October 29, 2011
The Hazards Of One-Size-Fits-All Performance Attribution
DAL Investments suggests that we should dispense with narrowly focused benchmarks for evaluating actively managed mutual funds, according to The New York Times. "As much as people in the fund industry may want to measure their performance against a narrowly defined index, the reality is that most investors judge their returns against the S.& P. 500, for better or worse," writes Times reporter Paul Sullivan. That's hardly a rationale for using the S&P 500, or any one benchmark, for analyzing a wide spectrum of investment strategies. Using one index certainly simplifies the critical task of portfolio attribution, but at what cost?
Don't misunderstand: the case for parsimonious models is well founded. As Einstein said, "Make things as simple as possible, but not simpler." Forcing explanations of what's driving returns through the prism of one benchmark, however, seems destined to violate this rule by erring on the side of excess simplicity.
Granted, the S&P 500 is probably the most popular benchmark in the money game. But unless you're reviewing a large-cap U.S. equity portfolio, the S&P is of limited value. Comparing apples to apples is crucial for evaluating investment results and distinguishing between skill and luck. The required analysis may be inconvenient when using multiple benchmarks, but there's not much point to relying on faulty analysis just because it's easy.
This is old news, of course. Every professional investment analyst worthy of the title understands why comparing, say, a small-cap manager to a big-cap index will lead to spurious conclusions. Similarly, if we're crunching the numbers on a multi-asset class strategy—mixing stocks and bonds, for instance—it's essential that we review the portfolio in the context of a multi-asset class benchmark in order to understand what's driving results.
One populuar methodology that can help is known as style analysis. Professor Bill Sharpe introduced the idea of returns-based style analysis in his influential 1988 paper "Determining a Fund's Effective Asset Mix." In a follow-up article he explains that "once a set of asset classes has been defined, it is important to determine the exposures of each component of an investor's overall portfolio to movements in their returns." Also, here's an interview with Sharpe where he discusses his views on style analysis in some detail.
(For a primer on multi-factor analysis with Excel, see financial planner William Bernstein's "Rolling Your Own: Three-Factor Analysis." Alternatively, you can let software, such as Zephyr's StyleAdvisor, perform the heavily quantitative lifting. For a quick style-analysis summary of multi-fund portfolios, see Morningstar's Instant X –Ray tool.)
The rationale for looking at portfolios through a style analysis lens is largely intuitive in light of decades of research in asset pricing that identifies a wide array of factors driving risk premia. The capital asset pricing model's one-factor description of market returns may still be a good description of asset pricing for broadly diversified portfolios across asset classes over the long term, but that leaves plenty of room for exceptions in the short run. Stephen Ross's arbitrage pricing model from the 1970s anticipated no less.
Even within the equity universe there's a rainbow of variables that appear to explain returns, from the widely recognized small-cap and value factors to the more exotic liquidity and momentum drivers, for instance. The message is that if you're trying to understand why a strategy or fund delivered a particular set of results over a specific time period, factor-based style analysis can wipe away a lot of the mystery. By contrast, using the S&P 500 alone for portfolio attribution is a bit like trying to analyze the business cycle by looking only at interest rates.
No wonder that reviewing historical returns solely through an S&P 500 prism isn't likely to reveal much if anything (unless you're looking at a plain-vanilla large-cap equity strategy that's focused now and forever on U.S. securities). DAL seems to think otherwise. According to the Times, DAL reviewed 306 funds that were founded before 1989 that are still with us in 2011 and
they all invest broadly with various styles and none concentrated on one sector. The data spans 21.75 years, from Dec. 31, 1989, to Sept. 30, 2011. The performance of the funds was measured against the Vanguard S.& P. 500 Index Fund, which had annual returns of 7.65 percent during that time…
Over the two decades of the data, no one investment strategy dominated, and most were successful for only four to five years, on average. Not one fund beat the benchmark every year.
In fact, most funds underperformed the S.& P. 500 about a third of the time.
It's debatable how much insight this type of analysis offers. Perhaps one could argue that if our goal is simply to beat the S&P, DAL's perspective is useful. But surely that's a goal that's far too narrow for most investors. Even if we think it's appropriate, identifying funds that beat the S&P without providing deeper analysis of why they outperformed doesn't offer much strategic insight.
To take an extreme example, if you're picking stocks from a pool of small-cap companies it's a safe bet that you'll report different risk and return results relative to a large-cap equity universe. In other words, your tracking error will be high vs. the S&P 500. But high tracking errors call out for a superior methodology for determining if a small-cap manager is adding value (or not) by analyzing the portfolio against a small-cap benchmark. Of course, high tracking errors vs. a specific benchmark could mean that you're using the wrong benchmark.
The analysis is more complicated for multi-asset class strategies, but Sharpe's style analysis helps here too. By regressing a fund's returns against several related benchmarks that are associated with the strategy, it's easy to identify the risk factors behind the performance. Style analysis isn't perfect, of course, and so there's a case for using other methodologies for analyzing returns and risk. But style analysis is easy to perform and it generally offers good results so it's an obvious place to start.
Multi-factor analysis may not reveal much beyond what's expected, although results can be surprising in some cases. For instance, it's not unusual to find out that a celebrated large-cap manager has been dipping into small-cap stocks to deliver impressive results. That's hardly a crime, although it's misleading to bill yourself as a brilliant large-cap manager while downplaying the fact that small caps are juicing returns. In my own quantitative travels, I routinely run multi-factor analysis on various funds and it's fairly common to find that a manager who purports to be a specialist in a given asset class or style is actually double- or triple-dipping into a range of risk factors.
When it comes to evaluating multi-asset strategies, there's more data to crunch but the principle's the same. For example, when running style analysis on asset allocation funds I regress returns against the Global Market Index (GMI), a passively weighted index of all the major asset classes. The question for active multi-asset class strategies is the same for evaluating single-asset class portfolios: Is the manager adding value? Standard finance theory suggests that a broadly defined, unmanaged benchmark of asset classes will deliver competitive results, and my own analysis of 1,000-plus multi-asset class mutual funds vs. GMI offers empirical support.
Another approach that tries to answer this question in quantitative terms is running a multi-factor analysis that regresses a fund's returns against several benchmarks that represent the opportunity set of asset classes.
Perhaps the main challenge in style analysis is choosing the right set benchmarks for the analysis. As investment consultant Ron Surz reminds, not all style indices are created equal.
The larger point is that style analysis is necessary unless we're confident that a strategy is pure and transparent. That's rarely the case, which is one of the arguments for using index funds: you're always sure that you own a particular beta.
Life is more complicated for for those who hold actively managed funds. But this much is clear: If performance attribution is to have any value, we need robust and relevant benchmarks. One size fits all may be an easy solution, but it's rarely the right solution.
Book Bits For Saturday: 10.29.2011
● The Handbook of Equity Market Anomalies: Translating Market Inefficiencies into Effective Investment Strategies
By Len Zacks
Summary via publisher, Wiley
The Handbook of Equity Market Anomalies organizes and summarizes research carried out by hundreds of finance and accounting professors over the last twenty years to identify and measure equity market inefficiencies and provides self-directed individual investors with a framework for incorporating the results of this research into their own investment processes. Edited by Len Zacks, CEO of Zacks Investment Research, and written by leading professors who have performed groundbreaking research on specific anomalies, this book succinctly summarizes the most important anomalies that savvy investors have used for decades to beat the market.
● Models.Behaving.Badly: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life
By Emanuel Derman
Review via Bloomberg
Disturbed, disillusioned and ashamed: Those aren’t emotions you expect a Wall Street quant to express when asked why taxpayers were obliged to bail out wealthy bankers. Unless, of course, the quant is Emanuel Derman, a particle physicist and former head of quantitative finance at Goldman Sachs Group Inc. “I am ashamed at the hypocrisies of the system,” Derman writes in “Models.Behaving.Badly,” an erudite yet pleasantly readable exploration of why financial models failed during the U.S. mortgage meltdown and why modelers must learn to use them more wisely. “We were told not to expect reward without risk, gain without the possibility of loss,” he says in disgust. “Now we have been forced to accept crony capitalism, private profits and socialized losses, and corporate welfare.” Unlike many quants, Derman says he wasn’t surprised that models failed in 2007, as events predicted to happen “once in 10,000 years happened every day for three days,” as one strategist at Lehman Brothers Holdings Inc. put it. The breakdown, Derman argues, flows from a misunderstanding of the difference between models and theories.
● The Big Handout: How Government Subsidies and Corporate Welfare Corrupt the World We Live In and Wreak Havoc on Our Food Bills
By Thomas Kostigen
Review via The Environmental Working Group
You’d be hard pressed to find a better time to release a book that dissects how federal farm subsidies sent America’s food and farm policies wildly off track. “The Big Handout” hits the stores today (Oct. 25) just as the Congressional Super Committee tasked with reining in the ballooning US deficit is said to be eyeballing farm subsidies as a place to find potential savings. (Of course, we don’t know for sure, because only certain well-connected lobbyists for industrial agriculture get to be in the loop.)
● No Fear Finance: An Introduction to Finance and Investment for the Non-finance Professional
By Guy Fraser-Sampson
Review via UK Analyst
To some people the world of finance can be as complicated to understand as medicine or particle physics. This seems sad given that money is a vital part of our everyday lives - unlike brain surgery or splitting the atom. But in No Fear Finance Guy Fraser-Sampson attempts to show that finance is not such a scary subject as it can sound and that anyone can learn to understand it by taking on some basic principals. The book, which after a short introduction to why the subject can be difficult to understand, introduces all of the key topics involved in finance which people should be aware of in today's world. It starts right at the beginning of the business process, with the various legal structures of enterprise explained. Moving on through basic accounting, bonds, the time value of money, equities and working capital, we then learn about more difficult subjects such as derivatives and the portfolio management concepts, alpha and beta. Each chapter also includes a useful summary section, with the main points of the text presented in an easy to read, bullet point format.
● The Legacy of the Crash: How the Financial Crisis Changed America and Britain
Edited by Terrence Casey
Review via London School of Economics
Three years ago the world was gripped by the aftermath of the collapse of Lehman Brothers... Fast-forward to the present and the sense of crisis is no less imperative. However, instead of worries about government inaction, the primary fear is now that the various stimulus package and bailouts have increased the burden of sovereign debt around the world to unsustainable levels. Consequently, despite anaemic growth and high unemployment, the political barometer has moved rightwards in many countries. The Legacy of the Crash: How the Financial Crisis Changed America and Britain, a collection of articles and essays on the effects of the crisis edited by Terrence Casey, attempts to explain these recent political shifts.
October 28, 2011
A story last month in the FT quoted several sources who argue that the sovereign debt crisis in Europe is a factor that's driving up correlations among asset classes lately. “It poses a big challenge for risk managers and portfolio managers," explains Pavan Wadhwa, head of global interest rate strategy at JPMorgan. "The more correlated the underlying assets in your portfolio, the less diversification you have."
Other analysts say that rising correlations are a secular trend as well, a byproduct of increasing globalization. In a world where moving money across borders, or from one asset class to another, is easy and inexpensive, the old barriers are giving way.
Whatever the reason, higher correlations imply lower risk premiums from simply diversifying across asset classes. Perhaps that's another way of saying that markets are becoming more efficient. But correlations are complicated and so it's hard to generalize. There are many ways to slice and dice the capital and commodity markets and so there's a wide array of correlation pairs to consider.
Let's start with the equity markets. As the first chart below shows, correlations are at or near their highest levels in years on a rolling 36-month basis for various slices of stock markets relative to the S&P 500. Foreign stocks in developed markets (MSCI EAFE) share a return correlation with the S&P of nearly 0.9. (Correlation readings range from 1.0 for perfect positive correlation to zero, which implies no correlation, to -1.0 or perfect negative correlation.)
Correlations have also risen for REITs and U.S. stocks in recent years, with a similar story describing the relationship between commodities and U.S. stocks. A notable exception: correlations between U.S. stocks and U.S. bonds have fallen lately (as depicted by the red line in chart below).
Let's take a slightly different view of asset class correlations and review how U.S. bonds compare with REITs and commodities. Note that the correlations for these pairings are still quite low, generally in the 0.3 range or below, as the next chart shows.
Correlations between U.S. investment-grade bonds and foreign bonds are somewhat higher, but low enough to inspire expectations that diversifying globally is still productive for fixed-income allocations. Meanwhile, correlation levels for U.S. investment-grade and domestic junk bonds in particular are considerably lower, flying under the 0.4 mark for the last three years.
By contrast, correlations between U.S. stocks and emerging market bonds are surprisingly high of late. Ditto for stocks and junk bonds. Fixed-income markets in foreign developed countries, by contrast, offer a more attractive correlation proposition.
Even if correlations overall are elevated, don't ignore other risk metrics for clues about the potential benefits of asset allocation strategies. For example, the MSCI EAFE and the S&P 500 share a tight relationship in terms of return correlations these days, but that doesn't mean that foreign and domestic stocks have similar returns. For the year through October 27, the S&P 500's price is higher by 8.6%. Over the same stretch, foreign stocks (MSCI EAFE) in unhedged dollar terms have dropped by 2.8%.
Rebalancing opportunities, in other words, can persist even when correlations are high. Meantime, don't assume that today's correlations are set in stone. Correlations, like volatility, run in cycles. We may not see correlations fall to previous lows in some cases, but it's also unreasonable to think that today's levels are permanent.
Statistically speaking, any correlation between 1.0 implies diversification benefits. There may be less of it, but it hasn't evaporated entirely.
Still, it's hard to ignore the larger message: generating risk premiums isn't getting any easier. That's one reason to stay diversified across multiple asset classes and rebalance the mix regularly, perhaps opportunistically at times. That may sound counterintuitive amid high correlations, but risk premiums don't rely on correlations alone.
That's part of the reason why the combination of a simple asset allocation and forecast-free rebalancing strategies still earn competitive returns on a risk adjusted basis during a period of high correlations, as the rebalanced Global Market Index reminds.
Rising correlations don't help, of course, but it's hardly fatal. Yes, you'll probably have to work harder to earn the same risk premium. But we should be used to that by now (even though we're not happy about it).
September's Rebound In Consumer Spending & Income
Personal income and spending jumped in September, offering an encouraging reversal from August's sluggish pace. The revival was particularly strong for consumer spending. The numbers aren't all that surprising in light of yesterday's mildly upbeat GDP report for the third quarter. Surprising or not, today's spending and income numbers reconfirm the statistical case for arguing that there was no sign of a recession in Q3. Deciding what happens in Q4 is guesswork, of course, but there seems to be a bit of momentum in the macro numbers these days and so a bit of optimism is the new new thing again… at least for the weekend.
