August 31, 2012
Thinking About The Big Finale For Interest Rates
If you had to pick one chart that summarizes the big picture in economics and finance over the past generation or so, what would choose? How about the benchmark 10-year Treasury Note yield? Not only does this history tell us quite a lot about where we’ve been in macro and markets, the 10-year yield’s track record also provides perspective on where we may be going and what we should expect.
A picture’s worth a thousand words, as they say—especially in this case. Here’s the monthly average yields on the 10-year Note from the early 1960s through July 2012. By the way, the 10-year yield as of yesterday: 1.63%, according to the Treasury Department. As you can see in the chart below, that's just about the lowest in modern financial history, and we may go lower still!
It’s clear that interest rates over the past half century or so have had two distinct regimes: rising and falling. The rising regime rolled out from the 1960s to the early 1980s, when the Volcker Fed crushed inflation, at which point rates embarked on a multi-decade fade.
It’s hard to overestimate the significance of this upside-down V history for economics and finance over the decades. Granted, there are multiple factors that come into play for assessing the path of economies and markets. But if we’re ranking the top 10, the V history above would have to be included as a key variable.
Thirty years of falling interest rates isn’t everything, but it’s a lot. For example, consider the great bull market in stocks from the early 1980s through 2000 (a bull market that's had a second life, twice, from roughly 2003-2008, and again for 2009-?). How much of the good times was financed by falling interest rates?
On that point, this is a good time for the uncomfortable observation that the great fall and decline in rates has just about run its course. Nominal yields may fall a bit further, of course, and low rates may persist for some time, depending largely on the economy’s capacity to grow (or not).
But any way you slice it, we’re nearing the end of an interest rate regime that’s been a foundational trend in macro and markets. Exactly when it’ll end is unknown. Many analysts in recent years have warned that the end was near, and they’ve been wrong. At some point this forecast will be right, although one can have a lively debate about whether the end will be next month or a decade from now.
In any case, the big picture on interest rates is worth pondering as you think about design and management of your investment portfolio. What might change if interest rates are no longer falling and flat line for years? Or, what if they start to climb for an extended period? No one really knows, but it’s useful to make some guesses and model the various outcomes.
The end of a 30-year trend of falling rates probably doesn’t mean much for day traders. Even a time horizon of a year or two may not be all that relevant, depending on how this plays out. But at some point, the big denouement in the price of money will affect us all.
August 30, 2012
Income & Spending Update Boosts July's Economic Profile
Today’s update on personal income and spending offers a fresh batch of data for thinking that recession risk remains low. Disposable personal income (DPI) continued to inch higher in July on a month-over-month basis. Meantime, personal consumption expenditures (PCE) staged a sharp revival in July, rising 0.42% vs. June—the best monthly improvement since February. As a result, the year-over-year trends for these indicators look considerably better—signs that income and spending may be stabilizing at moderate growth rates.
Here’s how the monthly profile compares over the past year:
The stronger July numbers clearly make a difference for the year-over-year profile. In particular, note that the annual percentage increase in income has been moving higher for five of the last six months. That’s a powerful clue for thinking that consumer spending isn’t poised to fall off a cliff, as some analysts have been predicting. Granted, spending’s annual rate of growth is still slipping, but given the improvement in income of late it’s reasonable to expect that PCE will stabilize at current levels if not turn moderately higher.
Reviewing the economy from a broader perspective also leaves room for optimism that the moderate growth of late will roll on for the foreseeable future. With today’s update, we have a nearly complete picture of July’s economic activity. As the table below reveals, the overwhelming majority of key indicators I track trended positive through July. That’s no guarantee that economy will enjoy smooth sailing in the months ahead. But if you’re looking for clear and pervasive signs that a recession has started, or is at high risk of commencing in August, you won't find much support in the latest set of numbers.
Plugging the indicators above into a diffusion index offers another perspective on the broad economic trend. As the next chart below shows, the percentage of these leading and coincident metrics trending positive remains above 80%--a strong sign that recession risk is low.
With July all but certain to go into the history books as another month of economic growth, the focus now turns to the August numbers, which start rolling in next week. Yes, the world is still rife with risks, and economic growth in the U.S. is sluggish. But based on the data so far, modest positive momentum still has an edge over cyclical darkness.
Correction: Decimal-point malfunction: An earlier version of this story incorrectly stated that personal consumption expenditures rose 4.2% in July. Actually, PCE rose 0.42%
Exports & A Strong Dollar: Not Necessarily Perfect Together
It’s become fashionable in this election cycle in some circles to promote the idea of a strong dollar as a key part of the solution to the economic ills that plague the U.S. But simple “solutions” in economics aren’t always what they seem. That's a caveat worth considering when it comes to America’s growing exports and how it relates to the value of the dollar. Arguing that America should have a strong dollar may sound good in a political speech, but the details can be messy.
It’s well established that changes in export levels tend to be inversely related to currency value, and for a rather obvious reason: domestic goods and services are less expensive in foreign markets when the home currency’s value falls. When prices decline, consumption usually rises. But there’s no free lunch here. A weaker currency also translates into higher prices for imports. That’s a key issue for the U.S., which is dependent on crude oil imports in rather large quantities--nearly 11.4 million barrels a day in 2011.
Nonetheless, it’s narrow-minded to talk about a strong dollar and ignore the fact that U.S. exports have increased sharply in recent years, in part thanks to a weaker greenback. Four years after the Great Recession ended, American exports are up 44% through June 2012, according to Census Bureau data. In 2010, exports’ share of U.S. GDP was 13%, up from 11% the year before, the World Bank reports. Roughly 10 million full-time jobs are directly related to exports, based on 2008 data, the International Trade Administration advises, which equates with nearly 7% of total employment.
Exports, in short, are big business, and getting bigger. A recent Brookings Institution report notes:
U.S. export sales grew by more than 11 percent in 2010 in real terms, the fastest growth since 1997. In terms of job creation, the number of U.S. total export-supported jobs increased by almost 6 percent in 2010, even as the overall economy was still losing jobs.
Unsurprisingly, the data show that a weaker (stronger) dollar is linked with higher (lower) exports, as the chart below shows. It’s not a perfect relationship, but nothing ever is in macroeconomics. What the relationship implies is that a stronger dollar at some point will trim exports and, perhaps, jobs, and vice versa. Funny how that risk is never discussed by the folks who bang the table for a strong dollar.
I don’t want to suggest that a mindless policy of weakening the dollar is an easy solution either. There are limits to what a lower dollar can deliver in terms of higher exports and new jobs. Let’s not forget the costs in terms of higher prices for imports via a weaker dollar. The great question is deciding where the sweet spot is for America? At what level does the dollar's value maximize exports/jobs without incurring a net loss for the economy in terms of higher import prices? That’s worth modeling and discussing, but it's a two-way street.
Discussing a strong dollar without talking about the potential impact on exports is, at best, a naive view of international trade. The next time someone tells you that we need a "strong dollar" policy, ask them: "Why?" You might follow up with: "How strong?" And the zinger: "What would a 'strong dollar' policy mean for exports?"
August 29, 2012
Have Sharpe Ratios Peaked?
There's a strong case for expecting that Sharpe ratios will be lower, perhaps a lot lower, for the stock and bond markets for the foreseeable future. What's the source of this outlook? Gravity.
Reviewing the past two decades reminds that equity and fixed-income returns, after adjusting for volatility and the risk-free rate (3-month T-bills), have been soaring. Bonds, in particular, have recently posted extraordinarily high levels of risk-adjusted returns. Using the Barclays Aggregate Bond Index as a proxy, the fixed-income market's Sharpe ratio rose to a multi-decade high of 2.71 back in February of this year, based on trailing annualized 3-year data. The Sharpe ratio for the U.S. stock market (Russell 3000) didn't fly quite as high, but it appears to have reached a recent peak as well.
This type of analysis is hardly the stuff for day trading. Rather, the analysis here provides some general context for market behavior, and it should be considered as the first step in a deeper round of research for designing and managing portfolios and forecasting risk premiums. That said, the bond market's Sharpe ratio looks especially vulnerable to falling in the months (and years?) ahead. For example, running the numbers through an ARIMA-based forecasting process (using software that automatically chooses a model based on the best fit of the data) projects that risk-adjusted returns for bonds will decline.
None of this should be terribly surprising. Sharpe ratios (along with returns and risk separately) fluctuate through time. Meantime, the economic turmoil in recent years makes it's tempting to think that history of late hasn't been a productive landscape for investing, but the numbers tell us otherwise. The bond market (Barclays Aggregate) has earned an annualized 6.9% total return over the past three years through the end of July, or near the best levels for the past decade. Stocks (Russell 3000) have delivered more than twice that performance: 14.2% over the past three years on an annualized total-return basis, also near the best results for past decade on a rolling 36-month basis.
Overall, investing since the Great Recession ended in mid-2009 has been kind for those willing to hold risky assets. Will the future deliver more of the same? Maybe, but the potential for turbulence via the power of gravity suggests that the headwinds may be a little stronger.
Performance volatility, it's safe to say, will endure. That doesn't mean that we're headed for the dog house when it comes to earning risk premia. But it's hard to ignore the fact that U.S. stocks and bonds have had a strong run over the last three years. Can it go on? Sure, but the mistake is thinking that the recent past will roll on indefinitely.
What's the antidote to the routine installment of uncertainty? Rebalancing a broad mix of asset classes is one response--and perhaps a timely one, considering the lofty levels in Sharpe ratios this year.
August 28, 2012
Research Review | 8.28.2012 | Risk Parity Investing Strategies
Will My Risk Parity Strategy Outperform?
Robert Anderson (University of California, Berkeley), et al. | July 2012
We gauge the return-generating potential of four investment strategies: value weighted, 60/40 fixed mix, unlevered and levered risk parity. We have three main findings. First, even over periods lasting decades, the start and end dates of a backtest can have a material effect on results; second, transaction costs can reverse ranking, especially when leverage is employed; third, a statistically significant return premium does not guarantee outperformance over reasonable investment horizons.
Risk Parity Research Summary
Wesley Gray (Empiritrage), et al. | May 2012
Our conclusion on risk parity as an asset allocation system is mixed. On one hand, the backtested results are solid. However, one must use significant amounts of leverage, it is unclear what the benchmark is when assessing risk parity portfolios, and there are open questions as to whether slight perturbations in estimation techniques affect results. In a future research report we will address these research questions—as well as others--in detail.
The Trend is Our Friend: Risk Parity, Momentum and Trend Following in Global Asset Allocation
Steve Thomas (City University London), et al. | August 2012
We examine the effectiveness of applying a trend following methodology to global asset allocation between equities,bonds,commodities and real estate.The application of trend following offers a substantial improvement in risk-adjusted performance compared to traditional buy-and-hold portfolios. We also find it to be a superior method of asset allocation than risk parity. Momentum and trend following have often been used interchangeably although the former is a relative concept and the latter absolute. By combining the two we find that one can achieve the higher return levels associated with momentum portfolios but with much reduced volatility and drawdowns due to trend following. We observe that a flexible asset allocation strategy that allocates capital to the best performing instruments irrespective of asset class enhances this further.
Diversified Risk Parity Strategies for Equity Portfolio Selection
Harald Lohre (Deka Investment), et al. | May 2012
We investigate a new way of equity portfolio selection that provides maximum diversification along the uncorrelated risk sources inherent in the S&P 500 constituents. This diversified risk parity strategy is distinct from prevailing risk-based portfolio construction paradigms. Especially, the strategy is characterized by a concentrated allocation that actively adjusts to changes in the underlying risk structure. In addition, x-raying the risk and diversification characteristics of traditional risk-based strategies like 1/N, minimum-variance, risk parity, or the most-diversified portfolio we find the diversified risk parity strategy to be superior. While most of these alternatives crucially pick up risk-based pricing anomalies like the low-volatility anomaly we observe the diversified risk parity strategy to more effectively exploit systematic factor tilts.
