April 30, 2011
Book Bits For Saturday: 4.30.2011
● The Most Important Thing: Uncommon Sense for the Thoughtful Investor
By Howard Marks
Summary via publisher, Columbia University Press
Howard Marks, the chairman and cofounder of Oaktree Capital Management, is renowned for his insightful assessments of market opportunity and risk. After four decades spent ascending to the top of the investment management profession, he is today sought out by the world's leading value investors, and his client memos brim with insightful commentary and a time-tested, fundamental philosophy. Now for the first time, all readers can benefit from Marks's wisdom, concentrated into a single volume that speaks to both the amateur and seasoned investor. Informed by a lifetime of experience and study, The Most Important Thing explains the keys to successful investment and the pitfalls that can destroy capital or ruin a career. Utilizing passages from his memos to illustrate his ideas, Marks teaches by example, detailing the development of an investment philosophy that fully acknowledges the complexities of investing and the perils of the financial world. Brilliantly applying insight to today's volatile markets, Marks offers a volume that is part memoir, part creed, with a number of broad takeaways.
● The Wizard of Lies: Bernie Madoff and the Death of Trust
By Diana Henriques
Review via NPR
The first journalist to interview Bernie Madoff after the money manager was sentenced to 150 years in prison says she was struck that Madoff hadn't fundamentally changed. Even behind bars, says New York Times financial writer Diana Henriques, Madoff was a "fluent liar." "The magic of his personality is how easy it is to believe him — almost how much you want to believe him," she tells Fresh Air's Terry Gross. "For example, he assured me in that first interview — and in emails subsequently that we exchanged — that he wasn't going to talk to other writers. ... Of course, it wasn't true, he was talking to others. It was all a lie."
● Brave New World Economy: Global Finance Threatens Our Future
By Wilhelm Hankel and Robert Isaak
Summary via publisher, Wiley
For decades, the U.S. dollar has served as the world's reserve currency. But after the global market meltdown and the resulting massive stimulus spending meant to keep the Great Recession from becoming an even Greater Depression, confidence in America's ability to make good on its growing debt is at all-time lows. In Brave New World Economy: Global Finance Threatens Our Future, Wilhelm Hankel and Robert Isaak—two extremely controversial, yet highly respected experts on international economics and management—describe how "Obamanomics," the Euro crisis, and shift of economic growth from the West to emerging economies, if handled properly, can lead to true economic stability and job creation.
● Financial Globalization, Economic Growth, and the Crisis of 2007-09
By William R. Cline
Review via Foreign Affairs
Following within a decade of the Asian financial crisis, the recent global financial crisis has revived the debate over the merits of openness to foreign finance, especially for developing countries. Restrictions on international capital movements are back in fashion. In this useful overview, Cline reviews the extensive and scattered economic literature on the contribution of financial openness to economic growth, correcting the mistaken impression that the literature provides little support for it. The results of many studies are overwhelmingly one-sided in showing that financial openness encourages growth -- it has boosted the GDPs of the emerging countries by 0.5 percent a year since 1990, Cline estimates, and it has boosted those of the rich countries by even more. The cumulative gains of opening up to foreign capital outweigh the losses attributable to occasional financial crises (as opposed to global recessions, which hurt countries largely by reducing trade).
● A Great Leap Forward: 1930s Depression and U.S. Economic Growth
By Alexander J. Field
Summary via publisher, Yale University Press
This bold re-examination of the history of U.S. economic growth is built around a novel claim, that productive capacity grew dramatically across the Depression years (1929-1941) and that this advance provided the foundation for the economic and military success of the United States during the Second World War as well as for the golden age (1948-1973) that followed. Alexander J. Field takes a fresh look at growth data and concludes that, behind a backdrop of double-digit unemployment, the 1930s actually experienced very high rates of technological and organizational innovation, fueled by the maturing of a privately funded research and development system and the government-funded build-out of the country's surface road infrastructure. This significant new volume in the Yale Series in Economic and Financial History invites new discussion of the causes and consequences of productivity growth over the last century and a half and on our current prospects.
● Fatal Risk: A Cautionary Tale of AIG's Corporate Suicide
By Roddy Boyd
Review via The Economist
The collapse of first Bear Stearns and then Lehman Brothers in 2008 were the emblematic events that triggered the financial crisis. But those companies were involved in investment banking, an inherently risky business. The demise of AIG, an insurance company that was for a long time judged to be an unimpeachable credit, was even more astonishing. Indeed, as Roddy Boyd demonstrates in his well-written study of AIG’s fall, it was the very solidity of the company’s credit rating that led it astray. Painstakingly built over the course of 40 years by an army veteran, Hank Greenberg, AIG was the ideal counterparty for Wall Street.
April 29, 2011
Strategic Briefing | 4.29.2011 | US 2011:Q1 GDP
Economic growth slows sharply; new jobless claims rise
LA Times | Apr 29
Many analysts shrugged off the report that gross domestic product grew just 1.8% in the first part of the year — down from 3.1% in the fourth quarter last year. Economists said the slowdown was caused mostly by temporary factors such as the harsh winter weather and a surge in oil and food prices, which took a bite out of consumer spending and the nation's trade. Officials at the Federal Reserve as well as many private forecasters expect GDP growth to bounce back to 3% or higher in the rest of the year. But that depends partly on an easing of global economic and political problems, particularly the unrest in the Middle East and North Africa that is behind the spike in petroleum prices.
US GDP growth slows to 1.8%, surprise jump in jobless rate
Economic Times | Apr 29
"Coming in at 1.8, to get to where Fed's forecast is, you're going to need some robust growth," said Bob Andres, chief investment strategist and economist at Merion Wealth Partners in Berwyn, Pennsylvania. 'In my mind, the Fed's forecast and the Street's forecast are more than likely a little too optimistic." Growth in the first quarter was curtailed by a sharp pull back in consumer spending, which expanded at a rate of 2.7% after a strong 4% gain in the final three months of 2010. Rising commodity prices meant the consumers , which drive about 70% of US economic activity, had less money to spend on other items. The report also underscored the pain that strong food and gasoline prices are inflicting on households.
Fresh blow for global economy as US slows
The Independent | Apr 29
Economists scaled back their expectations for the first quarter GDP figure as February and March drew on, but the first estimate published by the Commerce department yesterday was modestly weaker than even those lower forecasts. The consensus estimate had been 2 per cent. Many analysts noted temporary factors were keeping the figure low. Federal government spending dropped 7.9 per cent, with defence spending down 11.7 per cent, and commercial construction unexpectedly plunged 21.8 per cent. "Wild swings in government spending from quarter to quarter are notuncommon and are usually reversed quickly, and a severe series of winter storms held back construction in the first quarter," said Kevin Logan, chief US economist at HSBC. But he added: "For the year as a whole, constraints on government spending, in combination with moderate growth in consumer spending, will probably keep GDP growth below 3 per cent. It appears likely that GDP growth will fall short of the Fed's recent forecast of 3.1 per cent to 3.3 per cent on a fourth quarter-to-fourth quarter basis."
Economic growth slows to 1.8% in first months of 2011
The Washington Post | Apr 28
“All things considered, it could have been worse,” said Paul Ashworth, chief U.S. economist at Capital Economics, noting the temporary impact of energy prices and other factors. “Nevertheless, in a quarter when the economy began to benefit from additional monetary and fiscal stimulus, we had originally expected a lot more.”
Today’s GDP Report Perpetuates Myth That Imports “Subtract” from Growth
Cato Institute | Apr 28
The U.S. Commerce Department just released its initial snapshot of first-quarter economic growth this morning. The new news is that economic growth slowed to 1.8 percent, a disappointing rate that will do nothing to shrink unemployment. The old news is that the report continues to label rising imports as a “subtraction” from gross domestic product (GDP)...In Table 2, the Commerce Department calculates that rising imports subtracted 0.72 percentage points from real GDP in the first quarter. This will be widely interpreted as meaning that GDP growth would have been 2.5 percent last quarter if those burdensome imports had not increased. This is all bunk, as I try to explain in a Cato study released earlier this month, titled, “The Trade-Balance Creed: Debunking the Belief that Imports and Trade Deficits Are a ‘Drag on Growth.’” One source of confusion is the fact that the government estimates GDP, not by measuring what we actually produce each quarter, but by measuring what we spend.
U.S. real GDP advances by 1.8% (annualized) in Q1 as government spending pulls back
TD Economics | Apr 28
As Chairman Bernanke noted in his press conference yesterday, the slowdown in economic growth following the 3.1% print in the fourth quarter reflects a number of transitory elements including snow storms and a sharp decline in defense spending. Fortunately, economic growth appears to have gained traction as the quarter drew to a close in March. This sets the stage for a better result in Q2, which we expect will come in above 3.5%. Importantly, despite the slowdown in economic growth, the first quarter of this year was the best yet in terms of (ex-census) job creation with close to 500,000 new positions. Moreover, a number of indicators support a return to a more solid pace of expansion in the months ahead – in particular, credit quality continues to improve and credit growth to consumers and businesses has accelerated, giving further comfort that the slowdown in activity in the first quarter is a temporary blip. While government spending is likely to continue to be a drag over the next year, economic momentum is in the hands of the private sector, which will continue to drive the recovery forward.
2011:Q1 Real GDP Growth – One of the Three Smallest Gains in the Recovery
Northern Trust | Apr 28
In the first quarter, consumer spending (+2.7%) and equipment & software spending (+11.6%), and exports (+4.9%) and inventories ($43.8 billion vs. $16.2 billion) made positive contributions to real GDP growth, while residential investment expenditures (-4.1%),
non-residential structures (-21.8%), and government spending (-5.2%) partially offset these gains. It is noteworthy that real GDP in the first quarter crossed the peak reading in the fourth quarter of 2007 by a significant measure (see Chart 2) and the U.S. economy is most certainly on the path of expansion. Stronger growth is predicted for the second quarter of 2011 and a more moderate pace is likely in the second-half of the year, which puts the Q4-to-Q4 increase in 2011 around 2.9%. The FOMC’s projections show the central tendency for real GDP growth as 3.1%-3.3% in 2011.
April 28, 2011
Fresh Reminders That The Economic Recovery Continues To Struggle
Is the labor market headed for a fresh round of trouble? Today’s weekly jobless claims report provides some new motivation for going over to the dark side on this question. The usual caveat applies, of course: divining the future from any one number in this volatile series can be misleading. Unfortunately, the jump in new filings for unemployment benefits is no longer an isolated data point.
“It’s clearly disappointing,” Michael Feroli, chief U.S. economist at JPMorgan Chase, tells Bloomberg in the wake of today's update. “It may be that the pace of improvement is slowing.”
Peter Boockvar of Miller Tabak + Co. agrees, writing in note to clients today: "The trend over the past few weeks is clearly disappointing as signs were pointing to a more sustainable pick up in the labor market.”
A chart of recent history tells the story. New filings jumped to a seasonally adjusted 429,000 last week—the highest since January. More worrisome is the recent rise in the four-week moving average for weekly claims, a trend that increased to more than 408,000 last week. Save for one week earlier this month, the four-week average has risen continually since this measure bottomed out in early March at just under 389,000. And while we’re reviewing distressing signals in this corner, let's note too that the four-week average is now above the 400,000 mark for the first time since February.
Is it all just noise? Possibly. Much depends on whether there’s corroborating evidence from other corners of the economy, starting with the next report on nonfarm payrolls, which is scheduled for release next week (Friday, May 6). The last report revealed a fairly strong number: private job creation advanced by a net 230,000 in March. That's hardly a cure-all for the various ills that afflict the U.S., but it's far too strong to inspire writing the epitaph for the current recovery. Even with the concerns embedded in the latest jobless claims report, it still requires an especially negative interpretation of the vast majority of economic reports to argue that the labor market is set to crumble.
One reason for thinking positively is the recent momentum in U.S. corporate earnings and manufacturing. Ed Yardeni reminds that the news on these fronts has been quite positive recently. Even so, “the growth rate in earnings may be peaking,” he notes. “However, that doesn’t mean that it won’t continue to grow along with world exports.”
But the rough rule of thumb that jobless claims under 400,000 imply continued expansion in the labor market will weigh heavily on sentiment until (or if?) a fresh batch of numbers re-boost confidence.
Today’s estimate on Q1 GDP certainly isn’t up to the task. The U.S. economy expanded at a much-slower 1.8% real (inflation-adjusted) annual rate in the first three months of this year—a sharp downshift from the 3.1% pace in last year’s fourth quarter, the Bureau of Economic Analysis reports. The blame for the slower economic growth was a “sharp upturn in imports,” a “deceleration” in consumer spending, “a larger decrease in federal government spending, and decelerations in nonresidential fixed investment and in exports.”
Nonetheless, the bigger risk for now is that the economy’s rebound moderates rather than evaporates. In fact, that’s been the concern all along. There’s still forward momentum in the broad trend, but it’s not as potent or persistent as some have argued. And with various corners of the economy still firmly on the defensive, starting with the residential real estate market, there's little reason to assume that we're set to grow out of our troubles any time soon.
In short, the real danger is less about a new recession than coming to terms with an economy that struggles (still) to grow.
“There are some concerns going forward,” reminds Scott Brown, chief economist at Raymond James. “We think gasoline prices will continue to dampen the recovery,” he writes. “We are looking at a moderate recovery here. It will still some time before we see the economy fully recover.”
Damned If You Speak, Damned If You Don't
Ben Bernanke's performance at the Federal Reserve's historic first-ever press conference succeeded in pleasing no one while further stoking criticism from all sides. Perhaps that was inevitable. There was almost zero chance that one more prepared speech, or even taking questions from the press like a run-of-the-mill politician, would change deeply entrenched views about what the Fed could or couldn't do. But the former Princeton professor gave it a shot.
Congressman Ron Paul, Fed critic-in-chief, certainly wasn't impressed. He dismissed the event for most part, charging that Bernanke's media event was little more than "smooth talking, to make current policy sound reasonable."
For Paul and other critics, there was only disappointment that the Fed didn't raise interest rates to fend off what some say is an approaching wave of higher inflation fed by increasing commodity prices. Yet the policy of keeping rates near zero rolls on, as noted in yesterday's FOMC statement and reiterated in Bernanke's public chat.
If the lack of tightening frustrated some, others were distressed for what Bernanke didn't say, or at least didn't say clearly, in defense of QE2 and monetary stimulus. Economist David Beckworth, for instance, lamented that most of the inflation questions posed by reporters yesterday
were premised on the assumption that inflation is always a bad outcome that must be avoided at all cost. For example, Robin Harding of the FT asked Bernanke what the Fed could do to prevent inflation expectations from increasing. None of the reporters seemed to grasp and Bernanke failed to explain that a period of catch-up inflation--which really is just a symptom of catch-up nominal spending--could do the economy some good without jeopardizinng long-run inflation expectations. All the Fed would need is to set an explicit level target and run with it as I explain here. And make no mistake, the Fed has the power to make a difference. Just look at how successful the original QE program was in the 1930s, a time of far worse economic conditions.
To Marcus Nunes' ears, Bernanke sounded a bit more hawkish yesterday:
QE2 will end as planned in June. Monetary policy will “passively tighten”. In the Press Conference Bernanke fretted about core inflation going up, about the danger of rising commodity and oil prices and about inflation expectations – up but still anchored. The “hawks” are in control. There was unanimity but Bernanke conceded their points! To him, it´s a pity long term unemployment continues elevated, but the inflation “dangers” take precedence!
