciding exactly what, and exactly when, isn't getting any easier.
September 29, 2010
RETHINKING A DOLLAR-HEAVY ASSET ALLOCATION
"Like it or not, significant dollar depreciation is more probable than most now suppose," writes Simon Johnson, a professor at MIT’s Sloan School of Management, in a Bloomberg column today. The market seems to be discounting no less. Certainly the gold market is roaring higher in part because the odds that the dollar will fall in the months (years?) ahead look quite a bit better than even.
Johnson, co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, sees three reasons why the dollar will trend lower: 1) worries over political gridlock in Washington as the country grapples with a huge budget deficit; 2) sluggish U.S. economic growth, which will compel the Fed to focus on lowering long-term interest rates, a.k.a., a new round of quantitative easing; and 3) the growing appetite of emerging market nations to diversify their large and growing foreign exchange reserves into currencies other than the greenback. "The dollar is, therefore, likely to depreciate against all floating currencies," Johnson predicts.
That's hardly a radical idea these days, considering that the buck has been more or less weakening since June, as the chart below shows. The previous rebound in the dollar that prevailed in the first half of this year now appears to be over. One reason is because of an increased appetite for risk in the global economy in recent months. When macro anxiety rises, liquidity tends to gravitate into dollars, the world's reserve currency. But as investors and governments have become convinced recently that the economic challenges aren't quite so acute, particularly outside of the developed economies, the appeal of non-dollar assets and currencies has taken flight once more.
"The safe bet is to keep selling the dollar, especially given reasonably supportive data from the euro," Peter Frank, currency analyst at Societe Generale, tells Reuters today.
Safe? Well, that's going too far. But certainly it's prudent for U.S. investors to hold some amount of non-dollar allocations in their portfolios. There are several options, including broad commodity funds. Commodities, which are generally priced in dollars, tend to move in the opposite direction of the buck. Two of the more popular exchange traded products in this corner: iShares S&P GSCI Commodity-Indexed Trust (GSG) and iPath DJ-UBS Commodity Index TR ETN (DJP). The underlying index designs are energy heavy, however. For a lesser emphasis on oil and gas, take a look at ELEMENTS Rogers Intl Commodity ETN (RJI) and GreenHaven Continuous Commodity Index (GCC).
Gold in particular is the leading commodity alternative to the dollar. The world generally sees the precious metal as the antidote to Washington's fiat currency, which is why the pair generally share a negative correlation. Two leading gold ETFs: SPDR Gold Shares (GLD) and iShares COMEX Gold Trust (IAU).
Foreign stocks and bonds priced in local currencies are another option, although each must be analyzed in concert with the underlying fundamentals of their respective markets along with the forex outlook. Although most non-U.S. stock ETFs and mutual funds don't hedge forex, foreign currency exposure is a bit tougher to find in foreign bond products. Harder, but not impossible. A small but growing list includes SPDR Barclays Capital International Treasury Bond (BWX) and iShares S&P/Citigroup Int'l Treasury Bond (IGOV) Meanwhile, consider too the first local currency emerging market bond ETF: Van Eck Market Vectors Emerging Markets (EMLC). Keep in mind that the forex factor tends to be much larger for bonds vs. stocks. Why? Bonds generally have a relatively low expected return vs. equities, which means that the forex factor can easily overwhelm the risk/return profile for foreign bond portfolios.
If you can stomach the volatility and have a taste for speculation, there's also a wide choice of foreign currency ETFs to capitalize on a weakening dollar, ranging from the PowerShares DB US Dollar Index Bearish (UDN), which is primarily a euro and yen play, to the emerging-market focused choices (WisdomTree Dreyfus Emerging Currency Fund (CEW) as well as individual country targets (WisdomTree Dreyfus Brazilian Real Fund (BZF) and WisdomTree Dreyfus Chinese Yuan Fund (CYB).
Investing in currencies comes with a high risk, of course, and so it's not for the faint of heart. Caveat emptor.
But even if you're a conservative investor with a long-term outlook, and your portfolio is missing equity and/or bond allocations denominated in foreign currencies, it's time to rethink what amounts to a huge bet in favor of everything going well in the U.S. I wouldn't discount the possibility, but neither would I bet the farm on that scenario either.
READING ROUNDUP FOR WEDNESDAY: 9.29.2010
►Cultivating the Chinese Consumer
Stephen Roach/NY Times
"On Wednesday, the House of Representatives is set to pass legislation that would allow trade sanctions to be imposed on China as compensation for its supposedly undervalued currency…The currency fix won’t work. At best, it is a circuitous solution that would address only one of the many pressures shaping the imbalances between our two nations; at worst, it would lead to a trade war, or risk jeopardizing China’s understandable focus on financial and economic stability."
►Gold hits all time high, eyes on Fed's next move
"Gold hit a lifetime high on Wednesday, its 10th record in 12 sessions, as the dollar dropped against a basket of currencies on expectations the Federal Reserve would take new measures to shore up the economy."
►Currency Wars: A Fight to Be Weaker
Tom Lauricella and John Lyons/Wall Street Journal
"Tensions are growing in the global currency markets as political rhetoric heats up and countries battle to protect their exporters, raising concerns about potentially damaging trade wars."
►How to stop currency manipulation without a trade war
"With the US threatening to label China a 'currency manipulator,' this column presents a plan to address global imbalances without risking a trade war. It proposes a 'reciprocity' requirement – if the US can’t buy Chinese government bonds, then China can’t buy US bonds either."
►China Moves Closer to Becoming Currency King
"When U.S. President Barack Obama told Chinese Premier Wen Jiabao last week that the yuan’s peg to the dollar is unsustainable, he forgot to add one thing: It also threatens the world’s floating exchange-rate system.
China’s official currency reserves are simply becoming too large."
►The World Wakes Up to Threat of Currency Wars
Randall W. Forsyth/Barron's
"The specter of international currency wars has been raised by Guido Mantega, Brazil's finance minister. 'We're in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness,' the Financial Times quoted him as saying. In that, the FT asserted Mantega was saying out loud what policy makers were saying in private (not to mention what was being written in this space.) No doubt this will be a major topic of discussion at next week's annual meeting of the International Monetary Fund and World Bank in Washington."
►No Big Risk Of Currency War, IMF Chief Says
"There is no big risk of a global currency war, International Monetary Fund Managing Director Dominique Strauss-Kahn reportedly said on Tuesday.
'I don't think today that there is a big risk of a currency war, but that is part of the downside risk,' Strauss-Kahn told reporters."
►Does a 1930s-style trade war loom as recovery falters?
Michael Babad/The Globe and Mail
"Capital Economics in London today posed the question: Are we on the cusp of a currency war? Not likely, said senior markets economist John Higgins, though he does fear the rise of global trade sanctions.
'We continue to believe that the risk of global trade sanctions - which effectively amount to the same thing - is building,' Mr. Higgins said in a research note. 'If domestic demand remains depressed, policy makers will inevitably turn their attention abroad for a solution as they did in the 1930s.'"
September 28, 2010
PRICES WILL FLUCTUATE
So said J.P. Morgan one day when he was asked for a prediction about the stock market. The cagey banker gave us the only market forecast that's always right. Prices bounce around a lot. They always do. Sometimes they bounce higher (or fall lower) than usual. When that happens, cries of market inefficiency and irrational investors take flight. The alternative view is that markets are simply repricing assets based on new expectations for risk and return. What’s the evidence that rational pricing prevails? One clue is that the underlying fundamentals of the market change in line with prices.
Showing cause and effect between prices and fundamentals can be tricky, especially for stocks. Professor Robert Shiller made the case in an influential 1981 paper that equity prices "move too much to be justified by subsequent changes in dividends." But after 30 years of closer inspection, it's clear that the relation between equity prices, dividends and expected return is more nuanced. A 2008 paper by Professor John Cochrane, for instance, outlines a persuasive case that dividends provide valuable information about expected equity return, which is what you'd expect in well-functioning marketplace. Expected return, in other words, varies, and there's nothing inefficient about that per se. In a world where everything is changing, no less is required in the equity market. That can be disorienting in the short term, but over time it looks quite reasonable, based on the fluctuations in the economy overall.
Cochrane’s hardly alone in pointing out that current dividend yield for stocks overall offers a pretty good measure of what you’ll earn in the market over, say, the next decade or two. Comparing the current equity yield with subsequent 10-year returns, for instance, shows a moderately tight relationship, as a recent article published on Vox shows.
Why should you expect to earn more from stocks at one point in time vs. another? Perceptions of risk change. It's surely rational that the expected return for stocks was higher in late-2008/early 2009 than it is today, for instance. The macro risk was higher then compared with now.
Bond prices in relation to fundamental value also dispense clues about what to expect in the long run. We know the current yield at any given point and we also know that if you buy a bond today there's little mystery about the future return if you hold the security till maturity. With sovereign debt in particular, there's a high degree of confidence about expected return for buy-and-hold strategies. (Inflation complicates the analysis, but for now we'll leave that aside.) Today's current yield is basically the expected return for Treasuries, assuming that you hold the security to its maturity date. A 10-year Treasury Note currently yields a bit more than 2.5%. If you buy a Note today and hold it through maturity, chances are pretty good that you’ll earn a total return in the neighborhood of 2.5%.
But the calculation is more complicated with corporate bonds. The risk of default is higher, much higher, depending on the bond. Default risk, however, isn't constant; it fluctuates. BCA Research recently posted a chart of the 12-month trailing default rate for corporates here. Not surprisingly, the rate varies, sometimes by wide degrees. During the Great Recession, the default rate surged to around 14%, up from the previous cyclical low of about 2%. It's been falling recently, dipping to a recent level of under 6%.
Default risk is especially potent for junk bonds. No wonder, then, that bond prices in this corner move around a lot, sometimes dramatically in short periods. In turn, the trailing yield on junk bonds changes in kind. Consider the chart below, which shows the recent history of the yield spread for the high-yield bond sector relative to the 10-year Treasury. The spike in this spread to nearly 20% in late-2008/early 2009 from the previous low of 2.5% in mid-2007 is striking, but it’s hardly irrational. As the crowd came to grips with the threat of economic turmoil in 2008, junk bond prices fell, pushing yields up in the process.
The connection between asset prices and the economic cycle is quite strong. Making assumptions in real time is still precarious, of course, which means that the latest assessment via prices is always debatable in terms of accuracy. The crowd makes mistakes, a factor that’s further complicated by the short-term noise of traders. But over time, there’s quite a bit of economic logic to the fluctuation in prices. It’s not perfect, but it’d be a mistake to dismiss market prices as hopelessly irrational and bereft of useful information.
Ultimately, it’s all about the ebb and flow of the economy. Prices adjust based on the broad cycle. The market typically goes to excess on the upside during good times, followed by excess selling during recessions. Par for the course.
Yes, the future’s always uncertain, which means that the market’s latest attempt at discounting the morrow is always subject to revision. That’s a problem if we have to deploy all of our risk capital today, and put it in just one asset class. But we can manage the risk by owning multiple asset classes and making reasonable assumptions about the medium-to-long-run future based on current prices and valuations. In other words, we can engage in a degree of dynamic asset allocation as tool for managing risk, enhancing return, and perhaps a bit of both.
Is the market perfectly efficient? No, but neither is it perfectly inefficient. Like so much in finance, the truth lies somewhere between the extremes.
September 27, 2010
SOROS, BUFFETT, BETA & ALPHA
Who has more talent for minting alpha? Warren Buffett or George Soros? Nassim Taleb, author of The Black Swan, thinks Soros has the edge.
“I am not saying Buffett isn’t as good as Soros,” Taleb explained at a conference last week, according to Bloomberg News. “I am saying that the probability Soros’s returns come from randomness is much smaller because he did almost everything: he bought currencies, he sold currencies, he did arbitrages. He made a lot more decisions. Buffett followed a strategy to buy companies that had a certain earnings profile, and it worked for him. There is a lot more luck involved in this strategy.”
Perhaps, although it's easier to analyze Buffett's historical results and decide if he truly added value. But before we get into that, I think Taleb raises an interesting point about beta and alpha. In particular, it's important to think about those risk premiums that are available for the taking vs. those that can be earned only through hard work. In other words, there’s a distinction between investment returns that anyone can earn vs. those that require talent. Every investor (and institution) should carefully think through these concepts before investing real money. In other words, your expectations matter.
The good news is that beta vs. alpha is a rather simple notion, although the details can get messy. Indeed, the word “beta” gets thrown around a lot, but it has a very specific meaning. The short definition: beta is the market’s return and risk profile. Anyone can tap beta. It's a commodity, and so you don't want to overpay. Mathematically, the calculation is straightforward, as any good finance book will explain, such as The Portable MBA in Finance and Accounting. Beta is computed as the covariance between a security and its relevant market, divided by the variance of that market. You can also analyze an asset class—U.S. stocks, for instance—and compare it with the multi-asset class “market” portfolio, as I do with the Global Market Index. If you have the price histories on the security (or asset class) and the market, you can easily calculate beta by dumping the data into Excel.
Another way to think of beta is that it’s a measure of a security’s (or asset class’s) sensitivity to the broad market. In that sense, beta is one of many risk measures. Forecasting returns directly is difficult, perhaps impossible. Estimating risk, by contrast, is somewhat easier, or at least modestly more reliable. We know, for example, that stocks are riskier than Treasuries. Exactly how much more risk we're talking about is debatable, but as a general proposition there’s a fair degree of confidence in that assumption. In turn, we can infer expected return via risk assumptions. But that raises the question: How reliable is beta as a risk measure? Or any risk measure, for that matter. They're all flawed, usually in different ways, and so we need to look at several. But back to beta.
Standard finance theory advises that higher (lower) betas are associated with higher (lower) returns. Technically, this is an ex ante framework. In other words, betas should be used to reverse engineer expected returns. But as critics have been pointing out for years (decades!), historical analysis of beta and return—the ex post perspective—don’t always measure up. Beta, in sum, doesn’t fully explain the relationship between risk and return.
A widely cited example is the small-cap and value effect. Stocks with relatively slight capitalizations and/or companies trading at discounts to book value generate substantially higher returns vs. the forecasts via beta. Does this mean that beta is worthless? No, but it reminds that a simplified view of asset pricing doesn’t fully capture all that’s going on, especially over the short-to-medium run.
In fact, a true reading of how the markets price securities reveals a bevy of betas. Instead of one all-controlling market beta, as per the capital asset pricing model, there’s a rainbow of lesser betas running the show. Small cap and value betas are merely the tip of the iceberg. Financial economists have turned up a broad list of factors, including momentum, liquidity, volatility, and others. And they're finding more all the time. It’s debatable how much real-world opportunity is associated with the full compliment of known factors. After adjusting for taxes and trading costs, some if not most of the factors that look productive on paper become a return drag.
There’s also a capacity issue. If too many investors chase small value stocks, the associated risk premium will fade. That opens the door to wondering if, in the very long run, all the various lesser betas end up being a wash relative to the big-picture market beta that standard finance theory focuses on?
Even in the short run, assume that minting alpha (anything other than beta), is hard. Buffett seems to have beaten the odds. Ditto for Soros, who also boasts an impressive track record, at least in the days when he was managing money. What of Taleb’s suggestion that Soros has more talent? Or that there's less randomness involved in Soros's track record? There’s some theoretical support for that view, based on the fundamental law of active management, as outlined in Grinold and Kahn’s book Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Controlling Risk. This law states that beating the benchmark (beta) depends on forecasting skill and the number of independent investment decisions you deploy. It’s all about skill and opportunity.