Efficient Algorithms for Computing Risk Parity Portfolio Weights
Denis Chaves (Research Affiliates), et al. | July 2012
This paper presents two simple algorithms to calculate the portfolio weights for a risk parity strategy, where asset class covariance information is appropriately taken into consideration to achieve “true” equal risk contribution. Previous implementations of risk parity either (1) used a naïve 1/vol solution, which ignores asset class correlations, or (2) computed “true” risk parity weights using relatively complicated optimizations to solve a quadratic minimization program with non-linear constraints. The two iterative algorithms presented here require only simple computations and quickly converge to the optimal solution. In addition to the technical contribution, we also compute the parity in portfolio “risk allocation” using the Gini coefficient. We confirm that portfolio strategies with parity in “asset class allocation” can actually have high concentration in its “risk allocation”.
Diversification Return and Leveraged Portfolios
Edward Qian (PanAgoro) | Summer 2012 (Journal of Portfolio Management)
It is widely accepted that portfolio rebalancing adds diversification return to fixed-weight portfolios, but this is only true for long-only unleveraged portfolios. Qian provides analytical results regarding portfolio rebalancing and the associated diversification returns for different kinds of portfolios including long-only, long-short, and leveraged. He shows that portfolio rebalancing is linked to underlying portfolio dynamics. For long-only unleveraged portfolios, rebalancing amounts to a mean-reverting strategy, and the diversification return is always non-negative. But for short (or inverse) and leveraged portfolios, portfolio rebalancing on the top-down level amounts to a trend-following strategy that detracts from diversification return. Qian analyzes diversification returns of risk parity portfolios and shows that the diversification return of a leveraged long-only portfolio can generally be decomposed into two parts, both of which are related to a scaled unleveraged portfolio. The first part is the positive diversification return from rebalancing among individual assets at the bottom- up level, which is amplified by leverage. The second part is the negative diversification return caused by the leverage of the overall portfolio. His numerical examples show that diversification return is, in general, positive for leveraged risk parity portfolios when the leverage ratio is not too high. In addition, he shows that low correlations between different assets are crucial in achieving positive diversification return and reducing portfolio turnover for risk parity portfolios.
August 27, 2012
Estimating The Optimal Rebalancing Rules
Asset allocation and rebalancing are a powerful team with a history of improving the odds of earning a decent return. But in order to harvest the associated risk premium, you’ll have to deal with two big challenges. One is behavioral—rebalancing works best in a contrarian context, i.e., buy low, sell high. The other hurdle is technical—deciding when to rebalance, and by how much.
Rebalancing is a relatively new research area in finance, but the literature has been expanding rapidly. I devote a chapter to the topic in my book, Dynamic Asset Allocation, although the subject really deserves a book (or two) of its own. In any case, the advice on rebalancing runs the gamut, which means that clarity and simplicity are easily victimized in this corner. But if you’re looking for some relatively unbiased context from a quantitative perspective, a model outlined by Seth Masters at Alliance Bernstein (“Rebalancing: Establishing A Consistent Framework,” Journal of Portfolio Management, Spring 2003 ) is a good place to start.
The basic goal of the Masters model is to estimate the optimal rebalancing trigger points for each asset in a portfolio in an asset allocation framework. In other words, how far should you let a portfolio's asset allocation drift before rebalancing the pieces back to the target allocation? No one really knows the answer, of course, and no amount of analysis can fully solve this mystery, courtesy of our ancient nemesis: an uncertain future. Nonetheless, we can and should focus on developing an approximation of the ideal trigger point by intelligently analyzing the data. We shouldn't be slaves to the result, but going through the process is immensely productive for understanding how rebalancing can help us.
On that score, Masters offers a relatively easy and robust model. The analysis can be run in a simple Excel spreadsheet (or in more sophisticated software packages, such as R). Either way, the strategic insight can be invaluable.
To run the analysis, you'll need estimates for five inputs:
With those numbers in hand, it's a simple matter to plug in the numbers into Masters' formula for estimating the trigger points for each asset in a portfolio:
As a simple of example of how the Masters model works, consider a basic two-asset class portfolio with a target allocation of 60% stocks (S&P 500) and 40% bonds (Barclays Aggregate Bond). Per the variables above, the model requires that we make some assumptions. Let's briefly consider each:
• Investor risk tolerance is hard to pin down, although Masters writes that 5% is a rough estimate for many of his clients and so we'll stick with this number for a test drive.
• Masters also assumes a 1% cost of trading.
• Ideally, the volatility inputs should be projected values, but for simplicity let's use historical data: annualized standard deviations of monthly total returns for the past decade through July 2012 for each asset class.
• Each asset's correlation with the rest of the portfolio (which in this simple example is the other asset), based on monthly data for the trailing 10 years through July 2012.
With the numbers entered, here are the results:
Given our assumptions, the Masters model tells us to rebalance both the equity or bond portion of the portfolio whenever the allocation rises or falls by 4 percentage points.
What can you do with this information? First, a warning: no one should assume that this model gives us the last word on rebalancing rules. There are no silver bullets here, or anywhere else in financial analytics. But it's a valuable starting point—a benchmark for evaluating rebalancing rules for a specific portfolio with a particular set of assumptions. For deeper insight, you should compare the recommendations with advice from another methodology. If the two approaches dispense similar recommendations, that's an encouraging sign that you're in the ballpark for estimating the optimal rebalancing strategy. If they disagree sharply, however, it may be time to rethink your rebalancing strategy, including the underlying assumptions.
Remember, too, that all the standard caveats apply, including the garbage-in-garbage-out risk. The Masters model is only as reliable and robust as the estimates you put into it. But assuming that you can come up with reasonable guesses about the future, the formula can do quite a lot of the heavy lifting for deciding how and when to rebalance a portfolio.
Nonetheless, this model probably works best if you use it routinely and test it by plugging in a range of inputs. In other words, it's important to get a "feel" for how it works and what it's telling us. For instance, if we forecast that the volatility for equities will be 50% higher than the assumption above, that would lower the rebal trigger point for stocks only slightly to 2 percentage points from 3.
Before making real-world portfolio changes, it's crucial to "play" with the model to understand its sensitivity to each input. But don't expect too much. Mere mortals are destined to estimate risk and return with some degree of error. No one's immune. All the more reason to diversify across assets (far more than the two in our simple example), in part to diversify the blowback from error in predictions and less-than-perfect rebalancing decisions. Generally speaking, a prudent set of forecasts for 10 asset classes, aggregated up to the portfolio level, will be more statistically robust compared with predictions for two asset classes. As a foundation, consider holding a mix of the major asset classes via ETFs, index mutual funds, and/or your favorite actively managed products.
Ultimately, the real message in the Masters model is that you should spend a fair amount of time developing risk estimates for each of the asset classes, and the portfolio overall. The good news is that forecasting risk, while far from easy, is somewhat easier than predicting returns directly for asset classes across medium- and long-term horizons. Thanks to Masters, it's also easier to process the estimates for insight on when to rebalance a portfolio. Considering the importance of rebalancing for prudently generating risk premia, that's a big deal, and a potentially rewarding one too.
Correction: An earlier version of this story incorrectly explained Masters formula as it pertains to portfolio correlation and one of the estimates of volatility. The correction focuses on the fact that one of the volatility estimates is related to the rest of the portfolio, i.e., the volatility for assets other than the asset in question. Also, each asset's correlation relates to the rest of the portfolio as well. As such, some of the estimates for the two-asset class portfolio above have been changed. In a portfolio with only two asset classes, the "rest of the portfolio" is, of course, the other asset. Originally, I estimate vol and correlation by looking at the combined portfolio. Correcting this oversight results in dramatically different trigger points in the example. Sorry for the mix-up.
August 25, 2012
Book Bits | 8.25.2012
● The Ponzi Scheme Puzzle: A History and Analysis of Con Artists and Victims
By Tamar Frankel
Q&A with author, via The New York Times/DealBook blog
Maybe “Ponzi scheme” should have its own spot in the Dewey Decimal System. Along with biographies of the schemers, a growing stack of scholarly references, legal tomes and articles aims to collect knowledge about this age-old crime. But the latest entry in the category, “The Ponzi Scheme Puzzle: A History and Analysis of Con Artists and Victims” by Tamar Frankel, takes a different approach. While Professor Frankel is a legal scholar who has been on the faculty of the Boston University Law School since 1968, her book explores the psychology of the financial criminals and what makes them tick. She was inspired by a colleague who referred to them as “those mimics of trustworthiness: con artists.” She spent more than a decade researching the book, analyzing more than a hundred Ponzi schemes.
● How to Make Money with Junk Bonds
By Robert Levine
Review via CFA Institute
Authored by an experienced professional (Robert Levine was founding president of Kidder, Peabody High Yield Asset Management and later ran Nomura Corporate Research and Asset Management for two decades), How to Make Money with Junk Bonds is a well-written, clear, and occasionally humorous tutorial on investing in speculative-grade corporate debt. All essential aspects of high-yield debt are covered. Credit analysis, the bread and butter of high-yield investing, is explained at a rudimentary level. Levine shows, inter alia, how to calculate interest coverage and financial leverage ratios, why EBITDA (earnings before interest, taxes, depreciation, and amortization) is an imperfect measure of cash flow, and why one would want to invest in high-yield bonds in the first place. As a basic introduction to the high-yield debt market in fewer than 200 pages, the book can’t be beat.
● The Missing Risk Premium: Why Low Volatility Investing Works
By Eric Falkenstein
Blog post by author via Falkenblog
Schopenhauer said good new ideas are first ridiculed, then violently opposed, then accepted as obvious. While the idea that low volatility investing 'works' is becoming more common, the why remains rather unsettled. I am happy to have my argument neatly summarized in one terse book. Last Christmas it was about 20% larger, but I got it down to about 60k words or 160 pages with about 30 pages of references and endnotes. After years of being rejected by academics, and I guess in some sense this is an end run, as various journals have called my theory 'obvious' and 'wrong', or that it was 'not of interest to the general reader of the the Journal of Finance', or that I was arguing the Earth was flat and wasting their time.
Finance experts know one thing, that risk and return are positively linearly related via a covariance with something that conveniently hasn't been identified. They are wrong.
● Energy for Future Presidents: The Science Behind the Headlines
By Richard A. Muller
Summary via publisher, W.W. Norton
The author of Physics for Future Presidents returns to educate all of us on the most crucial conundrum facing the nation: energy. The near-meltdown of Fukushima, the upheavals in the Middle East, the BP oil rig explosion, and the looming reality of global warming have reminded the president and all U.S. citizens that nothing has more impact on our lives than the supply of and demand for energy. Its procurement dominates our economy and foreign policy more than any other factor. But the “energy question” is more confusing, contentious, and complicated than ever before. We need to know if nuclear power will ever really be safe. We need to know if solar and wind power will ever really be viable. And we desperately need to know if the natural gas deposits in Pennsylvania are a windfall of historic proportions or a false hope that will create more problems than solutions. Richard A. Muller provides all the answers in this must-read guide to our energy priorities now and in the coming years.
● The Undercover Economist, Revised and Updated Edition: Exposing Why the Rich Are Rich, the Poor Are Poor - and Why You Can Never Buy a Decent Used Car!
