November 30, 2010
IS HOUSING IN TROUBLE...AGAIN?
Is the housing recovery losing steam? It’s harder to dismiss the possibility after reading today’s update of the S&P/Case-Shiller Home Price Indices. Nationally, U.S. housing prices fell 2.0% in this year’s third quarter over the previous three months. That’s a sharp deceleration from the 4.7% rise in this year’s second quarter.
Looking at national housing prices on a rolling annual basis doesn’t brighten the trend. As the chart below shows, U.S. home prices overall in September were 1.5% lower compared with 12 months ago. “While housing prices are still above their spring 2009 lows, the end of the tax incentives and still active foreclosures appear to be weighing down the market,” S&P advises in a press release.
By some accounts, it all adds up to a humbled outlook for real estate in the foreseeable future. Housing “is on the brink of another substantial downturn,” warns Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott. “Supply far exceeds demand and the only remedy is further price declines,” he says via Bloomberg.
Even the ailing labor market is doing better than housing. No one will confuse the modest gains in net private nonfarm payrolls this year as a robust recovery, but the trend at least remains positive.
Not so for housing, according to the latest Case-Shiller numbers. If housing is faltering once again, there will be repercussions. As Professor Alex Schwartz reminds in his book Housing Policy in the United States, “Housing is a mainstay of the U.S. economy, consistently accounting for more than one fifth of the gross domestic product.”
If housing is in fact destined for a new downturn, the debate will be largely over how deep the damage. As Christopher Low, chief economist at FTN Financial, reminds via Reuters: "As far as consumers go, housing's not quite as significant as it used to be, but there is still a wealth effect. Falling home prices, for a lot of people, means that their wealth is eroding."
Ongoing housing weakness inspires rethinking some of the recent optimism tied to the uptick in markets and several non-housing corners of the economy. Was the autumn revival merely a headfake? It’s too soon to say for sure, but today’s housing update has injected a new strain of anxiety into the debate about what comes next.
At the very least, the latest dip in the Case-Shiller national index creates more pressure for good news in the next batch of economic reports. The crowd needs encouraging data points to temper the disappointing housing update. The rest of the week won’t disappoint for fresh macro meat to chew on, for good or ill, starting with tomorrow’s updates on the ISM Manufacturing Index, construction spending, auto sales, and ADP’s estimate of payrolls for November. Thursday brings word of last week’s tally of new jobless claims.
The big number arrives on Friday when the government publishes its nonfarm payrolls report for last month. The consensus estimate calls for a gain of 140,000, according to Briefing.com. Will that be enough to calm the bears and steady the bulls? Stay tuned.
READING ROOM FOR TUESDAY: 11.30.2010
►Contagion Fears Hit Euro; Spanish Bond Spreads Widen
Mark Brown and Eva Szalay/Wall Street Journal/Nov 30
Spanish and Italian bond spreads over German bunds rose sharply to new highs, as did the cost of European sovereign debt insurance, while the euro continued to tumble, as euro-zone contagion fears continue to roil currency and debt markets.
The premium demanded by investors to hold Spanish 10-year bonds over the benchmark German bund rose over 30 basis points to more than 300 basis points, while Italy’s 10-year bund spreads rose over 20 basis points to 215 basis points, according to Tradeweb, record highs in both cases.
►Asia stocks fall on Europe debt, China hike fears
Associated Press/Nov 30
Asian markets crumpled Tuesday as Chinese shares slid on fears of an interest rate hike and the European Union's bailout of Ireland failed to convince investors the continent's debt crisis has been contained...
Soaring prices in China, the world's No. 2 economy, are so far limited mostly to food, but analysts say price pressure could spread to other areas unless Beijing hikes interest rates and further tightens credit. Investors worry that might slow economic growth or reduce the amount of money flowing through the economy that is helping to finance stock trading.
"There is a little nervousness about how hard the policymakers will have to slam on the brakes to contain inflation," said David Cohen, an economist with Action Economics in Singapore.
►Will the Irish crisis spread to Italy?
Paolo Manasse and Giulio Trigilia/VOX/Nov 26
Is Italy the next European country to go? This column argues that the jury is still out, although the grace period will not extend beyond three years.
►German Unemployment Falls to Lowest in 18 Years
Rainer Buergin/Bloomberg/Nov 30
German unemployment fell for a 17th month in November as business optimism improved, underscoring the gulf between Europe’s biggest economy and peripheral nations struggling to cut debt.
►Germany watches with concern as euro falls despite Ireland bailout
Kate Connolly/LATimes/Nov 30
"Our economy is currently booming, so the experts tell us, but there's no room for celebration," said Christine Fromm, a dressmaker from Potsdam near Berlin. "Unemployment is lower than it's been for two decades, exports are up, growth is healthy, but our wages have been more or less frozen for years with the promise of increases always 'round the corner.
"Politicians praise workers for helping to keep Germany competitive," she added. "Yet if we keep bailing out the rest of Europe, we'll end up going down with the sinking ship."
►How Chinese Inflation Policy Will Shape The Yuan-Dollar Exchange Rate
Ed Dolan/Ed Dolan's Econ Blog/Nov 28
By freezing its exchange rate and pulling out all the stops on fiscal and monetary stimulus, China got through the global recession with only a mild slowdown in GDP growth. Now it is facing the inflationary consequences. Consumer price inflation, after rising steadily all year, hit a 4.4% annual rate in October, approaching the government's red line. How will China choose to deal with the inflation threat? The answer is important both for China and its trading partners, because anti-inflation policy will determine what happens to the exchange rate of the yuan over the coming months...
We can see, then, that rising inflation makes it harder than ever for Chinese policy makers to restrain the ongoing real appreciation of the yuan. If inflation continues, the real exchange rate would continue to rise even if the nominal exchange rate were frozen once again...
As long Chinese inflation remains above the U.S. rate, the real exchange of the yuan will continue its steady appreciation relative to the dollar. Contrary to the political bluster heard from some quarters, appreciation of the yuan will not solve all the world's problems. Over time, however, we can expect it to make a helpful contribution to easing some of the most acute global imbalances.
►Confidence and the Business Cycle
Sylvain Leduc/San Francisco Fed/Nov 22
The idea that business cycle fluctuations may stem partly from changes in consumer and business confidence is controversial. One way to test the idea is to use professional economic forecasts to measure confidence at specific points in time and correlate the results with future economic activity. Such an analysis suggests that changes in expectations regarding future economic performance are important drivers of economic fluctuations. Moreover, periods of heightened optimism are followed by a tightening of monetary policy...
In recent decades, cycles of boom and bust in Japan, East Asia, and the United States have focused renewed attention on the question of confidence. These experiences suggest that optimism about the future helped fuel economic booms and that subsequent buildups of pessimism contributed to the busts. Moreover, these episodes fostered intense debate about the role of monetary policy in boom-and-bust cycles. Central banks have been sharply criticized for stoking the booms and inflating confidence by setting excessively accommodative monetary policy.
November 29, 2010
MILTON FRIEDMAN & QE2
Economics professor David Beckworth writes that the case is closed over the debate about Milton Friedman and whether he would have supported the Fed's quantitative easing program: Yes, Friedman would have approved. The latest evidence is based on comments Friedman made in 2000. After reading the document, it's hard to disagree with Beckworth. Perhaps Alan Meltzer will retract his recent op-ed arguing that Friedman wouldn't have endorsed QE2.
Although the country under discussion was Japan, Friedman's analysis from a decade ago is relevant for the current macro challenges facing the U.S. Here's an excerpt from a Q&A with Friedman:
David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero, monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue?
Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy.
The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy. Essentially, you had deflation. The real interest rate was positive; it was not negative. What you needed in Japan was more liquidity.
During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasirecession ever since. Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?”
It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the highpowered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.
PONDERING THE NEXT PHASE OF THE DEBT CRISIS
The Fed’s latest round of monetary easing—QE2—has stabilized inflation expectations at a modestly higher level of late. Since mid-October, the inflation forecast based on the yield spread between the nominal and inflation-indexed 10-year Treasuries has bounced around in the low-2% range. That represents a victory of sorts from the summer plunge in the market’s inflation outlook, when fears of a new recession were on the rise.
It’s tempting to declare that QE2 has been a success and that all’s well. But that’s premature. It will take many more months to assess the impact on the economy. Meantime, we’re in a precarious state of stability.
For all the Fed’s monetary maneuverings of late, it’s still not clear if the higher inflation represents a fundamental change or a temporary bounce. Indeed, the forces of disinflation/deflation are still swirling in the global economy, as the debt troubles in Europe remind. What’s more, it’s not obvious that the current remedies are enough to ease worries of default. As today’s Telegraph relates:
It is clear to those working in the bond markets that the debt crisis in the EMU periphery is nearing danger point, and risks spiralling out of control as quickly as the Lehman-AIG-Fannie-Freddie crisis in 2008.
Prof Willem Buiter, chief economist at Citigroup, said last week that Portugal is likely to need a rescue before the end of the year and that Spain will follow “soon after”.
Elsewhere in The Telegraph today a European banker advising governments on the European Union’s financial crisis warns: "This is the next credit crunch, The markets feel very nervous at the moment and I think the sell-off we began to see last week could turn into a full-scale rout this week if the EU doesn't get a grip of the issue."
Back in the U.S., the stock seems to be waiting to see what happens next. The S&P 500 continues to move sideways after consolidating its autumn rally.
Meantime, the U.S. Dollar continues to rally, despite the formal announcement of QE2's monetary stimulus earlier this month. The greenback’s November rise is a sign that the global appetite for risk is waning…again.
The geopolitical fallout from North Korea’s latest attack on South Korea certainly adds to the safe-haven allure of the dollar, but there’s no denying that rush into greenbacks this month is also a function of the escalating debt crisis in Europe. As Bloomberg observes today:
European governments yesterday handed debt-strapped Ireland an 85 billion-euro ($113 billion) aid package. Finance chiefs ended crisis talks in Brussels by endorsing a Franco-German compromise on post-2013 rescues that means investors won’t automatically take losses to share the cost with taxpayers, a plan proposed by German Chancellor Angela Merkel.
“Attention is shifting to the ‘next Ireland’ like Portugal and Spain,” said Yuki Sakasai, a currency strategist at Barclays Bank Plc in Tokyo. “Europe’s problems will probably continue, so people are looking to sell the euro.”
For the moment, the markets aren't optimistic about the near-term outlook for the latest leg of the European financial crisis. As EuroIntelligence opines, “It is simply extraordinary how much credibility the EU has lost in such a short period of time.”
Debt, in other words, remains front and center as the key risk for the global economy, particularly in the developed world. The Federal Reserve has been fighting the blowback with monetary policy, and upping the ante recently with QE2. There’s been some traction with this policy, but its effects are now waning, in part because the debt crisis in Europe is reviving as a clear and present danger, as it did in the spring. Indeed, it was fears of a deeper European debt crisis earlier this year that triggered the summer selloff. Is a repeat performance brewing?
The risks are still low, but those risks are rising. That raises the pressure for good news with this week’s economic reports. The big number arrives Friday, with the November employment update. The consensus forecast calls for a net rise in nonfarm payrolls of 130,000, according to Briefing.com. Not great, but enough to keep the demons at debt at bay, at least for a time—assuming, of course, the forecast is accurate.
November 26, 2010
BOOK BITS FOR FRIDAY: 11.26.2010
● The Little Book of Sideways Markets: How to Make Money in Markets that Go Nowhere
By Vitaliy N. Katsenelson
Excerpt via publisher, John Wiley & Sons
Get ready for a great roller-coaster rise in the markets. For the next decade or so the Dow Jones Industrial Average and the S&P 500 index will likely do what they did over the preceding decade: go up and down, setting all-time highs and multiyear lows along the way. But at the end of the rise, index and buy-and-hold stock investors, having experienced ups and downs and swings akin to those on an amusement park rise, will find themselves pretty much back where they started.
● A Call for Judgment: Sensible Finance for a Dynamic Economy
By Amar Bhide
Review via Library Journal
Bhidé draws heavily on Friedrich Hayek's seminal essay, "The Use of Knowledge in Society," to argue that lending decisions had become overly mechanistic and centralized prior to the financial crisis that began in 2007 and that this was an important causal factor in the crisis. He traces this trend to an overreliance on statistical models, developed by financial economists, that often made unrealistic assumptions or were misused by practitioners, and to relatively recent changes in securities and banking regulations. Bhidé's central thesis is that the dialog and judgment required in lending are best exercised closer to the actual applicant. He suggests that banks be required to qualify loans in a more old-fashioned way—making personal, case-by-case evaluations of applicants—to prevent them from taking outsize risks. In addition, banks that accept short-term deposits from the public should be restricted in their business to lending and simple hedging.
● The Rise and Fall of an Economic Empire: With Lessons for Aspiring Economies
By Colin Read
Excerpt via publisher, Palgrave
The Law of Diminishing Returns proves that no institution can grow too big. At some point, greater size inevitably introduces inefficiencies. The very forces that ensured growth and dominance of an institution in one era can contribute to its decline in another. History has demonstrated this phenomenon over and over. From the extinction of the dinosaurs and the fall of the Roman Empire, to the transformation of the United Kingdom from an entity that dictated foreign policy to one that dealt in foreign policy, the eventual downfall or the surrender of dominance by the largest and most powerful military empires seems to be inevitable.
Economic empires are no different. Just like the dinosaurs, economies evolve and are governed by the harsh Darwinist law of survival of the fittest. This book documents the creation and evolution of economic empires and their eventual demise.
● A Moderate Compromise: Economic Policy Choice in an Era of Globalization
By Steven Suranovic
Summary via publisher, Macmillan
Looking at all sides of the globalization debate, Suranovic analyzes how international economic policy is made and how it has become so controversial. He offers a solution to the debate between free trade/unregulated markets and the push for greater government involvement that is consistent with both economic efficiency and social justice.
● Architects of Ruin: How big government liberals wrecked the global economy--and how they will do it again if no one stops them
By Peter Schweizer
Summary via publisher, HarperCollins
In Architects of Ruin, New York Times bestselling author and conservative historian Peter Schweizer argues that the economic crisis was caused by liberals who used the power of government to create a subprime mortgage bubble that has ravaged the global economy. Rebutting charges that the financial collapse was caused by conservative deregulatory zeal, Schweizer, the author of Do as I Say (Not as I Do): Profiles in Liberal Hypocrisy, shows that it was actually the result of “do-good capitalism.”