If you have a relatively lesser degree of skill, you can pick up the slack by making more bets. That can backfire, of course. But all things equal, if you’re trying to beat another active manager who’s smarter than you, your only hope is to make more bets. By contrast, if you’re smarter, you don’t need to make as many bets.
Consider an extreme example with two investors. One is average in terms of investment skill; the other's a genius. Now imagine two separate events that pit one against the other. In the first round, only one investment decision for each is allowed. In that case, we should expect that the genius has a huge advantage. In the second round, each investor can make 100 investment decisions. The genius probably still has an edge, but it's not as striking as it was before.
Meantime, it’s still hard to say for sure if Soros is truly the better investor. Yes, Buffett has piggybacked somewhat on equity beta’s run. Berkshire Hathaway, Buffett’s company, owns a portfolio of U.S. stocks, among other businesses. It’s hardly surprising the equity beta is embedded in Berkshire’s returns to a degree. But if you’re choosing stocks based on a methodology that looks for underpriced securities, as Buffett has clearly done at times, you can do well relative to beta. How well? For the past 15 years, Berkshire's shares have generated a roughly 10% annualized total return, according to Morningstar. That’s a tidy premium over the S&P 500’s 6.5% total return over that span. That's one clue that Buffett's adding value.
Soros hasn’t been involved in managing money in recent years, at least not in anything with publicly reported results, and so we can’t compare his performance to Buffett’s over the last 15 years. Even if we did have good numbers, it wouldn’t be clear if Soros was truly adding value (or not) compared with Buffett. Why? Because if Soros was trading currencies, commodities, stocks, bonds via long and short positions, perhaps adding leverage at times, it’s unclear what the benchmark should be. We don’t know what the relevant beta is.
We could label Soros as a global macro trader, of course, as many have over the years. That implies that we can compare Soros to a global macro benchmark, of which there are several available from the various index vendors. But that raises a host of new questions because there’s lots of moving parts in the design of hedge fund benchmarks vs. a cap-weighted equity index. How, for example, do you account for short positions and leverage? Or survivorship bias? There are no easy answers, and since small changes in assumptions can have big results, there are no reliable passive macro benchmarks that are the equivalent of the S&P 500, Russell 3000, etc. Measuring long-only equity beta is easy. Tally up the companies, weight them by their respective market values, and you're done.
Hedge fund betas, by contrast, are complicated. Yes, some are easier to define vs. others. But global macro isn’t one of them. If you had to define global macro as a rules-based investing process, you’d have a rough time. Among the dozen or so broad hedge fund styles, global macro is wide open to interpretation.
By contrast, there’s a hefty amount of small-cap and value risk premia available in beta form, i.e., index funds and ETFs targeting this area. Not surprisingly, those products do pretty good. You can capture a big part of the small-cap value factor by owning index funds.
Can you do the same with global macro? Maybe, but it’s complicated. So too is deciding if Soros added more value for a given unit of risk relative to Buffett. The problem is that there’s a good benchmark for comparing Berkshire’s performance and risk: the U.S. stock market. Or maybe we should upgrade that to a global measure of equities. Or add a value tilt. Soros, however, is another matter. What’s his benchmark? We don’t really know. Therein lies the allure and the hazards of global macro, and hedge funds generally. Quoting a high return is one thing. But if you can’t calculate the risk-adjusted return, you may be flying blind.
Then again, if you have a high degree of confidence that your manager is truly talented, faith is enough. But for some of us, faith isn't enough. Sure, you can engage in qualitative analysis--i.e., poring over the fund's trading history, talking to its managers, looking over its offices. But most investors aren't going to do that.
That leaves quantitative analysis. Granted, sometimes it's no help at all, depending on what you're trying to analyze. But it's the only game in town if faith isn't enough and you're not willing or able to spend a week at prospective manager's shop.
As for beta, there are limits here too. But in those cases where beta does a pretty good job of explaining risk and return (the major asset classes), and you can buy a proxy fund inexpensively, this is usually the superior choice on a work-adjusted basis.
September 24, 2010
BOOK BITS FOR FRIDAY: 9.24.2010
● Running Out of Water: The Looming Crisis and Solutions to Conserve Our Most Precious Resource
by Peter Rogers and Susan Leal
Water: The Epic Struggle for Wealth, Power, and Civilization
by Steven Solomon
Bottled and Sold: The Story Behind Our Obsession with Bottled Water
by Peter H. Gleick
Review via Foreign Affairs
"Three new books about water agree that the world is facing serious water crises but have very different ideas about how to address them, especially when it comes to deciding what roles the public and private sectors have to play."
● Aftershock: The Next Economy and America's Future
by Robert Reich
Review via Bloomberg
"Loose money and stimulus spending are more likely to deliver 'phantom recoveries' than sustainable growth, Reich writes. We can expect years of high unemployment and weak wages culminating in an 'aftershock' -- either a brutish political backlash or deep reforms, he says."
●Outperform: Inside the Investment Strategy of Billion Dollar Endowments
by John Baschab and Jon Piot
Excerpt via John Wiley & Sons, Inc.
"Although endowments manage considerable assets, their techniques, organization, strategy, and philosophy are relatively unknown outside the industry. Year in and year out new investment strategies surface and disappear with varied success. Meanwhile endowment managers have continued to score consistent gains year after year until the crisis of 2008 and 2009...The extent to which individuals can replicate specific techniques of endowments is a matter of some controversy in the endowment world. We believe the reader will benefit from understanding how some of the best minds in the investment management field think about their job and the future. We also think that the endowment approach can inform how an individual makes strategic investment decisions, particularly in defining broad asset classes that will compose their portfolio. There are several pieces to the endowment investing model that, if not easily replicable, are interesting and noteworthy and can improve the investment prowess of the average investor."
●The Rise of the State: Profitable Investing and Geopolitics in the 21st Century
by Yiannis G. Mostrous, Elliott H. Gue, and David F. Dittman
Review via Investing Daily
"In place of Pax Americana, a new world order of 'polycentricism' -- where no single country dominates – has emerged. The locus of world power is switching from the debt-laden West to the economically powerful East – led by Asian countries China and India that are flush with cash and whose relatively conservative economic policies allowed them to bypass the leveraged excesses that led to the 2008 financial crisis."
●The Betrayal of American Prosperity: Free Market Delusions, America's Decline, and How We Must Compete in the Post-Dollar Era
by Clyde Prestowitz
Review via Huffington Post
"The Betrayal of American Prosperity is the best book in its genre. Clyde Prestowitz masterfully and meticulously explained the reasons behind an ailing American economy."
●Retirementology: Rethinking the American Dream in a New Economy
by Gregory Salsbury
Review via Asheville Citizen-Times
"Gregory Salsbury, an executive in the insurance industry, gives a broad overview of behavioral finance. The book has a wealth of examples of how people make mistakes when emotions get in the way of their investment decisions."
ANOTHER DURABLE GOODS REPORT, ANOTHER ENCOUNTER WITH THE NEW NORMAL
New orders for durable goods fell 1.3% in August, the Census Bureau reported this morning. The drop more than reverses July’s 0.7% rise, which was the first since April. But the news isn’t quite as bad as the headline number suggests. Most of the decrease was due to a steep fall in orders from the volatile transportation sector. Excluding this group shows that new orders actually rose 2%. Meanwhile, new orders for capital equipment excluding aircraft jumped 4.1%, rebounding from the 5.3% drop in July. Corporate investment, in sum, rebounded last month.
Durable goods orders generally are a key sign of the business sector’s sentiment on the future for the economy and so we should pay close attention to the trend for this data series. Unfortunately, the month-to-month volatility in the series is often high, which complicates the analysis. That inspires looking at the longer-term trend. The 12-month rolling percentage change is a good place to start. On that score, new orders for durable goods have been rising sharply on a year-over-year basis, as the chart below shows. Even after August’s dip, new orders are higher by 11% vs. the year-ago figure. Of course, the percentage change looks impressive because the actual dollar level of new orders at this time last year was still depressed because of the recession, and so we shouldn't read too much into the recent pace.
In other words, the strong 12-month change in new orders of late was all but certain to trend lower after peaking at around 19% as of this past April, the highest in a decade. As year-over-year comparisons return to something closer to normal, so too will the annual trend.
The question, of course, is how much downshifting is coming? For some perspective, let's turn to the actual amount of money committed to new orders. As it stands now, the seasonally adjusted dollar value of new durable goods orders also peaked in April. As the second chart below shows, this measure of new orders have been more or less flat to slightly declining since the spring.
Expecting more of the same is probably a safe bet. Growth is likely to be sluggish, evaporating entirely at times. But a sharp decline from here on out looks unlikely. Short of a new shock to the economy of some magnitude, the economic recovery is likely to proceed, albeit slowly, tentatively and at times backtracking. As troubling as that outlook is, it’s not sufficient to expect big declines, if any, in the broad economic trend when over 90% of the labor market is still employed and interest rates are at or near historic nominal lows.
Is that enough to launch a new boom? Probably not, at least not any time soon, given the current climate of high debt on household balance sheets. But it’s probably enough to stave off a new recession.
"The double-dip seems to be off the table," Eric Mintz of Eagle Asset Management tells Bloomberg. "The durable goods report was strong, it supports the idea that companies are spending money which is important for overall economic growth, so it’s another bullish indicator."
"Though downshifting a tad, business capital spending remains one of the few consistent bright spots on the economic landscape," Sal Guatieri, senior economist at BMO Capital Markets, says via AP.
The problem is that there are offsetting factors to consider as well, starting with the weak growth in the labor market on a net basis. For the moment, it still all adds up to the new normal. What does that mean? Progress is going to come slowly in the months and quarters ahead. It'll be strong enough to fend off a new recession, but it's unclear how much more you can squeeze out of this stone.
THE RISING INFLUENCE OF BETA
The Wall Street Journal has an intriguing story today that highlights the case for thinking that macro forces are running the investment show these days. Or, to cite James Bianco of Bianco Research, as he opines in the article: "Stock picking is a dead art form. Macro themes dominate the market now more than ever."
That may be overstating the case, at least for the long term. But certainly there's a stronger argument for focusing on blending a range of betas these days. "In recent months, stocks have been moving in lock step to an almost unheard of degree," the article explains. As one example, S&P 500 stocks recently posted an 80% correlation, a measure of independence in price movement. During 2000-2006, by contrast, the correlation of S&P stocks was 27%, based on analysis by Barclays, according to the Journal.
"All stocks are moving in the same direction," says Cindy Sweeting, one of the managers of the Templeton Growth Fund. "I've spent three decades in this market, and it's the most macro-obsessed I've seen in a long time."
The article also reports:
Stock pickers say macro forces began moving stocks in a big way during the 2008 financial crisis, and that has continued this year following the European debt crisis. Traders also are focusing on the potential for a double-dip recession to hit corporate profits; on government deficits; and especially on what central banks will do about stimulus programs that pumped cash into the economy.
A host of other factors is contributing to the macro trend. The rise of exchange-traded funds, which typically track broad market indexes or benchmarks, has made it easier for investors to make broad bets on commodities, bonds and currencies. Such funds now account for 30% of daily stock-trading volume. Individual investors and pension funds have been pulling money out of stocks, leaving shares more vulnerable to trading by hedge funds with short time horizons.
It's debatable how much the rise of macro is something genuinely new. If you look at rolling 3-year return calculations for the stock market and compare it with the same pace of change for various measures of broad economic trends, such as industrial production and the ISM manufacturing index, you can see a degree of similarity. That's not surprising. In fact, cycles are ultimately at work in all the major asset classes as well as various risk factors, such as yield spreads and momentum.
The degree of macro influence waxes and wanes, of course. But it's usually the case that grabbing a properly defined measure of a given asset class's beta captures the lion's share of the risk/return profile over time. Can you do better? Sure, but you can also do worse. The nice thing about beta is that you always know what you're getting and--if you choose products wisely--at a reasonable cost.
I'm a fan of Professor John Cochrane's view that there are no alphas. Instead, as he explained to me for an article I recently wrote for Financial Advisor magazine, there are only betas we know and betas we have yet to identify.
Yes, true active management talents exists and it's worth pursuing in some cases. But it's hard to identify in advance and it can be costly. Meanwhile, the idea that you can manage a portfolio of betas is catching on. One reason is the growing recognition that if you own a multi-asset class portfolio, which is sound advice, then much of the risk and return for the overall strategy is driven by the design and management of the beta mix. In that case, it makes sense to focus on the betas.
That's an increasingly practical strategy because the menu of beta products keeps expanding. The possibilities for designing everything from a plain-vanilla balanced fund to a macro hedge fund using only ETFs and ETNs is reality. That's hardly a short cut to easy money. But to the extent that big-picture factors dominate in the long run, this is the golden age for capitalizing on these trends.
Update: Bloomberg recently ran a story that also highlighted the growing influence of macro. As the article explains:
Industry groups in the U.S. stock market are moving in lockstep with the Standard & Poor’s 500 Index at an almost record pace, showing that economic reports are having a bigger effect on the market than ever.
Exchange-traded funds that mimic the 10 main S&P 500 groups are moving with the U.S. equity gauge at almost the highest rate since 1998, when Bloomberg started compiling the data. The correlation coefficient that measures how closely assets rise and fall together exceeds 90 percent for seven of the industries relative to the index, BNY ConvergEx Group LLC data show.
Rising correlations show investors are ignoring relative values among industries and reacting to day-to-day signals on the economy, according to Mohamed El-Erian, the chief executive officer of Pacific Investment Management Co. The S&P 500 had the biggest rally in almost two months yesterday on better-than- estimated growth in U.S. and Chinese manufacturing.
September 23, 2010
THE BEST GOLD QUOTE I'VE READ THIS YEAR...
“What makes the gold story so interesting is that bullion has so many different correlations -- with inflation, with the dollar, with interest rates, with political uncertainty,” according to David Rosenberg, chief economist at Gluskin Sheff & Associates in Toronto. “This year, for example, gold has shifted from being a commodity toward being a currency -- the classic role as a monetary metal that is no government’s liability.”
JOBLESS CLAIMS RISE. A SIGN OF STRUCTURAL UNEMPLOYMENT?
Today’s update on new jobless claims for last week is a reminder that the labor market is still stuck in neutral. After a month of declines in new filings for unemployment benefits, the trend reversed last week. New claims jumped 12,000 for the week ending September 18, the government reported. That’s discouraging, but nothing’s really changed in terms of the broad trend this year. We're still going nowhere fast in the labor market.
As the chart below shows, seasonally adjusted jobless claims have been treading water this year by holding steady in roughly the 450,000-500,000 per week range. There's lots of volatility from week to week, but so far in 2010 there's nothing really new under this sun. That’s a sign that the labor market is struggling to generate new jobs on a net basis. That's discouraging news, but it's also old news.
But make no mistake: The longer the job market remains stuck in a rut, the stronger the case for arguing that we’re suffering a potent bout of structural unemployment. If so, the odds are lower--perhaps a lot lower--that a new round of monetary and/or fiscal stimulus (assuming they're tried) will provide any kick to the economy from here on out.
Is this a real and present danger? Is the high jobless rate even worse than it seems because of structural unemployment? Brad DeLong, an economics professor at the University of California at Berkeley, defines the problem and agrees that this particular disease is challenging. The good news (relatively speaking), he advised recently, is that fears of structural unemployment are overdone:
Let me be the first to say that structural unemployment is a true and severe danger. When people who in other circumstances could be happy, healthy, and productive members of the workforce lack the skills, confidence, social networks, and experience needed to find work worth paying for, we obviously have a problem. And if unemployment in Europe and North America stays elevated for two or three more years, it is highly likely that we will have to face it. For nothing converts cyclical unemployment into structural unemployment more certainly than prolonged unemployment.