By Tim Harford
Summary via publisher, Oxford University Press
With over one million copies sold, The Undercover Economist has been hailed worldwide as a fantastic guide to the fundamental principles of economics. An economist's version of The Way Things Work, this engaging volume is part Economics 101 and part expose of the economic principles lurking behind daily events, explaining everything from traffic jams to high coffee prices. This revised edition, newly updated to consider the banking crisis and economic turbulence of the last four years, is essential for anyone who has wondered why the gap between rich and poor nations is so great, or why they can't seem to find a decent second-hand car, or how to outwit Starbucks. Senior columnist for the Financial Times Tim Harford brings his experience and insight to bear as he ranges from Africa, Asia, Europe, and the United States to reveal how supermarkets, airlines, and coffee chains--to name just a few--are vacuuming money from our wallets.
● Brazil Is the New America: How Brazil Offers Upward Mobility in a Collapsing World
By James Dale Davidson
Summary via publisher, Wiley
Davidson points out that with a population just two-thirds the size of that of the U.S., Brazil has created over 15 million jobs in the past eight years, while the U.S. lost jobs. Combining energy independence and vast natural resources, including 60 percent of the world's unused arable land, and 25 percent of its fresh water, Brazil is the first tropical superpower, offering a whole new frontier for growth. Add in a young population, a relatively underleveraged consumer economy, and a per capita GDP that has more than doubled in the last decade, and you have a recipe for investment success.
● Freedom Manifesto: Why Free Markets Are Moral and Big Government Isn't
By Steve Forbes and Elizabeth Ames
Video interview with Forbes via C-SPAN
Steve Forbes talked about his book, Freedom Manifesto: Why Free Markets Are Moral and Big Government Isn't, a follow-up to his book, How Capitalism Will Save Us. He was interviewed while attending FreedomFest, which was held July 11-14, 2012, in Bally's Las Vegas Hotel and Casino.
● Financial Statistics and Mathematical Finance: Methods, Models and Applications
By Ansgar Steland
Summary via publisher, Wiley
Mathematical finance has grown into a huge area of research which requires a lot of care and a large number of sophisticated mathematical tools. Mathematically rigorous and yet accessible to advanced level practitioners and mathematicians alike, it considers various aspects of the application of statistical methods in finance and illustrates some of the many ways that statistical tools are used in financial applications.
August 24, 2012
Durable Goods Orders Rise In July, But Business Investment Slumps Again
New orders for durable goods rose by a healthy 4.2% last month, according to the U.S. Census Bureau, but the increase is marred by the ongoing drop in a widely monitored subset of these orders: business investment, defined as new orders for capital goods excluding aircraft and defense. Does the ongoing weakness in business investment tell us that we should ignore the otherwise encouraging news for broadly defined durable goods orders? If there are more clouds on the macro horizon than the top-line number suggests, what does that imply for the economy? In search of some perspective, let's take a closer look at the numbers.
What is clear is that new orders overall have been reviving in recent months, gaining 4.2% in July—the best month since last December. It's another story for business investment, which slumped again last month by 3.4%, the biggest drop since last November.
For a clearer look at the trend, let's turn to rolling 1-year percentage changes. Unfortunately, today's update also delivers a mixed bag on this front. Although top-line durable goods orders appear to be stabilizing at a 5%-a-year-growth pace, business investment continues to weaken on a year-over-year basis. For the second month in a row, in fact, business investment fell relative to a year ago. We haven't seen such a run of negativity since 2009, as the second chart below reminds.
The question, of course, is whether the deterioration in business investment is signaling trouble for durable goods orders generally (and the broader economy) in the months to come? That's certainly a risk at this point, and a growing one, according to history. The relatively tight correlation between these two measures through time tells us that one or the other is due for a correction in its respective trend. Quite simply, this divergence can't last much longer. Either top-line durable goods orders are set for a bigger fall, or business investment will improve.
“There’s uncertainty domestically about the tax environment, and there’s uncertainty globally about the outcome of the European crisis,” Millan Mulraine, a senior U.S. strategist at TD Securities, tells Bloomberg. Not surprisingly, this climate is “not engendering business investment and hiring. This would bolster the case for the Fed, suggesting that the soft underbelly of the recovery may be extending into the third quarter.”
But does that leave open the possibility that business investment revive if the uncertainty fades? If so, when will the uncertainty fade? What might trigger such a decline in uncertainty? And if we don't receive more clarity soon in favor of growth, is the slumping trend in business investment destined to lead the rest of the economic indicators into darkness? Once again, there's a fresh round of uncertainty to ponder. As usual, the answers aren't available in real time... yet.
What to do? We can start by looking for signs that negative trend in business investment is spilling over into other indicators. That's going to take a few weeks, however. To be precise: Will we see deeper troubles in more indicators in the August read relative to the generally upbeat trend numbers for July? Stay tuned…
Closet Indexing In The Age Of ETFs
Ian Salisbury at Marketwatch reminds us that some actively managed mutual funds may be loading up on ETFs. The preference to hold index funds in a portfolio that's supposed to be a collection of individually chosen securities can be a warning sign that you're paying actively managed fees for beta. Or in the parlance from the neighborhood of my youth, "You're getting ripped off, bud."
Sometimes the use of ETFs in an actively managed strategy is legitimate, but not always. How can you tell the difference and avoid owning what amounts to an overpriced index fund? Like everything else in the cause of intelligently choosing actively managed funds, the short answer is that you'll have to spend a fair of time digging through the numbers and analyzing the fund through time. No wonder that a growing number of investors are opting for index funds.
That said, one example of a legitimate use of ETFs in an active strategy is tracking the target market when a surge in new investment dollars arrives. For instance, let's say you're running a small cap fund with $300 million in assets and suddenly $50 million of new investment drops into the portfolio. That's a large relative increase in assets in a short time frame and the opportunities may be limited for deploying the money productively and quickly in terms of the portfolio's mandate. Perhaps you think small-cap stocks are overvalued, for instance. Even so, you're not going to turn down the money. What to do?
Keeping the new investments in cash is a poor choice because it will create an additional headwind for earning market-beating returns. A better option is buying a small-cap ETF as a temporary fix--emphasis on "temporary"--until more attractive opportunities emerge in individual small-cap stocks. The net result: the new capital can be deployed instantly, in a cost-efficient manner, and more or less in line with the underlying investment strategy. Meantime, you'll avoid the dead-cash factor that will degrade performance.
The trouble here is that the use of ETFs in this way shouldn't run on for too long. But where does one draw the line between a temporary fix and a long-term crutch? Hard to say, but just like the gray area of trying to identify pornography in advance, clear definitions are elusive but you'll probably know the offending item when you see it. Of course, you have to be looking. Choosing high-quality active strategies doesn't come easy, or quickly, but it's essential if you're going to rationalize paying the higher, perhaps substantially higher, fees relative to indexing.
The mere presence of ETFs in an actively managed portfolio isn't necessarily a smoking gun, but it's surely a warning sign until you learn more about the fund. Then again, some funds openly embrace ETFs as part of an actively managed beta strategy. A number of hedge-fund-like mutual funds and ETFs employ this strategy, for instance, in which case there's nothing dishonest about the practice. Unless, of course, they're charging exorbitant fees for owning betas and delivering risk-adjusted returns that you could easily replicate by holding a mix of ETFs that target markets across the spectrum of the major asset classes.
How can tell the difference? You can start by considering what's available via low-cost ETFs in a forecast-free strategy framework. For instance, as I discussed earlier this week, here's how several simple, broadly diversified asset allocation benchmarks stack up over the past 10 years:
Can you do better? Sure, although you can also do worse, and history suggests that doing worse isn't exactly rare, as my recent analysis of actively managed asset allocation funds suggests.
It's no surprise to learn that active managers are jumping on the beta bandwagon. But at some point you have to wonder if you're being overcharged for a strategy that requires minimal, if any, skill. The only time that indexing is bum deal is when you're overpaying for it. That's easy to avoid, but only if you're aware of it. Closet indexing has been around for decades, and it's in no danger of extinction, as today's Marketwatch story warns. Fortunately, there's a simple solution: use index funds from the start.
August 23, 2012
Jobless Claims Rise Slightly Last Week, But The Trend Is Still Encouraging
Jobless claims rose modestly last week, the Labor Department reports, but reviewing the numbers in context with recent history suggests that this indicator is still on track to trend positive. New filings for the week ended August 18 increased by 4,000 to a seasonally adjusted 372,000, the highest level in five weeks. But that pales as a relevant factor compared with the year-over-year change for unadjusted claims, which posted a 10% decline as of last week. That's in line with recent history and an encouraging sign that the labor market continues to heal, albeit slowly.
As usual, it’s best not to get worked up over the latest data point for this series, which has a habit of suffering lots of misleading short-term volatility. Even so, it’s worth mentioning that last week's seasonally adjusted update remains near a four-year low.
More importantly, the annual percentage change in new claims—before seasonal adjustment—is still comfortably below zero, dropping 10% last week from its year-earlier level. That’s roughly the pace we’ve seen for the better part of the past year, give or take the occasional diversion. The message is that new filings for unemployment benefits are still drifting lower, once we strip away the short-term noise and seasonal distortion.
It's the future, of course, that matters. Looking too far ahead is dangerous, but let's consider a few estimates of the next several weeks to come. Analyzing the past decade of weekly claims data with my ARIMA forecasting model projects that August overall will deliver another positive month for this indicator in terms of how the numbers compare with a year ago. That's not surprising, given the fact that a) we already have several weekly August numbers in hand, which look encouraging; and b) the year-over-year declines have prevailed for this data set on a monthly basis since November 2009. It would take a huge negative shock to derail the August trend at this point. Barring that, it's getting easier to assume that weekly claims will remain a positive factor for August generally in my recession risk model.
Jobless claims are an important leading indicator, although we should still look at a broad set of economic and financial numbers for a deeper read on the economy. It's never clear when any one indicator is steering us wrong. Nonetheless, for the moment, this is one variable that's not flashing warning signs, even if some pundits mistakenly think that last week's data point alone suggests otherwise.
Correction: An earlier version of this story incorrectly stated that last week's seasonally adjusted claims rose by 3,750. In fact, claims rose slightly more: +4,000 last week.
Fiscal Cliff Risk In Perspective
"It's the end of the world as we know it and I feel fine." -- R.E.M.
The Congressional Budget Office warned yesterday that there's a recession coming next year if Congress doesn't act to soften the blow from the scheduled expiration of tax cuts and automatic budget cuts. The so-called fiscal cliff, in short, is moving closer. What can you do with this information? Nothing. Unless, of course, you're prone to making decisions today based on forecasts six months or more into the future. But history suggests you should think twice before jumping off the forecasting cliff, regardless of who's dispensing the prediction.
Don't misunderstand: the scheduled expiration of tax cuts and automatic budget cuts represent real, albeit potential, threats to the economy. But so is the economic blowback via higher oil prices if Israel attacks Iran in a pre-emptive strike; or if Syria's civil war worsens and turns into a regional war. In fact, anyone can come up with a laundry list of plausible scenarios, both here and abroad, that would probably push the economy into recession. The fiscal cliff scenario is one of them, and it's a risk that we should take seriously, but not too seriously... at least not yet.
The problem is that there are always risks lurking that could derail economic growth. But it's also true that recessions rarely arrive as bolts out of the blue with no advance warning in the numbers. The idea that you could go to sleep on Monday, when all is fine, and wake up on Tuesday and find the economy contracting is the macro equivalent of worrying about hobgoblins under your bed.