But that´s what you get when you obsess with inflation. The hawks have been “crying wolf” for a long time, even while inflation was tanking during most of 2009 – 2010.
Tim Duy agrees:
The most interesting comments came in response to questions about whether the Fed should do more to lower unemployment and if QE2 is effective, shouldn’t the program continue? Here was a more hawkish Bernanke. As I noted earlier, growth forecasts returned to the pre-QE2 range, which should be a red flag. Unemployment remains high, with only moderate job creation. Core-inflation remains low, while the impulse from commodity prices on headline inflation is expected to be temporary. Finally, he claims that QE2 was in fact effective. So why not do more? Because the Fed needs “to pay attention to both sides of the mandate” and the “tradeoffs are less attractive.” Much talk by Bernanke at this point about inflation expectations, and the importance of maintaining those expectations, and not much (none, I think), about the issue (or non-issue) of wage inflation.
As for the market's outlook on inflation, yesterday's media circus didn't alter expectations much. The implied inflation forecast, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries, was 2.58% yesterday, or down slightly from earlier in the month and roughly in line with levels that preceded the financial crisis of late-2008.
The future, of course, is another matter, and one that Professor John Cochrane thinks may be troublesome. "To buy a 30-year Treasury at its current 4.5% yield and get a decent 2% return, you have to bet that inflation will not exceed 2.5% for the next 30 years," he writes. "You have to bet they will solve the 2025 deficit." The "they" he's referring to is the Congress, of course, and the 2025 deficit is the projected red ink thrown off by the ballooning spending for Social Security, Medicare and Medicaid in the years ahead. "Why do we need to fix the 2025 budget today?" Cochrane asks. "Two words: bond market."
Unfortunately, the short term isn't easily dismissed on the road to macroeconomic salvation. The Fed lowered its prediction for economic growth yesterday, forecasting GDP growth in the range of 3.1% to 3.3% for all of 2011—down from January's estimate of 3.4% to 3.9%. Keep in mind, too, that the unemployment rate is still unusually high at 8.8%. Meanwhile, interest rates remain unusually low—virtually nil via the Fed's target rate. Now here's the operative question: What do you think the outlook for GDP and unemployment would be if the Fed started hiking interest rates today? Hold that thought and then ask yourself: How would the stock market react?
Whatever constitutes a solution to the mess we're in, the clock is ticking. Cochrane advises:
We are still a great nation. The challenge is whether we will accept a vaguely rational tax system and a set of entitlements that protect the vulnerable without bankrupting the Treasury. It's not rocket science.
But we don't have much time. The bond market won't wait. The budget and debt problems will be much harder to solve if long-term interest rates spike, the dollar falls further, and inflation breaks out.
Perhaps the real question is deciding if the "solution" will help or hinder growth now. Focusing on 2025 is critical, but so is keeping GDP bubbling. Which one's more important? Heck, do you think you're right leg's more valuable than your left?
Bernanke can hold as many press conferernces as he wants, but the Great Uncertainty still lurks. Finding the path between promoting growth today and advancing fiscal rectitude tomorrow isn't going to be easy. In fact, it's going to be damn risky. No one's really sure what constitutes the right mix of austerity and stimulus. But Cochrane's certainly right about one thing: "Our only hope is growth." The details for minting that outcome, however, are still debatable.
April 27, 2011
Commodities, Inflation & Strange Bedfellows
Ben Bernanke is scheduled to deliver his first formal press conference later today on behalf of the Federal Reserve. It's a safe bet that the subject of inflation will be front and center. Although consumer price inflation is low by historical standards, there's no shortage of worries about the direction for pricing pressures. Fed critics are quick to note that the consumer price index (CPI) is higher by 2.7% for the year through last month. More worrisome, we're told, is that the trend is up sharply from as recently as last November's 1.1% annual pace.
Bernanke defends the central bank's near-zero interest rate policy in part by emphasizing that unemployment is still high. Meanwhile, core inflation is far lower than the trend in headline prices. CPI less food and energy rose by just 1.1% over the past year through March, or near the lowest annual rate of change since the early 1960s.
The rationale for giving greater weight to so-called core inflation is that it ignores those commodity prices that bounce around a lot in the short run, a tendency that can generate misleading signals for setting monetary policy. In fact, a number of studies demonstrate that core inflation has a better history of capturing the true inflation trend, thus the Fed's greater emphasis on overlook food and energy prices for monitoring broad pricing trends.
But nothing's sacred in economics and so it could be different this time. If commodity prices continue rising, core inflation's historical role as a superior measure may be due for a fall. The stakes are high, given the strong rally in commodities over the past year. Consider that the iPath DJ-UBS Commodity ETN (DJP) has climbed nearly 30% over the past year, well above the roughly 10% climb for U.S. stocks via the S&P 500 SPDR ETF (SPY).
Expecting commodity prices to roll higher is easy these days, given the recent trend. But one bull on raw materials counsels that it's time for moderating expectations. GMO's Jeremy Grantham has favored commodities for years and he continues to think that prices will rise in the long run. But he doesn't rule out a correction in the weeks and months ahead. As he writes in his latest quarterly outlook published this week:
Goldman Sachs and others have done such a good job of making the case for commodities as an attractive investment (on the old idea that investors were going to be paid for risk-taking), that the weight of money has pushed up the slope of the curve. This not only destroys the whole reason for investing in futures contracts in the first place, but, critically for this current argument, it lowers the cost to the farmers of laying off their price risk and thus enables, or at least encourages, them to plant more, as they have in spades. Ironically, institutional investing facilitates larger production and hence lower prices! Should both the sun shine and the rain rain at the right time and place, then we will have an absolutely record crop. This would be wonderful for the sadly reduced reserves, but potentially terrible for the spot price.
Grantham also sees more than an idle possibility that China's roaring economy could hit some turbulence in the near-term future. If so, that could undercut a key demand driver for commodities prices, including oil. "Quite separately, several of my smart colleagues agree with Jim Chanos that China’s structural imbalances will cause at least one wheel to come off of their economy within the next 12 months," he advises. "This is painful when traveling at warp speed – 10% a year in GDP growth."
It's ironic that Grantham, who has ferociously attacked the Fed's stimulus policy in recent years, is effectively providing some intellectual firepower for the central bank's focus on core inflation. Grantham surely would disagree with this assessment. But if there's a case for expecting a near-term correction in commodity prices, Bernanke's argument for focusing on core inflation may not be as hair-brained as some critics charge.
"If [commodity] prices continue to run away, then my small position will be a solace and I would then try to focus on the more reasonably priced – 'left behind' – commodities," Grantham concludes. "If on the other hand, more likely, they come down a lot, perhaps a lot lot, then I will grit my teeth and triple or quadruple my stake and look to own them forever."
Forever is a long time, but it still arrives one trading session (and FOMC meeting) at a time.
April 26, 2011
Strategic Briefing | 4.26.2011 | The Fed's First Press Conference
Fed Sweating the Details of First News Conference
The Wall Street Journal | Apr 26
The Federal Reserve is doing some careful stage planning for its first-ever public news conference Wednesday afternoon following a two-day policy meeting. Details that would be extremely mundane for most other institutions—such as who gets in, how Chairman Ben Bernanke should kick things off, and how questions will be asked—have potentially market-moving importance in this instance. Analysts and traders on Wall Street have been scrambling to find out what to expect. "People are trying to get their arms around the whole thing," said David Greenlaw, chief U.S. economist with Morgan Stanley. He has quizzed colleagues who follow the European Central Bank, which, like other central banks, has held news conferences for years, to understand how it might unfold.
Bernanke To Explain Fed's Action At News Conference
David Wessel, Wall Street Journal, via NPR | Apr 25
...it's a big deal because Fed chairmen generally haven't done them. They usually take questions in public only at congressional hearings, which usually means they don't end up talking very much about the substance of monetary policy. Mr. Bernanke has advocated for a long time doing this stuff in public. He believes in what he calls transparency. But I think there are two other things going on. One is the Fed knows that people don't trust them. It's the residue of the financial crisis. And he's looking to use this as an opportunity to build confidence in the Fed. And secondly, there's a big committee at the Fed, and they tend to all talk at the same time and confuse people. By being the first one out to talk to people after the Fed holds its policy meeting, he will set the tone and he will send a clear message, he hopes, that won't be so polluted by every - all the disagreements being aired in public.
Dollar falls to new low as markets await Fed's next move
The Guardian | Apr 26
City experts believe that this will be a defining week for the dollar. Ben Bernanke, chairman of the Fed, will for the first time hold a press conference on Wednesday evening immediately after the Federal open market committee has voted. Traders expect no change to the Fed's current loose monetary position. "The market will, as usual, be hanging off every word from Bernanke," said Jane Foley, senior currency strategist at Rabobank. "There is a small risk that the Fed will toughen its stance on inflation, but in the absence of this, loose monetary policy in the US is likely to continue to weigh on the dollar at least for the remainder of the year."
What Bernanke May Say at Fed Conference: Fixed Income Pro
CNBC | Apr 25
Don’t get too excited over Federal Reserve Chairman Ben Bernanke’s press conference on Wednesday, said David Zervos, head of global fixed income strategy at Jefferies. “I imagine we’ll get the typical clarity that we get from reading the minutes—I don’t think we’re going to get a whole lot of new information,” Zervos told CNBC. “The fact that we get some new bombshell information seems highly unlikely to me... Where you get answers from Bernanke is maybe how transitory are these commodity price increases, what are they thinking about in terms of the dollar, what are they thinking in terms of the immediate GDP consequences of what happened in Japan.”
Ben Bernanke Faces The Press Wednesday
Neon Tommy | Apr 26
... there has been pressure on the Federal Reserve to be more open. “The notion of being upfront about their actions is probably a step in the right direction,” said Ross Starr, professor of economics at UC San Diego. On the flip side, said UCLA economist Jerry Nickelsburg, press conferences could put Bernanke in a tough political situation. “On the one hand it allows Ben Bernanke to put monetary policy into the public arena for discussion and debate,” he said. “On the other hand, it can serve as a platform from which Chairman Bernanke can counter the influence of the other governors. This could make the discussions at the FOMC less incisive.”
Fed watch: Can you hear me now?
US Economic Weekly (Bank of America) | Apr 21
April’s FOMC meeting is unlikely to be notable on the policy front: the Fed is widely expected to maintain its current policy stance. But it will mark the beginning of a significant innovation to Fed communication strategy: a post-FOMC press conference. This will give Fed Chairman Ben Bernanke an opportunity to grab the media spotlight away from the ever-present but unrepresentative hawks, and help re-align market expectations to what we expect to be a continued long hold for US monetary policy well into next year.
April 25, 2011
The New Finance For A New Era
The myth persists that buy-and-hold strategies are worthless. We live in a new era, we’re told. The old rules of finance are gone. Ours is new age of active management for all portfolios at all times. But the reality is that not much has changed. Markets are still volatile, predicting return is still hard, and trading costs and taxes still take a heavy toll on gross returns over time. There are, however, new insights that inspire modifying the old advice. But that still falls short of throwing out the baby with the bathwater.
That's a nuanced point, and one that's too often minimized if not ignored outright. Why? It's not for lack of intelligence. But it’s also true (still) that different constituencies in the money game have different agendas. Wall Street, to cite the ancient example, is still conflicted between its business model and clients' best interests. No wonder that the first and last question to ask when it comes to Big Finance and your money is still: Where Are the Customers' Yachts?
There are other agendas to consider as well when it comes to your money. One might be called the media-finance complex, which is driven by the need to keep investment journalism focused on complexity and promoting the idea that nothing less than a homegrown hedge fund-type strategy will suffice for the new era that reportedly bedevils us all. But what makes for scintillating copy doesn't easily translate to worthwhile investment advice.
It’s true, of course, that financial economics over the last several decades has identified a broad array of insights that help us predict risk premiums for all the major asset classes. An extraordinary new book—Expected Returns: An Investor's Guide to Harvesting Market Rewards—surveys this literature. The message is two-fold. One, investors can’t afford to ignore this market intelligence. The opportunity to enhance realized return, reduce risk, or both, is quite real. But there’s a dark side as well, and this new book from Antti Ilmanen, a senior portfolio manager at Brevan Howard who earned a finance Ph.D. from the University of Chicago, does a masterful job of emphasizing the dual nature of what we’ve learned over the past generation:
Finance theories have changed dramatically over the past 30 years, away from the restrictive theories of the single-factor CAPM, efficient markets, and constant expected returns. Current academic views are more diverse, less tidy, and more realistic. Expected returns are now commonly seen as driven by multiple factors. Some determinants are rational (risk and liquidity premia), others irrational (psychological biases such as extrapolation and overconfidence). Expected returns on all factors may vary over time.
The smoking gun in all this, Ilmanen writes, is “required asset returns have little to do with an asset’s standalone volatility and more to do with when losses can be expected to occur. Investors should require high-risk premia for assets that fare poorly in bad times, whereas safe haven assets (that fare well in bad times and less well in good times) can justify low or even negative risk premia.” More precisely,
Forward-looking indicators such as valuation ratios have a better track record in forecasting future asset class returns than rearview mirror measures. The practice of using historical average returns as best estimates of future returns is dangerous when expected returns vary over time.
The implications of this market intelligence: a) portfolios should be diversified across risk factors; and b) the mix of risk factors should be actively managed in some degree, a point I discuss at some length in Dynamic Asset Allocation.
But here’s the problem: the substantial progress in peeling away the onion skin of uncertainty in projecting risk premia is, at best, only a partial solution. Even if you’re a wide-eyed optimist and argue that our confidence in predicting return is 50%, that implies that active asset allocation should constitute half of the portfolio strategy. What should dominate the other half? Passive management.
If expected returns were perfectly and forever random, asset allocation should be completely passive. There’s no point in trying to predict returns if future performance will be distributed along a bell-shaped curve. If that's the case, it suggests holding a passive mix of assets, as implied by a market-value-weighted portfolio. But we know that returns aren't randomly distributed. That provides us with some confidence for making forecasts and expecting a success rate that’s higher than what random results allow.
Unfortunately, the ability to make informed forecasts with a higher degree of accuracy is still well short of perfection. Returns aren't randomly distributed, but over the long term they come close. The short term, of course, is another story. Even with all the intellectual firepower that comes from standing on the shoulders of giants in finance, we still make mistakes. We should invest accordingly by factoring in our recurring capacity for screwing up.
The other challenge is a lack of discipline, a habit that afflicts the human species in matters of money management. It’s one thing to be told that expected returns vary and that there are tools for identifying how and when those forecasts vary. It’s quite another to consistently marshal the psychological fortitude to act on those forecasts--a discipline that's inherently a contrarian-based investment strategy.
History suggests that investors generally have little if any ability to exploit extreme conditions in a timely manner as it relates to expected return. For instance, few were buying stocks in late-2008 when equity prices were falling sharply. Conversely, the crowd was buying in 2006 and 2007, when prices were rising dramatically.