But is that true today? Does it look right now as if the biggest problem facing the economies of Europe and North America is structural unemployment? It does not.
But lots of folks disagree. And for the moment, you can argue either side. “The economic recovery remains painfully slow and the proof of this is companies are still reluctant to hire,” Chris Rupkey, chief financial economist at Bank of Tokyo- Mitsubishi UFJ, tells Bloomberg News today. “Those who lost their jobs in this recession will have to wait because the economy’s wheels are not turning fast enough to employ them.”
Is that evidence of structural unemployment, or a sign that the cyclical jobless rate is rebounding slower than usual? It’s hard to say for sure at this point, which is why the structural unemployment debate is still alive and kicking.
“The distinction between cyclical and structural unemployment may be well defined in theory, but it is not at all clear in practice,” notes Adolfo Laurenti, deputy chief economist at Mesirow Financial, in a research note last week. “Jobs are being created and lost both during expansions and recessions, and the dynamics that may appear obvious at an aggregate level are far from obvious when look at micro-data. Structural changes may be more apparent when associated to secular shifts across sectors (e.g., the decline in manufacturing employment), but harder to detect when taking place within industries and firms (e.g., when new technologies and equipment change the mix of skills to operate plants).”
If structural unemployment is in fact upon us, are there no policy options? It’s not quite that bad, Laurenti reminds, but there are no easy or quick fixes. Overall, Laurenti advises against “short-term fixes that would make the labor market more rigid, preventing the market to adjust to the new economic realities.” Instead,
We should focus on programs that facilitate, rather than hinder, the underlying changes taking place in the economy. From re-training programs to the portability of healthcare benefits, from the revision of the way unemployment benefits are calculated, to having them progressively phased-out rather than abruptly interrupted, there are many options to make incentives more aligned with the dynamics of the market process. The preservation of flexibility in the U.S. job market is of paramount importance.
But all that takes time, and a fair amount of political horse trading. The new normal, it seems, isn’t about to fade away any time soon. Unless the struggling labor market really is just recovering a lot slower this time. Unfortunately, it’s hard to tell the difference at the moment.
SHOULD WE WORRY ABOUT STRUCTURAL UNEMPLOYMENT?
Unemployment is still high—9.6% as of last month. But is it structurally high? In other words, is the rise of joblessness due to fundamental changes in the economy? Or is the fallout from the recession the main problem? The answer matters. If structural unemployment dominates, the case for additional stimulus—monetary or fiscal—is weakened. A new round of quantitative easing, for instance, would be of little if any value if the economy is suffering from structural unemployment.
The key challenge in a rise of noncyclical unemployment is the mismatch between the jobs offered in the economy and the available skills of the unemployed. Fixing this problem takes time, assuming it can be fixed at all short of waiting for a new generation of workers to come of age with the appropriate skill sets. By contrast, retraining older workers to find jobs in, say, technology vs. auto manufacturing is problematic at best and the antithesis of a quick fix.
By some accounts (here, for instance), there’s some statistical support for thinking that noncyclical forces have elevated the unemployment rate. And economist Edmund Phelps wrote last month that the economy is afflicted with structural unemployment. "Our economy is damaged by deep structural faults that no stimulus package will address," he opined in a New York Times op-ed.
But lots of people disagree. Dean Baker of the Center for Economic and Policy Research argued earlier this week that "There is No Evidence for the 'Structural Unemployment' Story." Economist Andy Harless recently told readers to "Stop Worrying About Structural Unemployment."
A new study from the Economic Policy Institute also attacks the idea that the surge in unemployment of late is mostly structural. Instead, the problem is cyclical, which means that monetary and/or fiscal stimulus is still relevant. Cyclical problems, in short, require cyclical fixes. As the EPI study explains,
The loss of consumers, along with financial market chaos brought on by the bubble’s burst, also led to a collapse in business investment. As consumer spending and business investment dried up, severe job loss followed. Further, even after economic output stopped contracting (in roughly the middle of 2009), its subsequent growth has not been nearly rapid enough to create the jobs needed to even keep pace with normal population growth, let alone to put the backlog of workers who lost their jobs during the collapse back to work.
Our view that this is the correct explanation for the jobs crisis is rooted in data—the observed collapse of overall output, reductions in consumption, and extensive excess capacity. The policy conclusion drawn from this narrative is that we need faster growth to increase the demand for workers and reduce unemployment.
So, who's right? Or, more importantly, how will we know who's right? The fact that this question is being debated so vigorously at the moment is by itself discouraging news. The jury, in other words, is still out--not an encouraging sign. The final judgment, however, will come in the data. If unemployment remains stubbornly high for an extended period, the case will be strengthened that we're suffering from structural joblessness. Alas, the data drips out slowly, one report at a time. Later today comes the next installment: initial jobless claims for last week. This data series has been going nowhere fast this year. Will today's report change the trend? Stay tuned.
September 21, 2010
A CHANGE OF STRATEGY FOR BERNANKE & CO? MAYBE, BUT NOT YET
The Federal Reserve announced it would keep Fed funds at a target rate of zero to 0.25%. No surprise. The economy is weak and the central bank intends to hold nominal rates at virtually nada for the foreseeable future. Tell us something we didn't know. How about detailing more of the internal thinking on the contentious issue of whether the Fed is set to roll out more quantitative easing (QE), such as buying Treasuries. QE, in its various forms, is the only policy option left at the zero bound and Bernanke and company appear to be laying the groundwork for rolling out a new round of this monetary medicine…maybe. Okay, that's a bit more intriguing.
Today's FOMC statement noted that while inflation is currently "at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability," the bank made it clear that it's "prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate."
By FOMC rhetorical standards, those are fightin' words. Of course, it remains to be seen if they remain all talk with no additional action.
Reacting to the Fed's commentary, economist David Beckworth wrote that "this afternoon a slumbering giant with a formidable arsenal of economic weapons began to awake."
In other words, deflation doesn't have a prayer. Does the crowd agree? "I think it’s still a close call and that in the end there will be enough positive signs to stop them" from deploying QE2, said Jim O’Sullivan, chief economist at MF Global, via FT.com. The numbers in the upcoming economic news, in sum, won't support an all-out fight against the D-risk.
Meantime, if the Fed's statement was designed to juice up the animal spirits on the inflationary front, there seems to be some reward for the effort. Gold popped today, with the SPDR Gold Trust (GLD) gaining 0.9% in Tuesday trading in New York. In sympathy, the dollar fell, with PowerShares DB US Dollar Index Bullish (UUP) slipping 1% on the day. In addition, the Treasury market's inflation outlook ticked up a bit, rising to 1.83% from 1.78%, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries (using government numbers). That's still a long way from the 2.45% level of late-April, but for the moment at least the deflationary argument is a bit weaker.
Ultimately, much depends on the future trend in the labor market, opined Vincent Reinhart, a resident scholar at the American Enterprise Institute and a former director of the Fed's division of monetary affairs. Speaking on a Bloomberg radio show today he said: "If the unemployment rate does stay up in the neighborhood of 9.5%, ultimately Fed officials are going to say they’ve got a reputational risk, that if they’re not seen as acting in a time of severe macro distress their reputation will be impaired."
But without foresight of the economic numbers scheduled to roll out in the coming weeks, the guesses about what happens next, and whether it's prudent, are inevitably all over the map. Consider this sampling of commentary from dismal scientists on the Fed's FOMC statement today. No matter your outlook or monetary preference, a bit of window shopping is sure to provide something that you like, or not.
READING ROUNDUP FOR TUESDAY: 9.21.2010
►18-month recession ended in June 2009
Megan Woolhouse/Boston Globe
"The Great Recession officially began in December 2007 and ended in June 2009, making the 18-month-long recession the longest since the end of World War II, according to the National Bureau of Economic Research, the Cambridge nonprofit that declares the start and end of such downturns."
►Why There's No Joy Over the Recession's End
Rick Newman/US News & World Report blog
"Maybe we need a new definition of 'recession.'"
►Recession's end is already priced into stock markets
Paul Hickey/USA Today
"'The stock market is forward-looking, and you typically see the strongest gains come in the early stages of the recovery,'" says Paul Hickey of Bespoke Investment Group. 'By the time the NBER gets around to (confirming when the recession ended), much of the gains are already priced in.'"
►Official end of recession doesn't spell relief
John Shoven/San Francisco Chornicle
"John Shoven, director of the Stanford Institute for Economic Policy Research, said the bureau's statement is simply a matter of semantics.
'All it means is the GDP has been growing, but that is a very low bar,' he said. 'People feel it in their gut: These are bad times. We are in a recovery, but the recovery is so weak that it's not creating anywhere near enough jobs to bring unemployment down meaningfully.'"
►Did the Recession End 15 Months Ago?
"We are still seeing employment growth that is below the trend rate of increase in the labor force, so the way that I think about it, we are still in a recession."
►The fat lady sings
"The NBER Business Cycle Dating Committee issued a statement today declaring that the bottom of the most recent recession was reached in June of 2009, with the economy in the expansion phase of the business cycle during the 15 months since then. This confirms the announcement issued by the Econbrowser Business Cycle Dating Committee last April…
So what does the statement really tell us? Simply that the economy, as measured by a variety of real economic indicators, has been growing rather than contracting for the last 15 months. Given that historically that condition of economic expansion tends to be highly persistent, in the absence of strong contrary indication, the most likely outcome is that we'll continue to see further economic growth in the months ahead."
►NBER: The Recession Ended in June 2009
"It’s important to note that this is an attempt to identify the trough of the recovery. It does not say we have recovered, only that we’ve turned the corner, and it doesn’t say anything about how long it will take to reach full employment."
►Is The Recession Really Over?
John Cassidy/New Yorker
"Just when you thought that the public’s esteem for economists couldn’t go any lower, along comes a panel of 'experts' from the National Bureau of Economic Research and announces that the recession that began in December, 2007, ended in June, 2009. Apparently, we have been enjoying fifteen months of economic recovery."
September 20, 2010
IT'S OFFICIAL: THE RECESSION ENDED IN JUNE 2009
They finally did it. The National Bureau of Economic Research today declared an official end to the Great Recession. The group announced that "a trough in business activity occurred in the U.S. economy in June 2009." According to NBER, the recession lasted 18 months, the longest in the post-World War II period. The previous records--16 months--were set in 1973-75 and again in 1981-82.
The announcement is hardly surprising. Many economists advised for much of the past year that the recession probably ended sometime in mid-2009. For the millions who remain unemployed, the recession roars on, of course, or at least something that looks and feels like one. But from the perspective of macroeconomics, at least as it's practiced by the cycle dating committee at NBER, the deepest economic contraction since the 1930s has been issued a formal death certificate.
Way back in March 2009, I wondered When Will It End? NBER has now offered the official response. It comes 15 months after the recession ended, but that's about par for the course with this group. Timely observations have never been its strong point.
In the March 2009 post, I noted that the initial jobless claims have a history of peaking well ahead of the official end of recessions. As I wrote at the time,
In the past six recessions, the four-week moving average of weekly jobless claims as a percentage of current nonfarm payrolls peaked either in the month the recession formally ended (as per NBER) or the month directly ahead of the recession's formal end. By this measure, in just one case since 1969 did the jobless claims peak arrive much earlier: the 1969-70 recession ended in November 1970; the jobless claims peak came in May 1970.
One incentive for considering initial jobless claims and other metrics for an early clue on when recessions end is the recognition that NBER takes its sweet time in making formal pronouncements about cyclical peaks and troughs. Today's news certainly doesn't change that standard.
Meanwhile, the simple four-week moving average of initial jobless claims (seasonally adjusted) proved its worth as a reliable early indicator of the cyclical trough. The four-week average peaked at 643,000 for the week through April 4, 2009—about two months ahead of the official end of the recession, as the chart below shows.
Unfortunately, learning of the official calendrical end of the recession doesn’t diminish the possibility that a new recession may be brewing. That risk may be low, but the odds that sluggish growth will prevail well into next year and perhaps beyond are uncomfortably high. The real danger is that there may little practical distinction between a new recession vs. an extended mediocre expansion. But at least we have closure about what NBER's thinking re: the cycle.
And in case you're wondering, NBER also advised that "any future downturn of the economy would be a new recession and not a continuation of the recession that began in December 2007." Hmmm. What are they trying to suggest? Whatever it is, we may have to wait a while for the official answer.
FUND CHOICES & STRATEGIC PERSPECTIVE
Two ETFs bit the dust last week—deservedly so. What was Geary Advisors LLC thinking when it launched state-focused ETFs? One targeted Texas stocks, the other held Oklahoma companies. Whatever the investment merits (and they were spare, at best, in my opinion), the marketplace has rendered its verdict. Apparently there are some products that are over the top, even in finance.
It's not the first time that questionable ETFs have been launched, nor will it be the last time that we see marginal products die. But this pair looked far out on the edge, even in an age of dubious fund ideas. Why in the world would anyone want to target stocks solely based on where the headquarters are located based on the political boundaries of states? Countries, maybe; regions of the world, sure. Different asset classes? Absolutely. But states? No way. Let’s just hope no one starts inventing ETFs for counties and individual towns.
Issuing arbitrarily defined portfolios of securities is, in fact, old hat. Over the years, mutual funds and ETFs have been rolled out that hold only stocks that trade on a certain exchange, for instance. A more popular idea is designing funds that hold ridiculously narrow slices of companies within a given industry.
With the ETF business entering middle age, new products are increasingly and inevitably of marginal value, if any, vs. the current choices. The low-hanging fruit has been picked. That doesn’t mean that new funds from here on out are destined for mediocrity or worse. But the caveat emptor advice takes on greater relevance as financial companies struggle to grab a share of the lucrative ETF marketplace in an already crowded field. The new players are especially keen on creating a buzz, which often promotes bold new ideas. Experiments are great, but not with your retirement money or the company's pension fund.
The bulk of the major asset classes are already represented by ETFs and mutual funds and so the argument for bringing out more often rests on thin ice. To the extent there's a rationale for new launches it's usually based on offering a lower-cost option for a given asset class vs. existing funds. Charles Schwab Investment Management’s recent entry into the ETF market focuses on offering competitive pricing in product areas that are already well established. The Schwab U.S. Broad Market ETF (SCHB), for instance, is less than a year old but it offers the lowest expense ratio of any broad-market U.S. stock fund available for retail investors: a mere 6 basis points, according to Morningstar Principia software.
There are also product launches that are productive by opening up formerly unavailable corners of the capital markets via indexing. For example, Van Eck Global in July launched the first local currency emerging-market bond ETF: Van Eck Market Vectors Emerging Markets Local Currency Bond (EMLC). And the recent arrival of two foreign corporate bond ETFs constitutes genuine progress by tapping into a broad swath of the global fixed-income market that was formerly unavailable via index funds for U.S. investors: SPDR Barclays Capital International Corporate Bond ETF (IBND) and PowerShares International Corporate Bond Portfolio (PICB).
But these are the exceptions to the rule these days. New funds with a raison d'être are increasingly rare. That doesn’t stop the financial industry from cranking out fresh products. Yet the existing population of ETFs is already quite extensive. For strategic-minded investors, in fact, the menu is too broad. One of the regular features in The Beta Investment Report is monitoring and analyzing the new ETF and index mutual fund arrivals in order to bring clarity and perspective to an increasingly dizzying array of options. The goal: creating (and occasionally pruning) a short list of the best ETFs and index mutual funds for each of the major asset classes. I also keep an eye on a few of the more compelling subcategories, such as small cap value for equities. But most of this work is excluding the vast majority of products that, for one reason or another, don't deserve a spot at the strategic-minded investing table.