A better approach is to monitor a broad set of indicators for signs that the economy is deteriorating and generating conservative assumptions about the very near future. In other words, use something approximating real-time analysis in an intelligently designed framework to guide your decisions for deploying capital, running your business, etc. By that standard, recession risk still looks low, as I discussed earlier this week. Yes, that too will change, and perhaps soon. When it does, you'll see the accumulating evidence in the economic and financial reports. The critical issue is recognizing when the preponderance of indicators slip over to the dark side, at which point recession risk will truly be a threat. When that day comes, you'll read about it here.
Meantime, cherry-picking risks and thinking that they represent fate for, say, next spring, is short-sighted. Yes, the fiscal cliff could kill us. But Congress may get its act together. There are also plenty of potential positive surprises that could alter the outlook for the better, even if the fiscal cliff strikes. We can play this game of "What if?" all day. Qualitative forecasting is an interesting exercise, and it can be production up to a point. But it's prone to lots of error. The same can be said for quantitative forecasts, particularly those attempt to look too far into the future.
For my money, "nowcasting" recession risk—analyzing a diversified set of published indicators that collectively offer a robust read on the economy—provides a more reliable method. Sure, the latest numbers are subject to revision, but that’s why a broad set of indicators is essential—some of the revisions cancel each other out. We can and should supplement the latest information with short-term forecasts via econometric modeling to get a "feel" for what the next batch of numbers are likely to tell us. This is hardly a perfect solution, but it's light years ahead of getting all worked up about the report du jour that singles out one particular hazard on the uncertain horizon.
August 22, 2012
Strategic Briefing | 8.22.12 | Analyzing Asset Classes
Arnott: Emerging Markets Are Today's Low-Hanging Fruit
Morningstar.com | August 9
The Research Affiliates chairman discusses why he see value in developing-markets bonds as well as the urgency for investors to build a 'third pillar' in their portfolios.
The Untold Story of Municipal Bond Defaults
Liberty Street Economics (NY Fed) | Aug 15
In our recent post on the state and local sector, we argued that structural problems in state and local budgets were exacerbated by the recession and would likely restrain the sector’s growth for years to come. The last couple of years have witnessed threatened or actual defaults in a diversity of places, ranging from Jefferson County, Alabama, to Harrisburg, Pennsylvania, to Stockton, California. But do these events point to a wave of future defaults by municipal borrowers? History—at least the history that most of us know—would seem to say no. But the municipal bond market is complex and defaults happen much more frequently than most casual observers are aware. This post describes the market and its risks.
[REIT] Valuations Expected to Climb in Second Half
REIT.com | August 9
Look for continued growth in valuations and operating income in the commercial real estate industry during the second half of 2012, according to Paul Whyte, managing director with Credit Suisse. Whyte heads Credit Suisse’s real estate investment banking division. In a video interview with REIT.com in New York at REITWorld 2012: NAREIT’s Investor Forum, Whyte offered his near-term outlook for REIT investment in the United States. He also discussed some of the potential pitfalls in both the real estate market and financial system that could give REIT investors problems.
Revisiting Stocks For The Long Run
James Biano (The Big Picture) | August 20
Dr. Siegel posited stocks are less risky than bonds as holding periods lengthen. The following table displays the relative frequency of stocks outperforming either bonds or Treasury bills as a function of holding period. Specifically, stocks outperformed bonds over a thirty-year holding period 100% of the time from 1871 to 1993. From 1802 to 1993 stocks outperformed 97.2% of the time. The only time other than the present when stocks underperformed bonds over 30 years was the 1840s. However, as the set of tables on the next page show, this trend has drastically changed in the wake of the financial crisis. The first table shows returns through September 30, 2011. Bonds have completely dominated stocks over every tenor from one month to 30 years. Critics would say that September 30 is a favorable period for bonds as the all-time high in yields (low price) was September 30, 1981. This is true, but since the 1840s there have been numerous peaks in yields and none of those produced a bond outperformance over stocks as was seen since 1981.
Fama: Why Small and Value Stocks Outperform
Fama/French Forum (Dimensional Funds) | June 7
I talked with Client Insights host Dan Richards about the problems with the Capital Asset Pricing Model (CAPM) and the development of the Fama/French three-factor model as a more accurate way of determining how average returns differ from one another. I also explain why higher expected returns for small and value stocks should persist.
Reaching for Yield in the Bond Market
Bo Becker and Victoria Ivashina (Harvard) | May 16
Reaching-for-yield — the propensity to buy riskier assets in order to achieve higher yields — is believed to be an important factor contributing to the credit cycle. This paper analyses this phenomenon in the corporate bond market. Specifically, we show evidence for reaching for yield among insurance companies, the largest institutional holders of corporate bonds. Insurance companies have capital requirements tied to the credit ratings of their investments. Conditional on ratings, insurance portfolios are systematically biased toward higher yield, higher CDS bonds. This behavior appears to be related to the business cycle, being most pronounced during economic expansions. It is also more pronounced for the insurance firms for which regulatory capital requirements are more binding. The results hold both at issuance and for trading in the secondary market and are robust to a series of bond and issuer controls, including issuer fixed effects as well as liquidity and duration. Comparison of the ex-post performance of bonds acquired by insurance companies does not show outperformance, but higher volatility of realized returns.
August 21, 2012
Profiling Success: One Financial Advisor's View On Asset Allocation & Rebalancing
Ron Vinder, a financial advisor at UBS Financial Services, says he's doing just fine by managing client portfolios with a broad set of ETFs. Rebalancing the mix is a critical part of the strategy, he explains via Barron's. "Whenever an asset class does well, that's when individuals want to buy more. And they want to sell what's doing poorly." That's all too typical, of course, which is part of the reason why the expected premium from rebalancing is so attractive. Indeed, if everyone was diversifying broadly and opportunistically rebalancing, the performance advantage would shrink considerably. But don't worry: crowd behavior is resiliently rigid—even when the evidence for change is overwhelmingly persuasive.
Vinder reports that a portfolio comprised of a broad mix of assets classes via ETFs returned 72% (in absolute terms) during 2002-2011. That sounds about right, according to my numbers, although let's update the record in annualized terms and provide more detail with my proprietary indices, namely, the suite of Global Market Index (GMI) benchmarks. GMI, as regular readers know, is a market-value weighted index of all the major asset classes, save for cash. I also calculate GMI in rebalanced (GMI.R) and equal-weight (GMI.E) versions. Each of these benchmarks, by the way, can be replicated with ETFs. Why should you care? Because GMI performs quite well over time. More precisely, it tends to earn average-to-above-average returns relative to the various efforts to beat it. Rebalancing GMI's mix tends to earn a slightly higher premium, and equally weighting (and rebalancing) does even better. Forecast-free strategies, in short, can do a lot. You may want to do more, but the foundation is quite solid. What's more, the advantages that accrue from a) diversifying across asset classes; and b) rebalancing the mix periodically holds up after adjusting for risk.
Consider, for instance, a basic profile of GMI indices relative to a traditional asset allocation benchmark: a 60%/40% portfolio of U.S. stocks and bonds (S&P 500 and Barclays Aggregate Bond Index). For the 10 years through the end of July 2012, GMI and its rebalanced and equally weighted versions posted a modest premium over the 60/40 strategy (see table below). Holding a wider pool of asset classes suffered a slightly higher volatility overall compared with the 60/40 benchmark, but the higher returns from rebalancing more than offset the slightly higher risk. In particular, GMI.R and GMI.E posted substantially higher risk-adjusted performances, as defined by the Sharpe ratio.
Is the advantage of combining asset allocation with rebalancing a surprise? No, or at least it shouldn't be. As I discussed in my book— Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor--decades of financial research tell us that these two cornerstones of portfolio management are the building blocks of successful investing. Yes, the real-world results also look good when measured against actively managed asset allocation funds.
It's encouraging to read that some advisors are on board with what should be standard practice for portfolio strategy. But let's not fret too much. To the extent that most of the investment world disagrees, or can't quite muster the discipline to diversify and rebalance effectively, on a timely basis, well, that leaves the rest of us with more opportunity to earn a bigger rebalancing bonus. There are no guarantees, of course, but it's hard to argue with real-world track records and finance theory. There's a finite supply of positive alpha available from managing a portfolio of broadly defined betas. But if history's a guide, the limited supply is more than ample for the relative few who are willing and able to exploit the potential opportunity.
August 20, 2012
Forecasting Economic Activity... Just Slightly
Last week’s update of the Capital Spectator Recession Risk Index (CSRRI)—a simple but revealing diffusion index based on a broad spectrum of economic and financial indicators—suggested that the probability was low that July will mark the start of a new recession. A broad review of recent history can reveal quite a lot about the business cycle, but it’s only a beginning. In an effort to peek ahead by projecting CSRRI's readings for the next several months, modern econometric modeling techniques can help.
In particular, by torturing the data with what’s known as an ARIMA model (short for autoregressive integrated moving average), we can develop a robust benchmark for peering forward. Yes, all the standard caveats apply—forecasting, like playing with matches at a gasoline station, can be dangerous in the wrong hands. But with a bit of adult supervision, predicting can help us to think productively about what may or may not be coming. With that in mind, let’s kick the tires on the possibilities.
As a preview, crunching the numbers with a series of ARIMA estimates for each of the 17 indicators in CSRRI, and aggregating the results, implies that recession risk will remain low for August. That’s no guarantee, of course, but it’s one signal (and arguably a robust one) that the slow-growth momentum will roll on for the near term.
For some of the details behind this forecast, read on. But first, some perspective on where we’ve been. Here’s how the latest reading on CSRRI’s indicators stack up via the published data so far:
Why should we care about this menu of numbers? This chart below explains:
As you can see in the graph above, the 80%-plus reading implies that the economy was comfortably above the tipping point. How confident should we be for expecting more of the same for the next month? Here’s where an ARIMA model can provide some guidance. The basic procedure is to apply the model to each data series to generate forecasts, one indicator at a time. With those forecasts in hand, the data can be aggregated to compute future expected values for CSRRI.
The challenge with ARIMA-based forecasting is selecting an optimal (or near-optimal) set of parameters for the model. Fortunately, there has been progress in automating the process to a degree by letting the data, in effect, choose the parameter mix. The optimal mix for, say, employment, will differ from the modeling details for industrial production. For projecting CSRRI values, I use Professor Rob Hyndman's forecasting package, which runs on R, a software tool for statistical computing. Cutting to the chase, let's compare the CSRRI forecasts with recent historical data:
As with any forecast, we should treat this one cautiously. Nonetheless, I've taken some precautions to keep the usual hazards to a minimum. First, the future values of CSRRI are estimated by forecasting each of the underlying 17 variables individually via ARIMA. Inevitably, each forecast will likely suffer from a fair amount of uncertainty—the standard errors at, say, the 95% confidence level, are wide enough to drive a truck through compared with the point forecasts. But a portion of this uncertainty is addressed by generating predictions for a broad mix of indicators. As a result, some of the errors in looking ahead are likely to cancel each other out. In other word, the excessively optimistic predictions will be offset by the overly pessimistic ones.
In addition, I'm only looking ahead by three months. As usual in the murky realms of forecasting, the further out in time you look, the wider the band of standard errors. To the extent that we treat forecasts with respect, the highest level of confidence is reserved for the next period ahead—in this case the August 2012 estimate for CSRRI.