The surge in consumer spending last month vs. August was certainly impressive. Jumping by 0.6% in September (roughly three times higher than August's pace) suggests that a willingness to spend is alive and well in these United States. Nonetheless, there's a potential danger lurking in the sluggish growth in disposable personal income. Indeed, the gap between income and spending has become unusually wide in recent months, implying that a day of reckoning may be coming. Spending after all is financed with income and while it's possible for the two to go their separate ways for a time, eventually any chasm must close, or at least narrow.
The diverging trend between income and spending is clear if we look at rolling 12-month changes. Personal consumption expenditures are higher by more than 5% through September vs. a year ago. By comparison, disposable personal income advanced 3.2% over the past year. The two-percentage-point difference in income and spending is at the outer range of normal conditions. The implication: spending is due to fall, income is set to rise, or a bit of both. Something, in short has to give, if only a little.
It's almost certain that a rebalancing in the relationship is near, but it needn't be fatal. Private sector wages also staged a rebound in September, rising by 0.3%. That's hardly a blow-out performance, but it's a world away from August's -0.2% stumble and it suggests that wage gains aren't beyond the pale in this climate.
Looking at wages on a rolling 12-month basis signals that the trend for growth has momentum. The 4.5% rise over a year ago isn't quite as strong as the years before the Great Recession, but the pace is well above levels that are historically associated with recessions.
The critical variable in all of this remains the labor market, of course. If there's any hope of maintaining the momentum in income, spending and the wider economy, job growth will have to persist if not accelerate. September's pace of job creation was relatively encouraging, but only in the sense that the labor market kept its nose up and avoided crashing. There's still a thin line between recession and growth these days, but at least the edge remains in favor of expansion. But confidence that the expansion has legs is unusually dependent on the number du jour. So, by all means, take comfort in today's spending and income report. We dodged a bullet in Q3. But don't get too comfortable with the optimism just yet. The Q4 numbers are just starting to roll in.
October 27, 2011
Jobless Claims: Still Going Nowhere Fast
Initial jobless claims slipped by a mere 2,000 last week to a seasonally adjusted 402,000. This leading indicator seems to be telling us that the economy can avoid a new recession--maybe--but that's about as far as the good news goes.
New filings for unemployment benefits remain stuck at elevated levels, offering a stark reminder that any optimism about the business cycle should be muted. An economy that's growing is all well and good, but it's a precarious growth without a stronger labor market.
“We’re not making much progress,” notes Robert Dye, chief economist at Comerica. “Unless we see the labor market improve, we won’t see income growth. The consumer will remain fundamentally constrained.”
The extent of that constraint is due for an update tomorrow, with the release of September figures for personal income and spending. For what it's worth, expectations are somewhat rosy (adjusted for the current climate). The consensus forecast calls for a 0.3% rise for income (vs. a 0.1% decline in August) and 0.6% gain for spending (vs. 0.2% in August), according to Briefing.com. Of course, some of this revival (assuming the forecasts are accurate) is already old news after today's GDP update.
US Economy Grew 2.5% In Third Quarter
The economy continues to struggle and recession risk is elevated, but today’s official estimate of third-quarter GDP shows that the economy didn’t surrender to contraction in the last three months. That may change, but for now the recession talk is on the defensive.
The economy grew at an annualized real rate of 2.5% in the third quarter, nearly twice as fast as the second quarter’s sluggish 1.3% pace. Today’s initial estimate of Q3 GDP from the Bureau of Economic is only the first stab at the numbers and so there’s revision risk to consider. Based on the number du jour, however, it seems as though the business cycle will live to fight another day for the forces of growth.
Digging into the details shows that several critical areas of the economy revived. Notably, personal consumption expenditures rose 2.4% in Q3, considerably better than Q2’s stall speed pace of 0.7%. A recovery in spending in durable goods over the last three months helped. A bigger rise in services spending was a plus too. Meanwhile, the government continues to be a net drag on GDP figures. This is good or bad news, depending on your policy view of fiscal austerity. In any case, nondefense Federal and state/local government columns are pinching GDP these days.
"This validates the economy is still growing, but probably not thriving, that's the bottom line,” advises Todd Salamone, director of research at Schaeffer’s Investment Research.
"Clearly today's GDP report is indicative of an economy that is extricating itself from a temporary soft patch, and not one that is rolling into another recession," according to Phil Orlando, chief equity strategist with Federated Investors.
Is all well with the business cycle? Hardly. But beggars can't be choosy these days. “It ain’t brilliant, but at least it’s heading in the right direction,” says Ian Shepherdson of High Frequency Economics. “I want to see 4 percent, but given that people were talking about a new recession, I’ll take 2.5 or 3, thanks very much.”
Of course, GDP is a lagging indicator and so it tells us what happened. The value here is limited for looking ahead. But this much is clear: Q3 wasn't the start of new recession. As for Q4, well, the narrative remains fluid.
The Forecast File: US Q3 GDP
GDP Growth Rate May Run Out of Steam
The Wall Street Journal | Oct 27
The Commerce Department will release its first estimate of third-quarter U.S. gross-domestic-product growth Thursday. Economists expect GDP in real terms to expand at about a 2.7% seasonally adjusted annualized pace, helped by a rebound in auto production after Japan-related shutdowns this year. This would be an improvement from the economy's average 0.9% growth rate in the first half of the year.
Economy in U.S. Probably Expanded at the Fastest Pace in a Year
Bloomberg | Oct 27
Gross domestic product, the value of all goods and services produced, rose at a 2.5 percent annual pace after advancing 1.3 percent in the previous three months, according to the median forecast of 83 economists surveyed by Bloomberg News. Household purchases, the biggest part of the economy, may have climbed more than twice as fast as in the second quarter.
GDP: good expectations for growth
The Washington Post | Oct 26
Forecasters expect that when the Commerce Department releases its first estimate of the number, gross domestic product will have risen at a 2.5 percent annual rate in the third quarter. That would be the highest growth rate in a year and would trump the 0.7 percent average pace over the first half of this year.
Analysts change tune on GDP, now see solid Q3
Reuters | Oct 26
Economists now estimate gross domestic product grew at an annual pace of 2.5 percent, according to the median of a Reuters poll. That would mark a sharp step up from the 1.3 percent logged in the second quarter and a far cry from what some feared just a few weeks ago.
US economy likely grew a little faster over summer
The Associated Press | Oct 27
The U.S. economy likely grew at a faster pace over the summer after a sluggish first half of the year. Consumers spent more on retail goods. Businesses kept investing in equipment. And U.S. auto production rebounded after supply-chain disruptions caused by the Japan crisis finally started to ease. For those reasons, economists are forecasting annual growth of 2.4 percent for the July-September quarter, according to a survey by FactSet.
GDP October Surprise: Big Jump Expected for 3Q
The Fiscal Times | Oct 26
Economists surveyed by various outlets have, over the last month, raised their forecasts for third-quarter GDP growth to 2.5 percent, up from much less rosy rates below 2 percent. Corporate earnings overall have come in better than expected — not unusual, but still a relief given fears that the stalling economy could grind away at profits. The stock market has responded with gusto.
October 25, 2011
I'm heading off to the NAPFA Practice Management & Investments Conference at the Brooklyn Marriott. I'm the luncheon speaker tomorrow (Wed). The topic: asset allocation. Strategy chatter on a full stomach. Is that wise? We'll see. In any case, blogging will go dark for the next day or so, with a resumption of the usual fare on Thursday.
Meanwhile, I see that today's S&P/Case-Shiller Home Price Indices were up in August. “We see a modest glimmer of hope with these data,” David Blitzer of S&P said via the press release.
There's no shortage of worrisome trends on the macro stage, but perhaps the most troubling is the trend in real (inflation-adjusted) hourly earnings and personal consumption expenditures. Both have been falling persistently on a year-over-year basis. Some economists see this as a dark sign for the business cycle. It's also a test of Hayek's idea that falling wages will plant the seeds of economic recovery. By that standard, macro salvation is coming.
The New Yorker's John Cassidy explains:
Before the Great Depression, most economists adhered to a Newtonian conception of the economy as a self-correcting system. When the economy entered a slump, businesses laid off workers and shut down factories—but these negative trends contained their own remedy. The trick was to look at price changes. Unemployment drove down wages (the price of labor) until firms found it profitable to start hiring again. Idling factories drove down interest rates (the price of borrowing) until entrepreneurs found it worthwhile to take out loans and re-start production. Before very long, prosperity would be restored. Attempts to hasten this process were liable to interfere with the natural forces of adjustment and make things worse. As Hayek wrote in “Prices and Production ” (1931), “The only way permanently to ‘mobilize’ all available resources is . . . not to use artificial stimulants—whether during a crisis or thereafter—but to leave it to time to effect a permanent cure.”
If there's hope in falling wages, the chart below should inspire Hayek's followers to see revival approaching. Real average earnings are plumbing depths unseen in recent history. And on Friday we can ponder a new data point via the September update for personal income and spending. The question before the house: Will Hayek's cure will bite or befriend? The crowd's reaction to Friday's report may offer a clue.
October 24, 2011
Another Look At The Stock Market & The Business Cycle?
The stock market’s annual performance is comfortably in the black again. After a brief slump into negative territory on a year-over-year price basis in late-September and early October, the S&P 500 is higher by 4.9% through Oct. 21. Is that a sign that the economy will keep growing? History offers some evidence for responding with a cautious “yes.”
The usual caveats apply, of course, starting with Paul Samuelson’s famous remark that the stock market has predicted nine of the last five recessions. Perfection is not Mr. Market’s forte when it comes to discounting the future. The same is true for every other forecasting technique (or forecaster), which brings us back to square one: Does the stock market have any value for evaluating the macro trend? Yes, it does, or so the track record suggests.
The main glitch in looking to the equity market for a guesstimate of what’s coming is the habit of seeing recessions that never materialize. By contrast, the market’s record in forecasting growth boasts a better record. For example, if we use the S&P 500’s 12-month percentage change as a measure for anticipating economic performance for the year ahead, the historical record is encouraging.
Over the past half century of the American business cycle (according to NBER dates), only one of the previous eight recessions has struck without a decline in the S&P 500's annual percentage change (either before or in the early stages of a downturn). The exception is the fleeting recession of 1980, which lasted a brief six months—the shortest on record.
Perhaps that record is anecdotal, which inspires looking for more quantitative evaluations. One possibility is analyzing the stock market’s annual performance relative to proxies of the business cycle, such as the 12-month percentage changes for industrial production and non-farm payrolls. Here too there’s reason to think that equity prices are a useful if flawed predictor of the broad cycle.
As an example, consider cross correlations for the annual changes of the S&P 500 and industrial production, as shown in the chart below. Correlation is a measure of statistical dependence with readings ranging from -1.0 (perfect negative correlation) to zero (no correlation) to 1.0 (perfect positive correlation). Correlation isn’t necessarily evidence of causation, of course, but it’s a useful way to begin looking for evidence (damning or otherwise) of relationships between data series. With that in mind, the cross correlations for the S&P and industrial production suggest that the equity market anticipates changes in industrial production at roughly six to eight months in advance. Or so one can infer from the peak in correlations for these series at roughly 0.55 at the -6 month level (see chart below).
The relationship isn’t as strong when we look at rolling 12-month changes for the equity market vs. the equivalent for non-farm payrolls. But it’s also hard not to notice that the correlations for this pair also show a relatively strong relationship at the -6 to -8 month readings. The implication: stock prices anticipate changes in the labor market by around six to eight months in advance.
Like every other predictor, you can’t count on the stock market for flawless forecasts. But as the charts above suggest, you shouldn’t dismiss Mr. Market’s implied predictions either. No one should use this or any other predictor in a vacuum. That said, the stock market appears to be voting in favor of growth these days, if only moderately. Yes, it’s the worst forecasting tool we have... except in comparison to most of the alternative techniques for peering into the future.
A Precarious Optimism For Q3 GDP
Worries about a new recession have been on a roll over the past month, but some forecasters are having second thoughts. "The U.S. economy probably grew in the third quarter at the fastest pace this year, easing anxiety that the recovery was on the verge of stalling, economists said before a report this week." Bloomberg reports. "Gross domestic product, the value of all goods and services produced, rose at a 2.5 percent annual rate after advancing 1.3 percent in the previous three months, according to the median forecast of 68 economists surveyed by Bloomberg News before the Commerce Department’s Oct. 27 release. Orders for business equipment rose in September and new-home sales stabilized, other data may show."
David Altig and Patrick Higgins at the Atlanta Fed note that recent surprises in the economic news have turned to the positive:
One aspect of this analysis is called a 'nowcasting' exercise that generates quarterly GDP estimates in real time. The technical details of this exercise are described here, but the idea is fairly simple. We use incoming data on 100-plus economic series to forecast 17 components of GDP for the current quarter. Those forecasts of GDP components are then aggregated to get a current-quarter estimate of overall GDP growth.
The outcomes of this exercise have been as positive in the third quarter as they were negative for the first two quarters of the year.
A bit of statistical corroboration for the modest improvement can be found in the latest data points of the Aruoba-Diebold-Scotti Business Conditions Index. This benchmark, which is "designed to track real business conditions at high frequency," has been recovering lately, albeit slowly and from a low level.
The main focus for economic news this week is on third-quarter GDP, which is scheduled for release on Thursday. The consensus forecast is calling for a 2.2% annualized real growth rate, according to Briefing.com. Marketwatch's polling of economists looks even better, projecting a 2.8% rise for the economy in Q3. By comparison, Q2's GDP rose a meek 1.3%.
But the modest revival in expectations may be hanging on a thread. The fear of blowback from Europe and the Continent's highwire act with the euro crisis looms large over any confidence that the near term offers smooth sailing for keeping growth alive.
Meanwhile, the recession call by the respected Economic Cycle Research Institute (ECRI) is still rattling the optimists. As Doug Short noted last week, ECRI's leading index has been falling since early August.
The week ahead may tell us if that pessimism is warranted or not. In addition to Q3 GDP, Wednesday brings news of the latest on new orders for durable goods, followed by Friday's update on personal income and spending. Economists generally see modest growth for these numbers as well, but forecasts count for even less than usual these days.
October 22, 2011
Book Bits For Saturday: 10.22.2011
● The Vigilant Investor: A Former SEC Enforcer Reveals How to Fraud-Proof Your Investments
By Pat Huddleston
Interview with author via Financial Impact Factor Radio
Today on the Financial Impact Factor Radio we had Pat Huddleston, author of “The Vigilant Investor: A Former SEC Enforcer Reveals How to Fraud-Proof Your Investments“, lawyer and CEO of Investors Watchdog LLC. As a former SEC Enforcer, he has seen more scams than you could imagine. With his new book, he takes those stories and the effect it has had on the victims and gives us the ultimate tell-all on how to spot what the people we may trust are actually doing – often right under our noses.