Keeping a short list of the best products across all the major asset classes is harder than it sounds as the ranks of funds proliferates and the definitions blur. But the fact remains: Most investors don't need 90% of the 1,000-plus ETFs that populate Morningstar Principia’s database. Separating the wheat from the chaff, however, takes time. But it’s worthwhile, although not because it’s a means to an end. Rather, developing a short list of ETFs and mutual fund index fund products is merely the first *and essential) step in the harder and much more important work of designing and managing asset allocation. If you're going to cook up attractive risk premiums in your investment pot, you need a solid list of the available ingredients and spices.
The critical factors for strategic-minded investing are: a) focusing on the interaction of the broad array of asset classes; b) monitoring/analyzing the trends within a given asset class; and c) managing the overall mix in a dynamic fashion to some degree. These are the tasks that should be emphasized. In practice, the world is generally consumed with other matters when it comes to markets and investment products.
Rolling out lots of new funds is a good business for Wall Street, of course. That’s old news. But so is the question: Where Are the Customers' Yachts?
The good news is that there’s already a rich assortment of betas for building and managing multi-asset class portfolios. Even if you limited your portfolio to broadly based betas, the full range of risk profiles available for both buy-and-hold and trading-oriented strategies is more than sufficient to accommodate most individual investors and even a fair sampling of institutional portfolios. But as so often happens in the securities business, 98% of the attention is directed at the margins. It all makes for a good story in the financial media, but it’s got little to with cultivating investment success in the long run.
So, what else is new?
September 19, 2010
BOOK BITS FOR SUNDAY: 9.19.2010
● The Postcatastrophe Economy: Rebuilding America and Avoiding the Next Bubble
by Eric Janszen
Excerpt via Street.com
"The bright side of the crisis we're currently facing is that it could serve as a political forcing function for the United States to develop its competitive muscle and eliminate its dependence on foreign borrowing and oil -- the main source of our current problems. To execute a true restructuring plan requires strong and uncompromising leaders who are willing to level with the American people, to explain the seriousness of our problems, the sacrifices we all must make to solve them, the new and better nation for ourselves and our children that we will enjoy if we do, and the disaster that awaits us if we fail to meet this challenge.
That sounds good, but how? I argue that we can nurture the seeds of a new American industrial economy -- a productive economy that generates profits from technological industries such as computers, biology, medicine, and high-technology materials -- by cultivating next-generation transportation, energy, and communications infrastructure. "
● Adam Smith: An Enlightened Life
by Nicholas Phillipson
Review via New Statesman
"The myth of Adam Smith is that he was the hard-nosed high priest of self-interested capitalism. A new biography shows that his intellectual goals were far greater and nobler."
● Crisis Economics: A Crash Course in the Future of Finance
by Nouriel Roubini
Video of speech by author via C-Span2/Book TV
● The Great Reflation: How Investors Can Profit From the New World of Money
by J. Anthony Boeckh
Review via Canadian Business Online Blog
"J. Anthony Boeckh’s book, The Great Reflation (2010), is well worth a read if you have a curiosity about economic/financial trends from an investor’s point of view, and want one of the clearest and most insightful analyses of past, present and future developments. Boeckh knows his stuff: he was chairman and editor-in-chief from 1968 to 2002 of BCA Publications, an advisor to institutional clients on economic and financial trends...
The near collapse of the financial system in 2008 occurred because central bankers were focused on fighting the last war. After the near hyperinflation of the 1970s, they thought their job was simply to keep the Consumer Price Index (CPI) low. So money and credit creation was allowed to run loose and respond to every bump in the road during the 1990s and 2000s because the low CPI signaled everything was OK. But the extra money and credit was puffing up asset bubbles that were later to go bust."
● Capital Offense: How Washington's Wise Men Turned America's Future Over to Wall Street
by Michael Hirsh
Excerpt via John Wiley & Sons, Inc.
"Most of what we now consider economic wisdom is the result of an endless series of arguments and counterarguments, lasting several hundred years, around this question of human rationality in the marketplace."
● Zombie Economics: How Dead Ideas Still Walk among Us
by John Quiggin
Excerpt via Princeton University Press
"It is clear that there is something badly wrong with the state of economics. A massive financial crisis developed under the eyes of the economics profession, and yet most failed to see anything wrong. Even after the crisis, there has been no proper reassessment. Too many economists are continuing as before, as if nothing had happened. Already, some are
starting to claim that nothing did happen, that the Global Financial Crisis and its aftermath constitute a mere “blip” that should not require any rethinking of fundamental ideas.
The ideas that caused the crisis and were, at least briefly, laid to rest by it are already reviving and clawing their way through up the soft earth. If we do not kill these zombie ideas once and for all, they will do even more damage next time."
READING ROUNDUP FOR SUNDAY: 9.19.2010
►Can the Fed Offer a Reason to Cheer?
Tyler Cowen/NY Times
The economy needs help, but monetary policy, which is the Fed’s responsibility, has not been very expansionary. This is true even though the Fed has increased the monetary base enormously since the onset of the financial crisis...If the Fed promises to keep increasing the money supply until prices rise by, say, 3 percent a year, people should eventually start spending. Otherwise, if they just held the money, it would be worth 3 percent less each year...
In failing to push harder for monetary expansion, is Mr. Bernanke a wise and prudent guardian of the limited discretionary powers of the Fed? Or is he acting like a too-hesitant bureaucrat, afraid to fail and take the blame when he should be gunning for success?
We still don’t know which narrative is more accurate, but the Fed is not receiving enough signals of support from Congress.
►US Inflation: What is the "Trimmed Mean" CPI and What Does It Tell Us?
Ed Dolan's Econ Blog
Monthly inflation figures can sometimes signal a turning point in inflation, but those turning points are just as often masked by random noise. At present, the core CPI and trimmed mean CPI show that US inflation is still on a downward trend. Expect the Fed to stick to its easy-money policy until the trend shows a clear upward turn.
►Consumer Sentiment in U.S. Hurt by Delay in Extending Tax Cuts
Shobhana Chandra/Bloomberg BusinessWeek
Concern that U.S. personal income taxes will increase next year caused an unexpected decline in consumer confidence in September, indicating the biggest part of the economy will struggle to pick up.
►Case closed: Milton Friedman would have favored monetary stimulus
Scott Sumner/The Money Illusion
Friedman would have understood that the financial crisis was a special case that led to a rush for liquidity and safety, and a temporary fall in M2 velocity. He would have seen the low interest rates and low TIPS spreads as indicators of tight money. He would have favored temporarily allowing higher M2 growth to offset the low velocity, until the economy was back to normal. Somehow modern conservatives seem to merely recall the bumper sticker message “stable money growth” but overlook the nuanced and highly sophisticated monetary analysis that made Milton Friedman an intellectual giant.
►Storm Clouds, but Maybe No Rain
Paul Lim/NY Times
If the financial markets predict economic health several months down the road, a quick survey of recent stock and bond performance seems to point to some major problems ahead.
►Gold settles at new high; silver notches 30-year best
Claudia Assis and Myra P. Saefong/MarketWatch
Goldman Sachs said gold futures could reach $1,300 an ounce sooner than the investment bank expects if quantitative easing resumes. Quantitative easing, usually defined as a new round of monetary stimulus, “would likely accelerate the move to our 6-month price target and provide upside risk to our forecast,” analysts at Goldman said in a note to clients Friday.
►High-Fee Passive Advisor Hypocrisy
The passive advisors are right! Index fund investing is a better choice. Of course, that's assuming you buy the right index funds and ETFs in the right amounts, and don't pay an arm and a leg to an advisor for portfolio advice and management services.
Unfortunately, many passive advisors talk the talk but don't walk the walk. They preach low-cost, but it doesn't apply to their own advisor fee. Many passive advisors will berate the brokerage industry and the fund companies for charging high fees, and then stick their clients with the same high fees for investment advice and portfolio management! That's not what a true believer in passive investing would do. It's what a hypocrite would do.
►The Second Austrian Moment
We are now witnessing many important developments that will affect economics and public perceptions for a long time to come. It is perhaps too late in their careers for most established economists to be much affected. They will go the epicycle route: rationalize, complicate, and immunize against criticism. Fine, this is in part what the “old guard” is supposed to do. And those with different ideas must struggle against them.
But look around. We are witnessing the clear unraveling of the New Deal legacy. The relative modest beginnings of the New Deal turn out to have been relatively unimportant. What was important were the tendencies that were set in motion. All those unreconstructed Republican opponents of FDR who talked of “socialism,” “the foot in the door,” “fascism,” and so forth had a substantial point. A new world was being set in motion. The pragmatic case-by-case problem solvers were ignoring a whole set of consequences – the dynamics of interventionism. Expanding entitlements became the way that countless politicians, both Democrat and Republican, were elected and re-elected.
►Which Comes First: Inflation or the FOMC’s Funds Rate Target?
Daniel L. Thornton/St. Louis Fed
Monetary policy has already been effective in improving economic activity: It is extremely likely that real gross domestic product will be at or above its prerecession peak level in the third quarter of 2010, and most forecasters expect economic growth at or near potential in 2011, even though growth is now expected to be slower than previously forecast for the remainder of the year. As Kocherlakota conjectured, employment growth could remain sluggish for some time and the unemployment rate uncomfortably high even as output grows at or near potential, but there is little that monetary policymakers can do to increase employment apart from promoting economic growth. Monetary policy alone cannot correct the dislocations in the labor market that resulted from the severe contractions in residential and commercial real estate and the recession more generally.
►A reckless bailout for Harrisburg
Nicole Gelinas/Philadelphia Inquirer
Gov. Rendell threw the state's debt-laden capital city a financial lifeline this week. But by swooping in to help Harrisburg avoid default on a bond payment, Rendell will make things worse for municipal borrowers and their lenders in the long run.
September 17, 2010
BENCHMARKS & MODEL PORTFOLIOS
The SEC is "looking into" model ETF portfolios offered by financial advisors, Investment News reports. "The practice has come to the attention of the staff and they are looking at various aspects," an SEC spokesman wrote in an email to the publication. The article suggests that the catalyst for the inquiry is the abuse of promoting model portfolios. As the story notes "some industry experts worry… that many of the advisers offering these model portfolios aren't sophisticated enough to do the proper due diligence on the underlying exchange-traded funds. In the long run, they say, investors could get hurt."
So what constitutes a reasonable model portfolio vs. a crummy one? There are no easy answers without knowing who the intended investor is. A model portfolio that looks reasonable for one type of investor may be egregiously inappropriate for another. Blanket statements about rules, then, aren't all that helpful here.
Of course, if we're talking about most individual investors saving for retirement, etc., then it's easy to spot abuses in the model portfolio game. Relatively undiversified portfolios are usually a warning sign on this front, for instance.
More generally, 50 years of financial economics suggest that we start the analysis of any model portfolio by looking to a strong benchmark for perspective. At the top of this list is the broadly defined market portfolio, which holds all the major asset classes on a global basis, with the constituent parts weighted by market value.
There are a number of advantages for using this broad measure of assets as a benchmark, as I explain in Dynamic Asset Allocation. One is that everyone can own this portfolio without moving the market. The broad market portfolio, in other words, can’t be manipulated. No matter how much money flows in, or out, of this benchmark, its value as a neutral measure of global markets remains intact. That makes this a robust yardstick for analysis in portfolio research.
Another plus is that a broad measure of the world’s market weighted by market values is simple and transparent. The underlying strategy is the essence of clarity and minimalism: 1) buy all the major asset classes, 2) weight each one by its relative market value, and 3) leave it alone. That’s a strong attribute for a benchmark. Indeed, keeping it simple generally is a powerful force for designing and managing investment portfolios. As Jonathan Burton advised earlier this month in The Wall Street Journal, simple is often better when it comes to investing.
Although a broadly diversified portfolio is a compelling benchmark for assessing model portfolios and many other investment recommendations that come down the pike, this approach to financial analytics is widely overlooked. That's a mistake, in my view, but it's understandable. Finding related analysis on broad multi-asset class benchmarks is difficult. In an effort to help fill the gap, I created a proxy for a broadly defined market portfolio—I call it the Global Market Index (GMI).
I routinely analyze and track GMI in The Beta Investment Report as a starting point for developing strategic intuition about how to manage asset allocation. I also track a real-world version of the Global Market Index using index funds. How has the benchmark done? For the 10 years through last month, GMI has generated a 3.4% annualized total return. That's not great, but it's been a rough 10 years. In any case, 3.4% looks pretty good vs. the 1.3% annualized loss in the U.S. stock market (Russell 3000). Meanwhile, a number of asset classes have done better, much better in some cases. Bonds in particular have had a good 10 years. In fact, by historical standards, fixed-income returns over the past decade have been at or near the best on record in some corners of bond land. No wonder, then, that a benchmark that holds everything did okay.
Should everyone run out and build their own Global Market Index portfolio? Probably not. In theory, this benchmark is the optimal investment for the average investor over the very long run. That describes almost no single investor, although it may come pretty close to describing some institutional investors. In any case, the point is that we should recognize that we're all different, which reminds that the main challenge in portfolio design and management is deciding how we're different. But different relative to what?
The Global Market Index is a good start for considering this critical question. Why? Because GMI makes no assumptions about what's going to be hot, or not. Instead, it's passive by holding everything, in weights determined by Mr. Market's valuation process. GMI, then, represents the opportunity set and accepts it at face value. That's one sign of good benchmark.
Is Mr. Market right? No, at least not always. Pricing securities today based on expectations of tomorrow's risks is fraught with any number of problems. Of course, that's why you expect to earn a premium over "safe" investments. More generally, there's a case for second guessing the benchmark, at least to some degree. Expected returns vary, with some degree of predictability. Exploiting this opportunity takes work, however, and relatively few are up to the task. No wonder that in the long run it's hard to add value over the broadly defined market portfolio, which is another reason why it's such a strong benchmark—or model portfolio, if you will. That's simply a statement that recognizes how markets work. Alpha, to invoke the academic term, sums to zero. For every investor who beats the benchmark, someone must trail it. And after we factor in trading costs, taxes and other frictions, it's easy to see that there's a natural headwind blowing on those who try to beat the market. Yes, some beat the odds, but just as many (if not more) lose. That calculus is a constant in the market, much as the house has the edge in the long run in a casino.
Keep in mind too that some who manage to beat the broad market do so by taking high risks—a factor that isn't necessarily a sign of superior portfolio design/management skill. To use an extreme example to illustrate the point, if you owned only emerging market stocks over the past decade, you'd have beaten the market portfolio. Yes, it worked--that time. But that was a high risk strategy. The problem is that you might have chosen wrong, and some certainly did. If you bet the farm instead on U.S. stocks a decade ago (a popular idea at the time, by the way), you'd be sitting on losses today.
The key point: It's easy to generate a high tracking error vs. a benchmark. But high tracking error isn't always a sign of intelligent investing, even if the results are impressive.
The goal of prudent asset allocation is generating the required returns to satisfy your future liabilities with as little risk as possible. That's hard to do. Once you adjust returns for risk, the population of investment wizards drops sharply.
In fact, relatively few investors end up winning in the long run. Why? Investing is a loser's game, as Charlie Ellis famously counseled. By that he means that the priority for most investors (the Warren Buffetts of the world excepted) is focusing on not losing rather than on winning. It's a subtle distinction, but an important one.