In fact, the limited ability of the average investor to exploit fluctuations in expected return goes a long way in explaining why ex ante risk premia bounce around so much. Yes, it's reasonable that the market offers bigger incentives for taking risk when potential threats loom large, or that Mr. Market is apt to be greedy in extending payments when the expectations are rosy. It's no less surprising that investors overall are frightened when trouble lurks, or overly exuberant when all seems well. No wonder, then, that average investment results are so tough to beat, a point that brings us back to buy-and-hold investing strategies.
Given what we know about asset pricing, managing asset allocation should be partly active. Exactly how much is debatable; a fair amount of the answer depends on the investor, and so the appropriate counsel will vary from person to person (or institution to institution).
Meantime, decades of financial research tell us that we shouldn’t ignore the clues that Mr. Market offers in the quest to peer into the future. But we should also be wary, a point that Ilmanen emphasizes:
Although I present large amounts of empirical evidence about historical returns and forward-looking indicators, as well as numerous theories in an attempt to make sense of the data, I believe it is important to stress humility. Hindsight bias makes us forget how difficult forecasting is, especially in highly competitive markets. Expected returns are unobservable and our understanding of them is limited. Even the best experts’ forecasts are noisy estimates of prospective returns.
The humility side of the equation suggests that we should make an effort to share in the premiums that arise from simply holding betas through time. As a simple example, consider how a 60% equity/40% bond portfolio fared over the 10 years through the end of 2010, as shown in the graph below. This portfolio was formed at the close of 2001. The equity piece was evenly divided at first between U.S. stocks (Russell 3000) and foreign stocks (MSCI EAFE). The bond slice was represented solely with U.S. investment-grade debt (Barclays Aggregate Bond). The buy-and-hold version of this strategy earned a 4.1% annualized total return over the last 10 years. If we rebalanced back to the initial 60/40 mix every December 31, the return increased to 4.9% a year.
The message is that asset allocation with little or no active management yields modest returns over time. That’s a point that’s routinely overlooked in the financial press, which likes to point out that a buy-and-hold strategy for U.S. equities led to a lost decade recently. True, but finance theory doesn’t recommend making extreme bets in asset allocation, which is what a U.S. equity-only portfolio amounts to.
Instead, investors should stay focused on the two broad pieces of strategic intelligence that have been documented over the past generation. One, the unmanaged market portfolio (or a reasonably proxy) will deliver competitive risk-adjusted returns over time. Given that this multi-asset class market beta is easy to procure, most investors should consider tapping into it as a foundation for their investment strategy. Two, expected returns fluctuate with some amount of predictability.
Putting these two “facts” together suggests that we should manage asset allocation actively to a degree, but only to the extent that we don’t completely give up the easy rewards of passive allocation. Advice that counsels going to either extreme is, well, extreme. The financial media aren’t fond (for the most part) of making this point. Why? Perhaps it’s a bit boring and repetitive compared with the sexier approach of highlighting the fund or manager du jour, or dissing this or that asset class in isolation while elevating another.
Don’t confuse the business demands of the media industry with prudent investing advice. Yes, the customers do in fact have yachts (or the financial equivalent), but they’ve been earned through strategies that you won’t routinely find with the usual suspects.
April 22, 2011
Book Bits For Friday: 4.22.2011
● The Strategic Dividend Investor
By Daniel Peris
Summary via publisher, McGraw Hill Business
There's a big difference between investing in the stock market and investing in companies through the stock market. The Strategic Dividend Investor shows you why, over the long run, investing in companies with high and rising distributions is far superior to "playing the market." Responsible for $4.5 billion in dividend-anchored portfolios, Daniel Peris demonstrates that, for most investors, buying a stock in the hope of making a quick buck by selling it in a few weeks or months is far from the best way to create wealth. Instead, you should use the stock market as a means of receiving a share of excess profits—dividends—from corporations in which you own stock. Over time, those payments—and the growth of those payments—represent the vast majority of stock market returns.
● Debt, Deficits, and the Demise of the American Economy
By Peter J. Tanous
Peter J. Tanous and Jeff Cox
Excerpt via publisher, Wiley
Here’s the problem. About 40 percent of our federal debt is scheduled to mature by midyear 2011. Seventy percent of the debt will mature within five years. If investors smell even a whiff of inflation, they will demand higher interest rates when the government attempts to roll over (reissue) the debt as it matures. And since so much federal debt is maturing within the next few years, it is very important to keep interest rates low in the short term. For a strategy of “inflating our way out of debt ” to work, we would need to have a much higher proportion of long-term debt to short-term debt. Indeed, we can ’ t infl ate our way home if infl ation causes us to roll over existing debt at much higher interest rates. Doing that just makes a bad problem even worse. Moreover, we also have TIPS bonds, which are Treasury bonds that adjust for inflation. These would react swiftly to a rise in infl ation since the principal amount on these bonds is adjusted for infl ation every six months. At this point, however, inflation-adjusted bonds (TIPS) account for only 7 percent of the total. The fact that 40 percent of outstanding Treasury securities will mature in 2011 sets the stage for the crisis. But in our view, the chain of events leading to a world stock market crash will start not in the United States, but rather in Europe.
● The Blind Spot: Science and the Crisis of Uncertainty
By William Byers
Summary via publisher, Princeton University Press
In today's unpredictable and chaotic world, we look to science to provide certainty and answers--and often blame it when things go wrong. The Blind Spot reveals why our faith in scientific certainty is a dangerous illusion, and how only by embracing science's inherent ambiguities and paradoxes can we truly appreciate its beauty and harness its potential.
Crackling with insights into our most perplexing contemporary dilemmas, from climate change to the global financial meltdown, this book challenges our most sacredly held beliefs about science, technology, and progress. At the same time, it shows how the secret to better science can be found where we least expect it--in the uncertain, the ambiguous, and the inevitably unpredictable. William Byers explains why the subjective element in scientific inquiry is in fact what makes it so dynamic, and deftly balances the need for certainty and rigor in science with the equally important need for creativity, freedom, and downright wonder. Drawing on an array of fascinating examples--from Wall Street's overreliance on algorithms to provide certainty in uncertain markets, to undecidable problems in mathematics and computer science, to Georg Cantor's paradoxical but true assertion about infinity--Byers demonstrates how we can and must learn from the existence of blind spots in our scientific and mathematical understanding.
● Climate Capitalism: Capitalism in the Age of Climate Change
By L. Hunter Lovins and Boyd Cohen
Excerpt via Reuters
The CEOs of the companies implementing greater sustainability in their business practices may not recognize it, but they are following the principles set forth a decade ago in this book's predecessor, Natural Capitalism. These principles have proved to be some of the best guides a company can use as it embraces sustainability in its own operations. They also represent a roadmap to a sustainable economy.
The first principle, buying time by using all resources as efficiently as possible, is cost-effective today and is the best way to address many of the worst problems facing humankind while delivering premium returns on investments. There are many smart companies implementing this principle, from measuring and managing their carbon footprints with the Carbon Disclosure Project, to Mi Rancho Tortilla's saving $175,000 a year by implementing efficiency measures because it knows it has to do so to meet Walmart's Sustainability Scorecard. It and the other small businesses participating in Natural Capitalism Solutions' "Solutions at the Speed of Business" program are enjoying returns on investment ranging from 100 percent to more than 600 percent.
● Money: Facts and Figures About Everyone's Favorite Thing to Do (Everything You Never Knew)
By Sandra & Harry Choron
Summary via publisher, Chronicle Books
Ever made a fast buck? How about traded cowrie shells for a bride or paid for gum with a $10,000 bill? This entertaining and information-packed miscellany explains our fascination with money and how it has shaped our world. Vintage photographs and artwork illustrate surprising facts, lists, and trivia about forgotten financial catastrophes and famous bank robbers, the history of bankruptcy and ancient money gods, wacky cash-related slang and get-rich-quick schemes for the ages. Witty and comprehensive, Money explores the one subject that really makes the world go round.
● Poor Economics: A Radical Rethinking of the Way to Fight Global Poverty
By Abhijit Banerjee and Esther Duflo
Review via The Economist
If it is a mistake to equate poverty and dependency, it is equally mistaken to believe the poor will lift themselves up by their bootstraps. The book crosses swords with the business gurus and philanthropists who project their own enthusiasm for Promethean entrepreneurship onto the poor. Yes, the poor are more likely to run their own business than the rest of us. But that is because they have no other choice. When asked, most of them aspire to a government post or a factory job. Developing countries are not full of billions of budding entrepreneurs; they are full of billions of budding salarymen. The authors also dissent from the “melancholy view” held by some economists, who argue that bad politics will always trump good policy. Why bother figuring out the best way to spend a dollar on education, when $0.87 will be diverted into the pockets of officials? These economists argue that you can’t do anything in a country with bad institutions—and you can’t do much about these bad institutions either. You just have to wait for a revolution.
April 21, 2011
Tactical ETF Review: 4.21.2011
The bulls are in control, according to our survey of ETF proxies for the major asset classes. As detailed below, sellers appear to be in the minority these days. The leading exception is found in U.S. bonds broadly defined, where a standoff between the bulls and bears drags on. Otherwise, optimism has broken out across the major asset classes. We’re not complaining, but a party that reaches into virtually every corner of the capital and commodity markets raises questions about what comes next. Let’s just say that this is a good time for rebalancing your portfolio. Whenever you can adjust the asset mix on your terms, it’s a good day. But gift horses don’t last forever, at least not in ample quantities. On the other hand, momentum is strong and it's usually a force to be reckoned with. In any case, let’s take a closer look at the party already in progress…
US STOCKS • Vanguard Total Market (VTI) • Benchmark: MSCI US Broad Market Index
The bulls have retaken the 50-day moving average line of defense for the second time this year...
FOREIGN DEVELOPED MARKET STOCKS • Vanguard Europe Pacific (VEA) • Benchmark: MSCI EAFE
A similar charge higher is underway in foreign developed-market stocks...
EMERGING MARKET STOCKS • Vanguard Emerging Markets (VWO) • Benchmark: MSCI Emerging Market
The skyward bias is even more pronounced in emerging market equities...
US BONDS • Vanguard Total Bond Market (BND) • Benchmark: Barclays US Aggregate
But the trend looks shaky for broadly defined investment-grade US bonds, where the 50-day moving average continues to trail the 200-day average...
INFLATION-INDEXED US TREASURIES • iShares Barclays TIPS Bond (TIP) • Benchmark: Barclays US TIPS
Inflation-indexed Treasuries, by contrast, are strong compared with conventional fixed-income securities...
HIGH YIELD BONDS • SPDR Barclays High Yield Bond (JNK) • Benchmark: Barclays High Yield Very Liquid
Technical strength is nothing new for junk bonds either...
COMMODITIES • iPath Dow Jones-UBS Commodity (DJP) • Benchmark: DJ-UBS Commodity
Commodities have had a strong run recently as well...
REAL ESTATE INVESTMENT TRUSTS • Vanguard REIT (VNQ) • Benchmark: MSCI US REIT
Meanwhile, the recent stumble in REITs looks like ancient history once more...
FOREIGN DEVLOPED MARKET GOVERNMENT BONDS • SPDR Barclays Int’l Treasury (BWX) •
Benchmark: Barclays Global Treasury ex-US Capped
In contrast with US bonds on the defensive, foreign fixed-income in mature markets is enjoying a nice run, thanks in no small part to the weakening dollar this year...
EMERGING MARKET GOVERNMENT BONDS • Van Eck Market Vectors Emg Mkt Local Currency Bond (EMLC) •
Benchmark: J.P. Morgan GBI-EMG Core
There's no shortage of buying in the land of emerging market bonds either...
FOREIGN GOVERNMENT INFLATION-LINKED BONDS • SPDR DB International Inflation-Protected Bond (WIP) •
Benchmark: DB Global Government ex-US Inflation-Linked Bond Capped
It's also safe to say that foreign inflation-linked bonds take a back seat to no one when it comes to rising markets of late...
FOREIGN CORPORATE BONDS • PowerShares International Corporate Bond (PICB) •
Benchmark: S&P International Corporate Bond
Finally, on the subject of technical strength, no one will confuse recent trading in foreign corporate bonds for anything less than a market dominated by the bulls...
Charts courtesy of StockCharts.com
April 20, 2011
The Power & Peril Of Rearview Mirrors
Investors shouldn't be slaves to market history, but neither can they afford to ignore the past. The thought comes to mind as I look through the new edition of the Ibbotson SBBI Classic Yearbook.
You can't see the future by looking in a rearview mirror, of course, but it's an exercise that's still essential. Historical context is a valuable ingredient for intelligently estimating risk premiums, but it's merely a starting point for making informed guesses about what's coming. The good news is that the Ibbotson SBBI Classic Yearbook makes this task a lot easier by presenting a large chunk of the key numbers clearly within a single volume.
You could spend the better part of a week poring over the statistical information in this book, although the data point that’s quoted the most is SBBI’s annualized total return of large-cap U.S. stocks (S&P 500) since 1926: 9.9% through the end of 2010. But as the book reminds, that return can and does vary dramatically over shorter periods.
For instance, in the decade that just passed (2001-2010), the annualized performance of U.S. equities was a spare 1.4%, a mere shadow of the long-run return for stocks. The comparison is even worse when you consider that the previous decade of the 1990s generated a stellar 18.2% annualized performance for U.S. equities.
Stocks may be winners in the long run, as Professor Jeremy Siegel argues in his best-selling book, but there's no guarantee that you'll receive a windfall (or even a positive return) from equities in shorter periods. And for those who think a decade is sufficiently long for defining "long term," the SBBI Yearbook is worth its price if only as a tool for outlook adjustment.
Meantime, recognizing the potential for trouble with an all-equity strategy encourages using asset allocation as a risk management tool. Here, too, the SBBI Yearbook offers some perspective with a simple benchmark that compares various combinations of U.S. stock/bond portfolios through time. As the table below shows, holding bonds and stocks delivered higher returns in the past decade compared with an equities-only strategy. A 50/50 mix, for instance, earned 4.7% a year, well above the pure stock portfolio’s 1.4%.
One of the key questions with asset allocation is estimating how the risk-return tradeoff will play out going forward based on varoius assumptions. Once again, history offers a clue, but it's not necessarily fate for the period ahead. Even so, it’s a useful place to start the analysis.
Using Ibbotson data, consider how portfolio volatility (annualized standard deviation of return) changes with performance, as illustrated in the chart below. The basic message: adding bonds to a portfolio of stock lowers volatility, or so the track record since 1926 shows. But in contrast to the last 10 years, which offered the unusual profile of lower volatility and higher return by holding bonds and stocks, the past eight decades suggest that lowering volatility also pares return. The 2001-2010 experience, it seems, was the exception. That inspires caution for assuming that adding bonds to a stock portfolio will always lower volatility and increase return.
Another variable to consider is rebalancing. Based on the Ibbotson data, rebalancing a stock/bond portfolio reduces volatility but at a cost of reducing return, albeit in varying degrees. For example, in the chart above, a rebalanced 50/50 mix of stocks and bonds earned 8.2% a year since 1926 with a volatility of 11.4. By comparison, an unrebalanced 50/50 mix (i.e., a portfolio that was evenly divided but then allowed to drift with the market) earned a modestly higher 9.0% a year, albeit at a slightly higher risk of 15.9.