● Regulators Gone Wild: How the EPA is Ruining American Industry
By Rich Trzupek
Review via Climate Realists
This book could not have been published at a more propitious time. As the economy falters, it seems that every critic of this administration cites the role of regulation in strangling American business and industry--thereby preventing them from hiring new workers. Rich Trzupek, a chemist and environmental consultant for twenty five years, provides much needed chapter and verse, focusing on the devastation wrought by what has become the most abusive agency in the government alphabet soup--the EPA.
● The Price of Civilization: Reawakening American Virtue and Prosperity
By Jeffrey Sachs
Review and author interview via NPR
Sachs explores the result of the widening income gap in his new book, The Price of Civilization: Reawakening American Virtue and Prosperity. The book's title was inspired by Supreme Court Justice Oliver Wendell Holmes, who once said, "Taxes are what we pay for civilized society." Sachs says middle-class growth suffered in the 1980s when taxes were reduced and programs like energy research were scaled back — programs that he says would have made the United States more competitive in the face of globalization. And he says current government policies, including President Obama's jobs plan, are short-term fixes that still leave the country vulnerable.
● Thinking, Fast and Slow
By Daniel Kahneman
Excerpt via The New York Times
Although professionals are able to extract a considerable amount of wealth from amateurs, few stock pickers, if any, have the skill needed to beat the market consistently, year after year. The diagnostic for the existence of any skill is the consistency of individual differences in achievement. The logic is simple: if individual differences in any one year are due entirely to luck, the ranking of investors and funds will vary erratically and the year-to-year correlation will be zero. Where there is skill, however, the rankings will be more stable. The persistence of individual differences is the measure by which we confirm the existence of skill among golfers, orthodontists or speedy toll collectors on the turnpike.
● The Global Minotaur: America, The True Origins of the Financial Crisis and the Future of the World Economy
By Yanis Varoufakis
Summary via publisher, Zed Books
In this remarkable and provocative book, Yanis Varoufakis explodes the myth that financialisation, ineffectual regulation of banks, greed and globalisation were the root causes of the global economic crisis. Rather, they are symptoms of a much deeper malaise which can be traced all the way back to the Great Crash of 1929, then on through to the 1970s: the time when a 'Global Minotaur' was born. Just as the Athenians maintained a steady flow of tributes to the Cretan beast, so the 'rest of the world' began sending incredible amounts of capital to America and Wall Street. Thus, the Global Minotaur became the 'engine' that pulled the world economy from the early 1980s to 2008.
● Can Economic Growth Be Sustained?: The Collected Papers of Vernon W. Ruttan and Yujiro Hayami
Edited by Keijiro Otsuka and C. Ford Runge
Summary via publisher, Oxford University Press
This collection of essays by Ruttan and Hayami spans their long career in the economics of technical and institutional change. At both a theoretical and empirical level, their analysis of induced innovation provides a solid foundation for understanding how and why technologies and institutions evolve in response to factors that constrain them. Can Economic Growth Be Sustained? provides a sweeping explanation of this process.
October 21, 2011
Strategic Briefing | 10.21.2011 | US Leading Indicators
September Leading Economic Index
Conference Board | Oct 20
The Conference Board Leading Economic Index (LEI) for the U.S. increased 0.2 percent in September to 116.4 (2004 = 100), following a 0.3 percent increase in August, and a 0.6 percent increase in July. Says Ataman Ozyildirim, economist at The Conference Board: “September data shows moderating growth in both the LEI and the CEI. The weaknesses among the leading indicator components have become slightly more widespread in September. Moreover, the CEI suggests current economic conditions have been slow, with weak gains in all four components over the past six months. The slow pace in the LEI suggests a growing chance that this sluggish economy is going to be here for a while.”
Conference Board sees 50 percent chance of recession
Reuters | Oct 20
The U.S. economy faces a 50 percent chance of recession despite modest gains in a leading index of activity, a private sector research group said on Thursday. The Conference Board's leading index rose 0.2 percent last month, a smaller rise than analysts had forecast in a Reuters poll, following a 0.3 percent gain in August.
U.S. Leading Economic Indicators Rose 0.2% in September
Bloomberg | Oct 20
The Conference Board’s gauge of the outlook for the next three to six months climbed 0.2 percent after a 0.3 percent gain in August, the New York-based research group said today. The September increase, the lowest since a decline in April, matched economists’ projections, according to the median forecast in a Bloomberg News survey.
Leading indicators edge up 0.2 percent in September, signaling modest growth in future
AP | Oct 20
For September, the Conference Board said that the biggest positive contribution to the index came from the difference in short-term and long-term interest rates. Other positive factors were the growth in the money supply, supplier delivery times, the index of consumer expectations and new orders for consumer goods and materials. The biggest negative factor for the index in September was weakness in applications for building permits followed by new orders for nondefense capital gods, stock prices and weekly claims for unemployment benefits.
Leading Indicators: Slower Growth is the Theme
John Silvia (Wells Fargo) | Oct 20
The leading economic index rose 0.2 percent in September and has risen 5 percent over the past three months. This pattern suggests continued growth for the next six months, yet the pace of growth remains modest.
October 20, 2011
A Small Dip In Jobless Claims Keeps Hope (And The Un-Recession) Alive
Today's update on new jobless claims is encouraging because of what didn’t' happen. New filings for unemployment benefits didn't rise last week, which keeps hope alive that a new recession can be avoided for the foreseeable future. But while new claims dropped by 6,000 last week to a seasonally adjusted 403,000, this mild decline isn't all that convincing. The ranks of the newly unemployed continue to swell each week by roughly 400,000, a stark reminder that the labor market is still struggling. As a result, the economy remains vulnerable, even if it's not at the tipping point.
If jobless claims surge higher at some point, so will the odds that another recession is upon us. By that standard, today's numbers suggest that the sluggish growth will prevail. But how much confidence do you have that next week (or the week after) will dodge a bullet as well?
No one can ignore the rising pressure on the economy. As one example, consider how the St. Louis Financial Stress Index compares with the broad economic trend (Chicago Fed National Activity Index) these days. As the chart below shows, the pressure is rising at a time when growth momentum has been decelerating. That' a toxic mix, and if it continues, well, the outcome is all but assured.
There are plenty of other warning signs as well, such as the rolling 12-month percentage change in real consumer spending and real average hourly earnings. Joseph Ellis, author of Ahead of the Curve: A Commonsense Guide to Forecasting Business And Market Cycle, cites these metrics as among the more valuable indicators for evaluating the outlook for the macro cycle. Unfortunately, the recent numbers don't look encouraging, as the chart below shows.
Persistently declining real wages and earnings on a year-over-year basis are hardly the raw material for producing robust periods of economic growth. But as long as the labor market doesn't succumb, the forces of darkness can be held off. Still, the defenses are weak, and perhaps weakening.
"We're running in place," says Scott Brown, chief economist at Raymond James. The latest jobless claims numbers are “consistent with lackluster to moderate growth in the job market and the economy."
Michael Woolfolk, senior currency strategist at BNY Mellon, advises that the latest updates on payrolls and retail sales have "effectively removed the double-dip scenario for the U.S." Today's drop in jobless claims is another piece of supporting evidence for this view, he notes. "But we are still a long distance from the 200,000 new jobs a month we need for a sustainable improvement in the unemployment rate."
Meantime, the un-recession rolls on.
Awkward History Lessons
Ron Paul, a Republican congressman running for president, indicts the Federal Reserve in today's Wall Street Journal. Surely there's no shortage of mistakes that can and should be leveled at the central bank. Institutions run by mere mortals are nobody's idea of perfection. Yet there's also some progress to report. In contrast to the early 1930s, the Fed's response to the financial crisis was better this time. That's a low standard, but at least we don't have 25% unemployment. Better, but not good enough. But as Paul sees it, the true solution is removing the central bank from the system. All will be well, he suggests, once we let the market take over the delicate task of managing the nation's money supply. The historical precedent for this idea, however, is thin, to say the least.
Paul's advice, of course, is a cute way of favoring a gold standard, although he never mentions the metal in this article. It sounds like a reasonable idea on the surface perhaps, but there are some awkward questions that never seem to come up for the gold bugs. But inquiring minds want to know how the anti-Fed crowd would respond to a surge in money demand?
Imagine a scenario where an economy suffers a macro shock and the business cycle bites into growth. Imagine also that the public's demand for money—for liquidity—rises sharply. Before we go on, hold that thought and reflect on the fact that dramatic swings in economic conditions, along with rising and falling demand for money, have a history in these United States--a history that predates the creation of the Federal Reserve in 1913. These pre-Fed fluctuations were neither trivial nor infrequent, according to NBER data.
Meanwhile, back to our theoretical scenario. Money demand surges, for whatever reason. What's the effect? Assuming no change in money supply, a rise in savings implies deflation for goods and services and therefore the economy overall. The question is whether there's an economic rationale for stabilizing a price decline driven by a surge in money demand that's triggered by a macro shock? Is there a case for printing money that wouldn't otherwise be available if left to "the market"? History has answered with a resounding "yes," a preference that applies with or without central banks.
In the last major financial crisis in the U.S. before the creation of the Federal Reserve there was yet another surge in money demand. The year was 1907 and capitalism was relatively unconstrained by 21st century regulatory standards. This was also a time when a form of the gold standard reigned supreme. And yet the decision was made to intervene in the money market. There was no central bank at the time and so a defacto institution was carved together, led by banking magnate J.P. Morgan. For the details you can read The Panic of 1907: Lessons Learned from the Market's Perfect Storm. The shorter version of this story is simply that someone or something was needed to restore order to stop the system from imploding. Was 1907 an anomaly? A rare event? Hardly. Booms and busts have been part of the economic fabric for centuries. The only thing that's changed is how nations respond to these recurring crises.
The pre-Federal Reserve era is, of course, conveniently overlooked in some circles in a rush to restore something akin to a gold standard. If we could only return to those halcyon days before a central bank mucked up what was formerly a kinder, gentler business cycle. It's a nice idea, but it's a fantasy. Removing the Fed wouldn't render the business cycle null and void, and it's quite possible that such a change could exacerbate the ups and downs of the business cycle. Perhaps that's a reasonable tradeoff, but history suggests there's no free lunch here.
There's a reason why central banks were invented. That's no excuse to be uncritical of the Fed, or to assume that it can do no wrong. But embracing the opposite extreme is no less misguided. As usual, the solution, or what comes closest to a solution, lies in the middle.
Successful monetary policy, in short, is complicated for a rather simple reason: the business cycle endures. Why does it endure? If we knew the answer, we wouldn't need a central bank (or a J.P. Morgan to act like one).
October 19, 2011
Housing Starts & Inflation Rise In September
This morning’s updates on consumer inflation and housing construction for September offer some additional support for my previous post on thinking that September won't be seen as the start of a new recession. The quick summary: housing starts rose 15% last month, the fastest pace since January; consumer inflation slowed, but only marginally, suggesting that disinflation/deflationary forces related to economic contraction remain minimal.
Today’s rise in housing starts is certainly welcome, although one number alone doesn’t change much in the grand scheme of the macro trend. The best you can say with September’s pop in new starts is that it adds a bit more heft against the case that another downturn is upon us. Even so, the number du jour for starts could easily turn out to be noise, as the chart below suggests. Also, the mildly encouraging news on starts was offset by a 5% fall in new building permits for September, implying that the great slump in residential real estate will drag on.
Today’s housing numbers, in other words, are a mixed bag. But that’s better than a clear sign of fresh deterioration. As such, it’s a touch of good news on the margins in the delicate art of real-time analysis of recession risk.
As for consumer inflation, the CPI rose 0.3% last month on a seasonally adjusted basis, down slightly from August’s 0.4% rate. For the year through September, CPI is higher by 3.9%. That’s the fastest pace in three years, although it still looks rather middling over the longer term. The average annual rate of change for annual inflation was 3.1% for the 20 years before the onset of the Great Recession—a period widely hailed as an era of contained inflation. Meanwhile, core inflation (less energy and food) is rising by 2.0% a year as of last month, at or near the upper range of the Fed’s unofficial long-run target.
Some analysts will argue that inflation’s rise of late is bad news, but as I explained a few days ago that line of reasoning in the current climate is misguided. Until the economy makes more progress in recovering from the blowback of the Great Recession, inflation expectations and the outlook for growth are positively correlated to an unusually high (and unhealthy) degree. As economist David Glasner observes, "investors don’t fear inflation, they yearn for it."
"My view is that this worst-case scenario is less likely than it appeared to be a couple of months ago," says Atlanta Fed President Dennis Lockhart. "I don’t expect a double-dip recession" based on “recent positive surprises in the data."
Not everyone agrees, and it's too early to dismiss darker predictions completely. "If the Europeans can’t solve the problem within a year, we are likely to have another worldwide recession," warns Dale Mortensen, a Nobel-prize winning economist. “So it’s very important for all of us to resolve that problem in the short term.”
Macroeconomic Advisers: US GDP Rose 0.4% In August
It's still too early to dismiss the threat of a new recession, but if there's macro trouble ahead it's not obvious in the big picture for August. Macroeconomic Advisers released its latest monthly estimate of U.S. GDP to the public yesterday and reports that the economy expanded 0.4% in August. That's down from July's 0.9% pace, and so the question is whether September's numbers will reflect a further slowing in the broad trend? Answering that question still requires guesswork since all of September's numbers haven't been released yet. (The official government GDP report is calculated quarterly and the first Q3 estimate is scheduled for release on Oct. 27.)
What we do know, based on the data so far, is that the economy grew in August, pushing Macroeconomic's estimate of GDP to the highest level since the Great Recession ended in June 2009.
As for the September indicators that are known, the numbers look moderately encouraging to date. For example, industrial production last month rose a modest 0.2%, up from no change in August. That's a weak performance, but at least it's a move in the right direction for thinking that September won't succumb to the forces of contraction. Looking at the year-over-year change in industrial production through September is more encouraging with annual growth of 3.2%, or well above levels that typically relate with recessions.
Job creation was still rolling along last month, too, with a net gain of 137,000 in private nonfarm payrolls in September--up sharply from August's meager 42,000 rise. September's rebound is still mild by historical standards, but it doesn't look like a smoking gun for arguing that we're in a recession. The recent trend in weekly jobless claims doesn't look ominous either, at least not for predicting a new recession is here.
The September update on retail sales also implies that the economy continued expanding last month. Consumer spending rose 1.1% in September, the most since February. On an annual basis, retail sales are higher by nearly 8% through September. Historically speaking, that's a strong pace and it's no trivial figure for an economy that relies heavily on consumer spending.
From the sentiment corner, optimists can point to the fact that the stock market is no longer in the red on a 12-month basis (as it was briefly for a few days in late September/early October). Equities are hardly a flawless predictor of the macro trend, but it's worth reminding that every recession in the past 50 years has been accompanied by a persistent 12-month price loss in the S&P 500. By that standard, the market hasn't yet thrown in the towel on the economic outlook.