There are many aspects to learning how to win the loser's game, most of which are widely recognized. Keeping expenses low, minimizing trading, diversifying broadly, rebalancing, and so on. Monitoring the right benchmark deserves a spot at this table too. It's also a piece of the strategic plan that's widely overlooked. Maybe the SEC's focus on model portfolios will shine a light on this otherwise dark corner of investment strategy.
September 16, 2010
STRATEGIC THINKING & MEAN REVERSION IN MARKETS
Contrarianism has a long history in investing, and quite a bit of success as well. Graham and Dodd's Security Analysis was an early investigation of the power of thinking independently as an investment framework. If you had to boil it down, Baron Rothschild's maxim to buy when there’s blood in the streets sums it up nicely. Kipling’s poem “If…” does the trick too: “If you can keep your head when all about you are losing theirs…”
Jumping back into finance proper, contrarianism draws support from the idea of mean reversion, which is another way of saying that what goes up comes down, and vice versa. Not immediately, of course. Between the medium-to-long-term reversions is momentum, or the tendency of asset prices to move up or down for periods of roughly 12 to 24 months. A fair amount of the art/science of managing money is deciding when momentum gives way to mean reversion, and then back to momentum in the other direction. Of course, if you were truly a long-term investor, you could ignore momentum. Or if your focus is on the short run, mean reversion could be and arguably should be overlooked. But for everyone else, a blending of the two may be practical.
In any case, it’d be foolish to mindlessly buy fallen angels, and sell the winners, but that’s more or less the idea in mean reversion. But the details matter.
Analyzing the phenomenon in stock prices was launched as a formal inquiry in a pair of 1988 studies—one from Fama and French and another written by Porterba and Summers. Fast forward to 2010, and you could spend a few years reviewing the finer points in the literature that supports the idea that betting against the crowd is a winning principle.
There’s lots of debate about why mean reversion exists. Some claim it’s evidence of market inefficiency and irrational investors. A competing line of analysis is that mean reversion tells us that expected returns fluctuate and that risk premiums, like everything else, vary, largely in line with changing expectations about the economy. The crowd demands higher—perhaps much higher—compensation during times of economic stress vs. those periods when all seems right with the world. Regardless of where you come down in this debate, the larger point is that mean reversion exists, or at least there’s a mountain of empirical studies telling us so.
And the research keeps on giving. A study from earlier this year, for instance, analyzed 17 stock markets in the developed world since 1900 and found that, yes, reversion to the mean is alive and kicking around the globe. But as the paper reminds, the potency of this factor varies, depending on the prevailing conditions. The authors report that the deeper the shock that knocked equities off the pedestal, the quicker the subsequent mean reversion.
Over the full period of study (1900-2008), the paper notes that "it takes stock prices on average 13.8 years to absorb half of a shock." But the results vary if you look at specific time periods. As the authors explain,
…using a rolling-window approach we establish large fluctuations in the speed of mean reversion over time. The highest speed of mean reversion is found for the period including the Great Depression and the start of World War II. Similarly, the early years of the Cold War and the period covering the Oil Crisis of 1973, the Energy Crisis of 1979 and Black Monday in 1987 also show relatively fast mean reversion. Overall, we document half-lives ranging from a minimum of 2.1 years to a maximum of 23.8 years. In a substantial number of time intervals no significant mean reversion is found at all, which underlines the fact that the choice of the data sample contributes substantially to the evidence in favor mean reversion. Our results suggest that stocks revert more rapidly to their fundamental value in periods of high economic uncertainty, caused by major economic and political events.
Mebane Faber, author of The Ivy Portfolio has crunched the numbers too and found some interesting results using asset classes. As he wrote earlier this week, "It is pretty well established that markets mean revert from returns of 2-4 years prior." Turning to the data, he analyzed five asset classes (U.S. stocks, foreign stocks, Treasuries, commodities and REITs) and reported that a simple portfolio that owns the worst performer over the past three years, and re-evaluates once a year, does quite well vs. buying and holding since the mid-1970s.
So, how does the current round-up of asset class returns look these days? The big losers for trailing 3-year annualized total return through August 31, 2010 are equities in the U.S. and foreign developed markets, commodities overall and REITs, according to data from Morningstar Principia:
Foreign stocks (MSCI EAFE): -10.8%
US Stocks (Russell 3000): -8.3%
Commodities (DJ-UBS): -6.6%
REITs (MSCI REIT): -6.1%
On the flip side, the leading winners for the major asset classes over the past three years comes down to bonds. Again using annualized 3-year total return:
Emerging Market Bonds (Citigroup ESBI-C): +10.7%
Foreign Developed Market Bonds (Citigroup WGBI ex-US): +8.3%
U.S. Bonds (Barclays US Aggregate Bond): +7.7%
TIPS (Barclays Treasury TIPS): +7.2%
Does this mean we should simply buy the losers and sell the winners? No, at least not without considering how our own portfolios are currently structured. Other factors to weigh include the details of our investment objective, risk tolerance, time horizon, etc. But the above list of winners and losers is a good place to start for evaluating how to rebalance an asset allocation that's wandered away from its strategic targets of late.
Yes, rebalancing has a history of modestly enhancing return, controlling risk, and perhaps both. True for broadly defined asset classes as well as within single-asset class portfolios. Why? Reversion to the mean offers some perspective. Indeed, once we consider reversion to the mean through the prism of rebalancing, it's hardly surprising to find a track of return-boosting results. Is it alpha or beta? That's another topic. But rebalancing is certainly part of the reason why the equal weighted S&P 500 has beaten its cap-weighted counterpart in recent years. It also helps explain why the fundamental indices designed by Research Affiliates have an encouraging track record against their conventional value-weighted equilvalents. Indeed, as Research Affiliates founder Rob Arnott and his co-authors discuss in The Fundamental Index, cap-weighted indices don't rebalance whereas fundamental weighted benchmarks do. That's not the entire story of why cap-weighted indices lag (the value and small-cap premia are relevant too, perhaps even more so). But rebalancing is certainly a critical factor.
Is using rebalancing as a tool for exploiting mean reversion a free lunch? No, absolutely not. When you rebalance—if you're doing so in a timely manner—you're embracing a particular type of risk at a time when the crowd generally seeks safety. A recent study makes a persuasive case that rebalancing boosts returns because relatively few investors do so in a timely manner, which in turn creates conditions for volatile swings in expected return. That opens the door for boosting performance with opportunistic rebalancing.
That reluctance to rebalance, or at least engage in timely rebalancing isn't surprising. How many of us were buying stocks in late 2008/early 2009 and selling bonds? Not many. For those who did, recent trailing returns today probably look quite handsome vs. those who waited for the all-clear sign. But to reap the higher return, you had to endure some sleepless nights. For most folks, it was much easier to sit in cash. But that comes at a price, even if that's a weak argument when the world seems to be coming apart. In fact, there are studies, such as this one, that document that rebalancing is relatively rare among individuals. That's one reason--maybe a big reason--why there's a risk premium connected with rebalancing for the few who exploit this opportunity.
There's no guarantee that mean reversion will work, although almost everything's suspect in finance in real time. But history suggests we should be cautious before dismissing the idea entirely.
September 15, 2010
HOW TO THINK ABOUT ECONOMICS, PART II
Last week I wrote about an intriguing new book—The Puzzle of Modern Economics—that grapples with the question of whether economics is fatally flawed or only partially blemished, in which case it’s better than the alternative of throwing up your hands and screaming. Yesterday I stumbled across another recent addition to the genre of reassessing the dismal science that’s no less thought provoking: Economyths: Ten Ways Economics Gets It Wrong.
My first reaction: There are only 10 missteps in economics? We could, of course, turn the subject around and focus on the 10 (or more?) things that economics gets right, like the deep understanding of why free markets and capitalism is generally preferable for promoting economic growth vs. the various state-centered alternatives. But the really big picture isn’t under scrutiny in Economyths, written by mathematician David Orrell, an author who’s tackled similar subjects before, including The Future of Everything: The Science of Prediction. His latest book gets into the nooks and crannies of economics and attempts to point out where theory and real-world application separate.
Orrell zeroes in on the basic problem under scrutiny when he writes: “Economics gains its credibility from its association with hard sciences like physics and mathematics.” But as many observers have pointed out in recent years, the fusion of the dismal science and hard science only goes so far, and at times the assumption that there is such a linkage is dangerous. But this is an old idea, as Orrell himself points out by quoting Issac Newton’s perennially relevant counsel from 1721: “I can calculate the motions of heavenly bodies, but not the madness of people.”
Have we learned anything in the subsequent centuries? Orrell offers some elegantly written arguments for staying cautious on answering “yes.” The central challenge, he opines, is breaking free of the legacy that binds us to the historical record in economics. “It turns out that many of the ideas that form the basis of modern economics have roots that stretch back to the beginning of recorded time,” he writes. “That’s one reason why they are proving so hard to dislodge.”
As one relatively recent example, he examines a staple in economics: the supply and demand curve. “If economics has an equivalent of Newton’s law of gravity, it is the law of supply and demand,” he reminds. And for good reason, considering that as a practical description of pricing, the supply and demand curve illustrates how markets reach equilibrium—the point at which supply and demand are balanced. If supply or demand changes, or both, so too will prices. As Orrell explains,
In one sense, the law of supply and demand captures an obvious truth – if something is in demand, then it will usually attract a higher price (unless it’s something like digital music, which is easily copied and distributed for free). The problem arises when you decide to go Newtonian, express the principle in mathematical terms, and use it to prove optimality or make predictions.
But while the law of supply and demand does a pretty good job of describing prices for general purposes, it’s not perfect and so it can be misleading at times in terms of predicting prices, at least in the short term. In other words, don’t confuse economics with physics, Orrell warns. The reason is that people are a key part of economic analysis, a distinction that doesn't harass astrophysicists or aerospace engineers. The classic rules of supply and demand break down at times because of the man on the street. Why? People and their seemingly odd preferences. Orrell explains that this distinction is particularly relevant for analyzing certain assets that are sought for their investment value.
The Economist recently made a similar observation:
Financial markets do not operate in the same way as those for other goods and services. When the price of a television set or software package goes up, demand for it generally falls. When the price of a financial asset rises, demand generally increases.
Why the difference? The reason is surely that goods and services are bought with a specific use in mind. Our desire for them may be driven by fashion or a desire to enhance our status. But those potential qualities are inherent in the goods themselves—the sports car, the designer sunglasses, the fitted kitchen. Such goods may be means to an end but the nature of the means is still important.
Overall, such differences between physics and economics “helps explain why large economic models, which are based on the same laws, fail to make accurate predictions,” Orrell advises. In fact, this is old news. Economists have been telling us for a long time that stuff happens and so the standard theories of what should happen are susceptible to, well, temporary insanity, heightened risk aversion, chaos, or whatever you’d like to call it.
Even the so-called classical economists recognized that markets aren’t perfect and sometimes succumb to the disequilibrium du jour. J.S. Mill’s Principles of Political Economy from 1848, for instance, noted that moments of “commercial crisis” arise at times. "At such times there is really an excess of all commodities above the money demand: in other words, there is an under-supply of money," Mill wrote.
Of course, Keynes emphasized the fluctuations in aggregate demand in The General Theory of Employment, Interest and Money as the critical variable in crises.
In any case, Orrell reminds that economics cannot be reduced to one fundamental law. There are multiple schools of thought in economics and not one is entirely right...or wrong. The evidence for thinking so is that predictions fail. They fail enough of the time to keep the crowd guessing. “One reason is that the economy is made up of people, rather than inanimate objects.”
Those damn people! If it wasn’t for all the wetware, maybe economics would resemble physics.
READING ROUNDUP FOR WEDNESDAY: 9.15.2010
►Richmond Fed’s Lacker Wants High Threshold For More Fed Action
Jon Hilsenrath/Wall Street Journal
"Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, sees modest growth in 2011, little change in inflation and little to spur the Fed to take new actions to support the economy."
►IMF Meetings Should Target Double-Dip Risk
Mohamed A. El-Erian (Pimco)/Bloomberg
"Many topics are being teed up for next month’s annual meetings of the International Monetary Fund and World Bank in Washington, a gathering that will draw about 190 country representatives. There is a substantial risk of disappointment, one that would be detrimental to the welfare of billions around the world over time."
► Killing Keynesianism?
J.T. Young/Washington Times
"Is the recession's great irony that government spending killed Keynesianism? With economists, bankers and investors perplexed over the economy's continued funk, we cannot be blamed for looking in odd places for answers. Could it possibly be that continuously increasing spending over eight decades has left little ability for government spending to affect the economy?"
►Macroeconomic and Financial Policies Before and After the Crisis
Barry Eichengreen/Conference on Global Economic Crisis
"…we will be debating the causes and consequences of the 2007-10 advanced-country financial crisis for years. Evaluations will continue to evolve along with events, no doubt, but it is not too early to begin drawing some provisional conclusions.
First, while this crisis, like all crises, had multiple causes, at its center were problems of
lax supervision and regulation. It is appropriate therefore that post-crisis efforts, both in the United States and at the level of the G20, should focus on regulatory reform. Unfortunately, accomplishments here are less than meet the eye. In the U.S., nothing has been done to downsize big banks."
►What is to be done?
Russ Roberts/Café Hayek
"We are in the mess we are in because of a combination of policy mistakes–artificially low interest rates, housing policy that distorted the construction industry and the price of housing, and implicit and explicit promises to honor the losses of bad financial bets. When you do those things, you can come to a bad end. It would be great to think that the housing market and the financial sector can be repaired without pain. I don’t know how to do it and I don’t think anyone does. It would be great to have a theory of what creates confidence in the future. We don’t have a theory of what creates confidence."
►Currency Intervention Madness
Mike Shedlock/Mish's Global Economic Trend Analysis
"Both China and Japan are intervening in the Forex markets for the same reason, to strengthen exports and stimulate the economy.
Pardon me for asking the obvious question but it needs to be asked: Why does Geithner give the green light for Japan to intervene in the currency markets but China is threatened with a currency manipulator label for doing the same thing?
►Just don't call it stimulus
"Business groups and Republicans have pummelled Barack Obama of late as a populist demagogue whose policies have failed to stimulate growth while blanketing companies with stifling uncertainty about taxes and regulation. This week Mr Obama unveiled a trio of proposals that look to have been designed less to power up the economy than to parry such attacks."
September 14, 2010
RETAIL SALES RISE IN AUGUST
If you’re looking for fresh news that the risk of deflation/economic deterioration is gaining momentum, you won’t find it in today’s retail sales report for August. The advance estimates indicate a seasonally adjusted rise of 0.4% last month vs. July, the Census Bureau reported today. That’s the second monthly rise for U.S. retails sales and the highest percentage gain since March.
If we look at the monthly trend of late, there’s an upside bias. It’s hardly definitive or strong enough to close the book on worries, but considering what might have been it’s okay and more than welcome.
Looking at dollars spent shows a similar reason for mild optimism. In fact, one can argue that the seasonally adjusted trend over the past two years remains intact: retail sales are rising, as the next chart reminds.
So, what’s the catch? One area to watch is the rolling 12-month percentage change in retail sales. The trend here, which is a proxy for the big picture change, may run into trouble in the months ahead. As the third chart below shows, the year-over-year change has weakened recently. It's one thing to elevate spending off of generational lows; it's another to keep the pace afloat in an age of hefty debt and balance sheet restructuring.
Even putting aside all the economic headwinds that lie ahead, the slowing in the annual rate of change for retail sales isn’t surprising. The rebound was always destined to level off. The reflation reached a peak in retail sales back in April, with an 8%-plus change vs. a year earlier--an unsustainable pace, of course, which is to say that some downshifting was and remains inevitable.