Was the higher return worthwhile for the extra risk? There are no easy answers for the simple reason that each investor's asset allocation should be customized to satisfy a range of factors, including age, risk tolerance, net worth, investment horizon, etc.
Let's remember too that the rebalancing history in the SBBI Yearbook is merely a benchmark, and a simple one at that. Rebalancing is a critical factor for designing and managing investment portfolios, but its effects vary considerably, depending on the asset classes, the time period and the frequency of the rebalancing.
In fact, it’s best to take history with a grain of salt with rebalancing studies. It’s important to study the past and understand why and how it delivered a particular risk-return profile, but the real insight comes primarily from studying the individual asset classes. But even this productive road only brings you so far. The danger is thinking that the future will deliver something comparable. There’s a case for extrapolating the past as a forecast of the future, but only as a prediction for the very long run using broadly defined asset classes and asset allocation strategies. And even that prediction is questionable, although less so relative to the short run. Indeed, periods as long as 10 to 20 years can be surprising, as the last decade painfully reminds.
The only intelligent application of historical market data is using it as a foundation on which to build estimates of risk and return with a variety of tools. Indeed, looking at long-run summaries of the past imply that returns and risk are static. In reality, expected return and risk jump around, sometimes dramatically over short periods. The central issue in asset allocation is getting a handle on how those jumps will play out for the foreseeable future.
The good news is that there are lots of research and financial models to help develop relatively robust forecasts. The bad news is that history, intriguing as it is, is of limited value for looking ahead. That doesn’t mean we can ignore history. But those who depend heavily on history as an excuse for not doing the hard work of projecting risk premiums by using additional tools are probably destined for disaster.
April 19, 2011
A Rebound In Housing For March, But The Old Challenges Still Apply
Today’s update on housing construction and newly issued building permits for March brings some welcome news after the sharp declines of February. But let’s not kid ourselves: the housing market is still depressed on several fronts and today’s numbers don’t really change much. What they do suggest is that residential real estate has found a bottom. That’s not much, but it’s an improvement over the dire outlook implied by February’s reports.
Privately-owned housing starts rose 7.2% last month at a seasonally adjusted annual rate. A respectable gain, but it still pales next to February’s nearly 19% loss. Building permits popped by more than 11% in March, the first gain for 2011. Nonetheless, as our chart below reminds, this all looks like noise in the broader trend: a housing market that’s merely coming to terms with the post-boom era of sharply lower levels of real estate development.
The fundamentals of the market continue to keep a lid on the sector's growth, and that’s not likely to change soon. This has been written about to death so there’s no point in revisiting the details again. Suffice to say, the unusually ample supply of houses for sale is a strong disincentive to bring new homes on the market. Working off that inventory is going to take years--even at this late date. Sure, there’ll be periods of growth at the margins and eventually a broad upswing will take root. But as a general trend, housing’s likely to tread water for the foreseeable future.
The good news is that the longer the trend in housing starts and permits move sideways, the higher the odds that the correction in real estate really is history. Today’s numbers offer a bit more reason for thinking optimistically. For the moment, however, that’s about much blood as you can squeeze out of this stone.
If you’re really disposed to see the glass as half full, perhaps you expect that housing starts and building permits are set to make some modest progress over the next year or so in climbing out of their respective holes. But much depends on how the economy fares in general, and the labor market in particular. Recent reports suggest reason for mild optimism with job creation, but here too the outlook calls for much less than what's needed to repair the damage quickly from the Great Recession.
Meanwhile, early clues of an approaching rebound in real estate worthy of the name will be conveyed in prices. “We’re going to have to see an extended period of stable prices before we see a meaningful pickup in sales, and we need to see a good pickup in sales before we see active building,” reminds Michael Moran, chief economist at Daiwa Capital Markets America.
Hope springs eternal, but it’s not obvious that prices are set to stabilize, much less rise. Fortunately, the lack of a revival in real estate’s fortunes haven't derailed the broader economy’s revival. As such, the expectation that the danger of a new drop in the housing market is receding is more than a statistical curiosity.
For the time being, that’s about as good as it’s likely to get when it comes to housing. Of course, if you’re a buyer, this is a golden age. Then again, if recent suffering in the housing market hasn’t brought higher prices by attracting buyers, it’s hard to imagine what will given the current realities of the macro outlook.
April 18, 2011
Another Review of Dynamic Asset Allocation
The March/April 2011 issue of the Financial Analysts Journal carries a review of my book, Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor. The reviewer is one Martin Fridson, global credit strategist at BNP Paribas Investment Partners. What does Fridson think of my modest effort? Judge for yourself by reading the review here.
The Big (Gasoline) Pinch
The sharp rise in gasoline prices over the past year has all but eaten up the payroll tax cut enacted late last year, advises Goldman Sachs via Fortune.com. The risk is that the ascent of fuel costs cuts sharply into consumer spending, which has been buoyant lately. “A key reason for concern is the sharp rise in gasoline prices so far in 2011 — nearly 70 cents per gallon — which is siphoning off household income at a run rate equivalent to $100 billion per year," notes Goldman economist Andrew Tilton.
With the demand boost from the summer driving season just around the corner, some analysts warn that even higher prices may be coming. The question is how deeply gasoline prices bite into consumer finances? Prices are one signal in searching for an answer, and by that standard Joe Sixpack is spending the most on gasoline these days since the summer of 2008. Average regular gas prices in the U.S. were $3.791 a gallon last week, the Energy Information Administration reports--a rise of more than 90 cents a gallon from a year ago.
We can also look at retail gasoline station sales as a percentage of total retail sales for context. As you might expect, that measure has been rising too. As the chart below shows, sales of gasoline stations grabbed 10.7% of total retail commerce in the U.S. last month—the highest since October 2008. For perspective, the chart also tracks several other major categories of retail spending as a percentage of total retail activity.
The issue is deciding if rising fuel costs will divert enough retail spending away from other sectors of the economy to trigger slower growth or even recession. The answer, of course, lies in the future price of gasoline. Higher gas prices have “a measurable impact on the economy,” U.S. Treasury Secretary Tim Geithner said yesterday and so the economic recovery is “modestly” slower. He added, however, that “it’s an impact we can withstand, we can absorb, because the economy itself is still gradually getting stronger.” But if gasoline prices keep rising, it may be time to reassess Geithner's optimism.
This much is clear: Higher energy costs inevitably bring changes in consumer habits. "In 2008 we spent 12 months with gas above $3" and consumers reacted, reminds David Portalatin of NPD Group, a consumer research firm. "Nearly half reduced their gas consumption by consolidated shopping trips, 29 percent cancelled or modified vacations, 25 percent found alternatives to driving. The more sustained price spike, the greater the impact."
Short of a dramatic drop in fuel prices in the near future, it’s a safe bet that Joe Sixpack’s behavior will adjust to higher gas prices. Exactly what that means is to be determined, but change in some degree is almost certainly coming.
Strategic Briefing | 4.18.2011 | Small Cap Equities
Are Small Caps Too Pricey?
The Wall Street Journal | Apr 18
The market's smallest stocks are commanding the largest premiums—and some of their biggest fans are becoming alarmed. The Russell 2000 Index, which comprises about 2,000 stocks with small market capitalizations, is within about 2% of a record closing high. It is a milestone that it looks destined to reach well before larger peers such as the Dow Jones Industrial Average and the Standard & Poor's 500-stock index, which are off their record highs by 13% and 16%, respectively. Small companies now command the widest premium over large-cap stocks in at least a generation, based on the ratio of price to earnings.
Small-cap investors pay too much for risk
MarketWatch | Apr 15
Watch out for small caps. That’s the latest warning from legendary fund manager Jeremy Grantham, chairman of fund shop GMO and one of the few people who successfully called the 2008 crash in advance. His firm’s latest calculations predict that investors in U.S. small-cap stocks will actually lose about a fifth of their money in real terms over the next seven or so years. That’s an annualized loss of about 2.8% after inflation. As always when it comes to predictions, there are no guarantees. But GMO’s forecasts have a good track record.
On the Money: Small cap outlook - fundamentals, economy and expectations are up
BizTimes (Joe Frohna, 1492 Capital Management) | Apr 15
Despite prognostications by market soothsayers that the run for small cap stocks is over, we remain bullish and believe that 2011 economic data and corporate profits will exceed expectations. Small cap outperformance cycles generally last 5.9 years on average, and we’re only two years into this cycle. Despite near-term headwinds like Japan’s earthquake disaster and rising oil prices due to Middle East unrest, there are many offsetting positives like rebounding fund flows, robust GDP growth, accelerating M&A activity and, ultimately, the $300 billion repair of northern Japan. Based on 3-5 percent GDP growth, our expectation for 2011 small cap stock returns is a 10-15 percent range. The average annual small cap return when GDP growth falls in this range is 17 percent in nine prior occurrences dating back to 1932. Based on our recent research, parts of the economy are booming (e.g. industrials). There are still stimulative forces at work, and all signs point to an accelerating, self sustaining economy.
1Q fund returns: More of the same, and think small
Associated Press | Apr 7
Small-cap stocks — generally, companies with a market value of $300 million to $2 billion — tend to be among the first to rise when the economy rebounds. They've also benefited from low-interest rates. The smaller the company, the more likely it is to depend on borrowing, and low rates can really help a bottom line. But small-cap gains have lifted the prices of those stocks so much that they now appear expensive compared with large-cap stocks, based on the profits they're expected to generate. That's a key reason why Chris Jones, a stock strategist with J.P. Morgan Asset Management, believes large-caps are overdue to retake the lead from small.
Jolley Asset Management | Spring 2011
Small caps appear rich to us at over 21 times forward earnings versus around 14 times forward earnings for the S&P 500 index. Other than chasing beta (Russell 2000 beta approximately 1.2 times), we don’t see the attraction. The larger capitalization companies have better balance sheets, better global growth prospects and better dividend yields. However, we must understand that much of what is going on today is about speculation and trading rather than investing which is based on fundamental analysis.
April 15, 2011
Book Bits For Friday: 4.15.2011
● Boombustology: Spotting Financial Bubbles Before They Burst
By Vikram Mansharamani
Interview with author via The Leonard Lopate Show
Vikram Mansharamani, lecturer at Yale University and a global equity investor, explains how to identify unsustainable booms and forthcoming busts. Boombustology: Spotting Financial Bubbles Before They Burst gives an in-depth look at several major booms and busts and shows how to identify upcoming financial bubbles and the tell-tale signs of a forthcoming bust.
● Money and Power: How Goldman Sachs Came to Rule the World
By William D. Cohan
Review via The Economist
Once upon a time, the evening before a long Memorial Day weekend, a senior partner of Goldman Sachs kept 40 new recruits waiting in a conference room for five hours, until 10pm, just to teach them the value of patience. The three who left early, overcome by the urge to begin their holidays, were sacked days later. Pointless cruelty? Or a simple way to communicate the corporate culture? The paradoxical message of William Cohan’s compelling history of the world’s most envied and—recently at least—most pilloried securities firm is that much of what Goldman does seems to warrant admiration and opprobrium in equal measure. There is no starker example than the role it played in the global credit crisis when it dodged the bullets that floored many rivals, but did so by cashing in on others’ misery and pushing the bounds of ethics.
● Ben Graham Was a Quant: Raising the IQ of the Intelligent Investor
By Steven P. Greiner
Excerpt via publisher, Wiley
Why is alpha so earnestly sought after in modern quantitative investment management? Alpha is the legacy of focus by most analysts and portfolio managers as ordered by chief investment officers (CIOs) because of the history of the field of investment management. In the early days, analysts performed portfolio management, and management meant reading, digesting, and regurgitating balance-sheet information. Prior to 1929, the assets of a firm were the most important consideration, and stock selection was predominately based on how good the book value was. Later, after the 1929 crash, earnings becamemore important, and Graham, in an article in Forbes, said value has come to be exclusively associated with earnings power, and the investor no longer was paying attention to a company’s assets, even its money in the bank. In addition, these early analysts believed (some still do today) that they were ascertaining, by their fundamental analysis, a company’s alpha simultaneously with its risk, and to a certain extent that was true. However, those early analysts never ascertained the co-varying risk this way, only the company-specific risk. This is because the typical fundamental analyst thought of individual companies as independent entities. There was a natural tendency to view investments in isolation, and not to think of the portfolio as a whole or of risks due to co-ownership of several correlated stocks.
● Treasure Islands: Uncovering the Damage of Offshore Banking and Tax Havens
By Nicholas Shaxson
Interview with author via Democracy Now!
As millions of Americans prepare to file their income taxes ahead of Monday’s deadline, we look at how corporations and the wealthy use offshore banks and tax havens to avoid paying taxes and other governmental regulations. "Tax havens have grown so fast in the era of globalization, since the 1970s, that they are now right at the heart of the global economy and are absolutely huge," says our guest, British journalist Nicholas Shaxson. "There are anywhere between $10 and $20 trillion sitting offshore at the moment. Half of world trade is processed in one way or another through tax havens." Shaxson is the author of the new book, Treasure Islands
● Oil's Endless Bid: Taming the Unreliable Price of Oil to Secure Our Economy
By Dan Dicker
Interview with author via CNNMoney
At this time last year, the nationwide average price for a gallon of unleaded was $2.83. That means that gas prices have gone up 87 cents, or 30%, over the last 12 months. "It's pretty bad and it's likely to get worse," said Dan Dicker, an oil trader for 25 years and author of "Oil's Endless Bid: Taming the Unreliable Price of Oil to Secure Our Economy." Dicker said the nationwide average price for gas could hit $4 again "if we get the regular kind of demand that we get during the summer driving season."
Are We At The Upper Range For "Safe" Inflation?
For the second consecutive month, consumer price inflation rose by 0.5% last month on a seasonally adjusted basis, the Labor Department reports. That’s the highest monthly rate in nearly two years. Higher energy and food costs are the key drivers for the higher inflation. In a world where inflation is bubbling around the globe—in China and India, for example—today’s news on U.S. inflation can’t be dismissed. But neither should today's U.S. numbers be overstated.
Although the consumer price index (CPI) rose at a relatively high pace last month, it’s still well within the range we’ve seen in recent years. Meanwhile, core inflation (CPI less food and energy prices) actually dipped in March. Unless you’re expecting a sustained rise in food and energy prices from here on out, then there’s a case for arguing that inflation’s not set for a dramatic upside breakout.
Let’s keep in mind too that monthly CPI numbers can be misleading if we're trying to get a handle on what's coming in the next several years. That inspires reviewing the longer-term trend instead. On that front, rolling 12-month changes in headline and core CPI still look quite modest in terms of the ranges for the past decade, as the second chart below shows. But let’s be clear: the margin for comfort is fading for tolerating ongoing increases from current levels.
That brings us back to commodities, the primary source of the recent pop in inflation in recent months. To some extent, the higher inflation is healthy because it represents a rebound from the deflationary pressures of the recent past. But too much of a good thing can turn ugly... eventually. The bottom line: the rise in commodities prices will keep everyone wary until it stops and/or reverses.
History suggests that the rising commodities prices of late will cease and desist at some point. Indeed, the long-term expected return on commodities is more or less zero, and for good reason. But commodities are a volatile lot and in the short-to-medium term there’s ample opportunity for sustained price momentum. Nonetheless, numerous studies show that forecasting inflation tends to benefit from looking at core inflation readings, but that’s always a questionable affair in real time, especially these days, when political volatility in the oil-rich Mideast is roiling confidence about future supplies of crude.