None of this is a guarantee that another recession isn't near. There are plenty of risks weighing on the global economy and the U.S. expansion is sufficiently precarious to wonder if the trend can survive another unexpected shock. But the mounting statistical evidence in the September reports suggests that last month wasn't the start of a new downturn. Maybe October's numbers (when they're released in November) will bring different news, but for the moment there's still a case for arguing that the weak recovery stumbles on.
October 18, 2011
The New Abnormal: Inflation Expectations & The Stock Market
There's a rumor going around that the crowd's worried about inflation. Tim Bond of Odey Asset Management speaks for many of this persuasion when he writes in the Financial Times that "the rise in inflation has been the main factor responsible for the sharp slowdown in global growth since the start of the year." Normally, worrying about pricing pressures is an accurate description of how the capital markets respond to higher inflation expectations, and rightly so. Inflation is a corrosive force that eats into wealth. But these aren't normal times.
As a barometer of how abnormal things are, consider the unusually tight relationship between the stock market and the market's inflation forecast, as defined by the yield spread in the nominal 10-year Treasury less its inflation-indexed counterpart. Normally, there's minimal correlation between price changes in the stock market and the market's inflation outlook. The two markets more or less go their separate ways. But in the wake of the financial crisis in late-2008, the normal state of affairs has given way to aberration, as the chart below shows.
Over the past year, for instance, the stock market's moves have been tightly correlated with changes in inflation expectations. Equities tend to rally when the Treasury market anticipates higher inflation, and vice versa. This relationship suggests "that investors don’t fear inflation, they yearn for it," as David Glasner explains. A formal economic explanation for what's happening can be filed under the heading of the "The Fisher Effect Under Deflationary Expectations," the title of a paper by Glasner.
The source of the problem, as Charles Evans of the Chicago Fed suggests, is an erosion of the central bank's credibility though a monetary policy of passive tightening. Speaking at a conference yesterday, Evans reviewed the challenges and the framework for a solution, if only a partial one:
Given the economic scenario and inflation outlook I have discussed, if it were possible, I would favor cutting the federal funds rate by several percentage points. But since the federal funds rate is already near zero now, that’s not an option. To date, the Fed’s policymaking committee, the FOMC, has used a number of nontraditional policy tools to impart greater financial accommodation. I have fully supported these policies. However, I would argue for further policy actions based on our dual mandate responsibilities and the strong impediments of the financial crisis.
Evans goes on to say that the "current financial conditions are more restrictive than I favor, in part because households, businesses and markets place too much weight on the possibility that Fed policy will turn restrictive in the near to medium term." Marcus Nunes simplifies the issue and simply notes that Bernanke "loses it," a reference to the Fed head's former promise to Milton Friedman that he understood the implications of the Fed's past mistakes in the 1930s and would do better in the future.
Changing the expectation that the Fed won't do more won't be easy, in part because central banks have fought long and hard to promote their inflation-fighting credentials and, well, it's hard to teach old dogs new tricks. But inflation fighting at the moment isn't appropriate, according to Evans: "Given this strong anti-inflationary orientation of central bankers, appropriate policy actions may face a credibility challenge of a different nature than we are used to talking about — can conservative central bankers be counted on to commit to keeping interest rates low in the event inflation rises above their long-run target?"
The answer seems to be "no," or so the high correlation between the stock market and inflation expectations imply. If there's any change, we'll likely see it in a disconnect between equity prices and the Treasury market's outlook for inflation. Meantime, the (unfulfilled) yearning continues.
October 17, 2011
The Trouble With Return Anomalies
Is the small cap risk premium dead? The question endures for a rather practical reason: sometimes the excess return on small stocks vs. large companies evaporates. No one's ever sure if it'll return. That's the nature of return "anomalies."
The idea that you'll earn a higher return for owning small stocks vs. large cap stocks is perhaps the most-famous of all the known return anomalies. It's also no stranger to systematic efforts at trying to extract small cap performance gold, as the sea of dedicated funds in this niche reminds. The long run track record certainly looks encouraging, as many researchers have documented through the years. A recent study, for instance, reports a small-cap premium of roughly 200 basis points over large caps in the U.S. since 1926 ("The behaviour of small cap vs. large cap stocks in recessions and recoveries: Empirical evidence for the United States and Canada," by Lorne N. Switzer). The international evidence in favor of small caps is also conspicuous ("Size, Value, and Momentum in International Stock Returns," Eugene Fama and Ken French). But expecting the small cap premium to arrive arrive in steady doses is expecting too much.
In recent years, small stocks have trailed their larger counterparts, according to Russell Investments. Over the last five years through Oct. 14, 2011, large caps have a slight edge. Is that the new normal? The large-cap advantage is even greater over the past 12 months. Is that a sign of things to come? Or just a temporary failure?
The weak relative performance in small companies of late is merely the tip of the iceberg, according to recent claims that the small-cap premium is less than it's cracked up to be once you adjust for risk. "The long-held belief that small stocks beat large on a risk-adjusted basis is simply not supported by the facts," report Gary Miller and Scott MacKillop of Frontier Asset Management in the September 2011 issue of Financial Advisor.
Even if you disagree, recent history reminds that being a small cap investor is no easy road to riches. Should we be surprised? No, not really. Return anomalies, whether it’s the value factor, momentum, liquidity risk, or any of the long list of other identified sources of excess return, the future's always uncertain.
We should be wary of becoming intellectually lazy when it comes to expectations of capturing higher returns over the broad market, either within an asset class or in a multi-asset class strategy. Everyone can't earn above-average returns. In the long run, positive alpha is offset by negative alpha. That's simply fate. A buy-and-hold strategy of overweighting small caps may work...if you wait long enough.
But timing may be crucial: there's lots of opportunity for beating the benchmarks by reweighting risk factors. But higher returns aren't a constant. Much depends on when you reweight... or don't. Easier said than done. No wonder that in the long run the average investor (as defined by the market-value-weighted return) earns average returns—Duh! The rest of the story is that there must be below-average investors—no anomaly is excepted. Someone has to pay for the above-average results that some of us will earn.
October 15, 2011
Book Bits For Saturday: 10.15.2011
● Red Alert: How China's Growing Prosperity Threatens the American Way of Life
By Stephen Leeb with Gregory Dorsey
Review via Publishers Weekly
he U.S. was galvanized by the terrorist attacks of September 11, but according to economist Leeb, what we should have been worrying about was the contemporaneous emergence of China's enormous impact on commodity conservation and use. By 2012, the Chinese will hold a leading position in every aspect of renewable energy. Leeb argues that we as a nation are not paying enough attention to the threat of China's growing influence; he paints a picture of our government as fundamentally scattered and shortsighted, though his ire isn't aimed at any particular administration. Our political and economic systems don't lend themselves to tackling major problems until they reach crisis proportions, whereas the Chinese are relentlessly long-term thinkers (furthermore, their leaders don't have to answer to a fickle electorate)... Terse, well-reasoned, and comprehensive, this is a much-needed shot in the arm for American complacency.
● The Smartest Portfolio You'll Ever Own: A Do-It-Yourself Breakthrough Strategy
Review via CBS MoneyWatch
Acclaimed and prolific investment author, Dan Solin, has written another terrific book that offers the reader timeless advice on building a portfolio. The Smartest Portfolio You’ll Ever Own concentrates on constructing a portfolio of low cost funds with a bent toward small cap and value stocks. Based on the Fama-French 3 Factor model, this type of portfolio construction can give you higher returns as compensation for taking more risk.
● Portfolio Design: A Modern Approach to Asset Allocation
By Richard C. Marston
Excerpt via Investment News
There is a key concept in retirement planning that most Americans have not even heard of. That is the concept of a spending rule, a rate of spending in retirement that can be sustained through time. Foundations have spending rules that guide their activities through time. So must retirees, since they also must live off of their endowment — the wealth they have accumulated for retirement. If the retiree has a defined-benefit retirement plan, spending can be tied to the income from that plan (plus Social Security). Most of us are not fortunate enough to have such a plan. For the many Americans with only defined-contribution retirement plans, there is no guaranteed income from those plans, and retirement spending must depend on returns from accumulated wealth. So a spending plan is necessary.
● The Age of Equality: The Twentieth Century in Economic Perspective
By Richard Pomfret
Summary via publisher, Harvard University Press
In 1900 the global average life expectancy at birth was thirty-one years. By 2000 it was sixty-six. Yet, alongside unprecedented improvements in longevity and material well-being, the twentieth century also saw the rise of fascism and communism and a second world war followed by a cold war. This book tells the story of the battles between economic systems that defined the last century and created today’s world.
● Keynes Hayek: The Clash that Defined Modern Economics
By Nicholas Wapshott
Summary via publisher, WW Norton
Can government fix a broken economy? Two great economists disagreed eighty years ago, and their debate dominates politics to this day.As the stock market crash of 1929 plunged the world into turmoil, two men emerged with competing claims on how to restore balance to economies gone awry. John Maynard Keynes, the mercurial Cambridge economist, believed that government had a duty to spend when others would not. He met his opposite in a little-known Austrian economics professor, Freidrich Hayek, who considered attempts to intervene both pointless and potentially dangerous. The battle lines thus drawn, Keynesian economics would dominate for decades and coincide with an era of unprecedented prosperity, but conservative economists and political leaders would eventually embrace and execute Hayek's contrary vision. From their first face-to-face encounter to the heated arguments between their ardent disciples, Nicholas Wapshott here unearths the contemporary relevance of Keynes and Hayek, as present-day arguments over the virtues of the free market and government intervention rage with the same ferocity as they did in the 1930s.
October 14, 2011
No Sign Of Recession In September Retail Sales
Any one economic indicator is suspect as a measure of the broad trend, but the updates arrive one at a time and so we must take ‘em as we get ‘em. Taking this morning’s retail sales report at face value suggests that the recession talk of late is premature. Retail purchases rose sharply last month, gaining 1.1% on a seasonally adjusted basis over August. That’s the best month for retail sales since February. Recession where is thy sting?
“It’s a strong performance,” says Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott. “Retailers are in good position to profit from the holiday season.”
It’s true that a big chunk of last month’s surge is due to auto sales. But excluding motor vehicle and parts dealers from the equation still leaves retail sales up by a healthy 0.6% last month. Proclaiming hard-and-fast rules in the dismal science is dangerous, but let's dispense with that caveat for a moment and state what's on everyone's minds this morning: It’s hard to argue there’s a recession under our noses in the face of robust consumption gains.
One month doesn’t make a trend, even a particularly strong month. But reviewing the 12-month rolling percentage change in retail sales doesn’t change the rosy glow that emanates from today’s update. September retail sales are higher by nearly 8% vs. the year-ago figure. For a mature economy the size of the U.S., that’s about as good as it gets. Is the strong annual pace a fluke? If it is, it’s a fluke that’s been unfolding for the better part of the last two years, as the chart below reminds.
The case for thinking there’s a recession near, or that one has already begun, looks weak if not laughable based on today’s retail sales report. Or have we hit a new strain of economic contraction that has no immediate effects on consumption? Never say never in economics, but I’d label that scenario as highly unlikely. History suggests that we’d see some deterioration in retail sales concurrently with the arrival of a new recession. As such, the evidence suggests we should be cautious in anticipating an outright contraction in GDP.
"It looks like third-quarter GDP is going to be better than the first and second quarter combined," advises John Canally, an investment strategist and economist for LPL Financial.
Then again, no one will confuse the current state of macro as healthy. The familiar troubles are still here, starting with the weak pace of job creation. But modest growth isn’t a recession, even if it feels like one.
Today’s retail sales report might be dismissed if there was no other supporting evidence of sluggish but sustained economic growth. But we have a number of recent updates that tell us the economy will muddle along. The ongoing if modest pace of job growth, for instance.
Can we be absolutely sure that a recession isn't upon us? Alas, no. Such definitive statements in matters of the business cycle can only be made with the benefit of hindsight. What we can say with confidence is that if there's a downturn brewing we'll see some evidence in slowing retail sales. The same is true for the trend in job creation, industrial production, and other crucial metrics. But there's no conspicuous decline in the broad numbers on several fronts. That's the basis for optimism. It's an optimism that comes with some baggage, of course. And the outlook could change, perhaps quickly. That's a risk for a precarious recovery. For the moment, however, the expansion looks slightly less wobbly.
Research Review | 10.14.2011 | Inflation Expectations
The Future of Inflation
Joseph G. Haubrich (Cleveland Fed) | Oct 5, 2011
To the extent that actual inflation varies more than expected inflation and expected inflation varies more than the central tendency, there is reason to think that the high rates we have been experiencing are temporary, soon to be replaced with a different cut from the deck.
Inflation Expectations and Behavior: Do Survey Respondents Act on Their Beliefs?
Olivier Armantier, et al. (NY Fed) | Aug 2011
We compare the inflation expectations reported by consumers in a survey with their behavior in a financially incentivized investment experiment designed such that future inflation affects payoffs. The inflation expectations survey is found to be informative in the sense that the beliefs reported by the respondents are correlated with their choices in the experiment. Furthermore, most respondents appear to act on their inflation expectations showing patterns consistent (both in direction and magnitude) with expected utility theory. Respondents whose behavior cannot be rationalized tend to be less educated and to score lower on a numeracy and financial literacy scale. These findings are therefore the first to provide support to the microfoundations of modern macroeconomic models.
How Flexible Can Inflation Targeting Be and Still Work?
Kenneth N. Kuttner and Adam S. Posen (Peterson Institute for Int'l Economics) | Sep 2011
After years of apparent success, inflation targeting (IT) has recently come under fire for its inability to prevent (or even its contribution to) the global financial crisis of 2008–09. The recent debate has largely centered on whether inflation targeting prevented central banks from responding sufficiently to asset price bubbles... We found no evidence to suggest that the Bank of England’s inflation target compelled it to fight inflation any more aggressively than the Fed. Inflation forecasts converge at comparable rates in both countries. The lack of any detectable asymmetry in either country between the responses to positive versus negative deviations suggest that overshooting the target has not damaged the central banks’ credibility; nor has above-target inflation elicited a disproportionately aggressive policy response. Similar results hold when comparing large versus small deviations from the target. Overall, the Bank of England seems to have been no less flexible than the Fed.