November 24, 2010
WEDNESDAY'S DATA DUMP
The U.S. Bureau of Economic Analysis published several economic reports today that collectively offer a mixed bag of macroeconomic news. The updates on new orders for durable goods, personal income and spending, and weekly jobless claims are usually dispatched on separate days. Because of the Thanksgiving holiday tomorrow, all three were released this morning, leaving an unusually hefty dose of statistics to review. Here’s a brief tour of some of the noteworthy data points:
New orders for durable goods dropped a hefty 3.3% on a seasonally adjusted basis in October vs. the previous month. The drop reverses September’s revised 5.0% rise, the Census Bureau reports. It’s too soon to say if October’s retreat for new orders is a sign of things to come, but it’s troubling nonetheless. Indeed, we haven’t seen such a deep fall in durable goods orders since the 8% tumble in January 2009, when the financial crisis and recession were raging. The setback was widespread. Even after ignoring the volatile aircraft sector, or removing the government’s defense-related orders, October was still a losing month for durable goods orders. The only good news is that new orders are still up sharply vs. a year ago, rising more than 10% last month vs. October 2009. And let's remember, too, that this is a volatile series. It's also a crucial leading indicator, and so for the moment there’s a new reason to wonder about the staying power of the economic recovery. One month is hardly definitive proof of anything, but any excuse to worry will do these days.
Personal Income & Spending
The trend was more encouraging for income and spending last month. Disposable personal income (DPI) rose by a seasonally adjusted 0.4% in October, more than repairing September’s modest 0.1% decline, according to the Bureau of Economic Analysis. DPI has increased every month this year except for September’s mild setback. Meanwhile, consumer spending marched upward last month as well. Personal consumption expenditures (PCE) advanced in October by a respectable 0.4% over September. That’s the fourth consecutive monthly rise. The increase in consumption was especially strong in the cyclically sensitive area of durable goods purchases, which gained 1.9% in October—the best month since March’s 3.5% jump.
Initial Jobless Claims
We saved the best for last. New filings for jobless benefits dropped by a robust 34,000 last week, the Labor Department advises. That pushed new weekly unemployment applications down to 407,000—the lowest since July 2008. Is the long-awaited drop in jobless claims finally here? If so, that bodes well for stronger job growth, or so history suggests. Of course, there’s always reason to doubt any one report. The obvious suspect for skewing the data is the Thanksgiving holiday. Did the newly unemployed delay filing last week because of Turkey day? We’ll know soon enough. But even if last week’s drop is misleading, there’s no denying the improvement in this series over the past few months. If the lower levels of jobless claims holds in the weeks ahead, it’s a strong sign of improving momentum in the labor market.
In fact, the update on private wages for October in the spending and income report suggests that the job market is on the mend. Or at least wage growth is. Private wages rose 0.6% last month, the fourth-straight monthly increase. On a year-over-year basis, the trend looks even stronger, as the chart below shows. Falling applications for jobless benefits and rising wages is a potent combination, assuming it lasts. It has so far.
SKIDELSKY VS. KEYNES
Keynes was no fan of the gold standard. In fact, he railed against it. In the mid-1920s, for instance, he pressed Winston Churchill to take England off the gold standard. Curiously, Robert Skidelsky, who’s written a best-selling biography that’s favorable to the economist—Keynes: The Return of the Master—seems to favor the gold standard.
Britain fired the first shot in the 1930’s currency war, leaving the gold standard in September 1931. The US retaliated by leaving the gold standard in April 1933. The pound fell against the dollar, then the dollar against the pound.
While the two main currencies of the day were slugging it out, France headed a European “gold bloc” of countries whose currencies became increasingly overvalued against both, until the bloc collapsed in 1936. A world economic conference, convened in London in 1933 to end the currency war, adjourned without reaching any decision.
Substitute China for Britain and today’s eurozone for the gold bloc and the trend of events today has the same ominous feel.
Ominious? Keynes clearly wanted Britain to abandon gold. In fact, there’s a small library of academic research published over the last several decades documenting how the gold standard helped turn a recession into the Great Depression in the 1930s. A few of the many examples: Lessons from the Great Depression and Golden Fetters: The Gold Standard and the Great Depression, 1919-1939, for instance. As a 2006 academic paper observed, “there is little debate that monetary contraction was a central cause of the Great Depression in the United States.” The overwhelming evidence is that the gold standard was at the heart of that contraction. Indeed, history shows that the sooner countries abandoned the gold standard in the 1930s, the sooner the recovery process began.
That’s hardly antithetical to what Keynes preached. And yet Skidelsky seems to argue that Britain, the U.S. and other countries were wrong to give up the gold standard in the thirties. In fact, Skidelsky’s latest essay suggests that the modern equivalent of abandoning gold in matters of monetary policy is wrong as well. Keynes would disagree.
November 23, 2010
Q3 GDP REVISED UP TO A 2.5% PACE
The U.S. economy expanded at a stronger pace in the third quarter than initially estimated, the Bureau of Economic Analysis (BEA) reports. The inflation-adjusted output of the nation’s goods and services rose at an annual rate of 2.5% for the three months through October, up from the 2.0% pace originally estimated for Q3. That puts a bit more distance over the second quarter’s lesser 1.7% gain.
What’s behind the rise? BEA explains…
The increase in real GDP in the third quarter primarily reflected positive contributions from personal consumption expenditures (PCE), private inventory investment, nonresidential fixed investment, exports, and federal government spending that were partly offset by a negative contribution from residential fixed investment. Imports, which are a subtraction in the calculation of GDP, increased.
The acceleration in real GDP in the third quarter primarily reflected a sharp deceleration in imports and accelerations in private inventory investment and in PCE that were partly offset by a downturn in residential fixed investment and decelerations in nonresidential fixed investment and in exports.
The 2.5% rise in Q3 GDP is a bit more than the 2.4% expected via the consensus outlook for economists, according to Briefing.com.
Personal consumption expenditures rose by 2.8% in the revised figures for Q3, up from 2.2% originally reported. That’s the strongest quarterly increase since Q4 2006. The robust pace of consumption throws cold water on the fear, at least for the moment, that consumer spending is set to give way in the face of sharply higher savings. Indeed, durable goods spending—the most cyclically sensitive portion of consumption—rose by 7.4% in Q3, according to today's update. That’s up from a strong 6.8% rate in Q2. And with signs that holiday spending could rise modestly over last year's level, rumors that Joe Sixpack’s profligate ways are at death’s door may be premature…again.
THE DEVIL & THE DETAILS IN THE 2008 FINANCIAL CRISIS
It’s human nature to search for a concise explanation of cause and effect. A reasonable pursuit with satisfactory results, most of the time. But untangling financial crises is different.
The new book All the Devils Are Here: The Hidden History of the Financial Crisis is a reminder that the near-implosion of the global financial system in late-2008 was the byproduct of multiple events over a period of years. Although some pundits are keen on pointing fingers at specific decisions by Congress or the Fed or certain financial institutions, there is no short list of catalysts that triggered the worst financial crisis since the Great Depression.
Journalists Bethany McLean (Vanity Fair) and Joe Nocera (New York Times) spin a tale that spans three decades and indicts a cornucopia of people, institutions, financial innovations, and legislative changes in the quest to explain the events of 2008. The subtext of the book is that while most of the smoking guns were conspicuous, they were veiled in the aggregate, hiding behind a curtain of complexity.
As the book reminds, studying any one factor in isolation tends to bring a fundamentally different perspective compared with considering the broader evolution that eventually gave use the 2008 crisis. Indeed, several of the individual factors that combined to deliver the perfect financial storm looked perfectly reasonable if not admirable as individual agents of change. The development of mortgage-backed securities from the 1970s onward, for instance, hardly look like weapons of mass financial destruction. Nor do the regulatory changes that promoted increased home ownership suggest a trend that was planting the seeds of economic destruction. And when the banking giant J.P. Morgan was developing a quantitative risk-management tool known as value-at-risk in 1990s, there was nothing patently treacherous about the effort. But when these and other trends were combined, the whole added up to more than the parts, and with devastating effects.
Even the successes of putting out various financial fires in the years leading up to 2008 now appear culpable as contributing factors to the crisis. The collapse of the hedge fund Long Term Capital Management in 1998 threatened the financial system for a brief period, thanks to its massive levering via derivatives. But the Federal Reserve and Wall Street contained the potential damage, leaving the impression that systematic risk could be successfully managed. One could make similar arguments about the relatively benign consequences of various currency crises in the 1990s, courtesy of deft interventions by the U.S. Treasury and Federal Reserve. Even the relatively mild economic pain in the wake of the 2001 recession, and the strong growth and low inflation that soon followed, can be seen as part of the web of factors that led to the 2008 collapse.
Stability is unstable, economist Hyman Minsky advised. McLean and Nocera’s book offers a detailed review of why and how that’s possible, and why it’s so difficult to see macro risks as they draw closer. Yes, there were a number of analysts warning in 2007 and early 2008 that trouble was brewing. But trouble’s always brewing, and there are always forward-looking strategists advising of the mounting risks.
The trouble is that the gathering storm can approach for years, fueled by a myriad of factors, without consequence. And the isolated product or regulatory change that looks productive on its own can secretly be adding to a larger threat.
Everyone laments the dark side of the business cycle, but nobody does anything about it. Why? Because cause and effect is complicated. History is littered with regulatory changes that were designed to prevent the next crisis. Yet the cycle prevails, in part because the details of cause and effect are continually evolving. The risk of fighting the last war is always lurking. That's understandable. It’s hard to defend against an enemy you can’t see.
What will be the triggers of the next crisis? Anything and everything is a potential catalyst for trouble. Sometimes the truth is no help at all.
CHASING ALPHA IS RISKY...
Sometimes the risk is a bit more than investors bargained for, as reported by Bloomberg:
FBI raids seeking documents from three investment firms are related to hedge fund insider trading investigations directed by the office of Manhattan U.S. Attorney Preet Bharara, according to a person familiar with the probes. The offices of Level Global Investors LP and Diamondback Capital Management LLC, firms founded by alumni of SAC Capital Advisors LLC, were searched by Federal Bureau of Investigation agents, the government said today. Agents also executed a search warrant at the offices of Loch Capital Management, according to another person familiar with the matter. Both declined to be identified because the probes are ongoing. “The government has decided it needs to use force to obtain all the information,” said Jacob Frenkel, a former federal prosecutor and lawyer with the Securities and Exchange Commission. “It has opted not to issue grand jury subpoenas but instead use the search warrant process.”
November 22, 2010
GENIUS IS A BULL MARKET IN 2010
As 2010 winds down, it’s time for a refresher on performance perspective for the global equity markets. The general theme: year-to-date returns are strong. Equity indices around the world have posted respectable if not stellar returns in 2010 through November 19, depending on the benchmark. Unsurprisingly, there’s also a bull market among active equity managers claiming unusual degrees of skill in the dark art of stock picking. Some of the congratulatory chatter is legitimate, but the primary explanation is the bullish tailwind that’s been blowing this year.
Year-to-date equity returns are solidly in positive territory for 2010 as of Friday, as the chart below shows. Dividing equities into their broad subcategories shows that emerging market stocks overall are firmly in the lead, rising by nearly 16%. U.S. stocks trailed at a considerable distance, but the 11.3% rise for American equities is above average when compared with the long-term track record. The weakest link: foreign developed markets, which means mostly western Europe and Japan. Still, the 8%-plus gain for the year so far is a decent rise for non-U.S. developed markets, given the macroeconomic headwinds of late.
The second chart below offers a more granular review of equity returns on a regional basis. The big winner is the Mideast/Africa category, which gained nearly 20%. In close pursuit: Asia's emerging markets. Meanwhile, in the cleanup position: the developed countries of Europe, which managed a modest 5% rise.
Yes, it’s been a good year for equity investments for the most part, but claims of genius in money management still rely to a fair degree on the kindness of the broad trend.
November 20, 2010
BOOK BITS FOR SATURDAY: 11.20.2010
● The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation
By Gary Shilling
Video interview with author via Daily Finance
Economist Gary Shilling, who correctly predicted the financial collapse, just released a new book, The Age of Deleveraging. In it Shilling explains why inflation isn't what investors should be fearing, but rather deflation. He also explains why he thinks the U.S. economy is in for a period of slow growth, talks about his outlook for stocks--and provides recommendations on 10 investments investors should now make.
● Boom and Bust: Financial Cycles and Human Propserity
By Alex J. Pollock
Review via Wall Street Journal
Alex J. Pollock isn't angry about the financial panic that erupted in 2008 and knocked the U.S. economy into the worst slump since the 1930s. Mr. Pollock, a resident fellow at the American Enterprise Institute and a former banker, isn't even looking for someone to blame. In "Boom & Bust," he swiftly identifies the villain—a familiar, sometimes endearing and invariably roguish character known as human nature.
As long as human nature is with us, periodic financial busts should be expected. Within the past decade or so, the U.S. has had two of them: the first involving the crash of dot-com stocks and the second, much worse, occasioned by the sudden realization that not everyone in America could afford a McMansion. Two financial crises in 10 years may seem like carelessness, but Mr. Pollock says that it is close to the norm: "The economic historian Charles Kindleberger, surveying three centuries of financial history, concluded that there has been a crisis about every 10 years." These busts, Mr. Pollock writes, "arise from the intrinsic nature of human financial behavior."
● The End of Arrogance: America in the Global Competition of Ideas
By Steven Weber and Bruce W. Jentleson
Review via Foreign Affairs
It is a widely held view that the American-centered international order that dominated the last half century is giving way to something new. But while few dispute that countries such as China, India, and Brazil will wield more power in the coming decades, it is less clear what they will do with their power. In this little book, two leading scholars offer a manifesto for U.S. leadership in a post-Western international system. Their major claim is that the era of U.S. ideological dominance is over. The world no longer gravitates to American-style ideas about the virtues of free markets, democracy, and hegemony. Power is diffusing not just to other states but to young people and social groups increasingly connected within an electronic global village.
● The Last Economic Superpower: The Retreat of Globalization, the End of American Dominance, and What We Can Do About It
By Joseph P. Quinlan
Excerpt via publisher, McGraw-Hill Professional
The financial crisis of 2008 was a circuit breaker—the global financial meltdown broke the supposed inexorable advance of free-market capitalism, throttled the primacy and influence of global finance, and undermined the economic superpower status of the United States. In another sense the crisis accelerated a number of key long-range trends that were already in motion before the crisis struck. The relative economic decline of the developed nations and the rising influence of the emerging markets in general and China in particular were fast-forwarded by the crisis and have, in turn, accelerated the move toward a less U.S.-centric, more multipolar world.
This new world will be more complex, fluid, and disruptive, notably for the architects and standard bearers of the postwar economic system: the United States, Europe, and to a lesser extent Japan. In the years ahead, global power and influence will be more diffused among nations and regions, making it more challenging to coordinate and craft solutions to pressing global problems. The era in which a handful of nations could meet for a weekend and set the global economic agenda for the rest of the world is over.
● The Bed of Procrustes: Philosophical and Practical Aphorisms
By Nassim Nicholas Taleb
Review via New York Times Book Review
No readers of “The Black Swan,” “Fooled by Randomness” or any of Mr. Taleb’s academic writings about economics, probability, risk, fragility, philosophy of statistics, applied epistemology, etc., will question whether he is qualified to dish out wisdom. And none will be surprised that Mr. Taleb, unlike the inspirational writer he calls “my compatriot from a neighboring (and warring) village in northern Lebanon, Kahlil Gibran, author of ‘The Prophet,’ ” can be blistering. His observations concern superiority, wealth, suckerdom, academia, modernity, technology and the all-purpose, ignorant "they" who dare to doubt him.