A number of analysts say that much of the rise in energy prices is due to the temporary influence of speculators. Perhaps, but there may be fundamental reasons for the higher oil prices as well. A research report today from Neil Beveridge and Liang Zhang at Bernstein Research focuses on this point by noting that OPEC’s global spare capacity has dropped sharply this year.
“The elimination of Libyan exports effectively takes us back to the same spare capacity levels last seen at the start of 2008,” the Bernstein analysts write. “How permanent this disruption will be is impossible to predict, although damage to Libyan oil infrastructure suggests that even in the event of hostilities ending it will take some time before exports are fully restored to pre-war levels.”
It seems that we’re at a critical juncture for inflation. The market’s forecast for inflation, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries, inched higher to 2.62% as of yesterday. That’s a hair above the previous peak set back in July 2008, on the eve of the financial crisis and during the all-time high in oil prices. That raises the question today: Are inflation pressures set to roll higher? Or will the cyclical aspect of commodities prices save us at the 11th hour? No one can be sure either way, which is why the coming weeks and months may be precarious.
The risk is that the Fed is forced to raise interest rates prematurely. That may please inflation hawks, but the potential for trouble is clear. The nominal Fed funds rate is still close to zero, yet the outlook for economic growth is still modest, at best. Higher interest rates aren't likely to to boost GDP projections, and tightening may even pare expectations by more than a little. We're not at the rock and the hard place yet, but it's a bit harder to dismiss the possibility.
April 14, 2011
New Jobless Claims Unexpectedly Rise Above 400k
New filings for jobless benefits rose by 27,000 on a seasonally adjusted basis last week—the biggest weekly increase in nearly two months. New claims, as a result, moved above the 400,000 mark for the first time in five weeks. It all adds up to a disappointment, but it’s too soon to wave the white flag. This is a volatile series and so no one should read too much into any one number. Meanwhile, the four-week moving average is still well below 400k, and so it’s not obvious that the recent downtrend has been broken.
Still, there’s no getting around the fact that economists were expecting a much lower figure. As Bloomberg reports, “Economists projected claims would be little changed at 380,000, according to the median estimate in a Bloomberg News survey. The increase in claims traditionally seen at the end of a quarter was larger than usual this year, a Labor Department spokesman said as the figures were released to the press.”
Stephen Stanley, chief economist at Pierpoint Securities, advises that “the Labor Department is attributing the rise [in jobless claims] to the turn in the calendar quarter but that is something that it should have accounted for. You just have a wait-and-see whether the weekly claims figure stays above 400,000. If you see that, then it would be worrisome,” he notes via Reuters.
3,768 Estimates Of The US Equity Risk Premium
What's the outlook for the excess return on US stocks over the "risk free" rate? The answer varies with the forecaster, of course. For some insight into how much the estimates of the equity risk premium vary, two finance professors and an assistant recently polled thousands of professors, economists and assorted analysts and companies via email, receiving 3,768 responses with specific forecasts for 2011. Among the findings, detailed in a new working paper: the average risk premium "used by professors and companies is higher than the one used by analysts."
The average estimate from the professors anticipates a risk premium of 5.7% for 2011. That compares with a forecast of 5.6% from respondents at "companies" and 5.0% from "analysts," according to "US Market Risk Premium used in 2011 by Professors, Analysts and Companies: a survey with 5.731 answers," authored by a pair of professors at the IESE Business School in Madrid.
The estimates from professors and analysts are slightly lower, on average, than their 2010 predictions, as reported in a preceding survey. By contrast, companies overall forecast a slightly higher risk premium for 2011 vs. last year.
Unsurprisingly, the new survey's main result is that "there is a lack of consensus among professors, analysts and companies about the magnitude of [the equity risk premium] for USA," the authors note. A key reason seems to be that the source material for estimating the excess return on stocks draws on a wide spectrum of methodologies. The paper asked about books or articles that are used in support of a given estimate. The answers stack up as follows:
Is estimating the equity risk premium an art or a science? Actually, it's both! The trick is figuring out which one dominates, and by how much.
Finally, a bit of historical perspective on what's actually unfolded in the market. For the decade through the end of 2010, the realized premium on US stocks is an annualized 1.37%, according to Professor Aswath Damodaran at the Stern School of Business at New York University. Ouch! Since 1961, the premium is a more reassuring 5.83%; since 1928, the annualized premium jumps to 7.62% through the end of last year. Anyone want to take a guess as to which slice of history applies from here on out? Or, perhaps you have a completely different forecast? If so, a team of professors in Madrid may be interested.
April 13, 2011
Another Pitch For Nominal GDP Targeting
The idea that the Fed's monetary policy should focus on stabilizing the growth rate of nominal GDP has been discussed at length by several economists since the Great Recession delivered an attitude adjustment in the land of macro. In fact, it's an idea that's been around in formal terms at least since the 1980s. But it's not obvious that there's any progress at the central bank, or in policy circles generally, for moving toward this worthy strategy, and so supporters of the concept keep on talking (and writing). The latest comes from David Beckworth, who lays out the reasoning in a concise essay in National Review.
Beckworth explains that
The simplicity of this approach can be illustrated by considering how the Federal Reserve would have responded to the sharp downturn of 2008–09 had it been targeting nominal GDP. During this time, the financial system was in distress and, as a result, there was a rush for liquidity. The rise in demand for highly liquid assets meant less spending and a drop in economic activity. Had the Federal Reserve been targeting nominal GDP at this time, it would have provided enough liquidity to fully offset the spike in liquidity demand. Such a response would have stabilized actual and expected nominal-GDP growth in 2008–09 and prevented the collapse of the economy. It is that simple.
The current Fed policy could be described as a type of ad-hoc approach that leaves plenty of room for confusion in the markets as to what the central bank is planning, or not, at any given moment. That's not a problem normally, but the stakes are high in times of financial crises a la September 2008. A nominal GDP target would go a long way in keeping the confusion to a minimum, and at the same time optimize the Fed's efficacy in keeping recessions from turning into disasters.
At its core, nominal GDP targeting is really just an extension of the practical realities of macro. Brad DeLong notes that the details on "how government can intervene strategically in financial markets to stabilize nominal GDP has been the subject of a lot of work--Tobin, Friedman, Kindleberger, Minsky, Hicks, Keynes, Fisher, Wicksell, Bagehot, John Stuart Mill." He goes on to advise,
The government provides liquidity, safety, and duration by guaranteeing stuff and by buying stuff and issuing its own liabilities in return. The government has to, as Bagehot put it, "lend freely"--and not just lend but buy--and in order to avoid enabling moral hazard for the next time the government has to lend at a penalty rate: and if institutions are not illiquid but insolvent so that the government cannot lend at a penalty rate the government must take equity.
Targeting nominal GDP isn't a silver bullet, and much depends on who's running a central bank. But even economists who find glitches aren't keen on rejecting it outright, if at all. For example, a 1989 study, finds much to like with nominal GDP targeting despite the warts.
But ours is an imperfect world and so waiting for perfection isn't an option. Perhaps it's best to call GDP targeting a poor choice, but one that's less poor compared with the alternatives. Accordingly, the question is whether the Fed could be doing a better job in matters of monetary policy. The answer is almost surely "yes." In that case, the burden is on critics of nominal GDP targeting to explain why adopting this policy isn't reasonable.
Skeptics can start with Paul Krugman's complaint: "targeting nominal GDP growth at some normal rate won’t work — you have to get people to believe in a period of way above normal price and GDP growth, or the whole thing falls flat."
Then again, the Fed could state its committment to the policy and back it up with action. In time, the makets and the public would believe. That wouldn't happen overnight, but with the right leadership it's certainly possible.
Why, then, hasn't the Fed adopted GDP targeting? Arnold Kling ponders some possibilities:
(a) They do not want to be embarrassed if they are unable to hit a target
(b) This is what Tyler Cowen would call a Straussian situation, in which the insiders must never reveal their true agenda, or horrible demons will be let loose, leading to social breakdown and bloodshed.
(c) They fear that announcing a target would create "lock-in" and cost flexibility.
(d) A target would make many of the departmental functions and rituals (such as FOMC meetings) long cherished at the Fed seem pointless.
(e) The Fed is institutionally more concerned with the stability and profitability of the banking system than with macroeconomic variables.
Retail Sales Rise Again In March
Retail sales for March continued to climb, the U.S. Census Bureau reports. In fact, last month’s seasonally adjusted 0.4% rise in U.S. retail and food services sales was the ninth consecutive monthly increase.
March’s gain was the smallest advance since the upward momentum began, but the positive trend is still intact. Does that make it easier to answer “yes” to the question we posed yesterday on the broad economic trend: “Will The Growth Momentum Last?” One reason for staying cautious on responding: after deducting sales figures from gasoline stations last month, retail sales edged up a scant 0.1% in March.
But let’s recognize too that oil prices fell sharply yesterday, and so the energy pinch may ease up in the weeks and months ahead. Even before the retreat in commodities prices, there was still reason for optimism. "It does look like the consumer is hanging in there in the face of higher energy prices,” Nicholas Colas, chief market strategist at the Convergex Group, tells Reuters. “That they wouldn't was everyone's concern."
State Street's senior fixed-income strategist agrees. "The consumer was more resilient in March than some of our concerns," John Herrmann advises via Bloomberg. "Improving labor-market conditions are helping support consumption. This is a very impressive pace of spending, with gains across a diverse range of products," he says.
Nonetheless, most of March’s economic reports still lie ahead and so it’s unclear how the full economic profile for last month will unfold. The good news is that the numbers that have been released so far are encouraging, including the news from the jobs front. Private nonfarm payrolls posted a relatively strong rise last month. Meanwhile, average weekly hours worked for production and nonsupervisory employees inched higher in March to 33.6—the highest since September 2008. The labor market is far from healed, but the modest rebound of late appears to be rolling ahead.
There are also signs that bank lending continues to revive, albeit from depressed levels. The total of reported commercial and industrial loans at large banks was nearly $630 million for the week through March 30, according to the Federal Reserve. That’s 1.5% higher from a month earlier and 2.8% above levels from a year ago, offering more evidence that economic activity continues to improve, if only marginally.
If there’s a joker in the deck, it may show up in tomorrow’s weekly update on initial jobless claims or Friday’s news on consumer price inflation for March. The consensus outlook among economists for both reports, however, calls for little or no changes from the previous numbers, according to Briefing.com.
Steady as she goes…
April 12, 2011
Commodity Prices & Inflation. How Stong Is The Link?
Do big increases in commodity prices always lead to sharp increases in inflation? And while we're pondering the topic, does a large drop in commodity prices invariably trim inflationary pressures? On both counts the answer is... no. Or so a new research essay from the Chicago Fed argues.
In particular, the article reports: "Clearly, higher prices of food and energy end up in the broadest measures of consumer price inflation, such as the Consumer Price Index. Since the mid-1980s, however, sharp increases and decreases in commodity prices have had little, if any, impact on core inflation, the measure that excludes food and energy prices."
That's no guarantee that the surging commodity prices of late won't trigger higher inflation this time. But at least we can say this much with some degree of confidence: A jump in commodity prices doesn't automatically lead to higher inflation. That's no excuse to stop monitoring inflation's ebb and flow, but it's a reminder that commodities markets alone don't dictate broad pricing trends. The details of monetary policy matter too, and quite possibly dominate the future path of inflation.
What's the glitch? Critics will no doubt argue that core inflation is bogus. Perhaps, although there's been quite a few studies over the years (including some from economists outside the Fed) that show that core inflation is a pretty good predictor of headline inflation down the road.
Will The Growth Momentum Last?
Small business confidence slipped last month, based on a report released today by National Federation of Independent Business. “It looks like everyone became more pessimistic in March,” said NFIB chief economist Bill Dunkelberg in a statement. “Or, perhaps, this is a ‘new normal’ and we are unlikely to see the surges usually experienced at the start of a recovery... Today’s recession-level reading is, all in all, a real disappointment.”
Is more disappointment coming for the economy overall? It's unclear, although there's a bit more reason for keeping the debate bubbling these days. The uncertainty can be blamed in no small part on the rise in oil prices in recent weeks, and the fallout seems to be infecting more than small businesses. Consumer sentiment in March, for instance, stumbled, partly due to higher gasoline costs.
But don't throw in the towel just yet. The last full month of economic reports (February) suggests that growth, while taking some hits, still has the upper hand, or at least a robust defense. The main drag is the housing market, which is no trivial factor. But it's not yet obvious that the weakness in real estate will torpedo the broader economy. Indeed, the optimistic view is that the economy has continued to expand despite the troubles in housing.
The broad trend certainly remains positive on a rolling 12-month basis, which offers some insulation from the fallout in housing...
But the question is whether the revival in economic fortunes is under pressure for the foreseeable future. Not necessarily, or so the early clues about March’s economic profile imply. Initial jobless claims, for instance, are still trending lower. Another hopeful sign: the labor market continues to mint new jobs in the private sector. The ISM Manufacturing Index for March also suggests that the economy will continue growing.
For the moment, fund managers are willing to give the recovery the benefit of the doubt. As Reuters reports today:
Investors pumped up their exposure to stocks in early April despite some concern that global growth will tail off, a Bank of America-Merrill Lynch poll showed on Tuesday. The investment bank's monthly survey of 282 fund managers found a net 50 percent to be overweight in equities compared with a net 45 percent in March. Cash holdings dropped to a net 10 percent overweight compared with 14 percent a month earlier. Bonds continued to be unpopular with a net 58 percent underweight, albeit a slight improvement from March's 59 percent. The growing risk appetite reflected by these numbers, however, comes against a backdrop of easing expectations about the global economy.
Update: There was an error in the original chart of the rolling annual percentage changes in the CS Economic Indices. A revised chart with the correct data has been posted.
Strategic Briefing | 4.12.2011 | Energy Prices & The Economy
Despite New Risks, Global Recovery Seen Gaining Strength
IMF World Economic Outlook | April 11
World real GDP growth is forecast to be about 4½ percent in 2011 and 2012, down modestly from 5 percent in 2010. Real GDP in advanced economies and emerging and developing economies is expected to expand by about 2½ percent and 6½ percent, respectively. Downside risks continue to outweigh upside risks. In advanced economies, weak sovereign balance sheets and still-moribund real estate markets continue to present major concerns, especially in certain euro area economies; fi nancial risks are also to the downside as a result of the high funding requirements of banks and sovereigns. New downside risks are building on account of commodity prices, notably for oil, and, relatedly, geopolitical uncertainty, as well as overheating and booming asset markets in emerging market economies. However, there is also the potential for upside surprises to growth in the short term, owing to strong corporate balance sheets in advanced economies and buoyant demand in emerging and developing economies.
IEA: Oil Market to Tighten Further
The Wall Street Journal | April 12
The oil market looks set to tighten further this year, with oil inventories shrinking as supply disruptions and political tensions in the Middle East and North Africa look set to persist for months, the International Energy Agency said Tuesday. However, although today's supply picture could imply rising prices, there are preliminary signs that the current high cost of oil may already be reducing demand growth, the IEA said. "The surest remedy for high prices my ultimately prove to be high prices themselves," it said.