In fact, it wouldn’t be shocking, or necessarily ominous, to see the annual pace of retail sales fall further in the months ahead. As of last month, sales were up 3.6% vs. a year ago. That’s vulnerable to lesser levels in the months ahead, based on the assumption that the economic rate of growth may suffer additional slippage. That was certainly the case in the latest GDP report, which revealed a significant slowdown in economic growth in the second quarter vs. the first: 1.6% real vs. 3.7% in Q1 (in nominal terms that works out to an annualized 3.6% rate in Q2, down from 4.8% in Q1).
But how much downshifting is too much? Good question, and no one can be sure in real time if we're returning to the new normal or falling into a new hole. It's going to be close, which is why everyone's watching the numbers so closely--more so than usual.
But for the moment, retail sales are holding up. That supports our long-running thesis that the economy this year and next would somehow muddle through, although there would be plenty of bumps along the way. The recovery theme has earned another day of reprieve today. And given the apparent change in monetary policy, as we noted earlier today, the appetite for risk may go up another notch or two.
One day at a time...
STOCKS UP, SO IS THE MONEY SUPPLY. A CONNECTION?
September has been a good month for equities, so far. The S&P 500 jumped nearly 7% for the month through Sep. 13. For the moment, the disinflationary/deflationary scare of the summer is over. Or is it merely taking a breather? There's no assurance that the crowd won't turn risk averse once more. It's all about incoming economic data…still. But looking at the latest trend in money supply figures and the slight jump in the market's inflation expectations suggest that there's something more in the rise in equity prices than rank speculation.
Let's start by looking at the annual percentage change in the seasonally adjusted weekly readings of MZM money. As the chart below shows, this measure of the money stock was just about flat as the end of August vs. a year ago. That's still cutting it close, assuming the economy is still at risk of further slowing. But no change in money supply on a year-over-year basis is higher than the 2% decline that prevailed earlier this year.
A comparable shift higher is also visible in the actual MZM totals in recent weeks, as the second chart shows.
Other measures of money supply, such as M1, also suggest that the Fed has reversed course from previous months and is now pumping up the printing presses. Overall, it's a notable change from, say, the end of June, when the annual pace of change in the money supply was falling like a rock, and the stock market wasn't doing much better.
Confirmation that there's been a change can be found in the market's inflation outlook, which has risen as well. Using the yield spread between nominal and inflation-indexed 10 year Treasuries, the crowd's estimating future inflation at 1.8% a year, as of yesterday. That's up slightly from just under 1.5% in late August, as we noted at the time.
Is this the all-clear sign for sweeping away the D risk worries that have plagued the market lately? Maybe, maybe not. It depends on what the next batch of economic numbers tell us. Meanwhile, there's the chatter from the monetary mavens to digest. St. Louis Fed President James Bullard--a voting member of the FOMC--told The Wall Street Journal a few days back that a 1% rate of consumer price inflation is "not extremely low." That worries Nick Rowe, who wonders if the Fed's 2%-2.5% inflation target (albeit, an assumed target) is in a deflationary spiral of its own..
Is Bullard's comment a sign that the Fed is laying the groundwork to permit a lower rate of inflation to prevail vs. what the bank used to anticipate? That certainly jibes with the latest outlook from the San Francisco Fed, which anticipates consumer price inflation of around 1% for the foreseeable future, as the chart from the bank's Sep. 8 Fed Views publication shows.
Many pundits will celebrate a lower outlook for inflation, reasoning that lower prices are good for everyone. There's some logic there, but it also comes with a fair amount of risk in the current climate. A 1% inflation rate is just dandy if the economy is humming along. If it's struggling, well, that's a recovery of a different color. If 2% inflation gets you 1%, then 1% may risk falling to zero if something goes wrong this autumn. Unless the Fed decides otherwise.
So, yes, the jump in stocks so far this month suggests that the deflation scare has abated for the moment. And the burst of optimism seems tied to better monetary numbers. But it's still early to say for sure. Meanwhile, it's best to assume that there's one more weasel in the hen house.
September 13, 2010
YOU (STILL) CAN'T PROVE ANYTHING IN ECONOMICS
Mark Thoma, a professor of the dark art/science who teaches economics at the University of Oregon, neatly summarizes what everyone knows and few discuss: you can persuasively make a case for just about anything in the dismal science, but proving it is something else. Meantime, it's all about organizing facts.
Or as Thoma writes:
Much of the uncertainty in economics derives from our inability to do laboratory experiments, and that includes uncertainty about which model best describes the macroeconmy.
When the present crisis is finally over, those who advocated fiscal policy, those who advocated monetary policy, and those who advocated no policy at all will all say "I told you so" based upon their reading of the evidence.
One quick example comes in the debate about whether Milton Friedman--who literally wrote the book (co-authored, actually) on monetary policy--would support or reject current calls for more quantitative easing at this point. Yes, of course, argues Scott Sumner; no, absolutely not, counters John Taylor.
Hey, what's going on here? Chalk it up to the Paradox of Economics. Or as Thoma concludes: "...for now we are stuck arguing about which model is best without the means to turn to the data and clearly distinguish one from the other." And sometimes it's about arguing over the "right" interpretation of a given model. Milton Friedman lived to a ripe old age, and left a healthy paper trail. But apparently it wasn't enough to send an unambigious message about how he thinks.
The possibility of making mistakes is, uh, slightly higher than it would be if we're writing rules for designing aircraft or cleaning the streets.
That leaves us with the question: What chance do 12 people have for pulling the right strings with the right force at the right time? We'll know soon enough.
BUY & HOLD, ASSET ALLOCATION AND REBALANCING
Is the buy-and-hold portfolio strategy dead? Morningstar has been discussing the question lately, and the answer is that, well, it's complicated.
Let's be clear about one thing: Very few investors are true buy-and-holders for the long run, nor should they be. Leaving a portfolio completely untended over years if not decades is simply abandoning the responsibilities of investing. That doesn’t mean you should trade frequently. But ignoring an investment strategy isn’t practical.
The idea of the "coffee can" portfolio, an idea espoused by Bob Kirby way back in 1984, has a certain appeal: Buy assets, sock 'em away, and forget about 'em for long, long periods of time. There's wisdom in the idea, in part because buy and hold cuts down on trading costs, taxes, and the anxiety of worrying about the short-term market noise. But financial economics has taught us much since 1984, and so the idea of literally buying and holding doesn't pass the smell test.
The problem is that assets can suffer lengthy periods of loss. U.S. stocks, to cite the obvious victim, have lost about 1.3% a year, based on the Russell 3000's annualized history over the past 10 years. Sounds pretty bad and it is. But a few thoughts.
First, if you look at the rolling annualized 10-year periods for U.S. stocks since 1926 (courtesy of Ibbotson Associates) you find that losses over a decade are quite rare. The fact that we just had one of those rare periods has many pundits crying foul and recommending that you avoid or substantially underweight equities from here on out. But where was that advice when you needed it?
A decade ago, the prevailing wisdom favored overweighting stocks. Certainly the case for equities looked compelling in early 2000, before the first stock market crash of the 21st century. Now, with stocks limping along and suffering one of their worst 10-year periods in history, the argument to avoid stocks is riding high. Maybe that's good advice, but it's worth thinking twice before beating the farm on expecting stocks to deliver another unusual loss over the decade ahead. Here’s one forecast you can count on: If stocks do well over, say, the next five years, there’ll be a surfeit of strategists telling you to overweight stocks.
But a careful reading of the research literature reminds that equities are volatile and they go in and out of favor. Risk premia have a tendency to mean revert, in other words. That's not surprising, although it can be a problem if you own a relatively small sampling of securities or asset classes.
Remember that stocks—domestic stocks in particular—are just one corner of the broad asset class pie. One of the smartest things investors can do is also one of the easiest: own a bunch of different asset classes. The broad categories are stocks, bonds, commodities and REITs. We can and probably should slice and dice each of those groups into subcategories, particularly with stocks and bonds, starting with the domestic/international distinction. Indeed, bonds now come in a variety of flavors that every investor should exploit on a cross-border basis, including governments, credits, nominal and inflation-indexed varieties.
Why focus on carving up the major asset classes into finer pieces? In a word, rebalancing. Asset allocation is a powerful tool for diversifying risk. But combining asset allocation with rebalancing creates an even stronger strategy. And by rebalancing I’m talking of resetting the portfolio mix back to its target weights. In that sense, rebalancing requires no forecasting skill. Tactical asset allocation, by contrast, is based on looking ahead, and so that’s a separate issue.
As for rebalancing, a number of studies over the years show that preventing asset allocation target weights from moving too far afield can modestly enhance return, reduce risk, or both. For example, a recent edition of Burton Malkiel's best seller A Random Walk Down Wall Street shows that annually rebalancing a 60/40 stock/bond mix boosts return by around 40 basis points while reducing volatility.
In Dynamic Asset Allocation, I review some of the research over the years that focuses on rebalancing. A number of studies show that a simple rebalancing strategy can boost return by 50 to 100 basis points over the long haul, assuming a multi-asset class portfolio.
Is this guaranteed? No, of course not, and neither is anything else in finance. Much depends on the period of time. If you rebalanced a stock/bond portfolio in the late-1990s, you would have reduced performance vs. simply leaving the asset allocation alone. Of course, rebalancing helped if you measure the results through 2000 and beyond, which includes a sharp drop in equities.
For another perspective, consider how a passive mix of all the major asset classes fared over the past 10 years in an unmanaged cap-weighted form and an annually rebalanced version. In my newsletter, The Beta Investment Report, I routinely analyze the Global Market Index and its main components for subscribers. One area of focus is monitoring the unmanaged and rebalanced versions of GMI. For the decade through last month, the straight GMI generated a 3.4% annualized total return. That’s quite a bit better than the -1.3% for U.S. stocks (Russell 3000).
The message here: asset allocation can help, or at least it did over the past decade. Why did it help? Because other asset classes did quite well over the past 10 years even though stocks fared poorly. A few examples include the 6.5% annualized total return for investment grade bonds (Barclays Aggregate) since 2000; 10.2% for REITs (FTSE NAREIT); 4.4% for commodities (DJ-UBS Commodity); and 11.2% a year for emerging market bonds (Citi ESBI-Capped).
No wonder that GMI, which owns everything, delivered 3.4% a year. And if you simply rebalanced GMI back to earlier weights every December 31, that 3.4% rises slightly to a 4.4% annualized total return. Asset allocation and rebalancing are powerful tools, particularly when they’re used in concert.
So, what are the caveats? Again, expecting rebalancing and/or even asset allocation to always boost return in every period is asking for trouble. It might not, depending on what’s going on with the markets. Indeed, some financial advisors argue that asset allocation and rebalancing are first and foremost tools for managing risk. As such, these fundamental components of portfolio management are considered by some as guardrails that keep investors from going into the ditch.
There’s also the challenge of deciding when to rebalance. Doing so on different dates can deliver different results. But this is less of a problem than it seems if you rebalance over long periods of time, which tends to smooth over the rough edges.
Nonetheless, it pays to monitor the major asset classes for signals that enhance the odds of rebalancing at timely moments. For example, I recently advised subscribers that it was timely to consider rebalancing out of U.S. bonds, Treasuries in particular. That recommendation was less about forecasting and more of reviewing the strong returns for bonds vs. stocks recently. Should you exit bonds entirely? No, but if your portfolio is heavily overweighted in fixed-income vs. your target weights, the case for trimming the bond allocation and redeploying is compelling.
But let's not forget that there are no silver bullets in portfolio management. Instead, success comes only through diligent monitoring and managing of the asset allocation. That starts by diversifying widely and planning on routine rebalancing every, say, year or two, or more frequently if you're opportunistically inclined. Yes, there’s more, much more to do, if you’re up to the task. But the thousand-mile journey still starts with the first two steps: asset allocation and rebalancing.
September 11, 2010
BERNANKE'S READING LIST
What's on Fed chairman Ben Bernanke's reading list these days? He was asked that question earlier this month during testimony to the Financial Crisis Inquiry Commission, the government's investigative posse charged with finding the smoking guns that triggered the financial crisis of 2008 and its evil twin, the Great Recession. One recommendation from the nation's central banker in chief: Lords of Finance: The Bankers Who Broke the World, which details a fascinating but widely misunderstand bit of history of how the world's central bankers at the time failed so spectacularly on the eve of the Great Depression.
If you haven't read this book, you should. It's ancient history, but it's also highly relevant (still) in the battles over monetary policy in the here and now. History doesn't repeat, but sometimes it rhymes. As Liaquat Ahamed, the book's author, writes in the epilogue…
For many years people believed—even today many continue to do so—that an economic cataclysm of the magnitude of the Great Depression could only have been the result of mysterious and inexorable tectonic forces that governments were somehow powerless to resist. Contemporaries frequently described the Depression as an economic earthquake, blizzard, maelstrom, deluge. All these metaphors suggested a world confronting a natural disaster for which no single individual or group could be blamed. To the contrary, in this book I maintain that the Great Depression was not some act of God or the result of some deep-rooted-contradictions of capitalism but the direct result of a series of misjudgments by economic policy makers, some made back in the 1920s, others after the first crises set in—by any measure the most dramatic sequence of collective blunders ever made by financial officials.
"Those who cannot remember the past are condemned to repeat it," Santayana warned. Are we repeating the past on the macroeconomic front? Or have we learned anything? If you package certain facts, you can argue persuasively on either side at the moment. The final verdict of history, however, is still unfolding. The grand dénouement is yet to be determined. The distant past, at least, is crystal clear…and it makes for a riveting story. The realization that some of the details are still relevant only sweetens the deal.
September 10, 2010
IT'S OFFICIAL: OBAMA PICKS GOOLSBEE AS ECO ADVISER
As expected, President Obama chose Austan Goolsbee as the new head of the White House Council of Economic Advisers. He is the replacement for the outgoing Christina Romer. Goolsbee, as AP reports today, "is already a central player on the Obama economic team, having served on the three-member economic council since the start of the administration. His relationship with Obama dates back to the 2008 presidential campaign, when he served as a senior economic policy adviser."
Ok, but what can we expect (or not) from Gooslbee? Reuters political columnist James Pethokoukis cautions against anticipating any dramatic stimulus-oriented tax cutting: "Goolsbee is extremely skeptical of supply-side tax arguments, calling the Laffer Curve a 'fleeting figment of economic imagination.'"
The Washington Post's Ezra Klein agrees that Austin's no fan of trimming taxes to spur economic activity. But that stance may cause a slight conflict with the current White House agenda. As Klein explains: "Austan Goolsbee's academic work suggests that investment tax credits don't do much for the economy. The White House that Goolsbee will work for is, however, proposing just such a credit, and Goolsbee will probably be defending it at some point."
The Wall Street Journal declared on Wednesday, "After 20 months and more than $1 trillion down the Keynesian drain, President Obama is discovering the virtue of tax cuts."
Nonetheless, Time asserts that choosing Goolsbee "augurs continuity with the approach of the past two years" and "is seen as somewhat of a counterweight to Larry Summers among the White House's economic voices."
Meanwhile, we know the new kid in the thick of it has a sense of humor. An economist by day, Goolsbee has a habit of moonlighting as a stand-up comic after the pols go home. Here he is delivering his shtick last year at the Washington Improv...
Finding humor in life is no small benefit these days for a dismal scientist trying to unwind after a day at the office in Washington, considering that the state of the economy is no laughing matter.