Even his book’s title, “The Bed of Procrustes,” is intentionally harsh. As he reminds readers in a brief introduction, the Procrustes of Greek mythology was the cruel and ill-advised fool who stretched or shortened people to make them fit his inflexible bed. Mr. Taleb’s new book addresses the latter-day ways in which "we humans, facing limits of knowledge, and things we do not observe, the unseen and the unknown, resolve the tension by squeezing life and the world into crisp commoditized ideas, reductive categories, specific vocabularies, and prepackaged narratives, which, on the occasion, has explosive consequences."
● The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty
By Sam L. Savage
Review via Journal of Financial Planning
The intent "is to help you make better judgments involving uncertainty and risk, both when you have the leisure to deliberate and, more importantly, when you don't."
There are three sections to the book: foundations, applications, and probability management, totaling almost 50 chapters. The foundations section is provided so readers become more able to intuitively grasp and visualize the consequences of uncertainty and risk. The segment is peppered with many familiar cautions about the erroneous use of averages, correlations, standard deviations, and other statistical calculations.
November 19, 2010
READING ROOM FOR FRIDAY: 11.19.2010
►Axis of Depression
Paul Krugman/NY Times/Nov 19
What do the government of China, the government of Germany and the Republican Party have in common? They’re all trying to bully the Federal Reserve into calling off its efforts to create jobs. And the motives of all three are highly suspect..."Why have officials in many emerging markets leaned against appreciation of their currencies toward levels more consistent with market fundamentals?" Mr. Bernanke asks. Mainly, he says, because they are sticking to a long-term strategy of pushing for export-led growth with cheap exchange rates.
►Bernanke Steps Up Stimulus Defense, Turns Tables on China
Scott Lanman/Bloomberg/Nov 19
Federal Reserve Chairman Ben S. Bernanke took his defense of the U.S. central bank’s monetary stimulus abroad, saying it will aid the world economy, and implicitly criticized China for keeping its currency weak...As Bernanke spoke, the Chinese central bank said it will raise the reserve ratio requirement for the nation’s banks by 50 basis points from Nov. 29.
►Bernanke Takes Aim at China
Jon Hilsenrath/Wall Street Journal/Nov 19
Federal Reserve Chairman Ben Bernanke is firing back amid criticism at home and abroad of the Fed's easy-money policies, arguing that China and others are causing global problems by preventing their currencies from strengthening as their economies boom..."Why have officials in many emerging markets leaned against appreciation of their currencies toward levels more consistent with market fundamentals?" Mr. Bernanke asks. Mainly, he says, because they are sticking to a long-term strategy of pushing for export-led growth with cheap exchange rates.
►After Food, China Faces Bigger Inflation Challenge
Joe McDonald/AP/Nov 18
After announcing steps to curb surging food prices that are stoking public anger, China's leaders face the challenge of curbing simmering inflation pressures throughout the economy without derailing its recovery. The double-digit jump in food costs that Beijing vowed Wednesday to tamp down is a symptom of widespread, growing price pressures, rather than the cause, analysts say.
►Merkel upsets Germany with economy boast
Tony Paterson/The Independent/Nov 19
Chancellor Angela Merkel faced a barrage of criticism from taxpayers and opposition parties yesterday after her government launched an extraordinary €3m advertising campaign boasting that Germany was the country that had "best overcome the global economic crisis".
In what appeared to be an effort to boost her conservative-led coalition's collapsing popularity and calm fears about an impending Irish bailout, the government placed advertisements online and in newspapers in a week-long drive to promote itself. The taxpayer-funded ads feature a photograph of a smiling Ms Merkel. "Thank you dear citizens," the Chancellor writes, "You have made Germany the country that has best overcome the global economic crisis."
►The G20: Captive in the prison of mercantilism
Ernesto Zedillo/Vox/Nov 18
Given the G20’s failure to provide an effective mechanism for macroeconomic policy coordination, it’s not hard to envision that as deficit developed countries try to overcome their economies’ sluggishness while the surplus emerging economies stick to the export-led strategies that yielded them high growth and strong recovery, the global imbalances will widen again. Even worse, the imbalances may not widen again but for the wrong reason. What if each key player engages in a tit-for-tat strategy to undo strategies of its perceived competitors and in the end the imbalances don’t widen because economic growth and trade are destroyed?
There’s already evidence of the kind of contention that could lead to this worst-case scenario. For example, China is accused of being stubbornly attached to a weak renminbi policy to sustain its export-led growth model at the expense of other economies’ expansion and has become the chief target of punitive ideas. Bills in the US Congress to apply discriminatory import tariffs on China; imposition of capital-market restrictions to prevent China from purchasing US Treasury bills; countervailing currency interventions to upset China’s own intervention in foreign-exchange markets; and even outright suggestions to declare trade war with China – all are examples of ideas put forward by otherwise reasonable people. Frankly, these proposals are impractical, counterproductive or even silly.
►Fed’s Kocherlakota Backs Bond-Buying Program
Michael S. Derby/WSJ Real Time Economics/Nov 18
A Federal Reserve official presumed to be uncomfortable with the current arc of the U.S. central bank’s monetary policy said he is in fact in favor of the Fed’s recent decision to buy $600 billion in longer-dated Treasurys.
“I did express support for the [Federal Open Market Committee's] decision at the recent meeting,” Minneapolis Federal Reserve Bank President Narayana Kocherlakota said Thursday. He called the policy, which buys Treasurys with the goal of easing credit conditions and lifting growth toward better levels, “a move in the right direction.”
But Kocherlakota noted observers shouldn’t see the Fed’s purchases, which will be joined with $300 billion in Treasury buying tied to the reinvestment of mortgage holdings, as a silver bullet. “There are good reasons to suspect that the ultimate effects of any amount of [quantitative easing] are likely to be relatively modest,” he said.
►Interview with IMF Managing Director Dominique Strauss-Kahn by Stern Magazine
Stern Magazine (via IMF)/Nov 18
Stern: The U.S. Federal Reserve, for example, just announced that it's going to print $600 billion to boost the American economy. We are at risk of being inundated with cheap dollars, and the rest of the world is hopping mad.
Strauss-Kahn: It's not that easy. The U.S. economy still accounts for about a quarter of the world's gross domestic product after all. When America is doing badly, the rest of the world is really doing badly. The economy is in such a state that we have to take all conceivable measures to boost demand in the United States.
Stern: But all those dollars are pushing the U.S. currency down artificially. This way other currencies become more expensive, including the euro. That's bad for exports. Are we now facing a currency war?
Strauss-Kahn: I don't like the expression…currency war.
Stern: You could put it another way: the Brazilian Finance Minister complained that it's like throwing money from a helicopter. His colleague Wolfgang Schäuble thinks the United States have been living on credit for too long. And Chancellor Merkel read President Obama the riot act.
Strauss-Kahn: The truth is that many countries use currencies as a political weapon. That's a real danger, as it threatens the recovery of the global economy.
Stern: Does the rest of the world have to pay for the fact that the United States have been living on credit for so many years?
Strauss-Kahn: That’s right. But the United States were the dominant economy for decades. They also used the dollar as a political instrument. We all know the expression, "the dollar is our currency and your problem".
November 18, 2010
THE DISINFLATION TREND ROLLS ON
Yesterday's update on consumer price inflation for October offers few reasons to think that disinflation has been banished. That means it's too soon to dismiss the risk that deflation may turn into outright deflation down the road. That's probably a low risk, thanks to the Federal Reserve's monetary stimulus efforts. But it's a risk that's not yet low enough to send this potential pitfall to the museum of irrelevant economic hazards. In a world struggling with unusually high levels of debt and weak growth, deflation still can't be ruled out.
Quite simply, the inflation trend isn't our friend. Sure, everyone likes lower prices, or at least consumers do. But the general decline in the pace of inflation is increasingly worrisome in an economic climate that remains sluggish. The core measure of the consumer price index (CPI) rose at just 0.6% over the past year as of last month. That'd be fine if core CPI stayed at that level. But as the chart below shows, core CPI's pace (red line) continues to fade.
The core reading of inflation strips out food and energy prices. Why do that? Aren't food and energy prices key factors for consumers? Of course. But food and energy prices change easily and quickly. As such, factoring in these two volatile elements can distort the longer-term inflation trend. As an example, take another look at the chart above and note that headline inflation (blue line) was rising in 2007 and the first half of 2008, giving the impression that inflation was exploding to the upside.
Core inflation, by contrast, suggested that broad pricing pressure was less threatening, and it turned out to be correct. In fact, there's a fair amount of economic research that finds core inflation is a better measure of analyzing clues about pricing trends over longer periods. That includes the evidence that the wide differences in headline and core inflation tend to narrow over time. The short-term noise of headline inflation, in other words, has a habit of balancing out eventually. That's not terribly important for Joe Sixpack, but it's valuable information for central banking and setting monetary policy, which influences economic activity and prices with a lag.
The question before the house is whether the balancing will take place via higher core inflation or lower headline inflation in the months and years ahead? Headline inflation's annual pace has recently been moving sideways in the low-1% range since June. Is this a sign that inflation has stabilized at a relatively low level? If true, that'd be welcome news on a number of levels. It would also undermine the case for arguing that the momentum in disinflation via core CPI remains a clear and present danger.
Predictably, minds will differ. But arguing that rising inflation is the central challenge now, today, this minute, requires ignoring the data, or dismissing it as erroneous.
"The data is definitely in the Fed's camp today and should help keep the Fed's critics at bay," Christopher Rupkey, chief financial economist at Bank of Tokyo-Mitsubish, said yesterday after the CPI report was released. "There is nothing in this data that would push the Fed off its course of continuing to buy government securities. Inflation is getting closer to becoming deflation and the recovery in housing seems to have been aborted," he explained via AP.
Eric Rosengren, who heads up the Boston Federal Reserve, offered a similar analysis yesterday in a speech at the Greater Providence Chamber of Commerce. He asserted that if inflation falls with short-term nominal interest rates stuck at just above zero, this amounts to a rise in the real rate of interest:
A decline in the inflation rate when interest rates are fixed amounts to monetary tightening. Given the state of the economy, a monetary contraction right now is both unintended and undesirable. So we want to prevent any further disinflation – not only because it gets us closer to a harmful deflationary situation, but also because it represents a monetary tightening when conditions are indicating that further accommodation is desirable.
If the federal funds rate was not close to zero right now, the arguments for reducing it – that is, for easing in monetary policy – would be quite strong. However, the federal funds rate is quite close to zero.
Thus the case an expanded round of monetary easing through purchases of Treasuries and other securities—a.k.a. quantitative easing. Again quoting Rosengren…
Are large-scale asset purchases (LSAP) a fundamentally different policy, either in intent and mechanics? The answer is no, LSAPs are much closer to traditional monetary policy than many commentators assume. We simply move in other markets than the federal funds market. And, like traditional monetary policy actions, we’re not talking about “bailouts” or stimulus spending or placing a debt burden on future generations. Let me explain.
In more normal times when the FOMC wants to ease monetary policy, we buy Treasury bills and, in paying the sellers for them, we create additional bank reserves. By making more reserves available to the banking system, we ease conditions in the overnight market for funds – the federal funds market – so the primary impact of these purchases is a reduction in the federal funds rate. But more importantly for the economy, we expect the reduction in the funds rate to over time translate into declines in mortgage rates, corporate bond rates, exchange rates, and a rise in stock prices – all of which of course help stimulate economic activity.
Now that the federal funds rate is near zero and the reserves in the system are quite large, the usual course is not an option. Instead of relying on the indirect effects of targeting a lower funds rate, we are opting to more directly affect the interest rates that have the greatest connection to real spending; by buying Treasury bonds and creating additional bank reserves. Since there are already substantial reserves in the system, the primary expected effect is lowering the long rate by purchasing a significant amount of longer-term Treasury bonds. Like conventional policy, one would expect that mortgage and corporate rates will fall, and exchange rates will be impacted, providing additional stimulus to the economy. That is in fact what has already happened…
Yes, but as we noted yesterday, QE2's big test is upon us. Even under the best of circumstances, QE2 isn't a silver bullet that magically repairs the economy. It's one policy tool and it arguably deserves to be applied now. Deciding how much of a positive impact it has is something else.
The frontline in deciding if it's working, and to what degree, arrives monthly in the inflation report. Based on yesterday's update, however, the case for thinking that the disinflation trend has been arrested is, at best, a mixed bag.
November 17, 2010
A NEW REVIEW...
The Journal of Financial Planning has just published a review of my book, Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor.
PUTTING QE2 TO THE TEST
The first big test of the Fed's latest phase of monetary stimulus (a.k.a. QE2) begins, well, now.
The jury's still out on the final verdict, but for the moment the disinflation momentum of the summer remains nipped in the bud. But it's a precarious stability. As of yesterday, the implied inflation rate based on the yield spread between the nominal and inflation-indexed 10-year Treasuries was just under 2%. That's down a bit from last week. Should we be concerned that a new downturn in the expected pace of inflation is coming? Yes, or at least that's the fear, even if it's not obvious that this is destiny. Indeed, the Fed is working overtime to prevent this outcome and so the odds are low that we'll see a revival in the disinflation trend. But low odds aren't zero odds.
The key factors that keep the risk of disinflation/deflation alive are the usual suspects that have been with us all along: lots of debt weighing on the economy and sluggish growth. The good news is that the economic news has been modestly brighter recently.
Retail sales for October, for instance, perked up by a better-than-expected 1.2% vs. September, led by a 5% surge in auto purchases. That translates into a gain in retail sales by more than 7% on a year-over-year basis, a sign that the economy is recovering. Job growth last month also surprised on the upside, with nonfarm payrolls rising by a net 159,000 in October, the best month since April.
But it's too soon to sleep easy. For starters, the inflation outlook in the Treasury market has, for the moment, topped out at just over 2% and is again slipping. It's too soon to say if that's just statistical noise in an otherwise stable state, or the start of another decline.
Keeping investors on edge about what happens next is the revival of contagion fears regarding debt worries in Europe. The latest concern is Ireland, which is struggling to manage its mountain of red ink. "There is so much uncertainty" surrounding the Irish debt situation, John Stopford, head of fixed income at Investec AM, tells Reuters today. "It is making a speculative decision on political decisions. We need a lot more clarity on how this is going to work out over the next five years."
Adding to investor anxiety at the moment are reports that China's prepared to fight rising inflation in its economy by raising interest rates. In turn, that raises concerns for the pace of growth in the global economy, which has relied heavily on emerging markets. "China coming back with tightening talk is making the market nervous again," opines Nader Naeimi, a Sydney-based strategist at AMP Capital Investors Ltd. "All the fears are back over China going too far, and what that will do to growth in the region. It’s giving investors the excuse to lock in profits," he explains via Bloomberg.