Avoiding Japan-Style Stagnation by Overcoming Bankers' DNA
Hrishikesh D. Vinod (Fordham University) | Aug 24, 2011
This paper shows that incentive-based macroeconomic scale policy tools can be applied even when an economy is in a liquidity trap. The bankers' DNA involving survival instinct, double entry book-keeping and inflation aversion needs to be overcome. The American economy added zero new jobs on a net basis in August 2011. The Fed is desperately trying to lower long-term interest rates. The Euro-zone is in serious trouble, while Japan remains stagnated and now unable to export her problems when the US consumer has stopped being the growth engine for the world. China continues her currency manipulation. It is obvious that the world economy faces an emergency. Bernanke et al. (2004) called for a non-standard" solution to the liquidity trap. A direct non-standard solution for the US is one-time suspension of double entry book-keeping to print" $500 billion, without creating any debit entry anywhere. The US creditors including China and Japan and the US industries sensitive to the price of imports would feel some pain. However, the pain will be worse if America were to fall into Japan-style decades long stagnation. In any case, printing money is almost painless compared to very high interest rates (20% per year in June 1981, under Fed Chairman Paul Volcker) to break the back of inflationary expectations.
How do Inflation Expectations Form? New Insights from a High-Frequency Survey
by Gabriele Galati, et al. (Bank for Int'l Settlements) | July 2011
We provide new insights on the formation of inflation expectations - in particular at a time of great financial and economic turmoil - by evaluating results from a survey conducted from July 2009 through July 2010. Participants in this survey answered a weekly questionnaire about their short-, medium- and long-term inflation expectations. Participants received common information sets with data relevant to euro area inflation. Our analysis of survey responses reveals several interesting results. First, our evidence is consistent with long-term expectations having remained well anchored to the ECB's definition of price stability, which acted as a focal point for long-term expectations. Second, the turmoil in euro area bond markets triggered by the Greek fiscal crisis influenced short- and medium-term inflation expectations but had only a very small impact on long-term expectations. By contrast, longterm expectations did not react to developments of the euro area wide fiscal burden. Third, participants changed their expectations fairly frequently. The longer the horizon, the less frequent but larger these changes were. Fourth, expectations exhibit a large degree of timevariant non-normality. Fifth, inflation expectations appear fairly homogenous across groups of agents at the shorter horizon but less so at the medium- and long-term horizons.
October 13, 2011
Caught In A Trap
There’s still not a whole heck of a lot going on with jobless claims. That’s good news to a degree since it suggests that the recession risk, while elevated, isn’t rising. But it’s also bad news because it’s a sign too that the labor market isn't likely to break out of its slump with a burst of strong job growth any time soon. This could on for a while and it probably will.
New filings for jobless benefits were virtually unchanged last week, slipping by 1,000 to a seasonally adjusted 404,000. Despite the usual volatility in claims data this year, this series hasn’t changed much since last Christmas.
“The labor market is treading water, maybe slightly better than that,” says Joshua Shapiro, chief U.S. economist at Maria Fiorini Ramirez Inc. “Hanging out around 400,000 claims is indicative of a still very soggy labor market that is not going anywhere fast.”
Until further notice, it’s best to wear boots as we slog through this statistical glop in the weeks ahead. Unless of course you see the glass as half full rather than empty. That’s a high standard these days but Jeffrey Greenberg, an economist at Nomura Securities, makes the trek: "The trend is going in the right direction,” he reasons.
Despite relatively week payrolls over the past few months, it's been an issue of firms not adding to their payrolls rather than firms starting to cut because of economic uncertainty. That means that firms are in the position to eventually start adding.
We see it as a relatively bright spot in a mixed bag of data and so far we've seen a lot of relatively strong hard data in the past few weeks despite sentiment and general soft data telling us there's been a lack of confidence. But as was made clear by the minutes to the FOMC yesterday and Plosser's comments, even if we get good data out of the U.S. it doesn't mean that much because the focus is really on Europe.
There's something to that. Compared to Europe, one can argue that the U.S. looks just peachy. Alas, it's hard to eat relative growth.
Living On A Prayer
If you're inclined to sit on the fence these days in the delicate art of anticipating the next phase of the business cycle, you'll get no argument from the latest update on the Chicago Fed National Activity Index, a monster index of indexes that encompasses 85 measures of U.S. economic activity. This benchmark has weakened this year but it's still not flashing a formal prediction of economic contraction. But it's a precarious existence on this side of the line.
The Chicago Fed index’s three-month moving average slipped to –0.28 in August from –0.27 in July, the Chicago Fed reports. No one will confuse that reading with a healthy economy, but it's not a recession signal either. Technically, we're in a "below trend" environment. By the rules of this benchmark, the tipping point is when the three-month average falls below -0.70. The latest reading of -0.28 for August is slightly above that level, but the margin of comfort is minimal. It seems that we're one exogenous shock away from deep trouble.
A Mixed Bag For Recession Risk
A new recession may be coming. Maybe it's already here. Then again, maybe not. Calling major turns in the business cycle in real time is perhaps the most coveted of skills in all of economics. It's also one of the most elusive gifts among self-proclaimed seers. That doesn't stop anyone from trying, including this recent warning that dark days ahead are a virtual certainty. The risk of trouble certainly looks higher to most observers, and it's not just in the U.S. Menzie Chinn of Econbrowser alerts us that the global economy "is close to stall speed." Perhaps, although it's still not obvious that the trend in the U.S. has definitively rolled over. For some perspective, let's review some of the latest indicators.
Small business sentiment turned up slightly in September, ending a six month decline, according to the National Federation of Independent Business. A small bit of good news, mostly because it suggests that the outlook isn't getting any worse.
Meantime, the stock market is no longer in the red on a year-over-year basis. The brief flirtation with annual losses for the S&P 500 has reversed, at least for the moment. That's a positive sign because every recession since the 1960s has been accompanied by an extended stretch of annual losses in equities, which suggests that the current revival is encouraging (if the rally holds).
The outlook is considerably darker when we look at spreads in corporate bonds, another market-based measure with a history of issuing early warning signs that the business cycle is deteriorating. Junk bond spreads are elevated these days, although the premium has come down slightly in recent days. In any case, the trend doesn't look helpful on this front.
The Treasury yield curve is more forgiving. The 10-year Note's yield is higher over 3-month Treasuries by roughly 200 basis points. History suggests that the odds of another recession are lower whenever the curve slopes upward. By that reasoning, the shape of the curve offers some support for thinking that the economy will muddle through its current problems. Skeptics, however, are quick to note that the Fed is manipulating the short end of the curve in the extreme and so the yield curve's predictive powers are diminished these days.
Meanwhile, the market's inflation forecast has stabilized recently. That's a good sign since the outlook for lower inflation at this point equates with higher odds of a new recession. As such, a resumption of the previous downtrend in inflation expectations would be dire.
The latest numbers for the labor market offers some support for thinking that the trend is in a holding pattern. That's not good, but it may be enough to keep the forces of contraction out of the henhouse. Job openings in August were essentially unchanged from July, the Labor Department notes. Compared with a year ago, job openings were up by nearly 8%, more or less confirming the slow but continued expansion in payrolls.
Overall, it's still debatable if another recession is fate. The risk is surely higher today than it was six months ago, but full clarity is still missing. Maybe the smoking gun will be found in the maternity ward. A new study from the Pew Research Center reports that "a sharp decline in fertility rates in the United States that started in 2008 is closely linked to the souring of the economy that began about the same time."
October 12, 2011
Dissecting The Historical Equity Risk Premium For Clues About The Future
What is the historical equity risk premium? It's a simple question, and a crucial one. Looking at the past alone is no panacea for predicting the future, but it's an obvious place to start. If you’re focused on making informed decisions about portfolio design and management, understanding where capital markets have been provides some useful context.
That's where the simplicity ends, as per the latest revision of Elroy Dimson and company's widely read reviews of equity risk premia. "Equity Premia Around the World" summarizes the "global evidence on the long-term realized equity risk premium, relative to both bills and bonds, in 19 different countries." The current paper (dated Oct. 7) is an extension of the data presented in the trio's 2002 book Triumph of the Optimists: 101 Years of Global Investment Returns. In the new research, the authors report:
Our study now runs from 1900 to the start of 2011. While there is considerable variation across countries, the realized equity risk premium was substantial everywhere. For our 19-country World index, over the entire 111 years, geometric mean real returns were an annualized 5.5%; the equity premium relative to Treasury bills was an annualized 4.5%; and the equity premium relative to long-term government bonds was an annualized 3.8%. The expected equity premium is lower, around 3% to 3½% on an annualized basis.
In a global economy, where political borders have diminishing relevance for capital, estimating equity risk premiums is a complicated affair. The first question for U.S. investors is whether it's reasonable to consider stocks in a global framework as part of the total analytical package? Yes, of course. That's not the tradition for those who live in the world's (still) largest economy, but the home bias for plotting investment strategy as the last word on equity evaluation looks ill-informed with each passing year. Certainly the old excuse that sticking to the home turf is practical is no longer an issue. For example, it’s easy and inexpensive to tap into the global equity beta through various ETFs, such as Vanguard Total World Stock Index ETF (VT) and iShares MSCI ACWI Index (ACWI). The ETF choices are, of course, far more extensive when we look at regional, industry, capitalization and style divisions for global equities. Accordingly, there’s a good case for breaking up a portion of one’s equity allocation to smaller pieces to facilitate rebalancing. Yet the case for a core global equity holding as a foundation isn’t chopped liver either.
In any case, Dimson and his associates at the London Business School offer valuable perspective on where we’ve been over the past century. For example, consider how returns differ with inflation (nominal performance) and without (real returns). The U.S. stock market gained 9.4% a year during the 1900-2010 period, the paper reports, but that drops to an annual 6.3% in real terms. That’s pretty good in comparison to markets around the world, as a chart from the research shows:
The question, of course, is how returns will compare from here on out? Dimson and his co-authors advise that “the historical equity premiums, presented here as annualized (i.e. geometric mean) estimates, are equal to investors’ ex ante expectations plus the impact of luck.” Alas, modeling luck--the error term--is the equivalent of financial alchemy, and so the usual caveats apply when it comes to forecasting generally. That said, the authors press on:
The worldwide historical premium was larger than investors are likely to have anticipated, on account of factors such as unforeseen exchange-rate gains and unanticipated expansion in valuation multiples. In addition, past returns were also enhanced during the second half of the 20th century by business conditions that improved on many dimensions.
With that, we move to the grand finale:
We infer that investors expect a long-run equity premium (relative to bills) of around 3%–3½% on a geometric mean basis and, by implication, an arithmetic mean premium for the world index of approximately 4½%– 5%.
As it turns out, that’s in line with my own number crunching from last month for estimating future risk premiums for stocks (along with the other major asset classes).
None of this is written in stone, of course. Predicting is still hard, especially about the future. In fact, one could argue that it’s not getting any easier these days. They don’t call them risk premiums for nothing.
Saving The Euro: Part 16-A/4.b (subsection F)
Managing a currency by popular vote every other week (or day) is water torture and almost surely doomed to fail. But with no other choice, the odyssey that is the euro rolls on, which means that the voting, the deal making, the deliberations, the polling--the rise and fall of governments--endures.
The latest installment in this strange drama arrived yesterday, with Slovakia's parliament rejecting an increase for the euro rescue fund. It's as if the Federal Reserve or U.S. Treasury needed to seek approval from California this week, Maryland the next, to conduct operations. How long can the Continent carry on with this madness? As long as it takes, and perhaps longer than reasonable minds might expect. But no one said it's going to be pretty (or effective).
Technically, the vote wasn't about monetary policy per se; rather, yesterday's vote was about pouring more money into the the European Financial Stability Facility, last year's brainchild that was designed to finance the bailout of Greece and, in the process, save the euro from itself. The lines between monetary and fiscal policies are anything but sharp in Europe these days and so it's unclear where one ends and the other begins. That, of course, is part of the problem. Managing a currency that relies on the kindness of politicians is an act of torture at best.
Slovakia is the odd country out at the moment, rejecting what 16 other euro nations have already embraced. It's a strange state of affairs to watch one of the world's leading currencies as it's held hostage by one small nation. Imagine if the city council of New York City had a final vote on the future of the dollar and you've got some sense of what's going on in Europe these days.
Just to keep things interesting, Slovakia's government collapsed after its vote yesterday. In other words, another vote is coming, and soon, with expectations high that a soon-to-be formed government will approve a bigger bailout fund. Time notes that Slovakian Prime Minister Iveta Radičová previously vowed that "the vote would be repeated until the bill is passed."
Meantime, Reuters reports:
Radicova's finance minister, Ivan Miklos, said Slovakia was still likely to find a way to ratify the agreement soon.
"There is an assumption that the EFSF [European Financial Stability Facility], one way or the other, will be approved by the end of the week," he told parliament ahead of the vote.
And if Slovakia disappoints on the next vote? No problem. The bailout will continue one way or another, we're told via The New York Times: "One European official speaking anonymously because of the fluidity of the situation, said that it would probably be possible to go ahead with the bailout without Slovakia, if necessary."
The fate of the euro rests on Slovakia… or not. “Eventually a yes vote will be secured,” predicts Tim Ash, head of emerging-market research at Royal Bank of Scotland Group. “Does Slovakia really want to be alone among 17 euro-zone members states on this one, and when the future of Europe is at stake?”
Uh, yes…maybe… probably. Whatever happens, this is no way to run a railroad (or a currency).
October 11, 2011
A Revival In Rational Expectations Theory?
Economic theory tied to rational expectations has taken a beating in recent years, at least in some circles. Remember this contentious skewering from Paul Krugman in 2009? Defenders of the faith responded with all guns firing, including this take-no-prisoners response from "freshwater" economist John Cochrane. Whatever you think of ratex, it earned some lofty recognition yesterday with the news that the Nobel economics prize was awarded to a pair of Americans.
Economists Thomas Sargent of New York University and Christopher Sims of Princeton were given the prize for the research on "the causal relationship between economic policy and different macroeconomic variables such as GDP, inflation, employment and investments," according to the press release from The Royal Swedish Academy of Sciences.
The Wall Street Journal notes that according to "Mr. Sargent's influential work on rational-expectations models… people do not respond passively to changes in economic policy or circumstances. They anticipate future conditions and adjust according to their best interests."
The New York Times says Sims' methodology, developed in the 1970s,
has been influential in subsequent decades among economists in many fields and of different political leanings. Research using his methodology, for example, has helped lend credence to New Keynesianism, the theory that says that an economy can go into recession because there is not enough demand.
“The idea that there could be an aggregate demand failure is a very old idea, but it had been completely banished in the ’70s, ’80s and ’90s,” said Lawrence J. Christiano, a professor at Northwestern University. “Really the center of gravity of macro was very much in places like Chicago and Minneapolis. That was bumped away in part by results of applying this new methodology, and Sims is the one who originated that.”
Sargent was interviewed a year ago and was asked to defend the rational expectations branch of macro, to which he has been a key contributor:
The criticism of real business cycle models and their close cousins, the so-called New Keynesian models, is misdirected and reflects a misunderstanding of the purpose for which those models were devised. These models were designed to describe aggregate economic fluctuations during normal times when markets can bring borrowers and lenders together in orderly ways, not during financial crises and market breakdowns.