Gas Prices Rise, and Economists Seek Tipping Point
The New York Times | April 11
Gas prices are approaching record highs, but so far most Americans do not appear to be drastically cutting back their driving or even their spending as they did in 2008. The question, economists agreed, is what happens if prices continue to go up and remain high. Prices for a gallon of regular unleaded gas are topping $4 at more service stations nationwide, revisiting the bleak territory of three years ago, when the average price for a gallon of regular gas reached a peak of $4.11 on July 17, 2008, according to the Oil Price Information Service... “Once we cross the $4 threshold, the pain will become more palpable, and it is going to show up more noticeably in the reduction in future consumer spending,” said Bernard Baumohl, the chief global economist for the Economic Outlook Group. He predicted that “spending on discretionary goods will be diminishing as the price of gasoline keeps moving higher.”
Rising oil prices beginning to hurt US economy
Associated Press | April 12
Just when companies have finally stepped up hiring, rising oil prices are threatening to halt the U.S. economy's gains. Some economists are scaling back their estimates for growth this year, in part because flat wages have left households struggling to pay higher gasoline prices. Oil has topped $108 a barrel, the highest price since 2008. Regular unleaded gasoline now goes for an average $3.69 a gallon, according to AAA's daily fuel gauge survey, up 86 cents from a year ago... "The surge in oil prices since the end of last year is already doing significant damage to the economy," says Mark Zandi, chief economist at Moody's Analytics.
The New Yorker | April 11
High oil prices are generally bad for the U.S.—oil spending goes largely to foreign producers, leaving less money for American goods and services—but if you look just at the dollars involved the terror they inspire is somewhat mysterious. Gas is a relatively small percentage of most household budgets, and prices are now about eighty-five cents a gallon higher than they were twelve months ago, which translates into a few hundred dollars more a year. That’s not trivial, particularly for lower-income Americans, but it’s not devastating. In fact, it’s less than the increase in income that most Americans will get this year as a result of the new payroll-tax cut.
Still, few things loom as large in the public imagination as gas prices, which have an unusual, and much studied, ability to make people feel poorer. Last month’s drop in consumer confidence was attributed almost entirely to the spike in gas prices, in line with a 2007 study, by the economists Paul Edelstein and Lutz Kilian, showing that spikes in oil prices have often depressed public sentiment in the past.
As OPEC sleeps, oil nears the tipping point
MSN Money | April 11
The trouble is OPEC -- the cartel that holds the world's spare production capacity -- doesn't seem worried as soaring crude oil pushes the economy to the brink. Consumer confidence is already plunging fast. Instead of reassuring statements and a proactive policy stance, we're getting just the opposite. Iraq's deputy prime minister, along with the oil minister of the United Arab Emirates, indicated to a conference in Paris recently that OPEC saw no need to respond the latest price rise by increasing output. The minister, Hussain al-Shahristani, said, "We have not seen any serious impact on world growth." And thus, they don't feel like they need to act, since oil at $113 only further pads the coffers of oil producers in the Middle East and elsewhere. Deutsche Bank economists have flagged oil at $125 a barrel as the economy's breaking point, a level that would push us back into recession. We're getting awfully close. Nigeria is the flashpoint that could send us over the edge. Presidential elections are due there on April 16 and gubernatorial elections on April 23. Barclays Capital analyst Helima Croft notes that this year's election is "proving to be more polarizing along regional and religious lines than past contests." And given that the past two elections -- in 2003 and 2007 -- were marred by rises in oil thefts and attacks on oil pipelines and other infrastructure, it's likely that we will see similar violence in the days to come.
April 11, 2011
Eyes On The Prize
It’s difficult to exaggerate the significance of estimating expected returns in the quest for long-term investment success. An obvious statement, perhaps, but the widespread evidence that many (most?) investors earn unecessarily low or even negative returns over time suggests that the focus on expected returns falls well short of practical necessity.
Yet the fact remains that developing robust performance forecasts--and acting on the information--is essential, perhaps on par with risk management. As Cliff Asness writes in the introduction to Antti Ilmanen’s newly published Expected Returns: An Investor's Guide to Harvesting Market Rewards, “...the study of expected returns deserves more of our attention.” The smoking gun that supports this counsel is the recognition that during 2000 and again in 2008 “investors were willing to accept far too low an expected return...”
Projecting expected returns is difficult, of course, and so there's no silver bullet here. There’s also the problem of time horizon, which can be a distraction for clear thinking on the subject. As Asness notes, “Good forecasts of expected return add up over the long term, but don’t matter for squat next week.”
The good news is that there’s no shortage of opportunity for developing robust estimates of future returns, as llmanen’s book reminds. In fact, the empirical and theoretical foundation for thinking that returns are partly predictable under certain conditions is more than marginal. As Professor John Cochrane points out in a magnificent survey of how financial economics has evolved over the last 40 years: the “pattern of predictability is pervasive across markets.” Why? “Asset prices should equal expected discounted cashflows flows.” You can't count on that truism to pan out next month, or even next year. But there’s a fair amount of historical evidence for anticipating no less as a general proposition through time.
The techniques for predicting returns are varied and the interpretations of how to apply them are vast, but we can start with some basic observations. Perhaps the first “fact” is that historical performance varies. If returns were completely random, there would be little point to estimating expected returns. But decades of research, along with simple observation, tells us otherwise.
The empirical record also shows that dividends and other fundamental metrics sometimes hold clues about expected returns. For example, consider how trailing dividend yield varies with subsequent 10-year performance on the S&P 500 through time:
Is the apparent connection a coincidence? Unlikely. Markets make mistakes in the short run, but eventually there are very few if any inefficiencies to exploit over, say, 10-year spans. Risk and return are related in something approximating the predictions embedded in modern finance when measured over long stretches.
Simple historical returns may also provide clues about the future. Monitoring how asset classes perform relative to one another, for instance, can provide useful context. As an example, note how U.S. equity (Russell 3000 Index) performance compares with U.S. bonds (Barclays Aggregate Index) on a rolling three-year basis. The trend over the past 20 years is one of alternating between periods of strong equity returns and lagging performance vs. bonds, and vice versa. The message is that when trailing returns are relatively extreme vs. recent history, it may be time to consider an alternative future vs. the one that the previous period just delivered.
Any one predictor is subject to failure, of course. In fact, you can count on it. That inspires forecasts of expected return that are built on a diversified mix of predictors. For instance, the dividend yield alone may not tell us much on a regular basis. But it’s a different story when it flashes a buy or sell signal that’s corroborated with other predictors. Recall that the dividend yield was crawling at post-World War II record lows in 1999 and 2000. That was a warning sign that future equity returns weren’t going to be as rich as recent history implied. The warning was stronger when the low yield accompanied high trailing returns for stocks over bonds.
There are, of course, many more tools for evaluating expected returns. The problem isn’t a lack of useful applications. Rather, the problem is us. In particular, the bigger challenge is discipline. It’s human nature to extrapolate the recent past into the future. That works for a time, but it’s almost always a strategy that eventually crumbles. There’s no guarantee that mean reversion will prevail, but you need more than intuition and guesswork for thinking it won’t.
But let's not fool ourselves. The solution for thinking strategically and acting tactically on matters of expected returns may get us into trouble if applied haphazardly. Mindlessly buying and holding a broadly diversified portfolio of multiple asset classes can deliver reasonable results for those who truly have a long-term focus. Those investors, however, are the exception. Some form of dynamic asset allocation, as a result, is warranted.
In the end, market volatility offers opportunity and risk. “Your emotional response to the market's gyrations may be one of your biggest costs as an investor,” notes Morningstar’s Karen Dolan. “The return lost to poor timing can even trump the cost of expense ratios.”
Fair enough. But sitting tight when expected returns rise and fall by more than trivial degrees may not be helpful either. As with most aspects of money management, the goal is finding a practical compromise that navigates between two extremes.
What's Up With Oil Prices?
Oil prices in New York remain north of $110 this morning--the highest in three years. What’s behind the spike in prices? There's no shortage of opinion, and it's not necessarily in agreement. For some perspective, several oil analysts opine on what's happening via a fresh round of interviews, courtesy of Integrity Research Associates.
Here are some excerpts:
Matt Smith, Summit Energy: “The recent rise in crude has predominantly been a risk premium added to prices rather than a change in supply.”
Peter Zeihan, STRATFOR: “The majority of it is driven by speculative activity.”
James L. Williams, WTRG Economics: “Inventories are high, which should be a bearish indicator for prices. However, there is a legitimate war and revolution supply interruption risk premium, which increases every time there is a potential problem in an exporting country, and this supply interruption risk premium tends to be greater the lower our spare capacity is. Right now, our supply interruption risk premium is high, and our spare capacity is lower than we had expected. However, this is all amplified by hedge fund and ETF speculation in futures.”
Max Krangle, ABS Energy Research: “The current price of oil is based more on political, economic, transport factors, rather than underlying supply issues. Simple fact is that global proven reserves of crude oil are relatively stable – and is actually increasing if you count oil sands in Canada. Even with roughly 80m barrels/day pulled out of the ground, reserves appear to remain relatively stable. This has been true for the last 20-30 years.”
April 9, 2011
Book Bits For Saturday: 4.9.2011
● The Big Secret for the Small Investor: A New Route to Long-Term Investment Success
By Joel Greenblatt
Summary via publisher, Crown Business/Random House
Let top hedge fund manager, Columbia business school professor, former Fortune 500 chairman and New York Times bestselling author, Joel Greenblatt, take you on a journey that will reveal the Big Secret for both individual and professional investors. Based on path-breaking new research, find out how anyone can beat the market, the index funds and the experts by following a new approach that relies on the principles of value investing, common sense and quantitative discipline. Along the way, learn where "value" comes from, how markets work, and what really happens on Wall Street. By journey's end, small investors (and even not-so-small investors) will have found their way to some excellent new investment choices.
● Financial Origami: How the Wall Street Model Broke
By Brendan Moynihan
Summary via publisher, Bloomberg Press/Wiley
Origami is the Japanese art of folding paper into intricate and aesthetically attractive shapes. As such, it is the perfect metaphor for the Wall Street financial engineering model, which ultimately proved to be the underlying cause of the 2008 financial crisis. In Financial Origami, Brendan Moynihan describes how the Wall Street business model evolved from a method to transfer risk into a method for manufacturing risk. Along the way, this timely book skillfully dissects financial engineering and addresses how it's often a mechanism to evade regulatory constraints, provide institutional investors with customized products, and, of course, generate revenue for financial engineers.
* Reveals how Wall Street's financial engineering business model morphed into something destructive.
* Highlights how the origami model worked well in the comparatively stable years of the early 2000s, when there was less risk to transfer.
* Discusses how Wall Street began manufacturing risk by creating products that multiplied risk exposures and encouraged subprime lending.
With the collapse of Lehman Brother the Wall Street business model effectively broke. But there are many lessons to be learned from what has transpired, and Financial Origami will show you what they are. With trillions of dollars worth of trades conducted every year in everything from U.S. Treasury bonds to mortgage-backed securities, the U.S. interest rate market is one of the largest fixed income markets in the world.
● The Next American Economy: Blueprint for a Real Recovery
By William J. Holstein
Summary via publisher, Walker Books
At a time when debate is raging about how to create jobs and revive the American economy, veteran business writer William J. Holstein argues that the best way for us to recover our economic footing is to do what Americans do best—innovate and create new industries. Contrary to the perception that the American economy has run out of inspiration and new ideas, Holstein uses compelling case studies to celebrate the innovation and business success being experienced in many industries, from technology and energy to retraining and exporting, across the country, from Boston to Orlando, Pittsburgh to San Diego. In the face of economic powerhouses such as Japan and China that are pursuing conscious national strategies, Holstein argues that Americans must find new avenues of cooperation among universities, business, and government to create the kind of sustainable growth we need. Replete with fresh insights into how Americans can create a real economic recovery, The Next American Economy is essential reading for business leaders, politicians, strategists, and anyone who cares about our future.
● Interest Rate Markets: A Practical Approach to Fixed Income
By Siddhartha Jha
Summary via publisher, Wiley
Interest Rate Markets: A Practical Approach to Fixed Income details the typical quantitative tools used to analyze rates markets; the range of fixed income products on the cash side; interest rate movements; and, the derivatives side of the business.
* Emphasizes the importance of hedging and quantitatively managing risks inherent in interest rate trades
* Details the common trades which can be used by investors to take views on interest rates in an efficient manner, the methods used to accurately set up these trades, as well as common pitfalls and risks providing examples from previous market stress events such as 2008
* Includes exclusive access to the Interest Rate Markets Web site which includes commonly used calculations and trade construction methods
Interest Rate Markets helps readers to understand the structural nature of the rates markets and to develop a framework for thinking about these markets intuitively, rather than focusing on mathematical models.
● Truth, Errors, and Lies: Politics and Economics in a Volatile World
By Grzegorz W. Kolodko
Interview with author via Wilson International Center
This week on dialogue host John Milewski interviews author Grzegorz Kolodko about his latest book, Truth, Errors, and Lies: Politics and Economics in a Volatile World. In the book, Kolodko applies an interdisciplinary framework for understanding the global economy. Mr. Kolodko is one of the world’s leading thinkers on economics and development policy and was a key architect in Poland’s successful economic reforms when he served as the countries Deputy Prime Minister and Minister of Finance. He’s currently a Professor at Kozminski University where he heads the think tank “TIGER”, which stands for Transformation, Integration, and Globalization Economic Research
April 8, 2011
More Thoughts On Estimating Equilibrium Returns
Several readers responded to my post on estimating equilibrium returns by claiming that the concept is seriously and hopelessly flawed. But the notion that analytical techniques must be all or nothing is dangerous and more than a little impractical.
It's widely understood that modern finance as classically outlined is flawed. The capital asset pricing model (CAPM), to cite the obvious blemish, has a tough time explaining the excess returns of small stocks and value stocks. This limitation inspires some to throw out the entire CAPM/modern finance edifice. But that's a drastic response and arguably excessive. CAPM and modern finance are flawed, and we need to be aware of those flaws, but that's a long way from saying there's no value here.
Indeed, it's clear that we live in a multi-factor world. But that's no basis for abandoning the market factor as outlined by CAPM. Granted, we shouldn't be slaves to it. Instead, we should consider a broader range of factors in our analysis, including CAPM's market beta. In fact, empirical studies show that analysis that combines the market, small cap and value factors does a better job of evaluating risk and return compared with any one factor on a stand-alone basis.
What's more, beta shows its durability when used in broad-minded portfolio concepts. It's still not perfect, but it's far from worthless. As one example, a recent study finds that beta does a reasonably good job of predicting risk and return over the last 40 years in real-world portfolios. In particular, high beta portfolios suffer bigger losses than low beta portfolios during so-called negative black swan events. Meanwhile, the opposite is true: high beta portfolios earn higher returns when markets rally compared with low beta portfolios.
That's hardly an argument to use beta in isolation. In fact, no single predictor is flawless. But that's no excuse to emphasize how any one predictor fails. Rather, the solution is to combine predictors and develop robust methodologies that can withstand the inevitable uncertainties that harass every attempt to forecast risk premiums. As a recent study reminds, this is a practical and productive way to approach the problem of managing risk when the future is forever cloudy.