By that standard, there's a good case to argue that the broadly positive readings for the nearly complete report card for July will spill over into August. What might derail this rosy outlook? A shock of some magnitude would do the trick. If the euro collapses, for example, the blowback across the Atlantic might be enough to push the U.S. economy over the edge. A greater level of mayhem in the Middle East that sends oil prices skyrocketing should also be on the short list of exogenous shocks that might trip up the modest growth momentum in the U.S.
There are, as always, monsters lurking in the shadows in the delicate art/science of predicting the economy--especially when growth is precarious and relatively sluggish. But based on the numbers in hand, and using the published data to make some conservative forecasts for the next month or so, the case for cautious optimism still looks like a reasonable assumption.
August 15, 2012
A Brief Pause In The Usual Routine….
The Capital Spectator will go dark for a few days. Hey, it's (still) summertime, right? The normal schedule of fun resumes on Monday, August 20. Cheers!
Another July Upside Surprise: Industrial Production
Industrial production grew at a substantially faster pace in July vs. June, the Federal Reserve reports. The encouraging news comes on the heels of yesterday's better-than-expected retail sales report for July. Considering these data points in context with a broader read on economic conditions strengthens the case for expecting economic growth in the near term.
Echoing the narrative for retail sales, industrial production revived last month after a run of sluggish activity. July's 0.6% increase is the best month for industrial activity since April's 0.8% gain.
Meantime, the year-over-year trend in industrial production appears to be stable in the 4%-5% range. In other words, there are no signs of cyclical trouble here. The 4.4% increase in industrial production last month vs. its year-earlier level is in line with annual growth rates we've been seeing lately; it's also a healthy pace that suggests that recession risk remains minimal.
That's also the message when we review the economic profile for July relative to history via the Capital Spectator Recession Risk Index (CSRRI), a diffusion index that reflects the trend for a broad mix of leading and coincident indicators.
With today's industrial production report in hand, here's how the lineup of indicators compares to date:
The future, as always, is open for debate, but the recent past looks quite clear in the dark art of calling peaks and troughs for the business cycle. The case for arguing that a recession began in July, it seems, is quickly fading. Data revisions could surprise us, of course, but that's a low-risk affair when it comes to year-over-year readings. In addition, revisions tend to cancel one another out when looking at a broad set of indicators.
In short, the odds are low that the economy fell off the cyclical cliff last month. That may come as a surprise to some analysts, especially those who rushed to judgment earlier this month when the ISM Manufacturing Index dispatched another mildly weak number for July, as reported on August 1. Some saw that as an ominous sign beyond dispute. Two weeks later, a broader read on the July data begs to differ, reminding once again that cherry-picking economic reports is a dangerous habit in macro analysis.
August 14, 2012
A Surprisingly Strong Retail Sales Report For July
If July is supposed to be the tipping point, when the business cycle succumbs to gravity, it's not obvious in today's update on retail sales. Spending rebounded strongly last month, the U.S. Census Bureau reports. The advance estimate of U.S. retail and food services sales for July, seasonally adjusted, popped 0.8%. That's the highest monthly gain since February's 1% surge. Economists generally were projecting a gain of roughly 0.3%, Bloomberg notes.
One month doesn't tell us much, of course. Still, it's worth noting that July's handsome revival is a break with the monthly declines of late. It's anyone's guess if this is a positive sign for consumer spending in the near term vs. a one-time event, but it's a lot easier to ponder the brighter possibility in light of today's numbers.
More importantly, the year-over-year percentage change in retail sales turned higher in July--for the first in five months. It's premature to say that the long deceleration in the annual rate of growth for retail sales has stabilized, but here again the thought resonates a bit stronger with the July update.
Today's news reminds once more that the rush to assume that a recession is near—or that another downturn has already started—looks impulsive. Forecasting the next move in the economy, in other words, is hazardous work. But judging the trend according to the numbers in hand remains a relatively transparent affair. Indeed, as I've been noting on these pages for some time, reviewing a broad set of the numbers in terms of their trend (i.e., mainly looking at year-over-year changes) still leaves plenty of doubt for expecting the worst. Tomorrow may tell us differently, of course, but let's not confuse that exercise (productive as it may be) with dissecting what we know currently.
On that note, how does the brighter reading on retail sales for July compare with a broad sampling of other economic and financial indicators that provide useful clues for assessing the business cycle? The short answer: the better-than-expected news today fits right in with a generally encouraging profile writ large.
For a more precise answer, let's start with the current estimate of the Capital Spectator Recession Risk Index (CSRRI), which is a simple diffusion index that tracks the percentage of indicators trending positive each month, and averaging each reading based on the trailing 3 months. As the next chart shows, CSRRI remains in the 80% to 90% range, based on the latest numbers--i.e, the majority of indicators are trending positive. The July reading of 83.8% implies that the odds are low that last month marked the start of a new recession. History suggests that a new recession will begin once this index is falling persistently and dives under 50%. For the moment, we're nowhere near that danger zone, using the data published to date.
Here's a closer look at the recent histories of the individual components used in calculating CSRRI:
Although we're missing several pieces of July's data profile, today's retail sales suggests that the upcoming personal spending update for last month (via the Bureau of Economic Analysis) will remain firmly in the black in terms of its year-over-year percentage change.
Nonetheless, no one should underestimate the risks that hang over the U.S. or the global economy. As such, CSRRI shouldn't be confused with a forecast. Instead, it's a reading on the numbers so far--a "nowcast" of recent history. That's hardly the last word on evaluating the business cycle or deciding if the economy's friendly or not, but it's a solid start.
Perhaps it's fair to say that the pessimists have some explaining to do. At the very least, they'll have to wait until the August data arrives for asserting that the end of the expansion is near (or here). Yes, the future may be turn out to be ugly. For now, however, cautious optimism rolls on.
August 13, 2012
Tactical ETF Review: 8.13.2012
Looking for an excuse to rebalance your portfolio? Here’s one: all the major asset classes, including my somewhat subjective list of proxy ETFs below, are sitting on gains this year, as of Friday, August 10.
Is it timely to rebalance a broad mix of assets? Probably, although it would help if we knew what the future holds. Alas, we don’t. What is clear is that systematically rebalancing a wide array of asset classes has an encouraging record of earning competitive returns. But tapping into the rebalancing bonus isn’t a free lunch. The price of entry: a contrarian mindset. That’s too pricey for most investors, which is why so few are able to exploit rebalancing in something close to a high degree. But that leaves lots of opportunity for the select few who have the discipline to harvest the rebalancing bonus by exploiting volatility. The relationship, by the way, is no accident. The reason why expected returns from rebalancing are so attractive is directly linked with the fact that relatively few investors are willing and/or able to capture this source of return premia.
The secret, of course, is quite simple: buy low, sell high. Duh! Obvious, particularly in retrospect. But this simple strategy is riddled with complication in real time--much of it bound up with our internal wetware. With that in mind, here’s a quick look at where we stand in terms of ETFs representing the major asset classes in recent history as of this past Friday. The common theme: everything’s comfortably in the black so far this year. In fact, Friday’s prices for our short list of ETFs show that several funds are just below their 52-week high, according to Morningstar.com. Time to take some profits, if only on the margins? Hmmm....
US STOCKS • Vanguard Total Market (VTI) • Benchmark: MSCI US Broad Market Index
FOREIGN DEVELOPED MARKET STOCKS • Vanguard Europe Pacific (VEA) • Benchmark: MSCI EAFE
EMERGING MARKET STOCKS • Vanguard Emerging Markets (VWO) • Benchmark: MSCI Emerging Market
US BONDS • Vanguard Total Bond Market (BND) • Benchmark: Barclays US Aggregate
INFLATION-INDEXED US TREASURIES • iShares Barclays TIPS Bond (TIP) • Benchmark: Barclays US TIPS
HIGH YIELD BONDS • SPDR Barclays High Yield Bond (JNK) • Benchmark: Barclays High Yield Very Liquid
COMMODITIES • iPath Dow Jones-UBS Commodity (DJP) • Benchmark: DJ-UBS Commodity
REAL ESTATE INVESTMENT TRUSTS • Vanguard REIT (VNQ) • Benchmark: MSCI US REIT
FOREIGN DEVELOPED MARKET GOVERNMENT BONDS • SPDR Barclays Int’l Treasury (BWX) •
Benchmark: Barclays Global Treasury ex-US Capped
EMERGING MARKET GOVERNMENT BONDS • Van Eck Market Vectors Emg Mkt Local Currency Bond (EMLC) •
Benchmark: J.P. Morgan GBI-EMG Core
FOREIGN GOVERNMENT INFLATION-LINKED BONDS • SPDR DB International Inflation-Protected Bond (WIP) •
Benchmark: DB Global Government ex-US Inflation-Linked Bond Capped
FOREIGN CORPORATE BONDS • PowerShares International Corporate Bond (PICB) •
Benchmark: S&P International Corporate Bond
Charts courtesy of StockCharts.com
August 11, 2012
Book Bits | 8.11.2012
● The Clash of the Cultures: Investment vs. Speculation
By John Bogle
Excerpt via publisher, Wiley
When I entered this business in 1951, right out of college, annual turnover of U.S. stocks was about 15 percent. Over the next 15 years, turnover averaged about 35 percent. By the late 1990s, it had gradually increased to the 100 percent range, and hit 150 percent in 2005. In 2008, stock turnover soared to the remarkable level of 280 percent, declining modestly to 250 percent in 2011.
Think for a moment about the numbers that create these rates. When I came into this field 60 years ago, stock-trading volumes averaged about 2 million shares per day. In recent years, we have traded about 8.5 billion shares of stock daily—4,250 times as many. Annualized, the
total comes to more than 2 trillion shares—in dollar terms, I estimate the trading to be worth some $33 trillion. That figure, in turn, is 220 percent of the $15 trillion market capitalization of U.S. stocks.
● The Little Book of Stock Market Cycles
By Jeffrey Hirsch
Blog post by author
In my upcoming book, The Little Book of Stock Market Cycles... I compare and contrast the performance of cyclical bull and bear markets within secular bull and bear markets. Cyclical markets were defined in last September’s post.
Defining secular bull and bear markets requires a less regimented and more outside-the-box line of thinking. By my reckoning, secular markets span a period of about 8-20 years. I classify secular bulls as an extended period of years, when the stock market produces successive new highs and higher lows. Secular bears are often impacted by protracted military campaigns, financial crisis and the market is unable to reach a significant new high.
Four secular bull markets ran from 1896-1906, 1921-1929, 1949-1966 and 1982-2000. The four bears span 1906-1921, 1929-1949, 1966-1982 and 2000 to the present. I prepared the below graphic for my new Little Book. By lining up all the cyclical bulls and bears within the secular bull markets and comparing them to those in secular bear markets the nature cyclical bull and bear markets within secular bull or bear markets is revealed.
● Strategic Capitalism: The New Economic Strategy for Winning the Capitalist Cold War
By Richard D'Aveni
Summary by publisher, McGraw-Hill
The United States and its economic allies are under attack by a force unlike any they have ever faced. China and other emerging nations are competing for markets around the world using their own versions of capitalism—and, thus far, they are winning handily. In Strategic Capitalism, one of the world’s leading authorities on global business strategy, Richard D’Aveni, describes how the “economic cold war” began, how it is being played out now, and how the West can change the course of events in its favor.
● The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal
By Ludwig B. Chincarini
Summary via publisher, Wiley
Financial markets are not immune to the human tendency to group together. Investors follow popular trends or latch onto profitable new strategies with herd-like single-mindedness. In The Crisis of Crowding, finance veteran and professor Ludwig Chincarini explores how this dramatic overcrowding has yielded terrifying results and contributed to recent financial crises. “Modern risk-measurement models generally ignore the presence of copycats and the resulting crowded spaces. As a result, a shock to the system can lead to sudden, sometimes large asset price moves, which can cause panic and failure among the institutions involved in that investment space,” explains Chincarini. “In the past 20 years, globalization, technology, and increased leverage have made the effects of overcrowding more apparent and dramatic. In fact, market crashes are happening more regularly than in the past.”