Tyler Cowen at Marginal Revolution writes
One of [Sargent's] most important (and depressing) papers is Sargent, Thomas J. and Neil Wallace (1981). "Some Unpleasant Monetarist Arithmetic." Federal Reserve Bank of Minneapolis Quarterly Review 5 (3): 1–17. The main idea of this paper is that good monetary policy requires good fiscal policy. Otherwise the fight against inflation will not be credible. This is probably his most important paper.
As to the burning question of whether the Sargent and Sims' research offers a solution to the economy's current problem, Sims manages expectations down. As Bloomberg reports:
Central bankers and government officials use the work the two men have done to help determine how changes in policy affect the economy and vice versa... [But] “there’s no simple way to apply it,” Sims said by phone during a press conference after the prize was announced, in response to a question on how his research could be used to analyze the current economic situation. “It requires a lot of slow work looking at data -- the methods I use and that Tom have developed are central to finding our way out of this mess.”
There are (still) no silver bullets in macro, but maybe there's a new beginning for reviving ratex's reputation. There's more than intellectual vanity at stake. As the FT opines:
Sargent’s work on expectations and monetary policy has fresh relevance for western economies thrown into uncharted territory. Much of his research has focused on how inflationary episodes end. In his book The Conquest of American Inflation., he studied the rise in inflation in the 1960s and 1970s and the subsequent “great moderation”.
Relevance is one thing. As for expecting ratex to inspire calm, uncontroversial discussions from here on out, well, that's probably just irrational thinking at this point.
Is The Levered ETF Tail Wagging The Market Dog?
Douglas Kass of Seabreeze Partners tells Andrew Ross Sorkin that levered ETFs "have turned the market into a casino on steroids. They accentuate the moves in every direction — the upside and the downside.”
Sorkin thinks that levered ETFs were the source of Monday's stock market surge in the last 18 minutes of trading. "The Standard & Poor’s 500-stock index jumped more than 10 points with no news to account for the rally," he writes.
Levered ETFs are a relatively recent innovation and a fast-growing business. Equity ETFs hold more than $15 billion in assets, according to ETFdb.com. The largest is ProShares UltraShort S&P 500 (SDS), with $2.7 billion in assets and average daily trading volume in excess of 50 million shares. Not too shabby for a five-year-old fund. There are also levered ETFs for other asset classes, including bonds, REITs, commodities and currencies. You can also find open-end mutual funds in the levered space. Overall, Sorkin estimates the total levered fund category at $1 trillion.
The key issue is the daily rebalancing aspect of these products. Sorkin explains via Kass:
At the end of every day, leveraged E.T.F.’s have to rebalance themselves by buying and selling millions of shares within minutes to remain properly weighted. If the E.T.F. made money that day, to remain balanced it has to reinvest the proceeds and leverage them again. In many cases, leveraged E.T.F.’s use options, swaps and index futures to keep themselves in balance.
But it's also true that levered funds in the aggregate make bullish and bearish bets. Over time, and perhaps at the end of each day, the net effect is a wash. Or is it? Unclear. Sounds like a topic for deeper analysis.
Meantime, what is clear is that worrying about levered ETFs is old hat. In 2009, for instance, Jason Zweig advised that "new research suggests that on days when the indexes make big moves, leveraged exchange-traded funds could trigger a trading cascade, turning the market close into a buying or selling frenzy."
As the levered ETF industry grows—Sorkin says it's "perhaps the hottest rage in investing"—the risk of this tail wagging the dog rises. True, levered ETFs can be productive tools, assuming they're used intelligently by sophisticated investors and money managers. But it's easy to abuse these potent portfolios. That's the nature of leverage: it exacerbates market moves, and investor behavior—good and bad.
Perhaps Todd Shriber sums it best by reminding that "leveraged and inverse ETFs are not investments. They are trades."
October 10, 2011
Sometimes (Macro) History Bites
By now there should be broad agreement on one point in the grand debate on macroeconomics. A recession born of a severe financial crisis is an especially destructive force, and one that isn't easily solved. Irving Fisher outlined the basic problem more than 80 years ago in his prophetic paper "The Debt-Deflation Theory of Great Depressions. The blowback cycle of unusually deep recessions and protracted recoveries after acute turmoil in the financial sector is a familiar syndrome, as economists Carmen Reinhart and Ken Rogoff detail in This Time Is Different: Eight Centuries of Financial Folly.
Recognizing the historical and recurring nature of the current ills doesn't lessen the pain, but ignoring or minimizing the lessons of the past can deepen and extend a crisis. That's the charge leveled against the Obama administration's response to the Great Recession in early 2009, according to a story by The Washington Post's Ezra Klein. For example, here's one telling mea culpa from Peter Orszag, the former head of the Office of Management and Budget, on his thinking during the dark days of early 2009: "I don’t think it’s too much of an exaggeration to say that everything follows from missing the call on Reinhart-Rogoff, and I include myself in that category. I didn’t realize we were in a Reinhart-Rogoff situation until 2010."
In December 2008, Rogoff wrote that “it is time for the world’s major central banks to acknowledge that a sudden burst of moderate inflation would be extremely helpful in unwinding today’s epic debt morass,” Klein notes. The Federal Reserve did in fact respond by engineering a large increase in the monetary base. There was also a sizable (at least by historical standards) fiscal stimulus.
All of which prompts Reinhart to tell Klein:
“The initial policy of monetary and fiscal stimulus really made a huge difference,” she says. “I would tattoo that on my forehead. The output decline we had was peanuts compared to the output decline we would otherwise have had in a crisis like this. That isn’t fully appreciated.”
In that way, Reinhart says, this time really was different — at least from the Great Depression, when output shrank by 30 percent and a quarter of the workforce was unemployed. “If the choice was this or the ’30s,” she says, “I’d take this hands down.”
But the so-called "market monetarist" school argues that the monetary stimulus hasn't been sufficient (advocates for fiscal stimulus make a similar case from the Keynesian perspective). And there's no shortage of evidence to support these complaints. Everywhere you look, the statistics are ugly. From high and persistent unemployment to feeble job growth, there's ample evidence that the policy response was insufficient this time. Indeed, a new study shows that household income has continued falling in the two years since the recession ended.
Even so, this is macroeconomics and so cause and effect are hotly debated. Harvard University economics professor Martin Feldstein tells The Wall Street Journal that the current recovery is "about as bad an expansion as I’ve ever seen." Nonetheless, he says the Fed “has gone too far recently in pushing for lower interest rates.” Huh?
So, has Fed policy been "easy"? In terms of looking at the increase in the monetary base and the fall in nominal interest rates, yes, policy has been easy, or so it appears. But relative to what's needed, there's a strong case for arguing that the Fed has been engaged in a policy of passive tightening.
How do we know this is true? Lars Christensen explains:
In a world of monetary disequilibrium, one cannot observe directly whether monetary conditions are tight or loose. However, one can observe the consequences of tight or loose monetary policy. If money is tight then nominal GDP tends to fall – or growth is slower. Similarly, excess demand for money will also be visible in other markets such as the stock market, the foreign exchange market, commodity markets and the bond markets. Hence, for Market Monetarists, the dictum is money and markets matter.
October 8, 2011
Book Bits For Saturday: 10.8.2011
● The Coming Jobs War
By Jim Clifton
Review via MoneyWeb
Clifton asserts that job creation will surpass all other issues to dominate politics. He likens the challenges to the second world war while further asserting that the war has already begun... It seems likely that “job creation” is destined to become the leader among business publication categories adding to the pressure on politicians everywhere. Few companies have Gallup’s experience in discerning data. The book points out that the world has 7 billion people with 5 billion being of working age. Of those, 3 billion desire full-time formal employment while globally there are only 1.2 billion jobs that meet his criteria, “pay check from an employer and steady work that averages 30-plus hours per week”.
● Capitalism at Risk: Rethinking the Role of Business
By Joseph L. Bower, Herman Leonard and Lynn Sharp Paine
Summary via publisher, Harvard Business Press Books
The spread of capitalism worldwide has made people wealthier than ever before. But capitalism's future is far from assured. The global financial meltdown of 2008 nearly produced a great depression. Economies in Europe are still teetering. Income inequality, resource depletion, mass migrations from poor to rich countries, religious fundamentalism-these are just a few of the threats to continuing prosperity. How can capitalism be sustained? And who should spearhead the effort? Critics turn to government. In Capitalism at Risk, Harvard Business School professors Joseph Bower, Herman Leonard, and Lynn Paine argue that while governments must play a role, businesses should take the lead. For enterprising companies-whether large multinationals, established regional players, or small start-ups-the current threats to market capitalism present important opportunities.
● Red-Blooded Risk: The Secret History of Wall Street
By Aaron Brown
Summary via publisher, Wiley
From 1987 to 1992, a small group of Wall Street quants invented an entirely new way of managing risk to maximize success: risk management for risk-takers. This is the secret that lets tiny quantitative edges create hedge fund billionaires, and defines the powerful modern global derivatives economy. The same practical techniques are still used today by risk-takers in finance as well as many other fields. Red-Blooded Risk examines this approach and offers valuable advice for the calculated risk-takers who need precise quantitative guidance that will help separate them from the rest of the pack. While most commentators say that the last financial crisis proved it's time to follow risk-minimizing techniques, they're wrong. The only way to succeed at anything is to manage true risk, which includes the chance of loss. Red-Blooded Risk presents specific, actionable strategies that will allow you to be a practical risk-taker in even the most dynamic markets.
● The Risk Premium Factor: A New Model for Understanding the Volatile Forces that Drive Stock Prices
By Stephen D. Hassett
Excerpt via publisher, Wiley
Many researchers have argued that the equity risk premium [ERP] changes over time—and that such fluctuations are a major source of stock price changes—and also that the ERP has experienced a “secular” decline during the past few decades. In Dow 36,000, Kevin Hassett (no relation) and James Glassman argued that the risk premium was declining because investors were viewing stocks as less risky. They went so far as to suggest that that the risk premium could vanish entirely since, given a sufficient amount of time, stocks appeared virtually certain to outperform bonds. In The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street, Justin Fox quotes Eugene Fama, one of the pioneers of the efficient market hypothesis as saying, “My own view is that the risk premium has gone down over time basically because we’ve convinced people that it’s there.” Ibbotson suggested that the decline in the risk premium is a onetime event. “We think of it as a windfall that you shouldn’t get again,” he said. I think Glassman and Hassett were right about the decline in the ERP, but not about the underlying cause.
● Collision Course: Ronald Reagan, the Air Traffic Controllers, and the Strike that Changed America
By Joseph A. McCartin
Review via Kirkus Reviews
As a two-time governor of California, Ronald Reagan regularly bargained with public-service employees and, as president (the only one in American history ever to have helmed a union), he offered PATCO, one of the few labor organizations to endorse his candidacy, an unprecedented contract in 1981. When PATCO rejected the proposal and called an illegal strike, Reagan issued a 48 hour return-to-work ultimatum. He ended up firing the vast majority of the more than 10,000 highly specialized controllers, destroyed PATCO and set a precedent that continues to reverberate. An expert on the labor movement, McCartin reviews the origins and evolution of public-sector unions—once universally decried, even by iconic liberal presidents—outlines and translates for the general reader the applicable laws and delivers a detailed history of PATCO from its 1968 founding to its demise. Demonstrating a thorough understanding of PATCO’s culture, the author powerfully describes the high-pressure world of air-traffic control, examines the historically contentious relations between the controllers and the hidebound FAA and charts PATCO’s increasing militancy, even as a powerful anti-union backlash gathered in the country.
October 7, 2011
Private Sector Jobs Rose 137,000 Last Month… Whew!
The labor market pulled back from the brink last month. Private-sector job growth rebounded in September for a net gain of 137,000, a dramatically higher pace over August’s meager 42,000 rise, the Labor Department reports. The case for expecting a recession's near, in other words, has fallen a notch or two. But while September’s job market improved, the growth rate is still weak. The unchanged 9.1% unemployment rate for September makes this point loud and clear.
The economy, it seems, looks poised to grow just enough to keep a new recession at bay. Expecting much more is probably asking too much, but it’s all we’ve got. The trend is hardly spectacular, but it’s hard to make the case that the economy will contract when private sector employment is rising by well over 100,000 a month.
But no one should see today’s number as definitive evidence that the economic recovery will survive. If today’s number had been a substantial move down from August’s thin advance, we’d all be talking about how deep the recession would be. We’re evaluating and reassessing the economy on a daily basis, and that’s not good. It’s a sign that visibility is unusually limited and subject to radical revision depending on the arrival of the next data point.
Another reason to stay cautious is the fact that about one-third of last month’s rise in private sector employment reflected the rehiring of 45,000 striking Verizon employees. That’s helpful, of course, but it was the Verizon strike that contributed to the dismal August report. Relying on the end of worker strikes is hardly the foundation for anticipating better days ahead for the labor market.
"Bottom line, 119k jobs per month have been created in 2011 on average, well below the 150-200k jobs that is needed to firmly lower the unemployment rate and eat into all the jobs lost in this recession,” reminds Miller Tabak’s equity strategist Peter Boockvar. "But certainly for today, the better number eased major concerns about where this economy is headed, at least for now.”
A number of strategists agree. "This is bolstering the case we are not entering a double dip but sort of muddling through," says Robert Lutts, chief investment officer at Cabot Money Management.
Nonetheless, there’s nothing in today’s report that changes the view that the economy is stuck in a low-growth rut. Even that thin reed requires the assumption that the economy doesn’t suffer another one of those infamous exogenous shocks. On that note, let's hope Europe gets its act together... soon.
Meanwhile, when you're flying low, the risk of hitting something is always lurking. Yes, this is about as precarious as it gets for growth. Welcome to the un-recession!
The Calm Before The Storm?
The Treasury market's inflation forecast has been a reliable barometer of the ebb and flow of crisis and recovery in recent years. In July and August of 2008, just ahead of the implosion of Lehman Brothers that triggered a financial panic, the yield spread between the nominal less inflation-indexed 10-year Treasuries was falling sharply. That was a warning sign of trouble ahead. In early 2009, by contrast, this inflation forecast started trending higher, telling us that the worst had passed. When inflation expectations softened again in the spring of 2010, the shift sent a message that the economy faced new challenges. Later on in the year, when this market forecast hit bottom at the end of August 2010 and started climbing soon after, it represented a vote of confidence that the Fed's newly announced QE2 monetary stimulus would have some traction in the economy. And earlier this year, when inflation expectations turned down again, starting in April, that was a sign that a new macro storm was lurking.