How does estimating equilibrium risk premiums fit in? It's valuable baseline for analyzing expected returns. Note that I didn't say it's the first and last step. Nor should this process be used without doing additional analysis using alternative approaches. In addition, estimating equilibrium returns should be a process as opposed to a one-time calculation.
Let's say that you estimate equilibrium returns once a quarter. In time, the information will be far more valuable than any one batch of numbers. Imagine that your equilibrium return estimate generally corresponds with alternative methodologies for predicting, say, the U.S. equity risk premium. But suddenly there's a wide divergence in the estimates. That may tell us something of immense value.
Estimated equilibrium returns (assuming they're calculated in a reasonable manner) can be useful benchmarks of what's available in the long run future because in the long run the average investor holds the market-value weighted portfolio. By reverse engineering the implications of this reality, we can develop strategic and tactical insights for managing money. Should we stop there? Of course not. But the process is relatively painless and serves as a foundation for additional analysis when it comes to evaluating asset allocation possibilities.
Embracing the process of routinely estimating equilibrium returns doesn't mean we have to give up anything. But adding this tool to our analysis does open the door for enhancing risk premium predictions.
April 7, 2011
Weekly Jobless Claims Drop By 10k
Weekly filings of new jobless claims continue to drift lower, and that’s encouraging. But oil prices remain elevated and various global risks continue to bubble. That raises the question of whether the falling trend in new filings for unemployment benefits has legs. The recent strength in jobs creation is one reason for answering "yes," although the fall in new jobless claims is beginning to look weak again.
In absolute terms, last week’s change was a winner. New claims dropped by a seasonally adjusted 10,000 to 382,000 last week, the Labor Department reports. Both the weekly number and its four-week moving average have been under the 400k mark for weeks now. That suggests that layoffs are retreating and job growth is increasing.
Today’s report doesn’t change that view. Indeed, there’s confirmation in the favorable trend in the continuing claims report, which tracks the population of the unemployed who were already collecting benefits. That number slipped too, falling by 9,000 to 3.723 million (seasonally adjusted) for the week through March 26 (this series lags new claims by one week). That’s the lowest level in nearly three years.
But the slow progress in the decline in new claims is worrisome, if only marginally. Maybe it’s just statistical noise (this series is notoriously volatile, even on a seasonally adjusted basis). Still, at this late date (nearly two years since the recession ended) there’s only modest evidence of job growth. Perhaps, then, the message is (still) that we shouldn’t expect much more than a mild recovery in the labor market. We’ve been anticipating no less all along, and today’s data point doesn’t offer any reason to rethink that forecast. The trouble is that mild job growth two years after the formal end of the recession doesn’t leave much in the way of a safety cushion if energy prices continue to rise and take a toll on the economy. Then again, there’s always something to worry about.
"The improvement in the labor market is for real," Eric Green, chief market economist at TD Securities, tells Bloomberg. "Growth is on a steady upswing. Sales expectations are rising with more hiring plans."
Omair Sharif, an economist at RBS, agrees. "The downtrend in initial claims remains firmly in place, and overall the data point to a continued gradual improvement in the underlying pace of layoffs, consistent with the steady progress that we have seen in the payrolls data," he tells Reuters.
The question is whether the oil market is going to play nice in the weeks and months ahead. As we write, crude in New York is above $109 a barrel. Meanwhile, gasoline prices continue to inch closer to $4 a gallon. "The main worry is that with more of the consumer's budget going toward gas at the pump, it will hold back the nascent recovery," advises Anthony Michael Sabino, a professor at St. John's University business school, via AP. "It will put a crimp into spending plans for corporate America, as the costs of energy, transportation, and so forth rise accordingly."
Predictably, economists are trimming their forecasts for the U.S. economy as energy prices rise. The good news is that predictions of economic growth, albeit lesser growth, are still the mainstream call.
Meantime, oil prices are volatile and so there's the possibility that today’s high and rising prices could quickly reverse in the weeks ahead. Maybe, but there’s no sign of that at the moment. Much depends on how much the recent rise in oil is due to fear vs. fundamentals. Parsiing that gray area is as much art as it is science, and so the market continues to struggle with pricing. But with no imminent resolution in sight for the ongoing turmoil in the Middle East—the civil war in Libya in particular—it takes industrial strength optimism to see sharply lower energy prices in the near future. Even then, a retreat in prices may only be temporary, some analysts warn.
For now, the all-important labor market rebound is still chugging ahead. Any signs to the contrary, however, could be a game changer.
Economist Mehmet Pasaogullari at the Cleveland Fed reviews inflation from several angles. If nothing else, he offers a timely reminder that there's more than one way to skin this statistical cat. Inflation comes in a variety of flavors. But while the numbers vary, there's a common trend afoot, he reports, noting that "all measures of short-term inflation expectations we have looked at show an upward trend since last summer."
Some measures showed higher increases, and others were much more limited. Measures of longer-term inflation expectations have also risen in the last six months... However, most of the increase in the market-based measures happened in September and October 2010. The recent increases in food and energy prices have had limited, if any, effect on the long-term expectations. They seem to be well-anchored and are in line with their averages of the previous decade.
The question (as always) is whether the past is prologue? Looking for answers in real time is forever problematic. That said, the inflation forecast based on the yield spread between the nominal and inflation-indexed 10-year Treasuries has inched higher since Pasaogullari's essay was published on April 1. In fact, the Treasury market's inflation outlook is 2.57%, as of yesterday. That matches the previous peak, set back in early July 2008, when oil was near an all-time high.
The last time we hit 2.57%, the peak was short lived. Inflation expectations started falling, and crashed soon after. That's not likely to happen this time, of course. Why? The catalyst isn't likely to make a repeat performance. Massive financial crises of the type that hit the world in late-2008, fortunately, are rare. So what does that mean for the inflation trend this time? Stay tuned...
April 6, 2011
Demystifying Monetary Policy (Again)
Ramesh Ponnuru of The National Review does a first-rate job of summarizing the counterintuitive nature of monetary policy and how it applies to recent history. In particular, he explains in clear and (mostly) non-technical terms how and why the Fed's "passive tightening" in late-2008 helped turn what might have been a relatively modest recession into something much worse. He also outlines why the subsequent QE2 was necessary and how many commentators (primarily conservatives) have misunderstood the necessary monetary policy solution, along with the fact that low interest rates of late aren't a sign of loose money.
These and related subjects have been discussed in great detail in recent years by such economists as Scott Sumner, David Beckworth and others. But the finer points of how a surge in the demand for money can change the rules of monetary policy still aren't widely understood. As Ponnuru explains,
Easier money can lead to a destabilizing run on the currency. Inflation can be associated with low real interest rates and an expanded monetary base. But not always: Not in the 1930s, and almost certainly not today, either. The late Milton Friedman, perhaps the most famous inflation hawk of his generation, spotted the fallacy in his analysis of 1990s Japan: Low interest rates can also be a symptom of an excessively tight monetary policy that has choked off opportunities for growth. A looser policy, by increasing expectations of future economic growth, could actually raise real interest rates.
Ponnuru isn't breaking new ground here, but he is outlining crucial details of how monetary policy ticks these days—details that (still) need to be discussed. Maybe because The National Review is pushing this story, it'll finally resonate with those on the right. In any case, this is a valuable overview that's worthy of everyone's attention.
A Brief Look At Estimating Equilibrium Risk Premiums
MarketWatch’s Robert Powell reports that “two legendary investors have conflicting points of views” on stocks and bonds. Rob Arnott is cautious on the outlook for equities and Bill Gross is anxious about expected returns for bonds. Putting the two together suggests it's time to avoid stocks and bonds.
In fact, there’s always a divergence of opinion on where asset classes are headed. Morningstar analyst Miriam Sjoblom wonders if the extra income from high yield bonds is still worth the risk. There’s also worries about REITs and commodities, which have posted exceptionally strong gains over the past year. Nonetheless, there’s no shortage of analysts who think these asset classes are still worth owning. No less is true for stocks and bonds.
In a world of endless opinions and predictions, it’s easy to lose perspective when it comes to strategic-minded investing. You’re surely asking for trouble if you let the data dump that is the Internet overwhelm the big picture. There are lots of smart analysts offering valuable insights, of course, but everyone needs a baseline to begin the critical business of estimating expected returns. But even here, the possibilities are endless and so it's easy to get lost in a sea of numbers.
How should we begin? One possibility is estimating equilibrium risk premiums for the long haul. It’s no silver bullet, but it offers a good starting point. The basic idea is that making some assumptions about risk and correlation for the major asset classes offers some useful, if not less than flawless forecasts. One of the attractions of this approach is that it refrains from trying to predict returns directly, which is especially hazardous. Instead, the guesswork is focused on the risk side of the equation, which is somewhat more reliable when it comes to divining the future. In turn, reasonable risk estimates imply what the returns should be in the long haul. That may not sound like much, but if can be a valuable foundation for deeper analysis.
The basic idea was outlined in a 1974 paper by Professor Bill Sharpe. Over the years, a number of analysts have reviewed the concept with an eye on practical applications. For example, Gary Brinson outlines a concise explanation of the process in Chapter 3 of The Portable MBA in Investment .
The concept is one of estimating what’s known as equilibrium risk premiums. That is, the excess returns for an asset class—performance less the "risk free" rate of return as defined by, say, 3-month Treasury bills. The equilibrium reference is the assumption that markets clear eventually and so supply equals demand. That’s not all that practical as a short run assumption, but in the long run it’s a fair reading of how markets work. If it were otherwise, beating broad indices would be a breeze, which is definitely not the case.
Here’s what Robert Litterman says of equilibrium risk premium estimates in his book Modern Investment Management: An Equilibrium Approach...
We need not assume that markets are always in equilibrium to find an equilibrium approach useful. Rather, we view the world as a complex, highly random system in which there is a constant barrage of new data and shocks to existing valuations that as often as not knock the system away from equilibrium. However, although we anticipate that these shocks constantly create deviations from equilibrium in financial markets, and we recognize that frictions prevent those deviations from disappearing immediately, we also assume that these deviations represent opportunities. Wise investors attempting to take advantage of these opportunities take actions that create the forces which continuously push the system back toward equilibrium. Thus, we view the financial markets as having a center of gravity that is defined by the equilibrium between supply and demand. Understanding the nature of that equilibrium helps us to understand financial markets as they constantly are shcoked around and then pushed back toward that equilibrium.
With that in mind, let’s make some assumptions about the long run future and see how estimated equilibrium risk premiums stack up. First, we need a forecast of the market price of risk. As Brinson notes, this is "the premium the market demands as compensation per unit of risk." Based on our analysis of our proprietary Global Market Index (a benchmark that passively weights all the major asset classes), our view is that the market portfolio will have a Sharpe ratio of 0.2. Next, we need forecasts of volatility for each of the major asset classes. The third input is estimating each asset class’s correlation with the market portfolio, as per GMI. With those estimates in hand, we can deduce expected risk premiums by multiplying the forecasts for the following variables:
Sharpe ratio for the market portfolio X Standard deviation of a given asset class X The asset class’s correlation with the market portfolio
For example, we’re assuming the market portfolio’s Sharpe ratio will be 0.2 going forward. For U.S. stocks, we’re assuming a 20% annualized standard deviation for returns and a correlation of 0.95 with GMI. The imputed risk premium from these inputs is an annualized 3.8% for domestic equities for the long run future. Remember, that’s before the risk free rate. If you think T-bills will return, say, 2%, then the 3.8% U.S. equity risk premium becomes a 5.8% total return estimate (2% plus 3.8%).
Running this analysis on all the major asset classes gives us the following profile:
The risk premium estimate for GMI is simply adding up the individual estimates and weighting each based on relative market values.
With equilibrium return estimates in hand, we can now turn to the hard work of comparing them with other estimates. The goal is to figure out if our long-run forecasts differ materially with shorter term predictions. If so, we may have developed some valuable tactical information for adjusting the asset allocation for, say, the next 12 months. Any number of alternative methods for forecasting returns can be used, of course. But we can start with a simple review of realized risk premiums. Here’s how the major asset classes compare over the past 10 years:
Keep in mind that the value here is the process as opposed to any one estimate. It goes without saying that some, perhaps all of our estimates will be wrong in some degree. That's par for the course with peering into the future, regardless of methodology. However, it's a safe assumption that the market portfolio will randomize the errors, which is why it’s such a competitive benchmark.
The point is that by routinely estimating returns by first considering risk factors, we can develop some useful context. If, for instance, you think that the 3.8% annualized risk premium for U.S. stocks is too low, or too high, that’s an invitation to go back and rethink the underlying assumptions and run additional analysis using alternative models of return forecasting. If your outlook for stocks still radically differs from the equilibrium estimate, maybe there’s a compelling basis for overweighting or underweighting equities relative to the market portfolio, depending on your view.
In the long run, the average investor must hold the market portfolio, which means that the average investor is destined to earn the market’s return. If you’re not satisfied with the prospect of earning an average return, then you need some confidence for rethinking Mr. Market’s asset allocation. Developing that confidence isn’t easy or riskless, but estimating equilibrium risk premiums is a productive way to begin. Just don't confuse it with an end.
April 5, 2011
Will Mr. Market's Asset Allocation Suffice?
The concept of a world allocation fund is a good one, although the “pickings are slim, so consider building your own,” Morningstar advises. Even if the menu was better, the case for designing and managing your own multi-asset class fund is still compelling. One reason is cost. You can probably build your own asset allocation strategy for less if you do it yourself. Another reason is that you can optimize the management of the asset classes according to the particulars of your financial profile. That's sure to provide superior results compared with a one-size-fits-all strategy.
But where to begin? With the market, of course. From the 30,000-foot level, there are a dozen major asset classes, not including cash and its equivalent, such as Treasury bills. Minds will differ as to definitions of broadly defined asset classes, but our list is a good place to start:
The tricky part is deciding how to weight the major asset classes--now and in the months and years ahead. Unfortunately, there are no generic answers. Every investor’s asset allocation should be customized to reflect her specific set of circumstances. The good news is that there’s an obvious benchmark to start the analysis: Mr. Market’s asset allocation.
If we weight all the major asset classes above by their market values, the resulting portfolio is a passive benchmark for a global asset allocation strategy. It’s hard to find such an index, which is why I built my own--I call it the Global Market Index (GMI). As I explain in some detail in my book Dynamic Asset Allocation, the finance literature tells us that the value-weighted market portfolio is the optimal strategy for the average investor with an infinite time horizon.
In other words, over the long haul it’s probably going to be difficult to beat a passive mix that holds everything, or something approximating everything. Of course, there are no "average" investors per se, and we all have finite time horizons. Nonetheless, GMI has performed competitively over the last decade. For the 10 years through last month, GMI earned an annualized total return of 6.5%. That compares with roughly 4.1% for U.S. stocks, based on the Russell 3000. If you mindlessly rebalanced GMI's mix every December 31 back to its allocation from the previous year, the benchmark's annual return rises to around 7.4%. Not bad for a know-nothing strategy.
How does Mr. Market’s allocation stack up these days? Here’s GMI's allocation at last month’s close:
Thanks to ETFs, you can replicate GMI for as little as 50 basis points. The tough part, however, is deciding how to customize Mr. Market’s asset allocation. The possibilities are endless, of course, as are the potential triumphs…and failures.