Speaking of the economy, what does Goolsbee think of the chances for a new economic contraction? The odds are slight, he said on August 30 on CNN (via Bloomberg): “I don’t think we will have a double-dip recession." But, he added: "Clearly anybody should keep their eye on that."
Does he think differently today? Maybe he'll enlighten us on Sunday, when he'll be a guest on ABC's "This Week" program.
THE NEW PUBLISHING SCHEDULE FOR THE BETA INVESTMENT REPORT
FYI for my newsletter subscribers...
Starting in September, The Beta Investment Report is published in multiple editions throughout each month. Previously, the newsletter was published in single monthly editions. Issues sent to subscribers so far this month:
9 September 2010 (Vol. 2 No. 9.5) "ETF, ETN & Index Fund News"
8 September 2010 (Vol. 2 No. 9.4) "Fund Focus: Foreign Gov't Bonds
In Developed Markets"
3 September 2010 (Vol. 2 No. 9.3) "Rebalancing & Bonds"
2 September 2010 (Vol. 2 No. 9.2) "Economic Review"
1 September 2010 (Vol. 2 No. 9.1) "Risky Assets Take A Hit In August"
HOUSING & THE GREAT RECESSION
Steven Gjerstad (presidential fellow at Chapman University) and economics professor Vernon Smith (also at Chapman) connect the dots between the housing market and the business cycle in a recent study. Unfortunately, they don't like what they see in the current climate. As they explain in an op-ed in The Wall Street Journal that summarizes their research, "If there is no recovery in housing expenditures, confirmed by a recovery in consumer durable goods expenditures, then there is no economic recovery." And in case you were wondering, there's no housing recovery to speak of at the moment.
Exhibit A in their analysis is the trend in expenditures on housing as a percentage of GDP. As the chart below shows (courtesy of the paper), this measure of spending "has declined before ten of eleven post-war recessions and the Great Depression" and "it has rarely declined substantially without a recession following soon afterward," the authors advise. In other words, this metric has proven to be a robust leading indicator of the business cycle.
They also note that spending on new housing has usually rebounded "faster than any other major sector of the economy after every recession since 1920-21," with the 1980 recession being the only exception. But the 1980 outlier was due in part to the fact that the brief slump that year (it ended in the year it began, according to NBER) was quickly by a new recession—a double dip.
Overall, housing is sensitive to monetary policy and so the sector "responds first to tightened policy and typically first recovers when policy is relaxed." That leaves us to ponder the fact that the current housing recovery "is the slowest rebound in residential construction in any sustained recovery from a postwar recession," Gjerstad and Smith write in the Journal. It's different this time, for a number of reasons.
The bottom line: there's no housing recovery worthy of the name at the moment, even if the sector has stabilized. It's clear that new housing starts remain severely depressed, as the second chart below reminds.
Judging by the trend in new building permits issued (see third chart below)--a measure of future housing investment--the prospect for an imminent turnaround in real estate spending still looks dim.
No wonder that Gjerstad and Smith recommend preparing for a protracted economic recovery. Or as they warn, "We are almost surely in for a long slog." If there's reason to think otherwise, you're likely to hear it first (or at least early) from the housing market.
September 9, 2010
JOBLESS CLAIMS DROP SHARPLY. CAN WE BELIEVE IT?
Seasonally adjusted jobless claims fell last week by 27,000—the biggest weekly drop in nearly two months and quite a bit more than the 2,000 retreat that economists generally were expecting. The news is a breath of fresh air for the business cycle, although it comes with some caveats. Nonetheless, the headline trend for the moment looks quite a bit better today: new filings for unemployment benefits dropped to 451,000 for the week through September 4, the lowest since early July.
Encouraging, but let’s remember that the Labor Day holiday weekend that just passed surely skewed the numbers. This data series is volatile to begin with and if you add in one of the biggest party weekends in the U.S. into the mix, well, you have to take the news with a grain of salt until the next round of updates. If you joined the ranks of the newly jobless last week, the temptation to take advantage of a long holiday weekend and think of other things for a few days can’t be ruled out. We’ll see if next week’s numbers offer any clarity.
Meanwhile, let’s take today’s drop to 451,000 at face value. A nice downward move, to be sure, and for all we know it signals a renewed bout of strength in the economy. But we’ve been here before, as the chart below reminds. In fact, this series dipped to 427,000 in early July. Until we move down to that level, and below it, it’s hard to dismiss the trendless trend that’s otherwise still in force this year for jobless claims.
For for the time being, the crowd’s likely to be pleased with the number du jour.
September 8, 2010
EMERGING MARKETS POISED TO GRAB MORE GLOBAL GDP & MARKET CAP
It's old news that emerging markets are expected to grow at rates in the years ahead that will make the developed world look stagnant. But the details still impress whenever new estimates are published.
The latest batch of numbers comes from Goldman Sachs, which predicts in a recent report that emerging markets could represent nearly half of global stock market capitalization in 20 years, as reported by the Financial Post. Currently, emerging market stocks are a small fraction of the world's equity value. Back in June, for instance, we crunched the numbers and found that the so-called emerging world held just 12% of global market cap. That's still a minor share, but it's up from around 1% a decade earlier. But even 12% is low once you consider that emerging markets harbor nearly half of the world's GDP, according to the OECD.
What's behind the rise of emerging market economies? Timothy Moe, the author of the new Goldman Sachs study, wrote that "the primary drivers are rapid economic growth and the maturing of equity markets that are at earlier stages of development," via Bloomberg. "Developed-market institutional asset management pools will need to increase their holdings of emerging-market equities."
Translated: the rich world will be buying more emerging market stocks in the years ahead, or so the report suggests. To be fair, lots of analysts have been arguing something similar for years. Based on the fundamental trend in the world economy, it's hard to argue otherwise.
The economies of China and India (to take the two obvious examples) have been expanding at much higher rates compared with the U.S. and the developed world. And more of the same is expected. China's GDP is forecast to jump by nearly 10% this year and more than 8% in 2011, according to The Economist. The outlook for India is almost as strong. By comparison, the U.S. will be lucky to grow by 3% this year and next, and even that looks appealing vs. the 1% GDP rise predicted for the euro region.
Another sign of the changes afoot comes in last month's news that China's economy surpassed Japan's for the first time.
"China and some other emerging markets have a number of positives going for them that don't exist in the advanced industrial economies," according to J. Anthony Boeckh in the recently published The Great Reflation: How Investors Can Profit From the New World of Money. Boeckh, a former editor of the highly respected Bank Credit Analyst, cites a list of plusses that make many emerging markets attractive. A few examples he notes in the book: undervalued exchange rates, strong fiscal profiles, highly liquid economies, strong underlying economic growth, and huge labor forces, to name but a few.
Is it any wonder, then, that emerging market stocks generally have soared over the past five years? The MSCI Emerging Markets Index has gained an annualized 12.3% through September 8, according to MSCIBarra.com. The biggest markets among emerging nations--Brazil, Russia, China and India (a.k.a. the BRICs) are up even more, posting an annualized 17% total return since 2005.
The developed world looks like a wet towel by comparison. The MSCI EAFE Index (a proxy for developed markets other than the U.S.), for instance, has risen a mere 1.2% a year in dollar terms. But even that modest gain looks good compared with the spare 0.1% annualized increase for MSCI's broad measure of U.S. stocks.
Emerging markets aren't so hot in 2010, however, advancing by a relatively mild 3.3% year to date through September 8. But in the current climate of diminished expectations, that's still enough to beat the slight loss in U.S. stocks and the 4% drop in EAFE.
The long-run outlook for emerging market stocks may be a no-brainer, but the near-term outlook is something else. Par for the course these days with risky assets. At least there's no shortage of strong choices for tapping into broad measures of emerging markets beta. The short list of funds (based on criteria set by The Beta Investment Report) provides seven solid choices for broad exposure, as shown in the table below.
And speaking of emerging markets, bonds issued by nations that fall under this heading have been a strong performer in recent years, and year-to-date performance is no exception. For example, the Citi Emerging Markets Sovereign Bond Index (Capped) is up an impressive 12.6% so far in 2010 through September 8. As broad betas go this year, it doesn't get much better than that. In fact, that's among the best performances among the major asset classes generally. What's going on? The short answer is that the combination of strong economic fundamentals in developing nations and the allure of bonds issued by countries with healthy balance sheets is a bullishly potent mix. Meanwhile, there are a number of compelling funds to tap into this brand of fixed-income beta, as the third table below shows.
Emerging markets, in short, have come a long way, but the journey's still in its infancy.
IS OBAMA'S BUSINESS INVESTMENT TAX CREDIT TOO LITTLE, TOO LATE?
President Obama is scheduled to announce a round of new tax breaks today for corporate America in a bid to stimulate the economy. The timing is no surprise. Worries persist that the already weak economic rebound is still faltering.
At the core of the tax-credit proposal, the Chicago Sun-Times reports, is "accelerating write-offs of investments in plants and equipment and expanding a tax credit for research and development." If the idea is focused on boosting business investment, the proposal doesn't come a minute too soon, even though its political viability is questionable at the moment.
In any case, the latest report on new orders for non-defense capital goods excluding aircraft (a statistic that economists use as a measure for business investment) dropped by a hefty 7% in July vs. June. As the chart below shows, that's the biggest month loss since the recession was formally tearing through the country in 2008 and 2009.
The implication: business investment is stalling, one more troubling sign for the future of the business cycle. True, one month a trend doesn't make. And if we look at actual dollars committed to this measure of business investment, the trend doesn't yet look fatal. Since mid-2009, new orders for non-defense capital goods ex-aircraft have been zig-zagging higher, as the second chart below shows. It's unclear if July's big retreat is a sign of things to come vs. one more downdraft on the path to even higher levels.
In fact, if the rest of the economy was humming along, the retreat in July of business investment wouldn't be a worry. But it's clear that there are other headwinds still blowing, starting with the feeble recovery in the labor market. In addition, the market is still pricing in disinflation/deflation risks. As economist David Beckworth observed yesterday, "eight months on and counting, expected inflation continues to fall at a steady pace…"
One prominent analyst of the business cycle offers this warning today via CNNMoney:
"We already are in a slowdown, so no matter what they do, there is a risk of another recession," said Lakshman Achuthan, managing director of Economic Cycle Research Institute. He said any action to spur the economy was needed near the beginning of this year when the economy still had momentum.
As we write, stocks in Europe and Asia are down, and the crowd is rushing back into bonds (again). It ain't over till it's over, as the saying goes, and the disinflation/deflationary-induced risk aversion that began in May isn't over.
September 7, 2010
BOOKS NOTED ON THE CAPITAL SPECTATOR
Please note the new "Book Store" link at the top of the page. Any and all books discussed on these pages are listed here.
HOW TO THINK ABOUT ECONOMICS
Has economics failed?
Yes, judging by the criticism heaped upon the dismal science in recent years. Macroeconomists in particular, we're told, were blind to the rising risks that eventually killed the economic expansion and unleashed the Great Recession—the deepest contraction since the Great Depression in the 1930s. In fact, economics is at once the problem and the solution, as Roger Backhouse argues in an intriguing new book: The Puzzle of Modern Economics: Science or Ideology?
Backhouse, a professor of the history and philosophy of economics at University of Birmingham, narrates a tale of evolution and debate in the dismal science in the 20th century in search of clues for deciding how (or if) economics has stumbled. At the core of this story is the mathematization of economics. As Backhouse recounts:
From the 1930s onward, the Econometric Society's conception of what it meant to be rigorous became increasingly influential. Economics came to be seen as a technical discipline centered on modeling—the construction of mathematical representations of the economic activity.
Promoting and strengthening better living through mathematically rigorous economics has been high on the agenda for economists for years. Indeed, some of the biggest names in the profession are closely linked with the rise of quantitative modeling. Thanks to John Maynard Keynes, Paul Samuelson, and others, the dismal science is primarily a quantitative field. As a result, Backhouse explains, "economists were applying formal, mathematical modeling to an increasingly wide range of economic problems" in an effort "to be scientific."
How, then, could economists be so blind to the risks that bubbled ahead of the Great Recession? The pursuit of science implies greater accuracy. But economics isn't physics. This hasn't been lost of the economics profession, even if the general public thinks otherwise. Backhouse reminds that criticism of economics has been ongoing from within. What's more, there's always debate about what's relevant, what's not, and what constitutes enlightened economics—macroeconomics in particular. Indeed, arguments over what caused the Great Depression of the 1930s still rages—80 years later! One could reasonably argue that there's too much debate, and that it rolls on for too long.
If endless debate is destiny in economics, that's no surprise. There are no easy answers—certainly no single, all-encompassing explanation in this field. There's ample room for criticism, of course, and praise. But if commentary is to have any relevance, it must be specific. Economics in the 21st century is too diverse, too wide ranging to be pigeonholed and summarized as right or wrong. The next best thing, Backhouse suggests, is understanding modern economics by way of understanding the theories that drive the profession. Here is where the proverbial rubber meets the road.
Our conception of whether the dismal science failed or triumphed in recent years depends on which brand of economics we're looking at and what expectations we harbor. Searching for clear answers about what ails economics is complicated by other factors, Backhouse advises, including the possibility that some economists use certain theories to advance political agendas. Meanwhile, a given economic theory's influence is largely dependent on whether it's the mainstream or not.
Why can't the debates be resolved by simply testing a given theory? The short answer: It's economics. "Thus when economists test theories, the results are often inconclusive," Backhouse writes. "Sometimes this is because they have not used the right data. It can also be a problem when there are too few observations to estimate models precisely, perhaps because the government has only recent started compiling statistics in a given area or because definitions have changed." And because economists often seek to identify the causes of economic changes, as opposed to simply finding reliable patterns in the data, the process of explaining cause and effect is riddled with nuance.
Ultimately, Backhouse can't tell us if economics has failed or triumphed. The profession won't submit to such a general test. It's akin to asking if science is productive or not. Instead, Backhouse offers the next-best thing: explaining how economics has evolved, why it's complicated, and how it's still useful despite the obvious shortcomings.
Along the way he presents a compelling case for dismissing the criticism that mathematical rigor is hurting economics. "The appropriate response to inadequate economic theories is not to abandon the attempt to be rigorous," he opines. "It is precisely because economists such as Akerlof or Stiglitz had developed abstract theories of how markets worked that they were able to see that the common sense view of how financial markets operated were wrong."
The closest Backhouse comes to sweeping conclusions are statements such as: "…where problems are narrowly and precisely defined, and where they involve agents whose motivations are well understood and who operate under well-understood constraints, economic analysis is remarkably powerful."
That's good news for microeconomics, and so the challenge is (still) in macroeconomics. That's not surprising. The factors that drive an economy are hopelessly vast and the interactions unfathomable. No wonder that economists reduce the infinitely complex relationships that comprise an entire economy to simplified models. That's a solution as well as a recipe for problems. Yes, economics works best when narrowly defined, as Backhouse asserts. But macroeconomics doesn't have that luxury. "Because the problems are so broad, the available theory and evidence leave much scope for the intrusion of both intellectual values and ideology."
Yes, macroeconomics has come a long way over the decades. But expecting macroeconomists to prevent recessions is a bit like asking meteorologists to deliver a particular type of weather next Thursday. Backhouse does a fine job of telling us why economics is so bedeviled, and why the profession is at perpetual war with itself. He also reminds that macroeconomics has made astonishing progress in explaining how economies tick, and which policies are likely to succeed or fail. But that falls well short of providing flawless prescriptions for how to avoid recessions or engineer growth in the next quarter.