● Inflation-Proof Your Portfolio: How to Protect Your Money from the Coming Government Hyperinflation
By David Voda
Summary via publisher, Wiley
The Petersen/Pew Commission on Budget Reform recently warned that the national debt was expected to grow from 40 percent of the gross domestic product (GDP) in 2009 to 85 percent in 8 years, 100 percent in 12 years, and 200 percent by 2038. In other words, in just a few years the U.S. will owe twice as much as it produces. Since no conceivable level of taxes and borrowing will enable the country to service such an enormous debt, it is inevitable that government will turn to the same tricks its antecedents have been playing since Ancient Rome: debasing the dollar and letting inflation run rampant. Inflation-Proof Your Portfolio: Protect Your Money from the Coming Government Hyperinflation is your guide to understanding the debt crisis and rising inflation, packed with the key tools you need to protect yourself from the fallout.
● Spreading the Wealth: How Obama is Robbing the Suburbs to Pay for the Cities
By Stanley Kurtz
Adapted excerpt by author via National Review
President Obama is not a fan of America’s suburbs. Indeed, he intends to abolish them. With suburban voters set to be the swing constituency of the 2012 election, the administration’s plans for this segment of the electorate deserve scrutiny. Obama is a longtime supporter of “regionalism,” the idea that the suburbs should be folded into the cities, merging schools, housing, transportation, and above all taxation. To this end, the president has already put programs in place designed to push the country toward a sweeping social transformation in a possible second term. The goal: income equalization via a massive redistribution of suburban tax money to the cities.
August 10, 2012
Research Review | 8.10.2012 | Portfolio Strategy
Dynamic Portfolio Choice
Andrew Ang (Columbia Business School) | July 2012
The foundation for a long-term investment strategy is rebalancing to fixed asset class positions, which are determined in a one-period portfolio choice problem where the asset weights reflect the investor’s attitude toward risk. Rebalancing is a counter-cyclical strategy that has worked well even during the Great Depression in the 1930s and during the Lost Decade of the 2000s. Rebalancing goes against investors’ behavioral tendencies and is also a short volatility strategy. When there are liabilities and asset returns vary over time, the long-term investor’s optimal portfolio consists of (i) a liability-hedging portfolio, (ii) a market (or myopic demand) portfolio that reflects optimal short-run asset positions, and (iii) an opportunistic (or long-term hedging demand) portfolio that allows a long-run investor to take advantage of changing investment returns.
The Trend is Our Friend: Global Asset Allocation Using Trend Following
Steve Thomas (City University London), et al. | June 2012
We examine the effectiveness of applying a trend following methodology to global asset allocation. The application of trend following offers a substantial improvement in risk-adjusted performance compared to traditional buy-and-hold portfolios. We also find it to be a superior method of asset allocation than risk parity. Momentum and trend following have often been used interchangeably although the former is a relative concept and the latter absolute. By combining the two we find that one can achieve the higher return levels associated with momentum portfolios but with much reduced volatility and draw downs due to trend following. We observe that a flexible asset allocation strategy that allocates capital to the best performing instruments irrespective of asset class enhances this further.
On the Style Switching Behavior of Mutual Fund Managers
Bart Frijns (Auckland University of Technology), et al. | July 2012
This paper develops an empirically testable model that is closely related to theoretical model for style switching behavior of Barberis and Shleifer (2003). We implement this model to examine the style switching behavior of US domestic equity mutual fund managers. Using monthly data for 2,044 mutual funds over the period 1961-2010, we find strong evidence for style switching behavior: on average nearly 53% of the funds in our sample engage in style switching. Overall, we find that growth funds tend to behave more as positive feedback (momentum) traders, whereas value funds tend to behave more as negative feedback (contrarian) traders. Linking the style switching behavior to fund characteristics, we typically find that funds that engage more aggressively in style switching tend to be younger and have higher total expense ratios. Linking the style switching behavior to risk-adjusted performance, we find no evidence of the ability of style switching to generate positive alpha.
Inflation Risk and Real Return
Mike Sebastian (Hewitt EnnisKnupp) | June 2012
Inflation risk is greatest in times of national or global stress; inflation risk is a form of a “tail risk.” A traditional portfolio of stocks and bonds is exposed to inflation risk. The specific nature of an investor’s liabilities and spending determines inflation sensitivity beyond that of the asset portfolio. Commodities and TIPS are the most effective short-term and long-term inflation hedges. Other traditionally recognized “inflation-hedging” assets offer more limited benefits. Investors have several attractive options for increasing inflation protection: Add or increase allocation to inflation-hedging assets, specifically commodities and TIPS, in the current asset allocation framework; Add a Real Return asset category, with a core of commodities and TIPS, funded proportionally from return-seeking and risk-reducing assets; Add inflation hedging assets to an "Opportunity Fund." Investors can expect to pay about 0.15% of assets in the form of reduced expected returns for a reasonable level of inflation protection, before any gains from active management. Investors with inflation-sensitive liabilities or spending should consider instituting an allocation to inflation hedging assets of 10% of the total fund.
Efficient Algorithms for Computing Risk Parity Portfolio Weights
Denis B. Chaves (Research Affiliates), et al. | July 2012
This paper presents two simple algorithms to calculate the portfolio weights for a risk parity strategy, where asset class covariance information is appropriately taken into consideration to achieve “true” equal risk contribution. Previous implementations of risk parity either (1) used a naïve 1/vol solution, which ignores asset class correlations, or (2) computed “true” risk parity weights using relatively complicated optimizations to solve a quadratic minimization program with non-linear constraints. The two iterative algorithms presented here require only simple computations and quickly converge to the optimal solution. In addition to the technical contribution, we also compute the parity in portfolio “risk allocation” using the Gini coefficient. We confirm that portfolio strategies with parity in “asset class allocation” can actually have high concentration in its “risk allocation”.
August 9, 2012
Weekly Jobless Claims Remain Near Four-Year Low
Today’s weekly update on initial jobless claims tells us that nothing much has changed. That’s a good thing when it comes to evaluating the business cycle at the moment. This leading indicator fell modestly by 6,000 last week to a seasonally adjusted 361,000, the Labor Department reports. That’s near a four-year low, a sign that recession risk is low.
With today's claims update in hand, it’s getting easier to argue that the past several months represent a temporary setback in the otherwise ongoing but slow downtrend in new filings for jobless benefits. If the labor market’s capacity for growth was truly collapsing, as some pessimists have argued, there’d be a clearer sign via deterioration in the claims numbers. So far, however, arguing on behalf a darker view is a stretch based on what we know as of this morning--a point supported by July's rebound in the growth of private payrolls.
The trend in jobless claims is clearer when we strip out the seasonal adjustments and look at the year-over-year percentage changes through time. On that score, the message is a familiar one relative to recent history: a respectable rate of decline. For most of the past year, the annual fall in new claims has fluctuated around -10%. That’s a compelling sign that the labor market continues to heal, albeit slowly. The trend also suggests that a recession hasn't started recently, or that a contraction is poised to strike in the very near future.
Jobless claims are but one statistic, of course, and so we can’t invest too much confidence in this series alone (or any one series, for that matter). But if we consider a broader review of data published for July so far, and preview the evidence for “nowcasting” recession risk, it appears that the low threat that prevailed in June will continue through last month. A bit more than half of the economic and financial indicators that I track for estimating recession risk have been published for July. Of the numbers reported, roughly 80% are trending positive (I'll review the details later this month, when we have more economic numbers available through July). Short of a dramatic collapse in the yet-to-be-published numbers for last month, the outlook for the full reading on July is encouraging, in part because of the ongoing year-over-year decline in jobless claims.
Yes, this analysis could change on a dime if, say, the euro crisis takes a sharp turn for the worse or one of several brush fires in the Middle East explodes into something far darker and drives the price of oil to the heavens. And let's not forget the fiscal-cliff risk that lurks for the U.S. Generally speaking, there's no guarantee that a broad review of the recent past will save us from unknown unknowns that could infect the numbers for August and beyond. The future, in short, will continue to play all its devilish tricks on us.
It's also worth reminding ourselves that an economy that appears to be avoiding recession risk isn't the same thing as an economy that's healthy and growing at a strong pace. Quantifying recession risk, in other words, is a separate and distinct effort from assessing the qualitative aspect of economic growth and what that implies for the future.
Meantime, don't mistake a forecast for a sober reading of the recent past. But using the numbers available to date, and making reasonable assumptions about what those numbers tell us overall, it's still hard to make a convincing case that a recession is upon us. When that analysis changes, as it one day will, you'll read about it here. Meantime, cautious optimism rolls on.
August 8, 2012
A Familiar Sight: Higher Equity Prices & Rising Inflation Expectations
The market’s inflation outlook has popped a bit in recent weeks. The stock market has moved higher too. The new abnormal, in other words, remains intact.
The new abnormal is my label for the unusually high positive correlation between changes in the stock market and inflation expectations, as defined by the 10-year Treasury’s yield less its inflation-indexed counterpart. In the grand scheme of history, higher inflation doesn’t normally inspire equity buying, but the standard relationship was upended after the financial crisis in late-2008 and the Great Recession. The positive link between the market’s inflation outlook and the stock market is abnormal, but it prevails until the economy returns to something approximating a “normal” state. (For the theory behind the empirical fact of late that ties the equity market with the inflation forecast, see David Glasner's research paper on the so-called Fisher effect.)
Last month it appeared that the stock market and the inflation outlook might finally be going their separate ways. But as we now know, it was only noise. The stock market turned higher and so did the market’s inflation forecast. This abnormal dance continues, courtesy of troubles related to debt-deflation concerns in the realm of macro. In short, more of the same.
The implied inflation outlook touched 2.31% yesterday via the yield spread in nominal less inflation-linked 10-year Notes—the highest since early April. No wonder that the stock market (S&P 500) is at a three-month high.
The message (still) is that higher inflation expectations are still greeted favorably. This news comes as a shock in some corners. Inflation, runs one school of thought, is forever and endlessly evil. That’s a generally sound rule of thumb… most of the time. The mistake is assuming that there are no economic conditions under which this prudent notion breaks down.
Why has this rule cracked in recent years? One way to quantify an answer is by looking at the velocity of money, a rough measure of how fast currency is circulating through the economy. Considering that velocity has dropped to record lows relative to its history over the past 60-plus years, it’s no surprise that the crowd views higher inflation as something other than monetary Armageddon.
The current sentiment isn’t written in stone, of course, but it persists until further notice. What might sever this abnormal linkage? Under what conditions would we return to something closer to normality in terms of the relationship between inflation and equity prices? The answer is obvious: when economic growth is stronger. That, too, is coming… one day. The real challenge is deciding when. Good luck with that.
Meantime, the strange dance of abnormality endures. That's another way of reminding equity bulls that inflation is still your friend... for now.
August 7, 2012
A Summer Dip For The Monetary Base
For the first time since late-2010, the monetary base in the U.S. has been contracting on a year-over-year basis as of this past June. Does that represent a significant change for assessing risk in the outlook for the business cycle? Possibly… if the contraction rolls on.