Contagion worries on the global stage are very much front and center again, warns Bruce McCain in the investment department at Key Private Bank in Cleveland. As he advises in today's Wall Street Journal: "All of this is raising the question about how sustainable this economic expansion is from here, both in the U.S. and globally. The fact that we have run stocks up since June just leaves the market open to the normal anxieties about whether we have come too far too fast."
Indeed, U.S. stocks and commodity prices tumbled yesterday. Another sign that the global appetite for risk is waning is the dollar's strength this month. The U.S. Dollar Index has climbed more than 3% so far in November. That's surprising, given all the chatter that the Fed's QE2 is destined to weaken the greenback.
Make no mistake: the U.S. economy is at a delicate point. The economy is on the mend, but it's a weak revival. It's picked up some speed in the last few months, although that's notable primarily because the imminent risk of a new recession has faded. That's quite a bit different than saying that the growth outlook has radically improved. Meantime, even the minimal improvement is vulnerable.
All bets are off if the disinflation trend picks up a new head of steam. That's unlikely, at least based on current data. But in a world burdened with a heavy debt load, weak growth, and wobbly optimism on the macro outlook, it's premature to assume that the future is clear. In fact, the Philadelphia Fed's newly published fourth-quarter survey of 43 economic forecasters reminds that there's still plenty of anxiety about the strength of the economic recovery:
The pace of recovery in output and employment in the U.S. economy looks a little slower now than it did three months ago, according to 43 forecasters surveyed by the Federal Reserve Bank of Philadelphia…The forecasters also predict weaker recovery in the labor market.
Sure, there's an encouraging history of central banking's use of quantitative easing to juice economies in recent history around the world, according to a report the St. Louis Fed. But the only thing that matters now: the real-time numbers in the economic reports. As usual, they drip out slowly, one statistic at a time.
It's going to be a long winter...again.
November 16, 2010
The repetition compulsion, according to Freud, is psychological behavior in which a person is driven to repeat certain destructive acts over and over. Casual observation suggests that the repetition compulsion is a recurring affliction in the money game.
The latest example arises with reports that General Motors, the poster boy for corporate failure in the Great Recession, is poised to issue new shares. Finding new buyers isn't likely to be a problem. In fact, the size of the IPO has just been increased by 20%, according to Reuters.
Amazingly, investors who were burned by GM's collapse during the recession are considering taking a fresh stake in the reorganized car maker. A story in yesterday's New York Times details that some GM retirees, despite suffering substantial investment losses after the company's recent implosion, are once again contemplating a new round of stock purchases.
The article quotes a former GM worker who lost enough money in the company's stock so "that I may not have to pay capital gains tax for about 73 years." Has that experience convinced him to look elsewhere for financial satisfaction? Not necessarily, he explains, telling the paper that he's "still on the fence" in weighing a fresh investment in GM.
Pondering a new round of investing in the automaker is, apparently, no isolated event among financial victims of the carmaker's recent downfall. The Times reports that discussions about investing a second time "is a decision being talked about at retiree clubs, union halls, and G.M. plants and offices across the country as the nation’s biggest automaker prepares to become a public company again."
For those who share a history with the company, GM is doing all it can to accommodate renewed interest in its shares. Again quoting the Times: "G.M. has set aside 5 percent of the 365 million shares in the offering, which is expected as early as Wednesday, for current and former personnel." The article goes on to note:
At a meeting of about 500 retired assembly plant workers last month in Lordstown, Ohio, the crowd was divided and very vocal about it, said Bill Bowers, head of the retiree group at United Auto Workers Local 1112.
"There were a lot of sour notes in the audience," Mr. Bowers said. "A lot of them had put a lot of money into the old stock and ended up with nothing."
You might think that losing significant amounts of money would be a powerful incentive to avoid the behavior that created the loss, but that's not necessarily how investors think, or act. But what investors do and what they should do aren't always one and the same. Diversification is the first law of risk management, and in an age of proliferating ETFs it's easy and inexpensive to adhere to this rule. And yet…
The inherent logic of diversification is perhaps the most conspicuous and most compelling lesson in money management. The details matter, and they necessarily vary from investor to investor. But its basic efficacy is easily demonstrated. History reminds again and again that those who fail to adequately diversify are subject to hefty losses. Some may avoid that fate, but hope isn't a strategy. Alas, no matter how many times this point is made, no matter how many studies back up the wisdom of diversification, substantial numbers of individuals feel compelled to put most or all of their financial eggs in one basket.
The compulsion is a recurring disorder. When the energy firm Enron blew up a decade ago, there were numerous reports of employees who had put most of their net worth into the company's stock, leaving them virtually wiped out when the dust cleared.
The urge to put everything in one bucket isn't limited to individual companies. After Madoff's massive Ponzi scheme blew up in December 2008, we learned that several investors had allocated most of their investable wealth with Bernie.
It's all a reminder that diversification within and across asset classes is essential in a world where uncertainty never takes a holiday. Yes, prudent asset allocation strategies can still suffer big losses, but asset classes don't go bankrupt. Reversion to the mean helps diversified investors sleep at night. That's no small advantage for achieving investment success in the long run. Building a solid core investment portfolio that's largely impervious to the high risk of individual companies, and the machinations of the investment wizard du jour, is critical. Sure, you can embrace a high-risk strategy on the side--just don't bet the farm on it.
Windham Capital Management boils down the essentials to three "Rules of Prudence for Individual Investors"…
2. Invest Passively
3. Avoid Taxes (see Rule 2)
Most investors should hold the lion's share of their investable wealth in a multi-asset class strategy using index mutual funds and/or ETFs. They should also manage the portfolio through time, starting with basic rebalancing to keep risk exposures from going to extremes. Yes, there are other things to do as well, and so sophisticated investors will probably augment a core portfolio with any number of additional strategies and products. But the basic outline for prudent investing is clear, even if the advice too often falls on deaf ears. As Morgan Stanley's David Darst explains in Mastering the Art of Asset Allocation: Comprehensive Approaches to Managing Risk and Optimizing Returns,
Many investors do not spend enough time thinking about an appropriate asset allocation during various time frames and financial market environments. Instead, they devote excessive attention to industry, sector, and specific investment selection; manager selection; market timing decisions; and other concerns.
Quite true, but this strategic mistake isn't likely to fade away anytime soon, or so it appears based on the misguided and obsessive focus on GM's pending IPO among some of the company's retirees.
November 15, 2010
THE GOLD STANDARD IS NO SILVER BULLET
Calls for a return to gold standard are in vogue these days. Tying the value of the dollar and other currencies to the precious metal is considered a monetary salve that will soothe the economic ills that harass us. It's an idea whose time has come…again, we're told. The World Bank's president last week suggested that the world should embrace, in part, a gold-based monetary system. And in yesterday's New York Times, financial writer James Grant eloquently pined for the gold standard of yore. "The classical gold standard, the one that was in place from 1880 to 1914, is what the world needs now," he writes.
Grant delivers a stirring brief for the precious metal as a monetary foundation. In advancing the agenda, he focuses on the benefits. But like so many gold bugs, Grant ignores the challenges. Those challenges are significant. Indeed, there are fundamental reasons why gold was abandoned as a monetary standard. Those reasons weren't trivial, nor would they be resolved in the 21st century. A gold standard, quite simply, is a wonderful thing…until it's not.
Every monetary system suffers tradeoffs. There is no ideal strategy for a) insuring price stability; b) minimizing economic volatility; and c) maximizing employment. Expecting gold will deliver will somehow dispense all three is expecting the impossible in the long run. True, anything's possible for a time, with or without gold. At times there's a virtuous circle of positive reinforcement in the business cycle that promotes that trio. One of those periods recently ended. The Great Moderation, as it's called, ran from roughly the mid-1980s through 2007, interrupted briefly in 2000-2002 with a severe stock market decline, albeit one that had relatively limited negative consequences for the real economy.
The Great Moderation was hardly perfect, but it was a potent run of employment growth, disinflation, and generally improving economic conditions in the U.S. and around the world. And in case you didn't notice, it all arrived without gold as a monetary standard. Fiat money has its problems, starting with the fact that it requires enlightened management. But it's not a hard-wired impediment to macroeconomic progress.
What, then, is behind the renewed urge to return to a gold standard? Like gold itself, the sentiment is an amalgam of allure and contradiction. Gold, after all, is first and foremost a prescription for putting a lid on inflation. But inflation is hardly a near and present danger. The economy's suffering from a severe bout of deleveraging, which is pushing the broad pricing trend lower. Yes, future inflation may be a threat in the years ahead, depending on what central bankers do, or don't do. But the macro priority du jour isn't looking for additional ways to reduce inflation, which is what a gold standard would impose. Rather, the principal task is arresting the fall in the inflation trend.
The annual rate of change in the core rate of consumer price inflation is running at roughly one-third the level these days compared with the 3% peak from two years ago. We can debate if that's accurate. But it's the trend that's troubling, not the specific level. Amazingly (for gold bugs), this disinflationary trend has come without a formal link to the world's favorite monetary metal. In a world of fiat money, gold bugs would have you believe, such a potent disinflation trend is impossible. Well, we now know different.
A miracle? Hardly. The source of the disinflation, which conceivably could turn into deflation, is the blowback from deleveraging. Economies accumulated too much debt in the boom years of the Great Moderation; servicing that debt in times of weak growth is a burden. Predictably, spending is down and saving is up—exactly what you'd expect in a deleveraging crisis. Moving to a gold standard would only exacerbate the deleveraging process, perhaps to the point of creating a new recession, or perhaps a depression.
We've been here before. The Great Depression of the 1930s was also a period deleveraging on a mass scale. Some of the catalysts were different, some the same vs. the current climate. One critical distinction between now and then: the gold standard. The U.S. was on a gold standard in the early 1930s; today we're not. That's a significant difference. But note that in both cases a deleveraging crisis arrived. Gold is no magical immunization that prevents financial crises. In fact, a gold standard may, at times, exacerbate those risks.
There's another distinction between now and then: the policy responses. Economists are in broad agreement that forcing "sound money" on an economy during a deleveraging crisis is the equivalent of taking away oxygen from a man who's having trouble breathing. The gold bugs always seem to overlook this point. Sure, if your only goal is maintaining the purchasing power of a currency, gold's your solution. But the body politic and most economists have a broader agenda during times of economic crisis. As such, gold is no help in periods of extreme macro stress.
Economic history is nothing if not clear on this point. Gold forced austerity on the world economies in the early 1930s at exactly the wrong time. To argue otherwise is to ignore a small library of research published over the decades. A few examples of how gold helped turn the economic troubles of the early 1930s into something far deeper can be found in Milton Friedman and Anna Schwartz's A Monetary History of the United States, 1867-1960, and the recent Lords of Finance: The Bankers Who Broke the World, by Liaquat Ahamed.
Yes, the gold standard as practiced was self regulating, a benefit that the gold bugs eagerly promote. True, but the dark side of that self-regulation is that gold supplies sometimes flow out of a country as a tool for adjusting trade imbalances. Sounds wonderful, except for the fact that a net outflow of gold is the equivalent of contracting the money supply. What's wrong with that? Nothing, most of the time. But during a severe financial crisis, such as the early 1930s or late-2008, a receding supply of money is akin to playing economic Russian roulette—with a fully loaded gun.
This wasn't widely understood as the 1930s began, but the message began to sink in…slowly. Countries abandoned the gold standard as the 1930s unfolded, with predictable results. As Barry Eichengreen's research shows, the earlier a nation left gold, the sooner its economy began to heal from the deleveraging crisis, as measures of industrial production clearly demonstrate in that period. France's relatively stagnant performance is linked to the fact that it stayed on the gold standard the longest of the major industrial nations. Eichengreen advises in his 1992 article in Economic History Review that "the timing and extent of depreciation can explain much of the variation in the timing and extent of the economic recovery."
Did abandoning gold--a massive quantitative easing policy of its time--usher in a period of sharply higher inflation? Nope, not even close. There were many econonmic complaints in the post-gold standard world of the 1930s, but inflation wasn't one of them.
If there's a case for returning to a gold standard in the modern era, surely it was stronger back in, say, 2005 and 2006, when inflation was rising and monetary policy appeared to be delivering too much stimulus. Ah-ha! the gold bugs will cry--that's going on now as well. Actually, no. The Federal Reserve isn't trying to raise inflation so much as keep it from falling further. To the casual eye this looks like a misguided policy of trying to stimulate unhealthy increases in inflation. But as the first chart above reminds, the key goal now is simply arresting the disinflation trend. Ours is a crisis bound up with deleveraging, which renders the historical inflation threat null and void, albeit only temporarily.
Yes, the gold standard does of great job of maintaining a currency's value. Most of the time, that's a prudent goal. But sometimes there's a need for intervention in monetary management. The onset of the Great Depression was one of those times. So too was the 2008 financial crisis. Although criticizing the central bank is easy now, pundits are too quick to minimize what might have happened if the Fed didn't inject huge quantities of liquidity into the system in the fall of 2008. By contrast, a full-blown repeat of the Great Depression was more than a minor risk if the Fed had repeated the errors of the 1930s in late-2008. Sometimes an emphasis on austerity via holding tight to the gold standard or its equivalent threatens economic suicide.
Monetary flexibility also carries risks, of course, but so too does putting monetary policy into a straight jacket, a.k.a. adhering to a gold standard. There are no free lunches. And let's also recognize that re-imposing a gold standard today is sure to have zero political tolerance in the next financial crisis. Yes, variations of the gold standard ran for decades in the late-18th and early 20th centuries. But the masses in the 21st century won't tolerate the side effects of a gold standard, such as painful periods of deflation that arose in the 1880s and 1890s. There was a political backlash at the time, culminating in William Jennings Bryan's famous “Cross of Gold” speech at the 1896 Democratic convention. But it was hardly fatal for gold's supporters.
The deflationary runs triggered by the gold standard a century ago carried a small political price. A repeat performance isn't likely. Even if it was politically feasible, a gold standard isn't economically viable. There's a reason why the developed world deserted gold: in times of crisis, it squeezes the economy to a point that the masses suffer. They did so quietly a century ago, but no one will suffer in silence anymore.
Gold bugs like to argue that a gold standard would minimize if not eradicate financial crises. But history says otherwise. Financial crises were a recurring feature during the heyday of the gold standard. Suffice to say, whether we're on a gold standard or running fiat currencies, financial crises will remain a hardy perennial. The question is how central banks deal with those rare but inevitable crises?
Romanticizing the gold standard as an alternative to fiat money provides dramatic copy for pundits, but as a practical solution it's sure to be a dud. Been there, done that.
November 13, 2010
BOOK BITS FOR SATURDAY: 11.13.2010
● All the Devils Are Here: The Hidden History of the Financial Crisis
By Bethany McLean and Joe Nocera
Review via Canadian Press
At its core, the story was about an intoxicating and uniquely American dream of home ownership, according to McLean and Nocera. The narrative let Federal Reserve Chairman Alan Greenspan recommend with a straight face against regulating mortgage securities and other derivatives because that would limit home ownership...Government-sponsored businesses such as Fannie Mae, Ginnie Mae and Freddie Mac could expand beyond any previous understanding of what was sustainable as long as they talked about middle-class borrowers — even if the only people who ultimately benefited were wealthy and institutional investors.