Most economists agree that a healthy dose of free market capitalism is a plus for creating wealth. But there's a furious debate over the details. How much is too much capitalism? How much regulation (if any) should there be? Is capitalism inherently unstable? Such questions are macroeconomic questions, but they're also political topics. Macroeconomics by its very nature invites debate, dissent and deliberation.
So, has economics failed? That's an unfair question, Backhouse's book suggests. Yes, the recent crisis has spurred a healthy re-evaluation of everything from Keynesian policies the to efficient markets hypothesis. But the flaws of most established economic theories are tightly bound up with their successes. Separating one from the other is devilishly difficult, if not impossible in economics. No wonder that simple answers in the dismal science are the exception rather than the rule.
READING ROUNDUP FOR TUESDAY: 9.07.2010
►Dangerous Defeatism is taking hold among America's economic elites
Ambrose Evans-Pritchard/Telegraph (U.K.)
"Blitz the market with bond purchases, but do so outside the banking system by buying from insurers, pension funds, and the public. This would gain traction on the broad M3 money instead of letting it collapse (yes, the "monetary base" has exploded, but that is a red herring), working through the classic Fisher/Friedman mechanisms of the quantity of money theory.
This is quite different from the Fed's QE which buys bonds from the banks and works by trying to drive down borrowing costs. While Bernanke's 'creditism' is certainly better than nothing, it is not gaining full traction."
►The Monetary Base and Bank Lending: You Can Lead a Horse to Water…
David C. Wheelock/St. Louis Fed
"Why was the increase in the money stock so small when the increase in the monetary base was so large? The answer centers on the willingness of depository institutions (banks) to lend and the perceived creditworthiness of potential borrowers. A deposit is created when a bank makes a loan. Ordinarily, bank loans—and hence deposits—increase when the Fed adds reserves to the banking system. How ever, despite an increase in reserves of over $1 trillion, total commercial bank loans were some $200 billion lower in May 2010 than in September 2008. Banks added to their holdings of securities, which resulted in a modest increase in deposits and the money stock, but many banks were reluctant to make new loans. Partly this reflected weak loan demand, but it also indicated a diminished appetite for risk on the part of bankers."
Stephen Williamson/New Monetarist Economics
We have important monetary policy issues to think about, but Krugman's NYT column this morning was too much to resist...
The 1938 recession is a key part of the Great Depression experience. It has long been part of our macroeconomic policy narrative, and has been used before in support of Keynesian-style responses to the financial crisis, in particular by Christina Romer. The FDR administration took the budget deficit from 5.5% of GDP in 1936 to a state (roughly) of budget balance in 1938. A Keynesian interpretation of that is that the contraction in fiscal policy helped cause the 1938 recession. Milton Friedman and Anna Schwartz, in their A Monetary History of the United States argued that monetary policy was important - principally the doubling in reserve requirements from 1936 to 1937. Hal Cole and Lee Ohanian argue here that you can explain a lot of the features of the latter Great Depression years as coming from FDR's labor market policies. This is far from an open and shut case. I think you could convince me that the state of the government deficit at the time had little to do with the 1938 recession.
►World markets rise as double-dip fears ease
"'The renewed flight to safety we have witnessed over the past month is overdone and risks an equally large reversal when the worries over a double dip subside,' analysts from Rabobank said in a report. 'As the unexciting, steady and below-trend global recovery continues, it's important not to confuse it with a double dip recession.'"
►We'll be lucky to merely brush by another recession
TJ Marta/Marta On The Markets
"Much like Hurricane Earl did with New Jersey and New York City, the data published last week suggest that we might just merely brush by another recession. The developments last week were sufficiently mixed to dissuade markets from the notion that the economy is going down in flames, although the data remain weak enough to underscore the characterization of the trajectory by Pimco's El-Erian as the "new normal" and keep the probability of tipping into another recession by yearend in our minds at a worrisome 40-50%."
►Jobs Data Keep Shaky Recovery Afloat
"Heather Boushey, senior economist at the Center for American Progress, said Friday that 'the labor market has entered a holding pattern.' The private sector's monthly average gains of 78,000 in June through August are 'not nearly enough to begin to reduce unemployment.'"
►Business Cycle Variation in the Risk-Return Trade-Off
Hanno N. Lustig and Adrien Verdelhan/SSRN.com
"In this paper, we take the opposite approach to the literature on equity and bond market return
predictability. Instead of looking for predictors of equity and bond excess returns and then studying the cyclical properties of these predictors, we simply measure realized excess returns at different points of the business cycle in the U.S. and other developed economies.
We obtain striking results. Realized equity excess returns and equity Sharpe ratios increase
during recessions and decrease during expansions. Variations are economically large and statistically significant. In a model with time-varying risk aversion, such dynamics are not puzzling: in bad times, investors are risk-averse and expected excess returns are high."
►A Mildly Discouraging Update on the Job Market
Gary Burtless/Brookings Institute
"According to the payroll survey, government employment losses in August more than offset the gains in private-sector employment. Most of the drop in public-sector payrolls is explained by the departure of 114,000 temporary Census workers. However, state and local government payrolls also continued to shrink in August. Since the start of this year state and local public-sector payrolls have fallen 135,000, or almost 17,000 per month. These job losses are almost certainly linked to the expected end of federal fiscal relief under the Administration’s stimulus program. Earlier in the recession public-sector employment was a bright spot in an otherwise gloomy employment picture. In spite of a huge falloff in state and local tax revenues, federal fiscal relief permitted state and local governments to maintain their payrolls. With weak revenues and poor prospects of future federal fiscal relief, state and local governments are now trimming their payrolls. The trend could continue for a number of months unless there is a sizeable pickup in local tax revenues."
September 3, 2010
THE LABOR TREND IN AUGUST: STILL STRUGGLING
Nonfarm payrolls retreated by a net 54,000 last month (seasonally adjusted) and the unemployment rate ticked up to 9.6% from 9.5% in July, the Bureau of Labor Statistics reported this morning. The payroll loss for August isn’t as steep as the 100,000-plus decline that economists expected, but that’s cold comfort for a labor market that’s still struggling to grow. But there’s better news once we focus on the net change for private-sector payrolls, which posted a 67,000 rise—comfortably above the consensus forecast of a 44,000 gain. Better, but unimpressive.
Why emphasize non-government payrolls? We must ignore the headline figure because the government laid off 114,000 temporary Census workers in August. After dismissing that statistical glitch, here’s how the monthly net change in private sector nonfarm payrolls has unfolded:
Private-sector job creation has managed to climb above zero this year, as graphed above, but at a disturbingly low rate. The average gain so far in 2010 is under 100,000 per month. That’s a dismally low figure given the steep losses in jobs in recent years and, more importantly, what’s required to keep the economy humming in the months ahead. As troubling as that is, the trend of late suggests that job creation in the private sector may be weakening. Indeed, last month’s 67,000 net rise in private payrolls is down sharply from July’s 107,000 rise and an even smaller fraction of April’s 241,000 burst higher.
Consider, too, that the bulk of last month's net rise of 67,000 jobs in the private sector was due primarily to hiring in health services, according to the government's breakout of the data. There's nothing wrong with that, and it's certainly welcome. But the health industry is hardly a cyclically sensitive corner of the job market/economy. The implication: last month's private-sector hiring had little to do with upside momentum in the business cycle. In fact, manufacturing-related employment, which is cyclically sensitive, shed 27,000 jobs last month, reversing most of July's 34,000 gain in this corner of the economy.
Feeling inspired yet? I’m not. Certainly there’s scant evidence that the labor market is improving on a meaningful basis. You can, however, argue that it’s treading water, echoing the trendless trend in initial jobless claims this year.
Yes, fears of a double-dip were probably exaggerated. We’ve been arguing all along that the economy was likely to "muddle through" and avoid an outright contraction in the second half of this year (as noted here and here, for instance).
But the outlook for subpar growth and weak job creation—although superior to a new recession—is a real and present danger, and today's employment report doesn't offer much reason to dismiss the danger. If the economy continues to struggle, eventually the risk of a recession will become more than a low-probability prediction.
READING ROUNDUP FOR FRIDAY: 9.03.2010
►Bond Bubble: A Sterile Debate
James Montier/The Big Picture
"…unless you believe that Japan is the correct template for the US (i.e. inflation will be zero for the next decade), government bonds don’t offer an attractive return as a buy-and-hold proposition."
►Tyson’s Keynesian Confusion
Mark A. Calabria/Cato@Liberty blog
"Unlike consumption, which has largely rebounded, investment today is about 20% below its peak. Of course we should keep in mind, that peak was a bubble. The good news is that investment in such things a equipment and software, are slowly, but steadily, climbing back. The real drag on investments is from the construction industry, particularly residential, which is still down about 50% from its peak…
What most of this suggests to me is that unemployment is being driven mainly by a mismatch between skills of the unemployed and available job openings. You simply cannot, overnight, turn a construction worker into a nurse or computer programmer...
At the end of the day, what we need to get employment increasing is to create an environment where business feel confident to invest."
►Fork In The Road For The Bond Market
"The strong disagreement about the direction of U.S. interest rates can be attributed in part to the distortive effects of unprecedented central bank intervention. The $1.25 trillion purchase of mortgage-backed securities was successful (in most minds) in pushing down mortgage rates to support housing. Without the support, however, are mortgage rates headed higher? Will the declaration to buy Treasuries with cash from the Federal Reserve balance sheet push risk-free rates lower? The central bank was no doubt sincere in the proclamation that the Federal Open Market Committee "is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly," but many still question the bank's ability to deliver."
►Nowhere To Go
The Economist's Free Exchange blog
"Ben Bernanke, in his recent assessment of the American recovery, shocked some people by declaring that the conditions are still in place for a recovery in 2011. Economic data have certainly been disappointing lately, leading many to extrapolate various downward pointing lines back into negative territory.
But Mr Bernanke has a point. The conditions are in place for a recovery. Primarily because they can't get much worse."
►U.S. stock futures edge up ahead of key payrolls data
"'It seems that every fresh U.S. data point is eagerly awaited at the moment,' said Jim Reid, strategist at Deutsche Bank, in a note to clients. 'This sharper focus will likely be a regular feature of the post-crisis world due to the likely lower trend rate of growth.'"
►Jobs report may show rise in unemployment rate
Christopher S. Rugaber/AP
"The unemployment rate may be about to rise again.
Economists are bracing for a weak showing in the August employment report, which is scheduled to be released Friday. The private sector is forecast to add a net total of only 41,000 jobs, the fewest since January, which isn't enough to keep up with population growth. The jobless rate is expected to increase to 9.6 percent from 9.5 percent, the first rise since April."
September 2, 2010
JOBLESS CLAIMS DIP, BUT REAL PROGRESS IS STILL MIA
Jobless claims fell slightly last week, dropping by 6,000. That's good news. The trouble is that we're still at an elevated 472,000 on a seasonally adjusted basis. One data point doesn't say much, of course. What does the longer-term trend show? Lots of volatility recently, but nothing much has changed.
As our chart below reminds, weekly filings for unemployment benefits is about the same today as it was in December 2009. We're going nowhere fast, a trendless trend that's occasionally interrupted by a surge up, or down. But so far, after the dust cleared, there's little if any progress in the labor market, at least by the standard of this series.
By some accounts, "the data can't get much worse." Maybe so, but there's still a shortage of reasons for thinking it's poised to get much better in the near term.
Is it all doom and gloom for the economy? Probably not. The Washington Post offers "five reasons to be optimistic about the economy."
But quick fixes are in short supply. "It took more than a decade to dig today’s hole, and climbing out of it will take a while, too," reminds Ken Rogoff of Harvard. "Why is it so tough to boost employment rapidly after a financial crisis?" One reason, he explains:
…is that the financial system takes time to heal – and thus for credit to begin flowing properly again. Pumping vast taxpayer funds into financial behemoths does not solve the deeper problem of deflating an overleveraged society. Americans borrowed and shopped until they were blue in the face, thinking that an ever-rising housing price market would wash away all financial sins. The rest of the world poured money into the US, making it seem as if life was one big free lunch.
The free lunch is over. "The bottom line is that Americans will have to be patient for many years as the financial sector regains its health and the economy climbs slowly out of its hole," Rogoff warns.
The trendless trend in jobless claims certainly offers no reason to think otherwise.
A BRIGHT LIGHT IN A DARK ROOM
Manufacturing activity turned up again last month, the Institute for Supply Management reported yesterday, offering the first statistical review of August's economic profile. The crowd was pleased: stocks soared and bond prices fell. But the bigger test of the trend in August comes tomorrow, when the government's payrolls report for last month is published.
Meantime, manufacturing's recovery is now well established. According to ISM, last month's rise in the sector's activity is the 13th consecutive month of growth. But the connection between manufacturing's improving fortunes and the broad trend in U.S. employment is still weak.
Yesterday's ADP Employment report advised that private-sector employment dropped by 10,000 last month. The consensus forecast among economists calls for a better reading tomorrow: private payrolls are expected to rise by 44,000, according to Briefing.com. Better, but still below the previous month's 71,000 net gain in private sector employment. (The headline payrolls number, which includes government jobs, is expected to show a drop of 120k for August.)
What's disturbing is that ADP's 10k dip is the first outright decline in six months. As the accompanying press release noted: "This month’s decline in employment followed six monthly increases from February through July. Over those six months, the average monthly gain in employment was 37,000 with no evidence of acceleration."
But the dark news from ADP was offset yesterday with a report announced job cuts fell sharply last month.
Mixed news, in short, is circulating, which is to say that nothing much has changed. The labor market is still weak, unless tomorrow's jobs report tells us otherwise.
September 1, 2010
A WARNING SIGN FROM "STICKY" INFLATION?
When we last checked in with the monthly consumer price index, headline inflation was running at an annualized 1.2% pace as of this past July, off sharply from 2.7% in January, the Labor Department reported. Clearly, the trend so far this year is down. The question is whether we’re headed for even lower rates of inflation? Or deflation?
The future's always open to debate, of course, but it’s clear that disinflationary momentum has had a head of steam lately. One reason for thinking the trend might roll on comes from separating so-called sticky components of CPI from the flexible parts. A study by the St. Louis Fed finds that the flexible component prices are quite volatile while the sticky ones are relatively calm. What’s the relevance? As one of the study’s authors explained last week, "sticky-priced components tend to be more forward-looking and better indicators of future inflation." He goes on to report:
Recently, the growth rate in the sticky CPI has been quite soft relative to its longer-term (five-year) trend growth rate of 2.3 percent. Also, compared to the core CPI, the sticky CPI has been on a sharper disinflationary path over the last two years—falling from a 12-month growth rate of 3.1 percent in mid-2008 to just 0.8 percent as of July (a series low with data back until 1968). Moreover, in July the sticky CPI rose 0.9 percent, consistent with its near-term trend, while the flexible CPI jumped up 11.4 percent after three consecutive monthly declines. After stripping away food and energy prices from the flexible price series, it still rose 5.2 percent in July and is up roughly 6.0 percent over the past three months, compared to its three-month annualized growth rate of −0.1 percent through the first three months of this year. Based on this evidence, it seems that the price increases from the more volatile flexible price series have been putting upward pressure on some underlying inflation measures, while the sticky-price series has continued on its subdued (but positive) inflation trend.
A chart from the St. Louis Fed tells the story:
Is this a smoking gun that guarantees inflation will continue falling in the months ahead? No, but it's one more reason to think twice before dismissing the disinflation/deflation risk. Sticky prices of late suggest that we go lower yet.
Meantime, the August update on consumer inflation arrives later this month, on September 17.