Today, the inflation forecast is under 2%, down from around 2.6% in early April. For the moment, however, the decline in the market's inflation outlook has stabilized. If it holds, that's an encouraging sign that the crowd thinks the economy won't suffer a new recession. That's hardly a forgone conclusion and so it's reasonable to wonder if the stability is the real deal. Given the precarious state of macro these days, one can only wonder if the current tranquility in this indicator is the calm before the next leg of the storm. Or have we really hit bottom?
The answer, of course, will be determined by the economic updates as they arrive. Whatever comes, the inflation forecast via the Treasury market is likely to remain an early warning system of the next big change.
It's worth noting that the stock market hit bottom earlier this week and has rallied sharply since a late-Wednesday rally. That could be noise, of course, but for the moment the sentiment has shifted toward optimism. It could all give way with one bad economic report, of course. The first test comes later today, when the government releases its September employment report.
Meanwhile, there's ongoing anxiety over what happens next in Europe. But there's a whiff of stability on the Continent too. "European stock indexes as well as shares in a number of sectors such as banking, insurance, oil, utilities and telecoms seem to be stabilizing," says Vincent Guenzi of Cholet Dupont via Reuters this morning. "This stabilization may be a sign of a strong rebound to come if we get significant progress in the resolution of the euro zone debt crisis."
Commodity prices are looking firmer too, with the asset class poised "for the first weekly advance in five, after European policy makers stepped up measures to contain the region’s debt crisis, boosting prospects for demand," notes Bloomberg.
There was even some cautiously optimistic words from the CEO corner yesterday. "We don't see a contraction; we don't see a recession," says the founder of FedEx. "It's steady as you go, slow growth." The head of GE agrees, opining that "recovery is underway, but it's a long, slow recovery. Slower than we'd like,"
Maybe this is as bad as it gets; maybe not. At this point, it's hard to be sure about anything. One discouraging number from the economic trenches could change everything. In any case, the market's inflation forecast is likely to offer an early signal of the future. For now, steady as she goes.
October 6, 2011
Dissecting The Problem (Down To The Bone)
Tim Duy's Fed Watch let's it fly in this post about the hurdles facing the economy courtesy of a central bank that tolerates passive tightening. In summary, Duy asserts: "Don't Let Monetary Policy Off The Hook." He charges that Fed Chairman Bernanke, via testimony earlier this week, is engaged in "a clear effort to shift the focus away from monetary policy onto the fiscal side of the equation," a strategy that Duy argues is seriously flawed.
Duy cuts to the chase, arguing that "the Federal Reserve needs to take responsibility for ending the liquidity trap." But the "stumbling block to real change" is a fear of inflation--a fear that "prevents the Federal Reserve from making an unconditional commitment" to end the liquidity trap. At this point, Duy let's loose:
It is virtually impossible to imagine reestablishing the pre-recession nominal GDP trend, and entirely impossible to regain the pre-recession price trend, without accepting a temporary acceleration of inflation along the way.
More succinctly, we will not lift the economy off the zero-bound without accepting higher than 2% inflation. Since the Federal Reserve has made it clear they will not accept inflation greater than 2%, the economy will not clear the zero-bound. And if the economy does not clear the zero-bound, we will be faced with perpetual and unavoidable deficit spending.
Deficit spending is not accommodated by the Federal Reserve via low interest rates; it is made necessary because the Federal Reserve sees no urgency ending the lower bound challenge. Which means it is ridiculous to believe that the Fed can dump off this problem on fiscal policymakers. How can the state of monetary policy have deteriorated so much that now even Bernanke claims “regulation” is holding back the economy? Yet here we are.
And here is where we'll probably stay unless Bernanke wakes up one morning and decides that it's time for a different agenda. It is time (in fact the hour is late), but it's up to central bankers to act. They seem to be acting at bit more these days at the Bank of England, which "announced its biggest stimulus since the depths of the recession, citing 'vulnerabilities' related to the euro-area turmoil."
Meantime, all is quiet at 20th and Constitution Avenue. Zzzz....
Bank Of England Embraces QE2
The Federal Reserve's second round of quantitative ended in June, but Britain's central bank today announced it was reviving monetary stimulus. "The Bank of England voted on Thursday to buy 75 billion pounds more in assets to shield Britain's economy from the euro zone debt crisis and keep the faltering recovery going," according to CNBC.
It seems that Adam Posen's counsel has some resonance after all. Last month Posen, an American economist who sits on the Bank of England's monetary policy committee, warned in a speech:
Both the UK and the global economy are facing a familiar foe at present: policy defeatism. Throughout modern economic history, whether in Western Europe in the 1920s, in the US and elsewhere in the 1930s, or in Japan in the 1990s, every major financial crisis-driven downturn has been followed by premature abandonment—if not reversal—of the macroeconomic stimulus policies that are necessary to sustained recovery. Every time, this was due to unduly influential voices claiming some combination of the destructiveness of further policy stimulus, the ineffectiveness of further policy stimulus, or the political corruption from further policy stimulus. Every time those voices were wrong on each and every count. Those voices are being heard again today, much too loudly. It is the duty of economic policymakers including central bankers to rebut these false claims head on. It is even more important that we do the right thing for the economy rather than be slowed, confused, or intimidated by such false claims.
One can only wonder if any of this will rub off on Mario Draghi, the the-soon-to-be-installed president of the European Central Bank. Or Ben Bernanke, for that matter.
Meanwhile, one can argue that the current ECB leadership isn't totally oblivious to the challenges that confront the euro countries. At least the ECB didn't raise rates today.
Diminished Expectations For Tomorrow's Employment Report
A week ago I asked if we should see late-September's sharp drop in weekly jobless claims as a sign of things to come. Today we have an answer, at least for the moment. New filings for unemployment benefits rose last week by 6,000 to a seasonally adjusted 401,000. As always, we shouldn't read too much into the latest data point in this volatile series. But it was just too tempting to surrender to a bit of optimism last week when jobless claims dipped under the 400,000 mark for the first time since the spring. Oh, well—another jobless claims report, another disappointment.
But let's not be too dramatic. The real story is that nothing much has changed. That's not good, but it may not be the stake in the economy's heart either. The labor market is stuck in neutral, as the past six months of a trendless trend for jobless claims reminds. As a critical leading indicator for both the labor market and, by extension, the broad economy, there's no way to mask the darkness in these numbers. The best you can say is that the trend isn't getting any worse. That's no reason for celebration, but it's still better than a sustained rise, which would be fatal. Instead, jobless claims remain near the lowest levels since the recession formally ended in June 2009, and that's better than nothing. Still, the lack of continued progress this year is a sign that the forces of recovery have gone into hibernation (or worse?).
The blowback is showing up in many corners, not the least of which is the flat-lining in continuing claims, a measure of unemployed workers already receiving benefits. The correlation between initial and continuing claims is strong and so it's unlikely that the ranks of the jobless are set for a substantial decline any time soon.
Perhaps the lone bright point in the claims data is the fact that the year-over-year percentage change in the unadjusted weekly numbers continues to fall at a robust rate--dropping by around 12% vs. this time a year ago at last count. But even that healthy change doesn't tell us much these days since it doesn't reflect the ongoing stagnation in the trend since this past spring. If the economy's set to perk up, the change will likely show up in a renewed drop in new jobless claims. That was true last year, when claims began dropping in early fall, signaling the short-lived economic and market revival.
But that was then. Today, we're going nowhere fast with claims data. Without a resumption of progress in the near term, even the 12-month change in claims is headed for zip in the near future. In fact, the upward drift in the 12-month change is warning of no less, as the third chart below shows.
Tomorrow's employment report for September is expected to at least offer a more encouraging update compared with August's dismal numbers, as yesterday's ADP estimate of the labor market suggests. But short of a surprisingly strong rise in the government's job creation tally, the case is strong for thinking that the economy will continue to struggle... at best.
John Hermann, a fixed-income strategist at State Street, sums up the mood when he says that "we have more or less a freeze on headcount. We’re in a wait-and-see mode."
But the jury's still out on whether all this leads to a new recession. There are signs that the economy has yet to give into the forces of contraction. The modest growth implied in the September readings of the services and manufacturing sectors via the ISM surveys tell us that the economy is still expanding, if slowly. And let's not forget that yesterday's ADP report advises that the labor market, while tepid, continues to mint new jobs on a net basis. But all this must be weighed against a rising tide of deterioration on other fronts—a deterioration that some analysts warn has brought us to the point of no return for the business cycle.
Forecasting a new contraction may still be premature, but it's hardly a radical notion at this stage. That alone is enough to worry. Maybe tomorrow's employment report will tell us different. Anything's possible, but today's jobless claims update recommends caution for expecting miracles.
Who Is Mario Draghi?
He's the incoming president of the European Central Bank, of course, and he inherits the euro mess that remains Jean-Claude Trichet's worry through the end of this month. The big policy question surrounding Mr. Draghi's arrival is whether he'll change course for the ECB and switch from Trichet's hawkish stance to using the central bank as a lender of last resort by purchasing the euro region's distressed debt in a bid to stave off the mounting pressures of deflation?
No one really knows if Draghi, currently the Bank of Italy's governor, will continue Trichet's policy or make a radical break. Perhaps Draghi himself is unsure of his plans. In a speech from this past July, he said "it is now necessary to give certainty to the procedure for handling sovereign crises: by clearly defining the political objectives, the instruments and the volume of resources. This is needed to ensure the stability of the area and its currency, and to take full advantage of the strength of its economy and monetary and financial situation." Does that mean he would act more aggressively and use the ECB to buy up the toxic sovereign debt that is weighing on Europe? Alas, he didn't say, at least not in this speech.
Whatever Draghi decides, the stakes could hardly be higher--for Europe and the rest of the global economy. The crisis in Europe is already roiling markets around the world, and it could get worse still. Much depends on how the ECB acts, or doesn't act, once Draghi arrives. For now, the future of ECB policy will likely remain a blank slate until the Italian assumes the helm. Unless, of course, you're expecting Trichet to make an 11th-hour Hail Mary pass before he departs later this month. Don't hold your breath.
What we do know is that the idea of a shock and awe campaign by the ECB in purchasing sovereign bonds is controversial in the extreme in Europe. The relatively limited purchases so far have already led to "led to strife on the ECB board," as The Telegraph put it. But by some accounts, a massive buying program is the only strategy left to save the euro.
Does Mario Draghi agree? To be determined. Meantime, one Italian official who's worked with Draghi says that the incoming ECB president "is very discreet, very introverted, very reserved. I don't think you can describe him as hawkish. He is very pragmatic. He has political intuition. He's not dogmatic in his approach. Every move will be very closely calculated."
But let's not be hasty on judging Draghi just yet. As the Financial Times suggests, it's not so easy to pigeonhole this central banker:
Germans fear that Mr Draghi will be soft on fiscally imprudent southern European countries. The fear in Italy, however, is that an early desire to win German support for the ECB will increase further the pressure on Rome. He has joined with Mr Trichet in piling pressure on Silvio Berlusconi, Italy’s prime minister, to implement fiscal and structural reforms. “If you look at his record on the Italian government, he is one of the central bankers who has taken the toughest stance,” says Elga Bartsch, European economist at Morgan Stanley.
Keeping everyone guessing may be a good thing. Central banks, after all, can sometimes do wonders by surprising the crowd. For good or ill, Draghi's capacity for engineering a surprise looks potent. But it's debatable through at least the end of the month if he'll use that power for Europe's benefit.
October 5, 2011
ADP Says Private Payrolls Rose 91,000 In September
The ADP Employment Report for September reveals another month of mediocre job growth in this data series, but that’s better than what the crowd’s been expecting. It sets us up for somewhat brighter expectations that Friday’s employment report from the government will confirm a mild revival in the labor market compared with August’s dismal number a la Washington's bean counters.
Employment in the U.S. nonfarm private business sector rose 91,000 on a seasonally adjusted basis last month, according to ADP. That’s only slightly higher than the 89,000 gain in August, based on ADP’s accounting. The question is whether the September data will bring the Labor Department’s estimate of job growth back from a near-death experience in the last report.
The ADP update suggests there’s reason for hope, as the chart above shows. The monthly gap between the two employment series wanders, but last month’s gap was the widest in absolute terms since January. The implication is that the spread will narrow in favor of growth. With the September ADP number in hand, the odds look a bit stronger that that the government’s report on Friday will bring us a higher number than August’s 17,000 net gain for private payrolls. A bounce back is expected even without the ADP support since the government's previous estimate was reportedly skewed to the downside because of a Verizon strike—a burden that evaporated when the strikers returned to work in late August.
Economists are inclined to agree that Friday's update will show some improvement over the August numbers. The consensus outlook is that the government's employment report for September will reveal an 83,000 net gain in private payrolls, according to Briefing.com. That's still weak by historical standards, but it'd be a lot better than the 17,000 private-sector rise for August. Last week’s encouraging update for initial jobless claims offers some additional support for thinking that the next data point will at least be moving in the right direction.
Even if the optimistic forecasts for Friday prove accurate, the best you can say is that the economy appears to be resisting the gravitational forces of recession, which some analysts are predicting is inevitable. It's premature to dismiss calls of a fresh downturn, but the ADP report offers a counterpoint, mild as it is. There’s no law that says a recession can't commence with private-sector job growth rising by 90,000 a month. But if we’re in or near another recession, it would be unusual to see the labor market expanding. We’ve heard of a jobless recovery; is there such an animal as a job-growth recession too?
Hold that thought as we wait for tomorrow’s weekly update on jobless claims and Friday’s employment report.
Who Moved My Market Anomaly?
A new study finds that "momentum profits have disappeared since the late 1990." Meanwhile, a pair of analysts report that "it is time to rethink the idea that small stocks outperform large stocks on a risk-adjusted basis." And value stocks have been trailing growth and broad equity benchmarks by substantial margins over the last five years, according to Russell benchmarks. What's going on? Should we be surprised? No, not really.
The idea that risk premiums are driven by multiple betas is still valid, but the case for thinking that you can do better than simply holding an expansive definition of the market always came with caveats. As Professor John Cochrane wrote in "Portfolio advice for a multifactor world":
Investments do not come with average returns as clearly marked as grocery prices, however. Investors have to figure out whether an investment opportunity that did well in the past will continue to do well. This is one reason that it is important to understand whether average returns come from real or irrational aversion to risk.
That's tricky, in part because even if there are truly bigger returns available by re-weighting the market portfolio, there's limited capacity for earning superior performance. The average investor holds the market portfolio and will likely earn a risk premium over time. But there's only so much room in small cap and value stocks, for instance, without bidding up prices to the point that expected returns fall to zero or perhaps even go negative. The same is true for the market overall, but the threat is less potent given the higher capacity.
Financial research over the last several decades has identified numerous "anomalies" (or risk factors or alternative betas, if you prefer). It's easier than ever to tap into these risk factors courtesy of an expanding menu of ETFs and index mutual funds. But anticipating that holding a non-market portfolio will bring a higher return premium is also a reminder that holding a customized mix of other betas could bring subpar results at times.