● The New Lombard Street: How the Fed Became the Dealer of Last Resort
By Perry Mehrling
Excerpt via Princeton University Press
“Lender of last resort” is the classic prescription for financial crisis. “Lend freely but at a high rate” is the mantra of all central bankers, ever since the publication of Walter Bagehot’s magisterial Lombard Street: A Description of the Money Market (1873). That is what the Fed did during the first stages of the crisis, as it sold off its holdings of Treasury securities and lent out the proceeds through various extensions of its discount facility.
But then, after the collapse of Lehman Brothers and AIG, and the consequent freeze-up of money markets both domestically and internationally, the Fed did even more, shifting much of the wholesale money market onto its own balance sheet, more than doubling its size in a matter of weeks. In retrospect this move can be seen as the beginning of a new role for the Fed that I call “dealer of last resort.”
And then, once it became apparent that the emergency measures had stopped the free fall, the Fed moved to replace its temporary loans to various elements of the financial sector with permanent holdings of mortgage-backed securities, essentially loans to households. This is something completely new, not Bagehot at all—an extension of “dealer of last resort” to the private capital market.
● Fed Up!: Our Fight to Save America from Washington
By Rick Perry
Review via NPR
Texas Gov. Rick Perry has just been elected to an unprecedented third term in office. And in his new book Fed Up! Perry broadcasts his belief that states should have more freedom from the federal government...Another issue Perry takes aim at is health care. Instead of forcing people to buy health insurance from a "Washington-devised program," he says, states should be allowed to compete in creating the best programs.
● As China Goes, So Goes the World: How Chinese Consumers Are Transforming Everything
By Karl Gerth
Review via Washington Monthly
As China Goes, So Goes the World has two underlying arguments. The first is that what’s happening in China today isn’t inevitable, but rather the result of specific government policies...The second major theme is that China won’t ever be just like America. Traditional Chinese thriftiness paired with the imperative most Chinese families feel to save for future and unpredictable health care costs (China’s social safety net has many gaping holes) makes it unlikely that China’s household savings rate, of up to 50 percent of earnings, will anytime soon approach the American standard, an average rate of just 1 percent in 2010.
● When the Luck of the Irish Ran Out: The World's Most Resilient Country and Its Struggle to Rise Again
By David Lynch
Review via Irish Times
David Lynch, a senior writer for Bloomberg news agency, has composed his postmortem for the Celtic Tiger with affection and the detachment that comes from a distance of five generations.
By a twist of fortune or misfortune, Lynch’s book, When the Luck of the Irish Ran Out: The World’s Most Resilient Country and Its Struggle to Rise Again , was published here this week, as US newspapers reported extensively on sinking Irish bonds and the danger of recourse to an EU bailout. The mood was so gloomy that a participant at the Global Irish Network meeting in New York suggested privately there was nothing left to do but to send food parcels.
November 12, 2010
A NEW BULL MARKET IN POLITICAL RISK
The reflation trade that's been bubbling since late-August has had a good run, and it's helped tip the outlook from negative to slightly positive. But the trend faces new challenges. The revival in expectations about the economy in recent months is still poised to prevail, and that's no small plus to help mend the macro ills. But there's a new batch of turbulence in town, and much of it is blowing from political debates. Even if everything was peachy keen with the pols (and it most certainly is not), the improved outlook for the U.S. economy in recent months remains a precarious renewal. Add in the new turmoil in Washington into the mix and the waning days of 2010 are likely to bring a fresh round of volatility to the capital and commodity markets.
On the plus side, expectations about the Federal Reserve's latest bit of monetary stimulus—dubbed QE2—have buoyed the crowd's sentiment since September. Stock prices are substantially higher from two months ago and the Fed's formal announcement of QE2's details last week are set to replace expectations with action. The New York Fed today will begin purchasing as much as $8 billion of Treasuries, and the buying could total $100 billion-plus by early next month.
Accompanying the Fed's latest efforts to stabilize falling inflation expectations and provide additional juice to the economy is marginally improved news on the jobs front. On Wednesday the Labor Department reported that weekly initial jobless claims fell to 435,000 for the week through November 6, the lowest since July. Meanwhile, last week's positive surprise for growth in October's payrolls is another down payment on keeping hope alive.
But the economy faces new potential setbacks to sentiment, and perhaps the real economy, as the year winds down. The uncertainty over the Bush tax cuts is one factor. There's also a dust-up over reports about the indecision that dominated the Group of 20 meeting in Seoul over the last few days on matters of so-called global imbalances. A third issue is the re-energized debate about U.S. fiscal policy and the government's debt load in the wake of details released from President Obama’s bipartisan debt-reduction commission
There's a sea of discussion about what it all means, and which path is prudent vs. reckless. The biggest issue at the moment, however, is the uncertainty that accompanies these hefty subjects.
The situation, however, is fluid. The uncertainty over the Bush tax cuts, for instance, may be giving way to resolution. "President Barack Obama's top adviser suggested to The Huffington Post late Wednesday that the administration is ready to accept an across-the-board, temporary continuation of steep Bush-era tax cuts, including those for the wealthiest taxpayers," The Huffington Post reported earlier this week.
But there are no free lunches. Extending the tax cuts would come at a steep price for expected government revenue. According to CBS News:
The tax cuts enacted in the early years of the Bush administration are set to expire at the end of the year if Congress does not act. President Obama has urged Congress to extend the tax cuts for all Americans, except for the top 2 percent of income earners. Letting the tax cuts lapse for the top 2 percent would save the government $700 billion over the next 10 years, the president has repeatedly argued.
However, Republicans are interested in extending all of the tax cuts, and after significant gains in the midterm elections, they are signaling they are not interested in compromising.
Damned if you do, damned if you don't. The case for extending the tax cuts, at least temporarily, has merit, given the weak and still-vulnerable economic recovery in the U.S. But left-of-center politicians and economists are fighting back on what appears to be the White House's new willingness to let Republicans have their way. Yesterday, "liberal groups made clear that if the president were going to agree to extending tax cuts for the wealthy—even temporarily—Democrats should demand concessions on other matters, such as extending unemployment benefits, according to two people familiar with the meeting," The Wall Street Journal reports.
But just when it looked like the White House had thrown in the towel and conceded to Republican demands to extent the tax cuts, senior White House adviser David Axelrod said that the negotiating process was still very much alive and kicking. "We're willing to discuss how we move forward,” Axelrod explained to the National Journal yesterday. "But we believe that it's imperative to extend the tax cuts for the middle class, and don't believe we can afford a permanent extension of tax cuts for the wealthy."
Tax cuts, it seems, are still in play and remain a work in progress. There' not much more clarity on the global front as it relates to the latest G20 meeting and how (or if) the world's biggest nations will address trade imbalances. As Reuters reports today:
G20 leaders closed ranks on Friday and agreed to a watered-down commitment to watch out for dangerous imbalances, yet offered investors little proof that the world was any safer from economic catastrophe.
After an acrimonious start, the developing and emerging nations agreed at a summit in Seoul to set vague "indicative guidelines" for measuring imbalances between their multi-speed economies but, calling a timeout to let tempers cool, left the details to be discussed in the first half of next year.
“It’s fair to say we didn’t resolve those issues here,” the Canadian prime minister, Stephen Harper, tells The New York Times. "These are not going to be easy issues to resolve but I think we’ve got everyone talking the same language, everyone understanding longer term what has to be done."
The outlook is hardly any clearer with the Obama's debt-reduction commission. If anything, news of the commission's plans have only achieved more debate about how to pare the country's red ink. "On Wednesday, the co-chairmen of Obama's debt commission, unable to forge consensus among the deadlocked commissioners, came out with their own version of a plan to conquer the deficit, reduce the debt, overhaul the tax code and put entitlement programs on solid ground. It was quickly pronounced dead on arrival by no-regrets Pelosi, who called it 'simply unacceptable,'" writes the Washington Post columnist Dana Milbank. "Is this how the next two years will look?" he asks. Probably, he opines.
The markets hate uncertainty, according to the old saying. Well, there's a fresh batch of uncertainty these days, and in quantities that are more than trivial. This time the offending variable is political. In any case, the stakes are high and the outlook is fuzzy...again. Back to the future.
Yes, this too shall pass. In fact, the period ahead may be favorable for savvy investors willing and able to tolerate volatility. But earning an enhanced risk premium won't come easy. That, at least, is one thing you can count on, no matter what they say or do in Washington.
November 11, 2010
READING ROOM FOR THURSDAY: 11.11.2010
►Jump in China inflation paves way for more tightening
Aileen Wang and Simon Rabinovitch/Reuters/Nov 11
Chinese inflation sped to a 25-month high in October and bank lending blew past expectations, highlighting the challenge faced by Beijing as it battles to keep a lid on price pressures.
The data left little doubt about why the central bank raised reserve requirements this week and pointed to further tightening steps, from rate rises to yuan appreciation, in coming months.
►Mervyn King: high inflation will not force rate rise
Larry Elliott and Nicholas Watt/Guardian/Nov 10
The Bank of England predicted today that inflation in Britain would remain above its target for the whole of next year as the rise in VAT in January and dearer imports affect the cost of living.
Mervyn King, the Bank's governor, admitted that inflation continued to exceed Threadneedle Street's expectations, but gave no hint that the nine-strong monetary policy committee was about to raise borrowing costs in response.
►Dollar pares gains after hitting 1-month high
Nick Godt and William L. Watts/MarketWatch/Nov 10
The dollar rose Wednesday to its best level against the euro since early October after a combination of better data in the U.S., a weak Portuguese bond auction and rising rates in China fueled interest in the U.S. currency.
►World Bank chief nixes return to gold standard
Chris Isidore/CNNMoney/Nov 10
A return to the gold standard by major economies is not practical, World Bank President Robert Zoellick said Wednesday, just two days after an opinion piece he wrote stirred talk of the need to do just that.
James Hamilton/Econobrowser/Nov 10
I feel that there is a pretty strong case for interpreting the recent surge in commodity prices as a monetary phenomenon. Now that we know there's a response when the Fed pushes the QE pedal, the question is how far to go.
►A Way, Day by Day, of Gauging Prices
Justin Lahart/Wall Street Journal/Nov 10
Economists will dissect next Wednesday's government report on consumer prices for any sign inflation is heating up—or cooling. But a pair of academics in Boston already has data they think show where prices went.
►Temporarily Unstable Government Debt and Inflation
Troy Davig and Eric M. Leeper/Working Paper/Oct 18
As countries enter an era of fiscal stress, policymakers will confront the implications of that stress, and its associated uncertainty, for inflation and the ability of monetary policy to control inflation and affect the economy in the usual ways. Debt can assume an explosive trajectory in periods when taxes are unable to move higher for political reasons and central banks continue to fight inflation aggressively. Explosive debt dynamics push countries toward their fiscal limits and can have powerful effects on inflation that depend on expectations of future monetary and fiscal policies. In most countries, political institutions do not anchor fiscal expectations on policies that would prevent inflation.
►GOP Victory May End Government Economic Intervention
Mark Thoma/Fiscal Times/Nov 9
We will be much less likely to use fiscal policy in the future, particularly government spending – much to the detriment of any future generations caught in a large downturn. As for the Fed, it still has considerable independence and a job to do in managing the economy, and it will continue to do that job. But the Fed will be far less willing to take bold steps to try to alter the direction of the economy, and far less likely to get the support from Congress it needs for another bailout to prevent a financial meltdown. And if the degree of independence the Fed currently enjoys is reduced through Congressional action, a very real possibility with people like Texas Rep. Ron Paul , a libertarian, as potential members of key oversight committees, even the routine management of the economy by the Fed could be affected.
►Deficit panel targets Social Security and taxes
Donna Smith and Jeff Mason/Reuters/Nov 10
Leaders of a presidential commission proposed raising taxes and the retirement age among bold ideas on Wednesday for slashing the U.S. budget deficit, but faced a difficult task in winning the support of Congress.
November 10, 2010
WHO'S SORRY NOW?
There are lots of reasons for using high-quality index funds, including low fees, high transparency and a clear mandate on the strategic goal. There's also the remorse factor to consider.
One benefit of indexing is never having to say you’re sorry, a feature that comes to mind after reading about the brouhaha over Vanguard’s “tardy” firing of AllianceBernstein as a co-subadvisor. As Investment News reports:
The Vanguard Group Inc.'s decision last month to fire AllianceBernstein LP as co-subadviser of its U.S. Growth Fund after nine years has caused a number of fund observers, including Vanguard founder John Bogle, to question why it took so long.
The move came after the fund underperformed its category for the past one-, three-, and five-year periods during AllianceBernstein's tenure, and for the 10- and 15-year periods encompassing that tenure, according to Morningstar Inc....
Some advisers said that Vanguard's unwillingness to fire Alliance even though it was clear that the firm wasn't turning around its performance might be an indication that Vanguard should stick to passive management.
“Why is this firm in active management at all?” asked Doug Flynn, co-founder of Flynn Zito Capital Management LLC, which has $265 million in assets under management. “And if they are going to do active management, I need to understand what kind of system and process they have in place that requires you to take this long to fire an underperforming manager.”
The debate over why Vanguard waited so long to fire an active manager is a bit odd, considering that Vanguard is primarily an indexing shop, and a successful one at that. Nonetheless, the firm does run a few actively managed funds, although the challenges are no less vexing for one of the largest financial firms on the planet.
Evaluating and monitoring active managers is no easy task. Even if you have deep pockets and lots of smart analysts under your roof, there’s still no assurance that you’ll excel in distinguishing true talent from luck, or recognize when a gifted manager has lost his touch rather than merely suffering from a temporary slump.
Much of what’s known about skill (or what appears to be skill) in conventional equity strategies is based on analysis of factors. The leading equity factors, for instance, are bound up with the degree of emphasis (for or against) market cap (small vs. big), style (value vs. growth), and short-term price momentum. It’s fairly easy to run a factor analysis to figure out if, say, a dedicated value manager is worth his expense ratio. The answer turns out to be “no” enough of the time to inspire using a low-cost value equity index fund.
What happens if you’re evaluating an active manager who’s a style timer? That’s a tougher nut to crack. Let’s say you’re considering a mutual fund run by a manager who opportunistically tilts the portfolio back and forth between large and small caps, and value and growth stocks. At certain times, he may decide that small-cap growth offers the superior risk/reward profile; a year later, he thinks it’s time to tilt the portfolio to large-cap value stocks.
The problem here for investors is that evaluating the presence (or absence) of style-timing skill is much more challenging vs. assessing a manager committed to a single style factor. Can it be done? Yes, but it demands a certain amount of finesse and quite a lot more effort—and data. That’s hardly a surprise. Over the past two decades, financial economists have been pointing out the challenges of identifying style-timing talent. So-called estimation errors, for instance, are one problem, advises a 1986 study (“Assessing the Market Training Performance of Managed Portfolios,” by Ravi Jagannathan and Robert A. Korajczyk, Journal of Business). Even when above-average performance is genuine, it’s turns out to be fleeting a fair amount of the time (“Short-Term Persistence in Mutual Fund Performance,” by Nicolas P. B. Bollen and Jeffrey A. Busse, 2004, Review of Financial Studies). And that only scratches the surface of the potential pitfalls.