A proper analysis of the business cycle requires the monitoring of several factors, of course, but there’s a strong case for putting the monetary base—“high-powered” money, as some call it—on the short list. In particular: the annual percentage change in the real (inflation-adjusted) monetary base. For perspective, consider how the base (let’s call it M0) has fared over the past half century after deflating it by the consumer price index and calculating the changes vs. year-earlier levels:
Note that the annual fluctuations in the real M0 tend to go negative either just before or during the early stages of economic recessions. No one should assume that this metric is flawless as a business cycle indicator, but it’s hardly irrelevant either. The dip under zero in late-2010, for instance, didn’t lead to a recession. Then again, M0’s descent was brief. It’s not obvious that trouble would have been avoided if a longer-lasting visit to negative terrain had prevailed.
The chart above ends in July 2008. Why? Because shortly after that date, the annual changes in the base exploded to the upside, courtesy of the Fed’s monetary reaction to the Great Recession and the financial crisis in the fall of 2008. As such, the scale changes dramatically. Here’s how recent history stacks up:
The monetary base may not be the last word on business cycles, but it’s a safe assumption that if M0’s year-over-year changes remain negative, the risk of economic trouble almost certainly will increase—all the more so if M0’s rate of contraction deepens in the months ahead.
It’s not inconceivable, however, that we may see offsetting factors in the near-term future, in which case the slightly negative change in M0 of late may turn out to be noise in the grand scheme of the business cycle. The Fed’s FOMC meeting next month (Sep. 12 and 13) comes to mind. Will the central bank launch a new round of quantitative easing and effectively reverse M0’s descent? Some analysts are calling for no less, including Boston Fed chief Eric Rosengren.
If QE3 is coming, the contraction in the monetary base may not be long for this world. But if the decline has legs, macro risk could be headed higher.
August 6, 2012
Beware Of Drama In Your Daily Dose Of Investment Advice
What’s the biggest challenge for investors these days? Macroeconomic risk? The threat of war in the Middle East? Slow economic growth? A collapsing euro? One can argue that the explosion of information and advice (much of contradictory) is the number-one hazard for thinking clearly and designing a portfolio that will succeed over the medium- and long-term horizons. What’s the antidote to the noise that permeates our digital world? It starts by considering the major asset classes and a benchmark of these betas, such as the Global Markets Index that's routinely updated on these pages.
The main question in money management is deciding how to reweight and rebalance assets. If you allow yourself to be pulled into the vortex of the media circus, it’s easy to become confused. In fact, you can count on it. The constant din of markets gurus predicting that, warning about this, and so on, is about as clarifying as filing paperwork in a hurricane.
One story published last week, for instance, outlines a guru’s case for seeing a new U.S. recession in the near future, followed by surging inflation. The recession, we’re told, may be triggered by higher taxes or a decline in government spending. Meanwhile, higher government debt will soon unleash an inflationary storm. The article goes through the pros and cons of holding various assets for dealing with this expected future, including gold, inflation-protected Treasuries, REITs, emerging markets stocks, and junk bonds. Some of these may do well, or not. And the potential for another recession could easily render some of the otherwise high-confidence advice null and void, we're told. By the end of the story, it’s easy to feel whipsawed.
That’s not unusual. The financial media’s agenda isn’t necessarily aligned with the best interests of investors. That’s old news, of course, and it’s not particularly shocking either. High-quality investment advice doesn’t lend itself to daily (or hourly) reinvention and a steady stream of new and dramatic headlines.
How to cut through the noise? Minds will differ, although there’s a strong case for considering everything as an opening bid and then deciding how to reweight and rebalance. This basic advice doesn’t change, which is why it gets old if you’re if you’re trying to make a splash in the financial publishing game. But in the pursuit of earning decent returns through time, and keeping risk to a minimum, thinking holistically has several compelling attributes.
Unfortunately, too many investors (including a number of pros who should know better) ignore or dismiss a broadly defined list of market betas for designing and managing asset allocation. I’m amazed at some of the reasons I hear for this oversight. Some critics say that looking to a broad array of asset classes ensures dismal returns. At the other end of the spectrum are those who say that a broad mix of assets, a la the major asset classes, is redundant vs. a lesser list. But both of these complaints are wrong, and demonstrably so.
It’s clear that if you monitor an expansive list of betas (including their representative ETFs), you'll find a fair amount of volatility and moderately low or even negative correlations between the components. That’s a sign that even simple rebalancing can yield productive, perhaps even stellar results. To cut to the chase, you can do a lot with a long list of betas—a lot more, in fact, than is generally recognized, and at a lower risk level compared with most of what passes as “professionally managed” portfolios.
What’s the catch? First, you have to be looking. Monitoring a broad list of betas, and becoming comfortable with each and every one of them, is far from standard practice. Second, you have to be prepared to act as a contrarian—buy low, sell high, basically—in order to reap the rewards of rebalancing. Third, you must hold a portfolio with a sufficiently broad mix of betas in order to exploit the volatility and correlation factors. There's a risk of slicing and dicing betas too narrowly, but there's also the headwind of owning too narrow a mix. By my definition, there's a dozen or so "major" asset classes, although this isn't written in stone. You could easily double that list by dividing the components into smaller pieces. Suffice to say, if your asset allocation is comprised of, say, five asset classes, you're probably making your job harder than it has to be, in which case you may pay a price in lower performance, higher risk, or both.
Yes, you can do a lot more beyond diversifying across asset classes and rebalancing the portfolio, and to some extent you should. For instance, you can dive into a more granular review of trailing and expected risk premiums for each asset class (as I did here last month). You can also do some basic modeling to evaluate how a multi-asset class benchmark fares through time (see my analysis here, for instance).
None of this would mean much if the real-world results were lackluster. Yet history tells us that a mindless benchmark of owning everything (and one that’s easily and inexpensively replicated with ETFs) earns competitive (to say the least) results vs. a broad set of actively managed multi-asset class mutual funds over the past 10 years. That's hardly a definitive historical analysis, but the past decade was a pretty good stress test.
It all adds up to a strong case for thinking that diversifying across a wide array of asset classes and rebalancing the mix periodically is the foundation of a successful investment strategy. It’s also a foundation that should be customized to a degree to fit your specific financial situation and investment goals. The building blocks are available at a low cost via ETFs (and/or index mutual funds), and so the basic strategy for how to proceed is clear. It may not make for exciting articles in the press, but the first rule of success in the money game is distinguishing between dramatic prose and prudent financial advice.
August 4, 2012
Book Bits | 8.4.2012
● Red Ink: Inside the High-Stakes Politics of the Federal Budget
By David Wessel
Interview with author via Yahoo's Daily Ticker
You're probably aware the U.S. government spends a lot of money and more than it brings in. But few Americans have a really good understanding of how the budget works, where the money comes from and where it goes. In Red Ink: Inside the High-Stakes Politics of the Federal Budget, Wall Street Journal economics editor David Wessel shines a light on the federal budget and seeks to clear up some of the "myths and unrealities"....
● The Betrayal of the American Dream
By Donald Barlett and James Steele
Review via The Wall Street Journal
Beware of investigative reporters offering economic analysis. There will usually be a conspiracy theory lurking somewhere. A serious study of economics—macroeconomics especially—doesn't mate well with conspiracy theories. The economic behavior of 312 million Americans and their trading partners abroad is far too complex to be successfully manipulated by some Wall Street Svengali or Beltway bum. Economics makes its own rules. But conspiracy theories sell well, and "The Betrayal of the American Dream," by Donald Barlett and James Steele, has a fair chance to do as well as their 1992 prequel, "America: What Went Wrong?," which made at least one best-seller list. It was based on the authors' lengthy Pulitzer Prize-winning series in the Philadelphia Inquirer about "inequality in America." Twenty years have gone by, and, judging from the similarities of the two books, things are as bad as ever.
● Public Forces and Private Politics in American Big Business
By Timothy Werner
Summary via publisher, Cambridge University Press
What are the political motivations behind firms' decisions to adopt policies that self-regulate their behavior in a manner that is beyond compliance with state, federal and local law? Public Forces and Private Politics in American Big Business advances a new understanding of the firm as a political actor that expands beyond the limited conceptualizations offered by economists and organization theorists. Timothy Werner develops a general theory of private politics that is tested using three case studies: the environment, gay rights and executive compensation. Using the conclusions of these case studies and an analysis of interviews with executives at 'Fortune 500' firms, Werner finds that politics can contribute significantly to our understanding of corporate decision-making on private policies and corporate social responsibility in the United States.
● Neoliberalism: Beyond the Free Market
Edited by Damien Cahill, Lindy Edwards, and Frank Stilwell
Summary via publisher, Edward Elgar Publishing
In this timely book, leading scholars of neoliberalism, together with emerging researchers from a range of intellectual traditions, reflect upon the nature of neoliberalism in light of the recent and ongoing global financial crisis. What emerges is an enlightening picture of the diversity of neoliberalism. The complex relationships between theory and practice are highlighted as the contributors recognise the need to move beyond the commonplace notion that neoliberalism is simply a system of free markets. Topical chapters examine the implications of the current crisis for neoliberalism, the likelihood of alternatives, and how these might arise.
● The Family Office Book: Investing Capital for the Ultra-Affluent
By Richard Wilson
Summary via publisher, Wiley
Understanding the basics of the family office industry is essential if you want to succeed in establishing a successful fund for a wealthy family. That's where The Family Office Book comes in. Outlining key strategies for family offices, from what a family office is to how the industry operates, and important global differences, the book is packed with interviews with experts from leading family offices. Providing readers with need-to-know tips and tools to succeed, The Family Office Book gives current and future practitioners everything they need to know about this popular segment of the financial industry.... A comprehensive and reliable resource, The Family Office Book details exactly how family offices are choosing investment managers and why, and how, to break into the industry.
● Too Much Is Not Enough: Incentives in Executive Compensation
By Robert W. Kolb
Summary via publisher, Oxford University Press
The scholarly literature on executive compensation is vast. As such, this literature provides an unparalleled resource for studying the interaction between the setting of incentives (or the attempted setting of incentives) and the behavior that is actually adduced. From this literature, there are several reasons for believing that one can set incentives in executive compensation with a high rate of success in guiding CEO behavior, and one might expect CEO compensation to be a textbook example of the successful use of incentives. Also, as executive compensation has been studied intensively in the academic literature, we might also expect the success of incentive compensation to be well-documented. Historically, however, this has been very far from the case. In Too Much Is Not Enough, Robert W. Kolb studies the performance of incentives in executive compensation across many dimensions of CEO performance. The book begins with an overview of incentives and unintended consequences. Then it focuses on the theory of incentives as applied to compensation generally, and as applied to executive compensation particularly.
August 3, 2012
Risky Business: Focusing On Monthly Employment Numbers
Some economics pundits needlessly bang their heads against the wall when it comes to the art/science of digesting the numbers. Today’s example: the Labor Department’s employment report for July. Although economists focus on the so-called establishment survey for assessing nonfarm payrolls, the government also publishes an alternative measure of the labor force via what’s labeled as the household survey. These are two different methodologies for quantifying changes in the labor force that, not surprisingly, don’t always agree on a month-to-month basis—July’s statistical conflict was unusually wide. The divergence creates a fair amount of confusion, but it shouldn’t. You can find a clearer view of the trend in the year-over-year changes, which is an antidote of sorts for the monthly noise.
As an example, let’s begin by comparing the monthly figures over the past year for the establishment and household surveys. No one will confuse the two series as dispatching similar, much less identical, results in any given month, as the chart below illustrates. Last month was particularly chaotic: the household survey reported that the number of employed persons in the U.S. fell a hefty 195,000 while the establishment survey advised that total nonfarm payrolls (including changes for government employees) jumped by 163,000 (private nonfarm payrolls increased by 172,000 last month).