A review of the various multi-asset class mutual funds in Morningstar Principia’s database (there are more than 1,000 with track records of at least 10 years) shows that most of the associated strategies have come up short vs. GMI’s performance history. That’s not surprising. Indeed, that more or less describes the historical record within single asset classes, and no less appears to be true for broad-minded asset allocation. Why? The short answer: Excess returns are a zero sum game, and the winners are financed by the losers. After deducting trading costs and taxes, there are only two basic strategies for beating Mr. Market’s asset allocation: taking bigger risks or being smarter than the crowd. Well, maybe there's a third... luck.
Meantime, it’s a relatively safe forecast that GMI will continue to deliver average to above-average results over the next 10 years. That inspires what is arguably the first question in designing asset allocation: Will Mr. Market’s strategy suffice relative to your expectations, financial needs and risk tolerance?
Strategic Briefing | 4.5.2011 | Inflation
Bernanke Says Fed Must Monitor Inflation ‘Extremely Closely’
Bloomberg | Apr 5
Federal Reserve Chairman Ben S. Bernanke said policy makers must watch inflation “extremely closely” for evidence that rising commodity costs are having more than a temporary impact on consumer prices. “So long as inflation expectations remain stable and well anchored” and the rise in commodity prices slows, as he’s forecasting, then “the increase in inflation will be transitory,” Bernanke said yesterday in response to audience questions after a speech in Stone Mountain, Georgia. “We have to monitor inflation and inflation expectations extremely closely because if my assumptions prove not to be correct, then we would certainly have to respond to that and ensure that we maintain price stability,” he said.
OECD Frets Over Inflation
Wall Street Journal | Apr 5
Economic growth in the world's richest countries outside disaster-stricken Japan is gaining strength, the Organization for Economic Cooperation and Development said Tuesday in an upbeat interim assessment, but warned that a rise in commodity prices may push up inflation expectations. "We are relatively upbeat; it seems that the recovery is gaining strength," OECD Chief Economist Pier Carlo Padoan said in an interview, noting that Group of Seven economies could reach annualized growth of about 3% in the first half of the year. Still, he noted that "we may be at the beginning of second-round effects, with commodity prices feeding into inflation expectations."
Inflation inflicting pain, as wages fail to keep pace with price hikes
Washington Post | Apr 4
It’s not just that prices are rising — it’s that wages aren’t. Previous bouts of inflation have usually meant a wage-price spiral, as pay and prices chase each other ever upward. But now paychecks are falling further and further behind. In the past three months, consumer prices have been rising at a 5.7 percent annual rate while average weekly wages have barely budged, increasing at an annual rate of only 1.3 percent.
Silver Advances to Most Expensive Versus Gold Since 1983 on Inflation Risk
Bloomberg | Apr 5
Silver climbed to its most expensive level versus gold since 1983 as rising inflation spurred by commodity shortages, economic recovery and turmoil in the Middle East bolstered demand. An ounce of gold bought 37.15 ounces of silver at 2:32 p.m. in Singapore, compared with an average of 62 in the past 10 years. Silver for immediate delivery has more than doubled in the past year while gold gained 27 percent, cutting the ratio from a high of 70 in June.
Fed’s own forecasts move to center stage
MarketWatch | Apr 4
When Federal Reserve Chairman Ben Bernanke sits down with reporters at his first press conference in late April, he will not come alone. He will bring with him the consensus economic forecast of Fed officials. These projections have been largely ignored, even by the Fed itself, especially during the Volcker and Greenspan eras. But Bernanke is dragging them into the limelight. “This is an effort to move the forecasts front and center,” said Lou Crandall, chief economist at Wrightson ICAP. The Fed will release the projections on the same day that Bernanke talks to the press. The past practice had been to delay release of the forecasts until three weeks following the meetings.
The Taylor Rule Is Wrong
Brian Wesbury (First Trust) | Apr 4
The working hypothesis of just about every forecaster or Fed-watcher in the world has been that the Fed would not tighten at all until 2012. That meant no interest rate hikes this year. And to avoid putting on any brakes at all, the Fed would even think about QE-III. But this view is now coming under fire, not just from the private sector, but from inside the Fed
Stronger gains in employment, along with some relatively hot inflation reports have pushed many regional Fed presidents to make hawkish statements. Charles Plosser, Philadelphia Fed President, said recently that the Fed might need to head for the “exit ramp.” Jeffrey Lacker, Richmond Fed President, said he would “not be surprised” if action were taken to fight inflation
before the end of the year. James Bullard, St. Louis Fed President, said “U.S. monetary policy cannot remain ultraaccommodative” and hinted about tightening this year.
Narayana Kocherlakota, Minneapolis Fed President, said it was “certainly possible” that interest rates could be lifted in late 2011.
For the record, we think the Fed is way behind the curve and that accelerating inflation over the next few years is already baked in the cake. However, the Washington-based board of the Federal Reserve holds the opposite view. They believe inflation is not a problem at all and it has
The Fed and Inflation
CNBC | Apr 1
Pimco market strategist and portfolio manager Tony Crescenzi said Fed officials have changed their tone slightly to express a change in inflation expectations. He said Fed Chairman Ben Bernanke, in his semiannual testimony to Congress last month, used the word inflation 22 times, compared to nine times in his prepared remarks six months earlier. "It seems that the Fed is trying to say, while the Fed itself is not concerned about headline inflation, it is concerned that the public is because it can affect inflation expectations, and inflation expectations can feed the enemy, inflation," Crescenzi said in an interview this week. Crescenzi said he expects the Fed to complete its quantitative easing (QE2) program, but notes in its last statement it acknowledged the possibility of inflation while removing concerns about deflation.
April 4, 2011
Will The Surge In Corporate Profits Bring Stronger Job Growth?
Corporate profits have soared since the Great Recession was formally declared at an end as of June 2009. Employment, by contrast, has had a tepid recovery. Is this a mismatch with legs? Or is job growth finally set to impress the crowd?
Private nonfarm payrolls are higher by 1.5% through last month over the past year on a seasonally adjusted basis. A charitable analysis says that's no better than middling compared with employment rebounds after recessions in the past. Then again, the final chapter has yet to be written for this cycle. As the chart below shows, it remains to be seen if the job market continues improving. Based on the rolling 12-month change in private nonfarm payrolls through last month, however, the labor market has hardly distinguished itself with strength.
It's a different story with corporate profits, which have exploded skyward recently on an annual basis, reaching record-high advances. The pace has fallen, but corporate profits remain near an all-time high? Why the disconnect between the renewed health of the corporate sector and job growth?
Ed Yardeni, chief investment strategist of Yardeni Research, says the problem has been government interference with the recovery. "We’ve been predicting and tracking the surprisingly strong growth in profits over the past two years," he writes on his blog. "We argued that the subpar recovery in employment was caused by all the regulatory meddling by Congress during 2008 and 2009."
But some economists say that the robust rise in corporate profits are extraordinary and don't necessarily reflect a healthy economic recovery. If so, one might wonder about the labor market's strength from here on out. "If you are looking at where profits are coming from ... cost control, strong capital discipline, strong control over the balance sheet - that's why you've seen this extraordinary recovery in profits, even though top-line growth hasn't been spectacular," opines Aaron Smith, a senior economist at Moody's Analytics.
Equity analyst Mark Provost charges that the high unemployment is directly related to the surge in corporate profits. "The private sector has not only been the chief source of massive dislocation in the labor market, but it is also a beneficiary," he asserts. "Over the past two years, productivity has soared while unit labor costs have plummeted. By imposing layoffs and wage concessions, U.S. companies are supplying their own demand for a tractable labor market."
Economist Rebecca Wilder sees a problem in what she argues is a corporate savings glut, which is "manifesting itself into the labor market, creating high and persistent unemployment. Some economists are wrongly referring to this as higher structural unemployment." She goes on to predict that
If the corporate excess saving glut just equaled zero, i.e., firms invested and saved at the same rate, the unemployment rate would be 5.8%. Now, if the corporate saving glut fell below zero to -2%, i.e., firms reinvested in the economy by way of capital investment in excess of saving, the simple model implies an unemployment rate of 4.7%.
The government doesn't need to add jobs, per se, the government needs to figure out how to get corporate America to drop the saving glut and re-invest in the economy.
Unemployment, of course, is a lagging indicator and so history reminds that this is among the last of the economic metrics to show signs of life. Given the depth of the Great Recession, the optimistic view is that payrolls have suffered longer than usual but better days are finally coming.
"We've had the unemployment rate drop a full percentage point very quickly over just four months and that's nearly unprecedented," observes Ellen Zentner, senior economist at Bank of Tokyo-Mitsubishi UFJ Ltd.
That implies that job growth is poised to catch up with the dramatic rise in corporate profits. Maybe, but if payrolls stumble in the months ahead, it's going to get a lot tougher to be an optimist on the employment outlook.
April 2, 2011
Book Bits For Saturday: 4.2.2011
● Government's Place in the Market
By Eliot Spitzer
Summary via publisher, Boston Review Books
As New York State Attorney General from 1998 to 2006, Eliot Spitzer successfully pursued corporate crime, including stock price inflation, securities fraud, and predatory lending practices. Drawing on those experiences, in this book Spitzer considers when and how the government should intervene in the workings of the market. The 2009 American bank bailout, he argues, was the wrong way: it understandably turned government intervention into a flashpoint for public disgust because it socialized risk, privatized benefit, and left standing institutions too big to fail, incompetent regulators, and deficient corporate governance. That’s unfortunate, because good regulatory policy, he claims, can make markets and firms work efficiently, equitably, and in service of fundamental public values.
● Expected Returns: An Investor's Guide to Harvesting Market Rewards
By Antti Ilmanen
Excerpt via publisher, Wiley
We should humbly recognize the limits of our understanding. Realized returns are dominated by randomness, structural uncertainty, and rare events. Expected returns are unobservable, at best estimated with noise. We should resist hindsight biases wired in us—the outcomes that materialized seem more inevitable or predictable than they truly were. It is worth recalling that experts can only explain a fraction of realized return variation afterwards, and this is an inherently easier task than predicting. Any observed return predictability is mild, possibly spurious, and rarely robust. Therefore I stress humility in interpreting empirical results and even more in making predictions and in trading based on them.
● Somebody in Charge: A Solution to Recessions?
By Pierre Lemieux
Review via Laissez Faire Books
Could the 2007-2009 recession have been prevented or stopped if somebody – some authority – had been in charge? Can public authorities prevent recessions and tame the business cycle? In this book, Pierre Lemieux argues that the answer is emphatically no. The fact is that there was somebody in charge as state power and regulation had grown basically non-stop over the early 20th century. The recession was a product of too much government authority, not too little. This is not surprising for 'public authorities' are nothing but politicians and bureaucrats.
● The Ten Trillion Dollar Gamble: The Coming Deficit Debacle and How to Invest Now: How Deficit Economics Will Change our Global Financial Climate
By Russ Koesterich
Review via Reading The Markets
Russ Koesterich, iShares chief investment strategist and global head of investment strategy for BlackRock Scientific Active Equities, anticipates a rather bleak economic future for the United States. In The Ten Trillion Dollar Gamble: The Coming Deficit Debacle and How to Invest Now (McGraw-Hill, 2011) he explains why we should expect higher interest rates and slow growth. He then offers solid practical advice for the investor... The picture Koesterich paints of the future is familiar. Barring major reform of entitlement programs, especially health-care spending, the U.S. structural deficit will only get worse. And “in the not-too distant future, it will start to push rates higher and economic growth lower, and it eventually may set off an inflationary spiral.” (p. 22)
● The Crash Course: The Unsustainable Future Of Our Economy, Energy, And Environment
By Chris Martenson
Excerpt via Business Insider
In 2008 and 2009, economic activity in the United States and most other developed nations tumbled off a cliff. At several points there was real panic in the air. Stock markets around the world fell to levels that wiped out more than a decade of gains. Trillions evaporated in the housing market, and global trade plummeted.
Questions remain: What happened? Where did all our money go? How did 10 years of wealth accumulation evaporate so quickly? More important,when can we expect a recovery?
In truth, our predicament goes far deeper than even these recent, disquieting economic events might suggest. It’s time to face the facts: A dangerous convergence of unsustainable trends in the economy, energy, and the environment will make the “twenty-teens” one of the most challenging decades ever. The Crash Course explains this predicament and provides sufﬁcient context to support the idea that it is well past time to begin preparing for a very different future.
April 1, 2011
March Performance Review For The Major Asset Classes
The major asset classes generally posted respectable gains in March, although red ink spoiled the party for foreign developed-market stocks and REITs. U.S. bonds overall managed to rise, but just barely, based on the Barclays U.S. Aggregate Bond Index, which inched higher by less than 0.1% last month. Inflation-linked Treasuries, however, jumped 1%--the third consecutive monthly gain for TIPS and the highest return since last October, as per the Barclays U.S. Treasury TIPS Index.
The Global Market Index (our proprietary benchmark that passively weights all the major classes) more or less moved sideways in March, advancing just 0.2%. For the year so far, GMI is ahead by 3.3%.
The big winner last month: emerging market equities. The MSCI Emerging Market Index soared nearly 6% in March, posting its first monthly gain since December. REITs also reversed the trend of late, albeit by suffering a 1.5% loss--the first round of monthly red ink for real estate securities since November as tracked by the MSCI REIT Index.
U.S. stocks generally edged higher in March for the seventh straight month, based on the Russell 3000, albeit by the smallest gain for domestic equities on a calendar-month basis since the rally began last September.
Private Sector Jobs Rise by 230k In March
In line with expectations, private-industry nonfarm payrolls rose 230,000 in March, down slightly from the 240,000 net gain posted in February, the Labor Department reports. A respectable rise, to be sure. All the more so since the job growth for March represents the 13th straight month of improvement for the private sector. In addition, last month's advance is near the highest level since the labor market started growing again in early 2010. But while those are all encouraging signs, we're still left with the fact that job growth of 200,000-plus a month isn't helping lower the still-elevated jobless rate. Unemployment was virtually unchanged in March, inching down to 8.8% from 8.9% in February.
Otherwise, job growth was fairly widespread across the private sector. Within the cyclically sensitive goods-producing sector, only construction slipped, shedding 1,000 jobs in March. Meantime, the services industries, which constitutes the bulk of the employment in the U.S., had a strong month, adding 199,000 jobs in March—the highest monthly gain since the Great Recession ended.
The labor market appears to be finally chugging ahead by minting new jobs consistently and at a relatively robust pace. “All the evidence is pointing to a strengthening labor market,” says Bill Cheney, chief economist at John Hancock Financial Services. The challenge, however, is coming to terms with the reality that a respectable rebound in the labor market isn't enough to make a dent in the lofty unemployment rate, which remains near its highest level in almost 30 years.
The good news is that the momentum and the direction in the job market are finally on the side of growth. "It is always possible that as the job market improves, people will start looking again and the unemployment rate could go up," warns John Hancock's Cheney. "But the normal pattern is once it starts coming down as rapidly as it has over the last few months, it keeps on going down."
It's just not likely to go down quickly or dramatically in a short period of time.