Index funds are an easier alternative. By using superior indexing products, you can reliably capture 50% to 80% of the target factor, depending on the asset class, the index fund, and the prevailing market conditions. Actively managed products can do better, of course, but they can also do worse. And since it's difficult to have a high degree of confidence that you've chosen the right active manager, it's important to recognize the additional layer of risk that accompanies the quest to tap alpha.
Beta, by contrast, is more reliable. In fact, the case for indexing is especially strong for managing a multi-asset class portfolio. Imagine that your asset allocation is divided up into, say, 15 corners of the capital and commodity markets. The odds are fairly low for continually choosing superior active managers in each bucket over the long haul, at least for most investors without deep analytical resources and a full-time commitment to the task. Those who attempt to beat the odds all too often end up with average results. In other words, they’re paying high fees for mediocre results.
It’s often preferable to stick with index funds from the start and cut the fees to the bone. That leaves you with a free hand to focus on what’s really important: designing and managing the asset allocation. In fact, you still have to do that if you use a mix of active managers, but you have the added burden of evaluating managers on an ongoing basis. Index funds cut out that extra step, and save you money in the process.
Remember, too, that there are some simple, forecast-free strategies for enhancing the pasive return of a multi-asset class portfolio. A basic rebalancing strategy for a broad array of asset classes, for instance, has a history of boosting return by 50 to 100 basis points over time.
Bottom line: using index funds to manage asset allocation is easier, less costly, and likely to deliver 50% to 80% of the return you’d achieve in the best-case scenario with active managers. Indexing, quite simply, means never having to say you’re sorry.
November 9, 2010
WAITING FOR THE NEXT INFLATION REPORT
It's all about inflation—or the lack thereof. Next week (Nov. 17) the Labor Department releases its October estimate for consumer price inflation. Economists are forecasting that core inflation rose 0.1% last month, slightly higher than September's flat performance, according to Briefing.com.
The inflation reports in the months ahead will be critical for assessing the severity of the recent disinflation trend and whether the Fed's latest expansion of its monetary stimulus is warranted. Meantime, the trend so far is clear. Core inflation's pace has been steadily falling. Over the past two years, core inflation's annual rate has dropped to 0.9% as of last month, down from the 3% range just before the autumn financial crisis of 2008.
The sharp disinflationary trend is what worries the Fed, and for good reason. At the unusually low levels of core inflation of late (the lowest in half a century), the risk of letting the trend continue is opening the door to outright deflation, or so one school of thought argues. The slippery slope is all the more threatening because the U.S. is also suffering from a hefty debt load.
Has the combination of disinflation and debt sealed the economy's fate? Maybe. We'll have some fresh data to assess next week. Meantime, the market's inflation outlook for the decade ahead is now comfortably above 2%, up from around 1.5% in late-August, based on the yield spread between nominal and inflation-indexed 10-year Treasuries. The summer's decline and fall in inflation expectations has been reversed. What changed the trend?
Arguably the critical factor is the central bank's publicly dispatched plans to engage in a new round of monetary stimulus. The revised strategy began with Fed Chairman Bernanke's August 27 speech in which he explained that even though nominal interest rates were near zero, "the Federal Reserve retains a number of tools and strategies for providing additional stimulus." Last week, the Fed formally annnounced that it would roll out this "additional stimulus."
The goal, as Bernanke has explained, is to stabilize inflation expectations. The risk of letting the crowd anticipate continued disinflation is especially hazardous when core inflation is at 50-year lows and falling. It's an open debate if inflation expectations have in fact been stabilized. For much of the past month, the market's implied future inflation rate, based on 10-year Treasury yield spreads, has remained modestly above 2%. That's not surprising, considering that the annual pace in the nation's money stock is no longer retreating.
But the economy is still weak in a number of key sectors, including housing and the labor market, and so disinflation in the future can't yet be ruled out. Next week's inflation update for October may peel away some of the uncertainty. Meantime, a precarious calm prevails.
November 8, 2010
CURRENCIES & THE BUSINESS CYCLE
Jim Rogers, one of the most respected investors of recent decades—and rightly so—thinks Fed Chairman Ben Bernanke is clueless on matters of macroeconomics. But enlightened macroeconomic analysis and succcessful investment evaluation don't always reside at the same address. "Dr. Bernanke unfortunately does not understand economics, he does not understand currencies, he does not understand finance," he charged last week in a speech, according to Bloomberg. That's a powerful criticism and, if true, would be deeply disturbing. Is Rogers right? No, or at least the criticism doesn't hold up given the framework Rogers set up to deliver his attack.
The core of Rogers' case is that the central bank is printing too much money these days. His rhetorical coup de grace: "Debasing your currency has never worked." It sound persuasive, but there's just one problem: History doesn't back up the statement. Printing money is sometimes the wrong choice, but not always. The economic context matters.
But before I offer some supporting evidence, a quick digression into the alleged debasement of the U.S. dollar. Yes, the hazards that apply to fiat currencies are well understood, and the risks apply to every central bank that issues paper money. Over the long haul, inflation is the path of least resistance. But this problem applies to every central bank, and so it's unfair to single out the Fed on this point.
On that note, consider how the U.S. Dollar Index has fared in recent years. As the chart below shows, the greenback is valued at a slightly higher level today compared with the depths of the financial crisis in late-2008. Conclusively declaring that the dollar has been debased is somewhat premature. We shouldn't minimize the risk, but for the moment the dollar is off its lows of recent years.
As to the claim that engineering a lower currency value is always destined to fail as a part of useful macroeconomic policy, history suggests otherwise. True, a lower dollar in and of itself isn't a silver bullet. But the timing matters quite a bit. In periods of falling inflation and a generally weak economy, a weaker dollar can be productive. That's another way of saying that a stronger dollar may bring deeper problems.
Exhibit A is the experience in the early 1930s, during the Great Depression. Economists have analyzed this period for decades and in considerable detail. Among the fundamental conclusions: efforts at maintaining a strong currency were counterproductive to creating macro policies that favored growth. Economist Christine Romer, for instance, wrote a few years ago that the sooner countries abandoned the gold standard in the early 1930s—an act that effectively devalued their currencies—the sooner their economies witnessed growth. As she writes:
Given the key roles of monetary contraction and the gold standard in causing the Great Depression, it is not surprising that currency devaluations and monetary expansion became the leading sources of recovery throughout the world. There is a notable correlation between the time countries abandoned the gold standard (or devalued their currencies substantially) and a renewed growth in their output. For example, Britain, which was forced off the gold standard in September 1931, recovered relatively early, while the United States, which did not effectively devalue its currency until 1933, recovered substantially later. Similarly, the Latin America countries of Argentina and Brazil, which began to devalue in 1929, had relatively mild downturns and were largely recovered by 1935. In contrast, the “Gold Bloc” countries of Belgium and France, which were particularly wedded to the gold standard and slow to devalue, still had industrial production in 1935 well below its 1929 level.
Romer's analysis is hardly a radical idea. Indeed, economists have studied the economic history of the period and made similar observations for years. Barry Eichengreen in a widely quoted 1992 article in Economic History Review, for instance, reported that "the timing and extent of depreciation can explain much of the variation in the timing and extent of the economic recovery." A chart from that paper illustrates the point. Countries that left the gold standard earlier experienced strong industrial production earlier. At the extreme, France stayed on the gold standard the longest, which came at a high price of depressing industrial production for several years.
More recently, the economic case has only strengthened for indicting the gold standard as a detrimental factor in identifying cause and effect for the deepest economic problems linked with the Great Depression. Keep in mind that the gold standard is effectively a policy of promoting a strong currency. That was exactly the wrong policy, however, during a time of weak employment growth and falling inflation. For instance, Douglas Irwin's research shows that France's ultra-hawkish embrace of the gold standard was not only hurting the French economy, it had devastating effects on the global economy in the 1930s. According to Irwin, "countries not on the gold standard managed to avoid the Great Depression almost entirely, while countries on the gold standard did not begin to recover until after they left it."
As for the current situation, what of the recently revived sentiment? Economists are now saying that the odds of a double-dip recession have fallen sharply. Why? What happened to change the outlook from the summer, when the forecast was much darker? Monetary policy surely has played a role. Back in June, there was criticism that the Fed wasn't doing enough. Now there's criticism that the Fed's doing too much. But it's hard to overlook the fact that the improved outlook on the economy coincided with a more aggressive monetary policy in recent months. Will it work? No one really knows, but forecasts are slightly better and there's even some recently improved news for the labor market, as last week's jobs report shows. Is everything fine? No, of course not. But the first question is whether monetary policy is helping or hurting. For the moment, it seems to be helping...again, on the margins. That's better than the alternative.
Is the higher degree of monetary stimulus and the rebound in the economic outlook coincidence? Not likely. Yes, there are other factors beyond monetary policy. And the Fed isn't the one and only solution to the economic ills of late. But dismissing the Fed's efforts in recent months as worthless is a misreading of history, distant and recent.
Clearly, there are still many risks to consider, and debating what should be done now (or not) is productive. But before we do anything, we need to focus on what actually happened in economic history and draw reasonable conclusions.
November 6, 2010
BOOK BITS FOR SATURDAY: 11.06.2010
● Crash of the Titans: Greed, Hubris, the Fall of Merrill Lynch, and the Near-Collapse of Bank of America
By Greg Farrell
Review via My Bank Tracker
Money, power and corruption — a killer combination. The new book CRASH OF THE TITANS: Greed, Hubris, the Fall of Merrill Lynch and the Near-Collapse of Bank of America, by Greg Farrell, includes all three...Farrell disproves the popular theory that the industry giant fell due to the unexpected downturn of the mortgage market. He reveals insider information on the names at the top of the headlines, including Stanley O’Neal, Osman Semerci, John Thain and Bank of America CEO Ken Lewis. Crash of the Titans gives a minute-by-minute recap of one of the most intense 48 hours in Wall Street history.
● A Call for Judgment: Sensible Finance for a Dynamic Economy
By Amar Bhide
Podcast interview with author via The Harvard Business Review
● Griftopia: Bubble Machines, Vampire Squids, and the Long Con That Is Breaking America
By Matt Taibbi
Interview with author via Wall Street Cheat Sheet
I caught up with Matt to hear what he’s learned while following Wall Street and Washington during these most extraordinary times …
Damien Hoffman: In your new book Griftopia, you talk about how Wall Street and Washington have ironically got middle class America to support their agenda. How is this happening? Will it last?
Matt Taibbi: The Grifters have been getting people to support Wall Street’s political agenda by seducing them with a [Ann] Randian and pseudo-libertarian ideology. It’s always been around, but it’s just reaching a fever pitch now. And it’s the only way ordinary people can be convinced to endorse a deregulatory agenda. I think it’s going to last.
● The Future of Finance: A New Model for Banking and Investment
By Moorad Choudhry, Gino Landuyt, and Frank J. Fabozzi
Excerpt via John Wiley & Sons Inc.
Often in the search for the causes of the financial crash of 2007–2009, globalization and the role of the Asian and oil-exporting countries are underestimated. In many analyses of the crisis, the successive emerging-market crises over the past decade and the undervalued currency of emerging-market economies gets credited with, at best, only a secondary role in the crisis.
This is to miss a fundamental aspect and causal factor of the crash, and one that had been building up for over a decade. We want to phrase it even more strongly. One of the biggest challenges that world political leaders will be facing in the next decade is to address the global imbalances that have been created over the previous decade. If they do not succeed in this, then even the most robust banking regulation will not be suffi cient to protect the financial industry from another financial crisis, the effects of which could be even worse than the one just experienced. In saying this, we recognize the role emerging markets played and are still playing as pivotal to the crash.
● The Frugal Superpower: America's Global Leadership in a Cash-Strapped Era
By Michael Mandelbaum
Review via Foreign Affairs
This book is not a work of declinism but an unsparing assessment of the constraints on American power in the years to come. No single power, or concert of powers, Mandelbaum warns, shall step forth to assume the American burden. Humanitarian interventions and military campaigns such as those in Afghanistan and Iraq are not likely to be repeated. Such endeavors, Mandelbaum writes, will be resisted by an "American public worried about increases in the costs and reductions in the benefits of entitlement programs."
November 5, 2010
THE OCTOBER SURPRISE IN PAYROLL GROWTH
Any one economic report, like a single baseball game or the election du jour, is prone to deliver a surprise every once in a while, for good or ill. Today's update on payrolls clearly falls into the category of positive surprise, and not a moment too soon.
Private nonfarm payrolls rose by a net 159,000 last month, the Labor Department reports. That's the highest monthly gain since April. The autumn revival in the economy after the summer slump, in other words, rolls on. And with the Federal Reserve committed to an additional round of monetary stimulus, there's no reason to think that the positive momentum of late is set to fade for the foreseeable future.
Today's employment news clearly surprised economists. The consensus forecast underestimated October's net payroll jump by roughly half. But today's surprise really shouldn't be a complete shock. In the September 26 edition of The Beta Investment Report, for instance, I considered the case for thinking that the risk of a new recession was in retreat. At the time, the idea that the economy had enough forward thrust to keep a new contraction at bay was a contrarian notion. Today, presumably, it's an idea with broader appeal.
"This is very optimistic news and it comes in the wake of other fairly good news,” Nariman Behravesh, chief economist at IHS Inc. in Lexington, Massachusetts, told Blooomberg today. “It looks like the last month or so things have started to move upward again, and the momentum is hopefully building."
Stephen Bronars, senior economist with Welch Consulting, says "it's maybe an indication that we're starting to turn the corner." In an interview with CNNMoney, he opines that the October jump in payrolls is "a small step, but at least we're going in the right direction. Things are definitely not going to get worse."
Agreed, but let's not overdo the celebrations just yet. Today's jobs report is encouraging, or at least relative to the trend in recent months. There's still a long way to go, however, and today's numbers still leave plenty of reasons to wonder what comes next. Yes, a net gain of 159,000 in private nonfarm payrolls is the best news we've had in months. Unfortunately, the bulk of last month's increase (about 97%) is concentrated in the services sector vs. the cyclically sensitive goods-producing industries. A job's a job, of course, and more is certainly better. But until and if the employment gains spread more convincingly to the cyclical corners of the economy, there's still an incentive to sleep with one eye open.
Perhaps that's nitpicking. Having weathered so much discouraging economic news for so long, it's easy to remain skeptical. All the more so when we've yet to see any convincing change for the better this year in new claims for jobless benefits, as yesterday's weekly update reminds.
Keep in mind too that for all the favorable aura that accompanies today's employment news, the pace of 159,000 new net jobs is still well below what's needed just to keep pace with population growth. Another way to think of today's news is that if the economy continued minting new jobs at a net 159,000 gain each month for the period ahead, it wouldn't be enough to dismiss the outlook for sluggish growth.