There are some in the blogosphere who look at the statistical chasm in the chart above as a sign that the employment numbers, if not quite worthless, are deeply misleading overall. Agreed—if you’re looking at monthly data, which can be a bit like looking for patterns in snowflakes in a wind tunnel.
The good news is that it’s a different story if we compare the data for the two surveys on a year-over-year percentage basis, as shown in the second chart.
Note that the pair of labor market estimates generally agree when we review annual percentage changes. It’s still not a perfect match—we shouldn’t expect it to be. The numbers reflect two different methodologies. But it’s no trivial point that the pair offer comparable messages about the trend. For example, both labor market measures went negative at roughly the same time during the early stages of the last recession. Both also started turning up around the same time just after the recession ended.
Fast forward to today’s labor market update and we find that both indices are rising on a year-over-year basis at relatively high levels vs. their histories. In other words, we see some corroborating evidence from two different measures of employment activity for thinking that the economy is still expanding. (By the way, nothing really changes if we look at year-over-year changes for unadjusted numbers, i.e., before seasonal adjustments.)
The monthly numbers, by contrast, are a mess. But that’s not unusual. Seasonal distortions and variations in calculation rules bedevil the short term. Some of the misleading noise is stripped away if we look at the annual changes. Annual profiling is still less than perfect, but there’s no reason to make macro analysis harder than it has to be. Then again, some analysts are gluttons for statistical punishment. Go figure!
Private Payrolls Rebound In July
Nonfarm private payrolls rose 172,000 last month on a seasonally adjusted basis, the Labor Department reports. That’s substantially higher than the roughly 100,000 gain predicted by the consensus forecast among economists. Today's number is also a respectable improvement over June’s revised increase of 73,000. The better-than-expected result for July isn’t a complete surprise, however, given the hints in Wednesday’s ADP Employment Report. Surprising or not, today’s employment report offers another data point for arguing that the economy isn’t falling off a cliff into a new recession.
Obsessing over the month-to-month changes in the payrolls report—or any other economic indicator—is subject to lots of statistical noise and so we should take these numbers with a grain of salt. A more robust reading on the payrolls trend comes from monitoring the year-over-year percentage change. The good news is that the annual pace of jobs growth is holding its ground at just under 1.8% (black line in chart below). That’s down a bit from the 2.1% increases logged in January and February, but it’s no trivial matter that the year-over-year rate remains near a six-year high.
There’s been some discussion in the blogosphere lately about the limitations of the government’s payrolls figures due to the distorting effects of the seasonal adjustments. This is one more reason why looking at year-over-year changes is essential. Even if we review the raw payrolls numbers—i.e., before seasonal adjustments—the year-over-year percentage change still looks encouraging as of last month: rising nearly 1.8% vs. the year-earlier level.
In fact, the weekly jobless claims data have been telling us that the labor market wasn’t buckling. The year-over-year change in unadjusted claims figures has been falling by roughly 10% for most of its recent history. That’s another signal for thinking that the labor market, for all its woes, has yet to exhibit clear and pervasive signs of tanking.
As crucial as the labor market is for evaluating the business cycle, it’s still not enough. But a broader read on the economy, and one that focuses primarily on year-over-year changes, also tells us that recession risk was low as of June, the last full month of published data. The limited set of July numbers in hand is a mixed bag so far. Yesterday’s ISM Manufacturing Index delivered another mildly weak reading, for instance. But today’s employment report for July suggests we should reserve judgment for expecting the worst.
In short, the U.S. economy continues to grow, albeit slowly and well below the levels that are needed to bring down the still-elevated unemployment rate, which actually ticked up to 8.3% last month. But based on a broad reading of the numbers in hand, the case for seeing a recession as an imminent threat remains minimal.
What might change that outlook? An explosion in the euro crisis could send recessionary shock waves across the Atlantic. Ditto for a new flare-up of troubles in the Middle East that sends oil prices skyrocketing. A further weakening in China’s already softening economy could bring trouble too. And let's not forget the home-grown menace known as the fiscal cliff as a potential economic spoiler.
There are no shortage of potential shocks that could kill the fragile expansion in the U.S. But for the moment, the published numbers overall still inspire modest optimism that sluggish growth is the path of least resistance.
August 2, 2012
Jobless Claims Rise, But Remain Near 4-Year Low
Initial jobless claims rose moderately last week, but this doesn’t tell us much. The good news is that claims remain close to a four-year low and the unadjusted year-over-year change in new filings for unemployment benefits continues to fall by roughly 10%. In short, there’s still no sign of trouble in the claims data, which suggests that the labor market will continue to expand slowly.
Last week’s increase of 8,000 pushed total claims up to a seasonally adjusted 365,000. But stepping back and considering the jump in context with recent history implies that nothing much changed last week. This data series isn’t improving, but neither is it deteriorating. No news is still marginally good news, however, with the weekly numbers bouncing around the lowest levels in several years.
A more-encouraging signal can (still) be found in the annual pace of unadjusted claims. As the second chart shows, claims continue to fall at a healthy pace—roughly 10%--relative to year-earlier levels. If and when the year-over-year change moves sharply above zero, that would be a dark sign for the labor market and the economy overall. For the moment, however, there’s still a sizable margin of comfort between here and there.
The question is whether the recent deterioration in the manufacturing sector, both in the U.S. and abroad, is a sign of bigger problems to come in the weeks and months ahead? If it is, we’ll see clear signals in the data, including jobless claims. But not yet. The last full month of data (June) looked supportive for arguing that recession risk was low, a message confirmed in other metrics, such as the Chicago Fed National Activity Index.
July’s update may tell us different. Next up on that front is tomorrow’s jobs report for July from the Labor Department. We need an encouraging number here to keep the macro blues at bay. The ADP Employment Report for July suggests that a marginally rosy outcome is a possibility and the consensus forecast agrees. Economists are looking for a net gain of around 105,000 in private non-farm payrolls for last month, according to Briefing.com. That would be a modest improvement over June’s 84,000 rise. Better, but we need triples and home runs as opposed to singles, which is the more likely scenario. And so, for the moment, we are on the fence, with the potential for tipping either way.
“It is still a difficult job market,” Ryan Sweet, a senior economist at Moody’s Analytics, tells Bloomberg. “Companies are not panicking by cutting workers. They are going to wait out the uncertainty related to Europe and the U.S. fiscal cliff.”
"The claims number is not that bad," observes Cary Leahey, a senior economist at Decision Economics, via Reuters. "There does seem to be some difficulty dealing with the seasonals this time of year whether it's auto plant closures or lack thereof."
Maybe tomorrow's payrolls news will set us straight.
August 1, 2012
Another Weak Report With The July Update Of The ISM Mfg Index
For the second month in a row, the ISM Manufacturing Index was under 50—a sign that the manufacturing sector is contracting, if only slightly. Many analysts argue that a reading under 50 for this benchmark is an early warning that a new recession is near, or perhaps one that's already started. But like any other indicator, the ISM index isn't flawless: there have been a dozen or so instances over its 60-year-plus history when a below-50 reading wasn't quickly followed by a recession. Still, the fact that this benchmark is now under 50 for the second consecutive month—the first run of below-50 readings since the last recession—is a sign that the manufacturing sector is struggling.
The only good news is that the July reading inched higher vs. June—49.8 vs. 49.7. It's also mildly encouraging that the index remains just under 50, which suggests that the economy is suffering from slow growth rather than a clear case of outright contraction... maybe.
All the more reason to watch tomorrow's weekly update on new jobless claims for another clue about the broader economy and whether it's weakening, or not. The previous news on initial claims suggested that the labor market wasn't caving, a view that drew fresh support with this morning's ADP report. If the next data point on claims doesn't pop, and we see improvement in the government's July estimate of private payrolls, the case for seeing today's ISM number as noise will resonate.
Is that relatively rosy scenario plausible? Yes, according to the range of consensus forecasts for tomorrow's claims update via Bloomberg. Economists expect new claims as low as 340,000 up to 380,000 vs. last week's 353,000 (seasonally adjusted). The outlook for the growth in private payrolls for July in Friday's report ranges from 80,000 to 180,000 vs. the reported 84,000 for June. Plausible still leaves plenty of room for disappointment, however.
A Better-Than-Expected Gain In July Payrolls, ADP Reports
Private nonfarm payrolls for the U.S. increased a better-than-expected 163,000 in July, according to the ADP Employment Report. The consensus forecast was looking for a substantially lower 125,000 gain, according to Briefing.com. Is the relatively upbeat news a sign that we could see another upside surprise in Friday's official report from the Labor Department on the state of the jobs market? It's a thought worth considering.
Consider how the ADP monthly payrolls estimates compare with the government's establishment survey over the past year (see first chart below). Note that the ADP numbers have exceeded the Labor Department's figures since March. History suggests that the difference between the two series tends to be random over the longer term. In that case, we shouldn't expect to see an ongoing positive bias in favor of the ADP data. In short, it's time for the Labor Department's payrolls estimate to move closer, if not exceed, the ADP report. Will the July update be the month for convergence?
For a bit of statistical support for thinking optimistically, let's compare the monthly difference between the ADP and Labor Department estimates over the last 10 years. The second chart below shows the difference in the monthly net change in the ADP number less its counterpart via government figures. For example, ADP advises that private payrolls added a net 172,000 jobs in June vs. an 84,000 gain that month via the Labor Department's tally. The difference is 88,000 (172,000 less 84,000). Tracking the monthly difference through time shows a largely random fluctuation around zero--weakly stationary, in econometric-speak. That's a good sign for thinking that there's minimal bias in one data series relative to the other. As such, we should expect any positive or negative bias to close… eventually and perhaps soon. Given that a positive bias in favor of the ADP numbers has prevailed since March, it's reasonable to wonder if the gap is poised to close, or at least narrow. If July's the month, that implies a much stronger employment report on Friday relative to June's disappointing update.
But let's not go overboard. Even if the Labor Department reports a net gain in jobs last month on par with the ADP figures, the rise would still fall under the heading of slow growth. But stronger slow growth is at least better than suffering the opposite change.
"This is another resilient outcome," says Sean Incremona, an economist at 4Cast Ltd, about today's ADP report. "It does show that things are chugging along and this is pretty respectable."
Hold that thought as we await confirmation (or rejection) in Friday's update.
Major Asset Classes | July 2012 | Performance Review
The global economy may be facing a new round of trouble, but you wouldn't know it by looking at last month's returns for the major asset classes. The gains fell well short of June's rally, but there was no mistaking the across-the-board rise in asset prices in July.
Last month's big winner: commodities, as tracked by the DJ-UBS Commodity Index, which jumped 6.5% in July. At the opposite spectrum, the fractional loss for cash (3-month T-bills) was a loner among the red-ink club last month. The last time everything (save cash) moved higher: January 2012.
Drawing on the widespread strength, the Global Market Index posted a 1.2% total return in July, building on June's 2.9% increase. For the year through July 31, GMI is higher by 5.6%. If the positive momentum continues—a big "if"—GMI is on track for dispensing an above-average calendar year of performance by New Year's Eve.
But there's a long road between now and the end of the year. Any number of risks are lurking on the horizon, including the ongoing mess that bedevils the euro economies and the so-called fiscal cliff that threatens in the U.S. But for the moment, broad diversification across the major asset classes continues to deliver competitive if not superior gains. That's not surprising, as history reminds, although it's certainly reassuring at a time of heightened uncertainty.