In other words, there's generally more risk in holding something other than the market portfolio. In the long run, alpha sums to zero. If too many investors are chasing alpha by holding non-market portfolios, simple mathematics will catch up with them eventually. Then again, a day of reckoning may be a sign of new opportunities.
Yes, the average investor must hold the market portfolio, but that doesn't mean you have to follow that advice. But holding something different from the crowd is no free lunch.
October 4, 2011
Strategic Briefing | 10.4.2011 | Recession Risk
Still Front End of Recession: A good ISM reading doesn’t change the call
Larry Kudlow (National Review) | Oct 3
The stronger-than-expected ISM manufacturing-index reading for September might normally suggest that the economy, at least for now, has dodged a recession bullet. After zero jobs and zero real consumer spending in August, which put the stalled economy on the front end of recession, the ISM number is the first major September reading. But economist Michael Darda says hold the applause: Inside the ISM, new orders and order backlogs either flat-lined or declined and remain below 50 — the DMZ recession marker on the index. Darda believes weak data in the U.S., plus the ongoing European crisis, plus the China slowdown, plus widened corporate credit spreads and stressful financial conditions, all point to a declining economy and additional stock market drops.
ISM: Manufacturing Gains Remain Modest—Prices Steady
John Silvia (Wells Fargo) | Oct 3
American manufacturing firms continue to align production and employment with a subpar pace of growth in the overall economy... We are sticking with our outlook for a moderate pace of growth for the national economy in the second half. Employment showed a nice gain of 2 points to 53.8 after a drop in August to 51.8, and this intimates a continued string of modest gains in manufacturing jobs going forward. According to the ISM survey, nine industries reported a gain in jobs, including paper, chemicals, transportation and machinery.
Recession Watch: No Evidence Yet of Double-Dip
Mark Perry (Carpe Diem) | Oct 3
All of the variables reported above [industrial production, employment payrolls, real GDP, real retail sales, auto sales, ISM Manufacturing Index, rail shipments, Jeremy Piger's "recession probability"] are positive except for real retail sales. Taken together as a group, these positive indicators suggest that while the current expansion might be sub-par, the economy is certainly not experiencing any of the significant, persistent and widespread declines that would lead the NBER to declare sometime next year that the U.S. economy entered a recession in any of the recent months.
To Cure the Economy
Joseph Stiglitz (Project Syndicate) | Oct 3
The prescription for what ails the global economy follows directly from the diagnosis: strong government expenditures, aimed at facilitating restructuring, promoting energy conservation, and reducing inequality, and a reform of the global financial system that creates an alternative to the buildup of reserves. Eventually, the world’s leaders – and the voters who elect them – will come to recognize this. As growth prospects continue to weaken, they will have no choice. But how much pain will we have to bear in the meantime?
Recession Risk Overtaking ’New Normal': Gross
Bloomberg | Oct 3
Bill Gross, the manager of the world’s biggest bond fund, said the global economy risks lapsing into recession with the pace of growth falling below the “new normal” level the firm has predicted since 2009. “Sovereign balance sheets resemble an overweight diabetic on the verge of a heart attack,” Gross wrote in a monthly investment outlook posted on Newport Beach, California-based Pacific Investment Management Co.’s website today. “If global policy makers could focus on structural as opposed to cyclical financial solutions, new normal growth as opposed to recession might be possible. Long-term profits cannot ultimately grow unless they are partnered with near equal benefits for labor.”
Manufacturing may help fight off new U.S. recession
Reuters | Oct 3
U.S. factories grew more quickly in September as production and hiring increased, suggesting that manufacturing would help keep the economy from slipping into a new recession. Other data on Monday offered more good news for the troubled U.S. economy, with strong demand for new motor vehicles putting sales on track to surpass August's rate, and construction spending unexpectedly rebounding in August. "That hardly sounds like an economy flat on its back. The economy is still moving forward. But no one should confuse direction with speed," said Joel Naroff, chief economist at Naroff Economic Advisors in Holland, Pennsylvania.
A self-induced recession
Free Exchange (The Economist) | Oct 3
The probability of recession spiked in early August as financial markets around the world swooned and American economic momentum abruptly drained away. Since then, the economic data have not, for the most part, gone into freefall. This morning we learned the Institute for Supply Management’s manufacturing purchasing managers index rose to 51.6 in September from 50.6, modestly better than expected; current production is growing but new orders are weakening slightly. Construction spending was also quite a bit better than expected in August, with across the board strength in residential, commercial and government. Third quarter growth rates have been revised up. Indeed, as this chart from Macroeconomic Advisers shows, consensus third quarter growth estimates between late August and last Friday generally edged higher. Update: U.S. auto sales in September came in above expectations, according to Autodata: 13.1m annualized units, v 12.1m in August.
September 2011 - What Double-Dip Recession Edition
Autoblog | Oct 3
The U.S. auto industry appears to be roaring based on sales figures for the month of September 2011. This, despite every other economic indicator wafting between stagnant growth for the economy and an outright plunge into another recession. Don't tell the folks selling cars in these great United States, though, because people are buying despite the doom and gloom coming out of Wall Street.
October 3, 2011
Manufacturing Activity Perks Up In September
The ISM Manufacturing Index increased in September to 51.6 from 50.6, reflecting a stronger pace of expansion in the manufacturing sector. As an early reading of last month's economic activity, the ISM index offers a bit of optimism at a time of rising fears that a new recession is approaching.
A reading above 50 indicates growth and so the higher number is encouraging if only because it suggests that the odds of another contraction look a bit lower compared with expectations ahead of the report. Every post-war recession has been accompanied by below-50 levels in the ISM. Although every predictor is flawed, today's ISM update offers one more data point on the side of optimism.
Let's also note that even with September's rise the ISM index has fallen sharply from the 60-plus readings from earlier this year. It's obvious that the economy has slowed and the decline in the ISM since this year's first quarter confirms the retreat. The question is one of whether the economy will continue to stumble. For what it's worth, the ISM update suggests there's still reason to wonder.
For some additional context, let's review ISM's rolling 12-month percentage change vs. the stock market, industrial production and new orders for durable goods (note that only equities and ISM are updated through September). The ISM Manufacturing Index is turning up on an annual basis and at a slightly faster pace compared with the August change. That's in contrast with the S&P 500, which declined slightly through the end of September vs. a year ago. Is that a sign that stocks will play catch-up in the near term? Or is the ISM's latest bout of optimism misguided?
“We’re seeing the post-Japan rebound in auto production and auto sales,” says Julia Coronado, chief economist for North America at BNP Paribas. “That’s pushing up the production index, but new orders remain relatively anemic. There is still some underlying weakness, but we’re getting that post-Japan rebound.”
Tom Porcelli, chief U.S. economist at RBC Capital Markets, is impressed, if only slightly. "ISM is showing some pretty strong resilience here,” he says. “I'm surprised at how well it's performing, particularly in the face of all of these headwinds. As a key leading economic indicator this has got to be a pretty big relief to most people.”
Is That A Recession Lurking In The Distance?
A new recession is inevitable, predicts the Economic Cycle Research Institute. "Early last week, ECRI notified clients that the U.S. economy is indeed tipping into a new recession," the consultancy announced on Friday. "And there’s nothing that policy makers can do to head it off."
"The vicious cycle is starting where lower sales, lower production, lower employment and lower income [leads] back to lower sales," ECRI co-founder Lakshman Achuthan told the Daily Ticker. And on Bloomberg TV he explained that another recession is coming because of "contagion in the forward-looking indicators." A new contraction is "inescapable," advised the co-author of Beating the Business Cycle, which outlines ECRI's methodology for analyzing the business cycle.
ECRI has a good record in calling turning points in the macro trend and so we should take Achuthan's warning seriously. The stock market indicator is looking bearish again too, offering some confirmation for the recession call. The S&P 500 is down fractionally as of Friday's close vs. a year ago. Every recession in the last 50 years has been accompanied by an annual decline and so the red ink isn't encouraging. Then again, let's not forget that not every annual loss in the stock market leads to a recession.
Meantime, the Treasury yield curve continues to suggest that the economy will muddle through. The term spread has a history of anticipating a new recession when short rates rise above long rates. By that standard, there's still reason for hope. As of Friday, the 3-month T-bill yielded roughly zero percent vs. a 1.9% rate on the 10 year note.
Some analysts respond by noting that the short rate is being manipulated by the Federal Reserve, which invalidates the yield curve's macro forecast. But isn't Fed manipulation of interest rates a constant in the affairs of monetary policy? True, the manipulation is extraordinary these days, but it's not clear if that detail negates the economic effects that generally flow from monetary policy.
Major Asset Classes | Sep 30, 2011 | Performance Update
September was a cruel month for risky assets, delivering the worst batch of red ink among the major asset classes since the financial crisis was roaring in October 2008. Quite simply, there was no place to hide from the selling. Well, almost no place.
The safety of investment-grade bonds was the only game in town--Treasuries in particular. The Barclays U.S. Aggregate Bond Index stood out among the broadly defined asset classes last month with an attribute that was short in supply and high in demand: a positive return. This fixed-income benchmark led the pack in September, advancing 0.7% on the month. For the year through September 30, the Aggregate Bond Index is higher by 6.7%, another first-place rise. Bonds may be in a bubble, as so many analysts have said this year, but there's no sign of popping yet.
Falling prices were the standard almost everywhere else among the major asset classes. U.S. stocks, for instance, tumbled nearly 8% in September. That's five down months in a row, a rare wave of selling in U.S. equities that hasn't darkened the performance ledger since the November 2007-March 2008 downturn.
What are the odds that U.S. stocks will suffer in October? Another down month would be six consecutive months of loss for equities when measured by calendar months. That's rare, but not unprecedented. Since 1957, the S&P 500 on a price basis has suffered only three cases of non-stop monthly red ink for six months or more: the first six months of 1973; a string of nine straight monthly losses in 1974 through September of that year; and the April-through-September 1981 selling wave, according to the St. Louis Fed's database.
As for the rest of last month's losers, commodities were hit hardest, crumbling nearly 15% overall, based on the Dow Jones-UBS Commodity Index. That's the steepest monthly loss in almost three years. Even gold's safe-haven status was tarnished in September. No wonder, then, that the U.S. Dollar Index gained a hefty 6%. Gold and the world's reserve currency have a habit of moving in opposite directions, and last month was no exception. But the rush to hold greenbacks came with consequences: sizable losses in unhedged foreign bond positions.
The potential for more volatility is alive and kicking for the week ahead, with the update for September payrolls scheduled for release this Friday. The consensus forecast calls for net job growth of 90,000, which would be considerably higher than August's dismal gain of 17,000. But at a time when tolerance for mediocre news, much less bad news, is wearing thin, it's anyone's guess if a rise of 90,000 in Friday's jobs report would be greeted with cheers. Then again, there's little doubt what will happen if the crowd is surprised with a lower-than-expected number.
October 1, 2011
Book Bits For Saturday: 10.1.2011
● The End of Progress: How Modern Economics Has Failed Us
By Graeme Maxton
Author's lecture and book summary via publisher, Wiley
We live in an Age of Endarkenment. Our economic, social and political systems have failed us. Modern economics has not done what it promised. It has widened the gap between rich and poor. It has not allocated the world's resources fairly. It has brought the West to the brink of financial ruin. It has valued short-term gain more than long-term progress. It has made us focus on the individual, not society. The social consequences are easy to see. Much of the world is laden with debt. Our planet is being scraped clean of the resources needed by future generations. Science and technology are exploited for profit, not social advancement. The cult of celebrity, rise in global greed and belief that information is knowledge are limiting our imaginations. We are ill-equipped to respond to these challenges. We have been dumbed-down. Our politicians have become self-serving. They play on our fears, monitor us without justification and promote conflicts for their own interests. China's rise will make these problems worse... Economist Graeme Maxton looks at what brought us to this state and what we can do about it.
● The Myth of Choice: Personal Responsibility in a World of Limits
By Kent Greenfield
Summary via publisher, Yale University Press
In this provocative book, Kent Greenfield poses unsettling questions about the choices we make. What if they are more constrained and limited than we like to think? If we have less free will than we realize, what are the implications for us as individuals and for our society? To uncover the answers, Greenfield taps into scholarship on topics ranging from brain science to economics, political theory to sociology. His discoveries—told through an entertaining array of news events, personal anecdotes, crime stories, and legal decisions—confirm that many factors, conscious and unconscious, limit our free will. Worse, by failing to perceive them we leave ourselves open to manipulation. But Greenfield offers useful suggestions to help us become better decision makers as individuals, and to ensure that in our laws and public policy we acknowledge the complexity of choice.
● Unexpected Consequences: Why The Things We Trust Fail
By James William Martin
Summary via publisher, Praeger
The world is full of wonderful products and services that occasionally disappoint and even harm us. Unexpected Consequences: Why The Things We Trust Fail explores the reasons these failures occur, examining them from technological, human, and organizational perspectives. Using more than 40 recent catastrophic events to illustrate its points, the book discusses structural and machine failure, but also the often-overlooked failure of people and of systems related to such things as information technology, healthcare, and security.
● Black Box Casino: How Wall Street's Risky Shadow Banking Crashed Global Finance
By Robert Stowe England
Interview with author via Gaston Gazette
“A black box in the financial world is a financial instrument that is very opaque and unless you’re inside, you don’t know what’s going on. The biggest black boxes were Fannie and Freddie. They were under pressure to lend more and more money to increase home ownership. The same thing was happening on Wall Street. So my view is that there was a lot of speculative, risky activity going on inside those black boxes. A lot of the financial activity had moved into shadow banking. The traditional banking system has deposits and loans. In shadow banking, they turn those into securities … which are less secure.”
● The Fall of the House of Forbes: The Inside Story of the Collapse of a Media Empire
By Stewart Pinkerton
Review via CNNMoney/Fortune
Stewart Pinkerton, the magazine's former managing editor -- one of the top editorial bosses during my tenure there -- has woven together a lively narrative that paints a less grim picture than the title heralds. But what it lacks in news-breaking revelations it more than makes up for with a tale rich in memorable anecdotes and colorful characters.
● Risk and Meaning: Adversaries in Art, Science and Philosophy
By Nicolas Bouleau
Summary via publisher, Springer
Risk and Meaning is a richly illustrated book exploring how chance and risk, on the one hand, and meaning or significance on the other, compete for the limelight in art, in philosophy, and in science. In modern society, prudence and probability calculation permeate our daily lives. Yet it is clear for all to see that neither cautious bank regulations nor mathematics have prevented economic crises from occurring time and again. Nicolas Bouleau argues in Risk and Meaning that it is the meaning we assign to an event that determines the perceived risk, and that we generally turn a blind eye to this important fact, because the word "meaning" is itself awkward to explain.