Indeed, it's no trivial matter to note that while the labor market added a net 159,000 jobs last month, the unemployment rate was unchanged at 9.6% in October. By almost any standard in modern American economic history, a 9.6% jobless rate is a sign of severe distress.
We're a little bit less distressed today, and perhaps more of the same is on tap for the future. But a fair reading over the broad macro picture still suggests that the best-case scenario, which is still subject to change, is that a sluggish rebound is the path of least resistance. Today's employment report lends more weight to that view. That's both good news and bad. Weak growth is better than recession, but it's still not good enough.
THE CASE FOR HOLDING A CORE GLOBAL EQUITY ALLOCATION
The world is getting smaller, and that has implications for investing. Perhaps the leading change is the reduction in the potency of the country and industry factors as drivers of the equity risk premium. These sources of priced risk aren't going away, nor are they irrelevant. But they just don't pack as much punch as they once did.
That's not surprising—analysts have been writing about the trend for decades. As capital flows more easily across borders, political and industry distinctions count for less. That doesn't mean that it's time to abandon industry and country analysis, assuming those are your preferences. Those aspects of investing still matter, and they always will. For investors with the skills and desire to analyze and choose industries and countries, there's still opportunity to earn a higher return (or suffer a bigger loss) than the average investor. But as globalization rolls on and investing becomes more competitive internationally, industry and country factors matter less. In turn, the global equity risk premium's influence is rising.
Recognizing the trend, institutional investors have been increasingly focused on global equity mandates. As a new paper from MSCI Barra reports, there's been a "strong increase in the initial funding of global equity mandates: from a mere 6% in 2000, it has grown to represent 38% of all global and international equity initial funding in 2009." A chart from the paper--"The 'New Classic' Equity Allocation?"--illustrates the change:
There are, of course, additional factors to consider for pricing and selecting equities. Financial economics has made great strides over the years in deciphering Mr. Market's rules for asset pricing. So-called style factors are now widely seen as critical drivers of equity return too. Momentum, volatility, value and size, for instance, are key risk factors that are worthy of consideration for designing and managing equity strategies. Indeed, there's an increasing menu of index funds that target these factors as separate and distinct building blocks for customizing portfolios.
But in a world where capital flows freely, the influence of a global equity premium is stronger. From a U.S. perspective, thinking globally has even greater resonance now that the lion's share of the world's equity capitalization resides in foreign stocks.
As of this past September, U.S. equities represented a bit more than 40% of market capitalization on a global basis, according to Standard & Poor's. That's down from more than 50% at the close of 1999.
In other words, the case for holding a globally diversified core equity position is compelling. Institutional investors certainly think so. As MSCI Barra reports, "our research suggests that global equity mandates, together with dedicated emerging market mandates and small cap mandates, may be emerging as the 'new classic' structure for implementing equity allocation."
How much of your total allocation to equities should reside in a global equity fund? The answer varies, depending on your strategy, risk tolerance, time horizon, etc. If, for instance, you're engaging in a relatively high degree of active management, it's reasonable to put a lesser chunk of assets in a core global equity fund. On the other hand, if you have a long time horizon and shun market timing, a higher allocation to a global equity position may be reasonable.
In any case, a global equity mandate should almost always total less than 100% of the portfolio's allocation to stocks, perhaps a lot less. Why? Because if your entire equity position resides in one fund, you're effectively forgoing the rebalancing bonus. By implementing an equity allocation with multiple funds, you can exploit price volatility with a relatively simple strategy of rebalancing--maintaining the strategic equity mix over the long haul by opportunistically cutting back on the winning stocks and buying more of the relative losers. This is complicated and risky with individual securities, but is prudent when implemented using broad definitions of equities. In addition, rebalancing is an easy, forecast-free way of modestly boosting return, or so history suggests. There are other strategic and tactical applications to consider, of course, but rebalancing is a good start for almost every investor.
Holding some amount of your equity allocation in multiple funds also opens the door for tapping tax-loss-harvesting benefits, which can enhance after-tax performance.
Considering these opportunities, a possible equity mix might be constructed with a 50% weight in a global equity fund with the remaining 50% allocated in regional, industry and/or style funds. The latter slice could be rebalanced once or twice a year, while the global equity position constitutes the foundation for capturing the equity risk premium.
The critical variable in all this is finding products that offer all the world's stocks in a low-cost portfolio that efficiently replicates the global equity market. Two strong choices are: Vanguard Total World Stock Index ETF (VT) and iShares MSCI ACWI (ACWI). The Vanguard fund's expense ratio is a low 0.30%; the iShares ETF is slightly higher at 0.35%. Both cover the world, holding U.S. and foreign stocks, in developed and emerging markets, weighted by market cap.
In essence, these funds offer all the world's stocks in a single portfolio at a low cost. As such, they're on the short list as core positions for designing and managing an equity allocation. Institutional investing techniques at institutional pricing are no longer limited to institutions.
November 4, 2010
HORNSWAGGLED AGAIN WITH INITIAL JOBLESS CLAIMS
Last week’s sharp drop in new filings for jobless benefits claims evaporated in today’s follow-up report.The trendless trend in initial claims rolls on.
There was a brief, shining moment a week ago when it was easy to imagine something better. Yes, we should have known better, but the desire to believe that better times are just around the corner is a strong emotion in these United States. Alas, the glass-is-half-full perspective continues to take a beating. Indeed, as the chart below reminds, last week's dip in jobless claims didn’t last long. Par for the course in 2010, a year that’s distinguished itself as keeping the labor market in a state of perpetual non motion.
The news that job creation is sluggish at best is old news, of course, but it’s no less troubling. "The labor market is still very weak," Joshua Shapiro, chief U.S. economist at Maria Fiorini Ramirez Inc., tells Bloomberg. "Things will probably improve very gradually, but really painfully."
The next installment on defining the pain and gradualism in more detail arrives in tomorrow’s payrolls report for October. The Labor Department is expected to announced that the economy added 60,000 new private jobs last month on a net basis, according to the consensus forecast of economists via Briefing.com.
Any rise in the labor market is welcome news, of course, but a 60,000 advance is well short of what’s required just keep the jobless rate steady. That’s a fairly low standard, but at the moment that's about all that the expectations traffic can bear. As the Associated Press reports today, "the economy needs to add at least 200,000 jobs a month to keep up with population growth and to help get some of the 15 million unemployed back to work." Unfortunately, such gains are nowhere on the horizon.
The economy will likely continue bubbling along with enough momentum to keep us out of a new recession for the near term, all the more so now that the Federal Reserve is set to launch a new round of monetary stimulus. Given what we know now, however, that's about as good as it gets until further notice. But since that's not good enough, there's still plenty of uncertainty lurking in the shadows.
READING ROOM FOR THURSDAY: 11.4.2010
►Fed to Spend $600 Billion to Speed Up Recovery
David Sanger and Sewell Chan/NY Times/Nov 3
The Federal Reserve, getting ahead of the battles that will dominate national politics over the next two years, moved Wednesday to jolt the economy into recovery with a bold but risky plan to pump $600 billion into the banking system.
►What the Fed did and why: supporting the recovery and sustaining price stability
Ben Bernanke/Washington Post/Nov 4
Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run. Although low inflation is generally good, inflation that is too low can pose risks to the economy - especially when the economy is struggling. In the most extreme case, very low inflation can morph into deflation (falling prices and wages), which can contribute to long periods of economic stagnation...Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation.Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation.
►World stock markets rally on Fed move
Julia Kollewe/Guardian/Nov 4
Stock markets around the world rallied today as investors welcomed the US Federal Reserve's long-awaited decision to pump more money into the American economy.
►Fed Plan Lifts Asian Markets
Shri Navaratnam, Wei-Zhe Tan and Phani Kumar/Wall Street Journal/Nov 4
"It was a wild night …but with QE2 in the bag, the market might start to view positive U.S. economic data in a more bullish light," said Macquarie Private Wealth adviser Shannon Briggs
►Will It Work?
Scott Sumner/The Money Illusion/Nov 3
...the market movements over the last few weeks seem to be telling us that QE2 is likely to provide a modest boost to the economy, and that a double dip recession is less likely than in August. But overall the future still looks bleak. The Fed’s action fell pitifully short of what was needed. At a minimum, I would have liked to have seen enough stimulus to raise 5 year TIPS spreads to 2.0%, instead they merely rose from 1.61% to 1.65%.
Paul Krugman/The Conscience of a Liberal/Nov 3
Conventional monetary policy involves buying short-term government debt; it has no traction now because interest rates on short-term debt are near zero.
So now the Fed is buying longer-term debt — but still only 5-year debt, with a current interest rate of slightly over 1 percent. How much more effective is that likely to be?
And $600 billion really isn’t a lot when you’re trying to move a $15 trillion economy.
►Comments on FOMC statement
Bill McBride/Calculated Risk/Nov 3
Goldman Sachs believes that the FOMC will announce additional purchases throughout 2011 and probably into 2012 totalling about $2 trillion for QE2. (not counting reinvestment). If so, this is just the beginning of QE2 ...
►FOMC Statement, 11/03/10
Stephen Williamson/New Monetarist Economics/Nov 3
Today's FOMC statement was much as expected...Note that, in spite of the fact that Bernanke and others on the FOMC have been quite explicit about the 2% inflation target, they do not put that in the statement. They also do not say what the unemployment rate is that they view as being consistent with "maximum employment."...the FOMC is retaining the change in policy from the August 10 statement, which would have simply replaced mortgage-backed securities and agency securities that run off with long Treasuries. In addition to that, the Fed is committing (as long as nothing unexpected happens) to the purchase of long-term Treasuries, at the rate of about $75 billion per month, until the second quarter of 2011. This represents an increase over an 8-month period in the stock of outside money of about 45% at an annual rate. Given the experimental nature of this action, it is of course sensible that this is a contingent plan that can be revised in light of new information. I'm as curious as anyone to see what happens.
►The Fed shouldn’t be “solving problems,” their job is to avoid creating problems
Scott Sumner/The Money Illusion/Nov 3
The Fed should be trying to target expectations. Right now inflation expectations are too low. Of course NGDP targeting would be better, but if they are going to insist on targeting inflation, then at a minimum they should do enough QE to raise inflation expectations to 2%, and preferably a bit higher to make up for the recent undershoot. That’s not “disaster,” that’s what happens when the Fed does its job.
November 3, 2010
ADP SAYS PRIVATE-SECTOR JOB CREATION WAS +43k IN OCTOBER
If today’s better-than-expected good news in the ADP Employment Report is a sign of things to come, the freshly minted Republican takeover of the U.S. House of Representatives is starting with a favorable tailwind. Actually, make that a modestly less troubling tailwind.
The economy created a net 43,000 private-sector jobs last month, ADP reports. That's about double the amount that economists were forecasting. Of course, economists weren't expecting much to begin with, which makes beating expectations these days a bit like outrunning the town drunk who's passed out in the parking lot. A win's a win, but under these circumstances it's nothing to brag about.
Nonethless, today's number marks a clear reversal from September's revised 2,000 loss, based on ADP's calculations. But that's as far as it goes. Even 43,000 new jobs is a world below what's needed and what one would expect at this point after such a deep recession. In short, we're still seeing only tepid growth in the labor market. It's a consistently tepid growth trend, but that's all. And so while the Republicans scored a potent political victory last night, they're stuck with all the economic problems that helped reduce the Democrats' power in Washington.
Joel Prakken, Chairman of Macroeconomic Advisers (the consultancy that co-produces the report with ADP), says via a statement today:
Since employment began rising in February, the monthly gain has averaged 34,000 with a range of -2,000 to +65,000 during the period. October's figure is within this recent range and is consistent with the deceleration of economic growth that occurred in the spring. Employment gains of this magnitude are not sufficient to lower the unemployment rate. Given modest GDP growth in the second and thirds quarters, and the usual lag of employment behind GDP, it would not be surprising to see several more months of lethargic employment gains, even if the economic recovery gathers momentum.
As the first stat out of the gate after yesterday's Republican renaissance, today's employment number could be seen as a small gift--relative to what might have been. For a moment, at least, the headlines are still focused on politics. Today's ADP jobs update is hardly encouraging, considering what the economy needs. But it's good enough to push the economic problems into the future as far as the media's concerned. Grace periods, however, aren't likely to last long these days when it comes to macro challenges.
THE MORNING AFTER IN WASHINGTON: YOU WANT IT? YOU GOT IT
The Republicans took control of the House of Representatives in yesterday’s election and made progress but fell short of a majority in the Senate. The GOP, in other words, now has co-responsibility for the economy. Deciding if this is a political boon, or the equivalent of walking into a business cycle trap, will take time to assess. Meanwhile, this much is clear: the sluggish economy is no less sluggish now that the Republicans have a formal stake in the macro outcome. The only question is how the new party in power will influence policy in Washington and what that will mean, if anything, for the labor market, GDP, government debt levels, and all the rest.
It’s debatable if the Democrats could have done better over the past two years, when the party held the presidency and both chambers of Congress. It's hard to solve an economic crisis that gave us the worst recession in 80 years. Clearly, a rising share of the American public thinks there’s a better way, and there always is. Finding it within the realities of Washington's politics is something else.
One of the Republican planks is that Washington has been too quick to embrace fiscal deficits to juice the economy. Spending cuts, as a result, are the new game in town now that Republicans are overseeing the purse strings in the House.
The newly elevated Republicans should “get serious about spending cuts,” advises David Boaz, the Cato Institute’s executive vice president. "Annual federal spending rose by a trillion dollars under President George W. Bush—before the gusher of spending when the financial crisis hit. Bush became the biggest spender since President Lyndon B. Johnson funded the Great Society and the Vietnam War." Boaz goes on to assert that
Victorious Republicans must demonstrate to voters that they're serious—finally—about more freedom and less government. They destroyed the Reaganite Republican brand during the Bush years. It's harder to rebuild a brand than to destroy it. But the backlash against the Barack Obama- Harry Reid- Nancy Pelosi big-government agenda has given them another chance.
A chance for glory... or failure. Yes, it's easy to talk about pursuing rectitude. The problem is that it requires spending cuts, tax increases or both. That may work well in firing up the electorate in a time of swelling deficits before the election. But when it comes time to dive into the details, it's no party. Nor is it clear that deficit slashing is a short cut to higher economic growth in the near term.
What is obvious is that making headway on reducing red ink will require hard choices that will do little to ingratiate the Republicans with the electorate in the short run. Yes, there are long-term benefits—maybe, depending on the details of how the cuts are implemented. But it's not clear that you can mint a political advantage out of the process by the time the 2012 elections roll around. Economics, in other words, is destined to be infected with politics in the next two years. Same old, same old.
Regardless, the electorate says it wants lower deficits. Reuters reports that more than 90% of Americans last month said they want new Congress to lower the deficit. And just to keep things interesting, the Republicans have to come up with a plan for minimizing the red ink that also satisfies the Democrat in the White House and his counterparts in the Senate.
The first skirmish in this political/economic debate will be the so-called Bush tax cuts that are due to expire at the end of this year. The White House wants to extend the cuts for families earning less than $250,000 while the Republicans want to keep the tax cuts for everyone. But here's the problem, according to a recent report from the Congressional Research Service:
Allowing the Bush tax cuts to expire as scheduled will somewhat improve the fiscal condition, but could stifle the economic recovery. At the other extreme, permanently extending all of the Bush tax cuts would not undercut the economic recovery, but would worsen the longer-term fiscal outlook and possibly signal a lack of progress in dealing with the long-term fiscal situation.
Damned if you do, damned if you don't. Politics as usual? Maybe, except that the economic stakes are higher, perhaps a lot higher. Meanwhile, there's nobody left to blame. Sink or swim, the Republicans and Democrats are now on the hook together. That, at least, is one change you can count on in Washington over the next two years. The Democrats, for better or worse, are no longer a solo act and the Republicans aren't on the outside looking in.
November 2, 2010
THE CRUX OF THE QE2 BISCUIT...
It's all about expectations. A nebulous concept, to be sure, but one that's not beyond influencing macro outcomes with some control via monetary policy. To what extent? To what end? Ideally, it runs like this, as per Professor David Beckworth: "Here is why I think QE will pack an economic punch, if done correctly. The expectation of permanently higher prices will cause cash-flushed firms, households, and other entities to start spending more today. Right now there is an excess money demand problem that could be stemmed by meaningfully changing the inflation outlook."
Those folks and entities hoarding money would on the margin face an greater incentive to start spending given an significant increase in inflation expectations. (Yes, many households with weakened balance sheets are deleveraging and saving more. However, the rise in saving by these troubled households--by paying off debt, cutting back on spending, or buying other assets--should lead to more money for other non-troubled households unless the money is being hoarded somewhere else. Maybe the non-troubled households choose to sit on their money, maybe the creditors to whom the troubled households send their money are sitting on the money, or maybe it's the creditors' creditors that are sitting on the money. The details are not important, what is important is that somewhere in the economy there is an excess demand for money right now that is not being met by the Fed.)
Now assume the Fed does indeed address this excess money demand problem with QEII. Given sticky wages and prices, this pickup in spending (i.e. drop in money demand) will translate into real economic gains. This will encourage banks to start lending more as they see better credit risk going forward while the improved economic outlook encourages firms and households to start borrowing more too. On top of that, the higher expected inflation will drop the real interest rate and encourage more interest-sensitive spending. Next, we could consider how the pick up in asset prices might have a wealth effect on consumption. The pickup in asset prices could also improve troubled households balance sheets and thereby enhancing their access to credit. Finally, further depreciation of the dollar may spur exports. Bottom line is that there are multiple channels through which QE could work.
ANOTHER LOOK AT REBALANCING...
Is rebalancing a tool for managing risk? Or maybe it's a source for minting benchmark-beating returns. No, wait--it might be both. Really? In the new issue of Financial Advisor magazine, I take a fresh look at rebalancing in: Rethinking Rebalancing.
QE2's SUCCESS SO FAR...
Critics of the anticipated launch of the Fed’s new round of quantitative easing (QE2) to lower medium and long-term interest rates have fallen into two broad camps. One says that the policy won’t work. The second argues that QE2 threatens to create new problems for the economy, ranging from higher inflation that spirals out of control to asset bubbles and other negative consequences. And, of course, some attacks incorporate both of these points.
In another post, I’ll take a closer look at QE2’s potential for creating havoc down the road. Meantime, let’s address the criticism that QE2 can’t possibly work, since nominal interest rates are already at or near zero, as defined by the Fed’s target rate. In fact, that criticism looks unfounded.
QE2, after all, is all about arresting the disinflation/deflationary trend that developed over the summer. By engineering higher inflation expectations, the Fed can minimize if not wholly reverse this risk, which can be considerable if left unchecked. So far, there appears to be support for thinking that something's changed lately, and for the better. Consider that the mere talk of QE2 over the past months has delivered a down payment on the objective of nipping the disinflation/deflation momentum in the bud. Asset prices generally have risen sharply over the past two months. Is that merely a statistical oddity unrelated to the general pricing trend? Not likely, since the Treasury market’s inflation expectations have also risen since early September.
The inflation forecast is now 2.17%, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries, as of yesterday. In late-August, this inflation prediction was 1.5%.
Keep in mind that the market’s upwardly revised outlook on inflation has arrived primarily through chatter about QE2. The Fed’s formal launch of the program is expected to be announced tomorrow, at the conclusion of the FOMC’s current meeting. The message, once again, is that expectations are just as important, if not more important than the actual reported numbers, which arrive with a lag.
Is QE2 going to solve all the economic problems? Of course not. Is it guaranteed to work? No. Are there risks? Yes, absolutely. But all those caveats are no less relevant if we leaned in the other direction and the Fed announced that there would be no QE2. There are always hazards. The challenge is choosing policies that are prudent based on a clear-headed assessment of whether the potential results outweigh the apparent risks, and if a given scenario is likely to fare better than the alternatives.
Accordingly, the central bank is leaning toward QE2. For a more detailed look at the case for thinking this is productive, two posts by economist David Beckworth (here and here) are worth reviewing as a starting point for analyzing the challenge du jour. As a preview, here are two excerpts from Beckworth:
The expectation of permanently higher prices will cause cash-flushed firms, households, and other entities to start spending more today. Right now there is an excess money demand problem that could be stemmed by meaningfully changing the inflation outlook. Those folks and entities hoarding money would on the margin face a greater incentive to start spending given an significant increase in inflation expectations.
QE has been done before in the United States and it worked incredibly well. It was initiated in early 1934 when FDR and his treasury officials decided to (1) devalue the value of the dollar relative to gold and (2) quit sterilizing gold inflows. It was initiated in early 1934 when FDR and his treasury officials decided to (1) devalue the value of the dollar relative to gold and (2) quit sterilizing gold inflows. Now this was a radical move at the time, much like QE2 is to many folks today. The gold standard was viewed then almost as a sacred institution. FDR was going to weaken it and allow prices to permanently increase. How dare he! But that is exactly what was needed, a big permanent shock to inflation expectations that served to stop the deflationary spiral, end the liquidity trap, and allow a recovery in aggregate demand. Now this policy move was backed up with significant and permanent increases in the monetary base over time: it went from about $8 billion right before the policy change to about $24 billion by the end of the 1930s.
November 1, 2010
PERSONAL INCOME SLIPS, SPENDING RISES FOR SEPTEMBER
Disposable personal income (DPI) slipped last month while personal consumption expenditures (PCE) rose, the U.S. Bureau of Economic Analysis reports. The mixed profile for September isn’t surprising these days, although it does offer one more piece of statistical evidence for keeping optimism in check about the near-term prospects for economic growth.
The 0.2% drop in personal income for September is the first monthly retreat in a year. Disposable income, by contrast, rose last month for the third time in a row.
Measured by rolling 12-month percentage change, both income and spending remain firmly in the black, as our chart below shows. That’s a reminder that economic recovery, while weak, is likely to continue forging ahead at the margins. But the macro revival is precarious, and today’s update on DPI and PCE don’t offer much reason to think differently.
The optimists will be cheered by the fact that consumption was generally higher last month. For the moment, the fear is overblown that Joe Sixpack is set to dive into a bold new lifestyle of thrift and throw the economy into a new recession. Durable and nondurable goods purchases, as well as services, posted higher consumption figures in September.
Meanwhile, the broad trend in private wages remains positive. On a year-over-year basis, paychecks in the private sector rose 2.4% for the 12-months through September. As the second chart below shows, that’s roughly a return to levels that prevailed before the recession and financial crisis hit in 2008. This critical measure, in short, continues to climb. That’s good news, and it’s one reason why there’s been an economic rebound from the depths of the Great Recession, even if doesn't feel like one on Main Street.
But if you’re looking for reasons to stay cautious, you don’t have to look very far these days. Private wage growth is still positive, but the trend is wobbly when looking at the monthly readings. Indeed, September’s private sector wages increased by the thinnest of margins. What’s more, monthly changes in private wages, while mostly positive this year, remain stuck in a low range that hovers just above zero.
It all comes back to the single-biggest weight on the economic recovery: jobs, or the lack thereof. The labor market is minting new jobs on a net basis, but at a pace that’s unusually spare. Private sector payrolls have been rising on a net basis in each and every month this year, but the gains have been low and the trend has been slipping, as last month’s update reminds.
Will this Friday’s payroll report for October deliver more encouraging news? Maybe, or so one could reason after last week’s update on initial jobless claims. As we reported last Thursday, new filings for jobless benefits dipped to their lowest level since July for the week ending October 23. Is that a sign that the labor market’s about to enjoy a new round of improvement? Or is it just another bit of misleading statistical noise?
Too soon to say. Meanwhile, the consensus forecast among economists calls for more of the same: a sluggish recovery in the labor market. Dismal scientists predict another modest net rise in private nonfarm payolls for October, according to Briefing.com. At this stage of the economic cycle, there’s only one thing that’s going to convince the crowd that the economy’s shifting to a higher gear of growth: cold, hard numbers.
We’re now in the show-me-the-money stage of economic reports. Hope is nice, but it just won’t suffice any longer. Until and if we see materially better numbers, the path of least resistance is one of expecting more of the same.
Yes, there’s an economic recovery underway, and it’s enough to keep us out of a new recession, at least for the foreseeable future. But that’s about as good as it gets these days for peering into the future. And soon, perhaps sooner than we think, even that won't be enough.
THE BRAVE NEW (AND EVOLVING) WORLD OF ALTERNATIVE BETAS
PowerShares is planning to launch five factor ETFs based on the S&P 500, according to an SEC filing. It's one more sign that a new era is dawning for alternative betas and enhanced asset allocation opportunities.
The proposed ETFs from PowerShares:
S&P 500 High Beta Portfolio
S&P 500 Low Beta Portfolio
S&P 500 High Momentum Portfolio
S&P 500 High Volatility Portfolio
S&P 500 Low Volatility Portfolio
There’s already a fairly intriguing lineup of funds targeting specific factors. A few examples include the S&P 500 VIX Short-Term Futures Index, AQR's trio of equity momentum index funds, the PowerShares DB G10 Currency Harvest Fund, the Merger Fund, and the iPathUS Treasury Steepener and iPath US Treasury Flattener ETNs.
The latest PowerShares proposal suggests that we'll be seeing more funds that mine previously untapped strategies/unconventional betas in the months and years ahead. Strategically speaking, an expanding menu of products targeting specific risk factors expands opportunity for asset allocation beyond the possibilities bound up with conventional betas. It’s hardly a free lunch, but for sophisticated investors who understand the risks it all adds up to a productive evolution in fund choices. Indeed, more is better when it comes to the beta menu because in theory additional funds boost the ability to generate better results and weather rough investment seas.
Securitizing new factors has, in fact, been going on for years. It’s old hat now, but once upon a time there was a new-fangled beta focus called small-cap and value equity funds, for instance. Over the years, the list has continued to lengthen, such as adding high-yield bond funds and emerging market equity funds. More recently, we've seen the first generation of index funds targeting foreign bonds denominated in foreign currencies. And, of course, there's also been an explosion of forex funds proper.
Overall, it's fair to say that fund companies have been filling out their product lines over the last decade or so in the basic corners of risk factors. As a result, there's a broad array of index funds targeting stocks, bonds, REITs and commodities, along with numerous subsets of each. There's also a niche arena with short and levered exposures as well. This phase of the securitizing standard betas is now nearly complete.
But the era of securitizing unconventional betas has only just begun. Why is this relevant? Because the trend of minting new funds that capture various factor exposures potentially opens the door to a wider menu of asset allocation possibilities. In theory, the ability to tap into an expanded set of betas enhances the possibility of juicing risk-adjusted return. Asset allocation benefits from additional choices, in part because investors can exploit the varying risk profiles and lower correlations between standard and alternative betas. As a 2009 research monograph published by MSCI Barra explained, an expanded palette of betas improves the strategic opportunities for raising return, lowering risk, or both.
The improved asset allocation possibilities are partly a function of lower correlations between alternative betas and their conventional counterparts. What's more, correlations between alternative betas are often low or even negative. Consider a table from the MSCI Barra paper, which summarizes correlations between a select list of factors:
The basic message is that alternative betas exhibit lower correlations with both standard asset classes and among themselves. The data in the table above, the MSCI Barra research observes, reflect that “most of the correlations are below 0.25 and confirm that the risk premia captured unique return characteristics and offered diversification over this period. Note the highly negative correlation of -0.47 between Momentum and Value - two factors that are often deployed in quantitative equity investing.” (A correlation of 1.0 indicates perfect positive correlation; a correlation reading of zero indicates no correlation, and -1.0 reflects perfect negative correlation.)
The accompanying challenge in this brave new world of alternative betas is that much of the common wisdom that’s been developed with standard asset allocation will require an upgrade. Although academic researchers have long toiled in this arena, moving portfolio strategy to the next level for the masses is still in its infancy.
One aspect of this learning curve is understanding how alternative betas interact with one another. It's not always as intuitive as it is with standard betas. As such, mindlessly diversifying doesn’t necessarily add value when it comes to non-standard factors. For instance, as MSCI Barra notes, “the correlation between high yield and credit spread is high at 0.56, suggesting that these two factors are at least partially redundant.”
By contrast, you can be reasonably confident that diversifying among all the standard betas is generally a productive move. If you only own stocks, for instance, you don’t need to analyze a correlation matrix to rationalize the case for owning some bonds, REITs and commodities. Or, if you only only domestic stocks, expanding the portfolio into foreign equities is a no-brainer.
On the other hand, deciding if merger arb and convertible arb, or the carry trade and currency momentum, are complimentary pairings requires deeper analysis. Greater complexity can be a friend, but it may be a foe, depending on the investor, the prevailing market and economic conditions, and the set of factors under consideration.
The details matter for the individual funds as well. Simply rolling out a new alternative beta ETF or ETN in and of itself isn't a reason to buy the product. Expenses tend to be higher (perhaps dramatically higher) in this niche compared with the indexing of conventional betas, and so the stakes are higher for evaluating each fund on a case-by-case basis. The expected risk premium for certain alternative betas can look good on paper but end up as far less attractive (or even negative) in the real world after deducting expenses and navigating the extra layers of complication for mining these financial niches. Capturing the effects of some factors, in other words, can be costly and complicated compared with replicating standard betas.
Nonetheless, the future for asset allocation is evolving, one alternative beta product at a time. That's generally a step in the right direction. If we think of asset allocation as a chess game, portfolio management is shifting from a conventional one-dimensional board to 3-D chess. Accordingly, we're entering a new era of possibilities for minting superior results. But there’s also more complication and higher expenses to consider.
The core rule of investing, however, is unchanged. The opportunity for earning higher returns comes prepackaged with the possibility of suffering bigger losses. Risk and return are still closely linked in new world of betas, even if those connections are becoming more nuanced and varied.