Short rates keep rising, long rates may be inclined to follow, but the stock market doesn’t seem to mind. In fact, the big stumble so far this year through March 30 among the major asset classes seems to be commodities, as the chart below shows.

Indices/Funds: S&P 500, Lehman Bros. Agg Bond, ML US High Yield Master II, MSCI EAFE, MSCI EM, Russell 2000, Pimco Commodity Real Return Fund A, Pimco EM Bond Fund, Vanguard Inflation Protected Securities Fund, Vanguard Prime MM Fund, Pimco Foreign Bond (Unhedged) A
Equity risk, in short, continues to pay off in 2006. Small-cap stocks are firmly in the lead so far this year, with emerging markets stocks close behind.
It doesn’t hurt the bullish case for stocks overall with news that U.S. corporate profits jumped 21.3% in the past year. In fact, the Department of Commerce yesterday reported that corporate profits now represent the biggest slice of national income in 40 years.
Momentum, as a result, looks set to dominate in the land of equities. Is that affecting the perpetual race between value and growth stocks? Yes, and no, depending on how you slice it.
In the large-cap arena, value stocks are well ahead of their growth counterparts so far this year, based on the Russell 1000 style indices. By these gauges, growth is up 3.44% in 2006 through March 30, well below value’s 6.26%.
But it’s a close year-to-date race over in small caps, with growth leading only by a nose relative to value in the Russell 2000 style indices: 13.96% v. 13.15%.
If Fed Chairman Ben Bernanke wants investors to err on the side of caution, he’s still got his work cut out for him. Another 25-basis-point rate hike for May?

The price of money affects everything financial. When the price changes, so does everything else, including perceptions. Relationships adjust, risk-reward dynamics move, and investors rethink, recalculate and review.
Evolution on this plane usually moves at a snail’s pace over a day or two, only to reveal itself more fully in longer stretches, with the repercussions rippling across asset classes, markets, and borders. So, when the Federal Reserve raises interest rates for the 15th time in a row, as it did on Tuesday, and the dollar reacts by slipping, you may wonder what Mr. Market is thinking.
The U.S. Dollar Index is lower this morning, despite this week’s 25-basis-point bump in Fed funds to 4.75%. In fact, the Dollar Index is considerably lower than compared to mid-November, a moment in time when Fed funds were a relatively slight 4.0%.
Higher interest rates and a falling dollar. What gives?

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Fed Chairman Ben Bernanke’s at war with the bond market, and himself.
Yesterday’s 25-basis-point hike in the Fed funds rate was the 15th in a row for the central bank, and the first for Bernanke, who took over from his predecessor, Alan Greenspan, on January 31. Judging by the FOMC statement that accompanied Tuesday’s rate hike, more rate hikes may be coming: “The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance.”
Traders in the Fed funds futures market responded immediately, repricing the May contract a bit in anticipation of another 25-basis-point hike, which would bring Fed funds to 5.0% when the FOMC meets next on May 10.
Traders in the bond market followed suit, selling the 10-year Treasury with a vengeance, and thereby boosting the yield yesterday to around 4.78%, or up by nearly 8 basis points over Monday’s close. In fact, as we write, the selling continues, pushing the 10-year yield to 4.80%, which is approaching the highest levels in almost two years.

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The first oil ETF is almost here.
The Wall Street Journal (subscription required) today reports that the American Stock Exchange will launch a crude oil fund next Monday, with the symbol USO. (For a copy of the SEC filing, click here.) Another milestone in the world ETFs, which trade on exchanges like stocks.
Once the ETF is trading, investors will be able to buy direct exposure to crude oil futures contracts via a listed security for the first time. The question, of course, is whether there’s a compelling case for buying oil futures at this juncture.
Leave it to Wall Street to come out with a product after the price of oil has been climbing for the better part of nine years. That, of course, is the way the financial system works. When oil was languishing at just over $10 a barrel in late 1998, the idea of oil-related investment products was the financial equivalent of leprosy. Today, in the wake of a near five-fold climb in the price of crude from late-1998, the Street can’t talk enough about of the opportunities in energy. Indeed, there are any number of hedge funds dedicated to energy plying the markets that were mere ideas a few years back.

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Until tomorrow afternoon, debate over whether the Fed will or won’t raise interest rates again, and whether the decision is warranted, promises to dominate conversations on Wall Street. We don’t have any special insight into what’s coming, but it’s clear that Mr. Market is anticipating another 25-basis-point rise to 4.75% in Fed funds tomorrow. That, at least, is the message coming from the April contract on Fed funds.

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Now it’s official. The M3 money-supply series is dead and buried. The official word from the Fed and its minions: it’s no big deal, really. (For some background on M3 and its scheduled demise, see our previous post here.)
In yesterday’s weekly release of money supply data, the central bank said of the newly defunct series: “M3 does not appear to convey any additional information about economic activity that is not already embodied in M2 and has not played a role in the monetary policy process for many years. Consequently, the Board judged that the costs of collecting the underlying data and publishing M3 outweigh the benefits.”
Maybe this is the Fed’s contribution for reducing the government budget deficit. In any case, Edward Nelson of the St. Louis Fed agrees with the powers that be back in Washington, explaining that a wider definition of money supply, which is M3’s raison d’etre relative to M2, isn’t always better. Writing in the April issue of the St. Louis bank’s Monetary Trends, Nelson asserts that a “broader definition of money is not necessarily always preferable….Monetary analysis needs to draw the line between money and nonmoney assets, and some financial instruments lack sufficient similarities with traditional money to merit inclusion in a monetary aggregate.”

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Will the Federal Reserve raise interest rates again next week, when the FOMC convenes on March 27 and 28? Another way of asking the question: is the central bank willing to add momentum to the forces that have generated an inverted yield curve? If so, what message will the Fed be sending to the markets?
As we write, the two-year Treasury carries a yield that’s four basis points above the 10-year Treasury. Elevating Fed funds up by 25-basis points to 4.75% threatens to increase the inversion by raising the price of short-term money. Indeed, the six-month T-bill is currently 4.80%. Tacking on another 25 basis points would push it over 5.0%.
If there’s any doubt that another 25-basis-point hike is coming next week you won’t find many skeptics in the market for Fed funds futures. The April contract has for some time been priced in anticipation of 4.75%.

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Commodities have been discovered by the masses in recent years. Rediscovered is probably the more accurate description, since raw materials were formerly all the rage in investing circles in the 1970s and through the first half of the 1980s. The fact that Wall Street and Main Street are finding reason anew to embrace a broad mix of commodities is arguably a more-strategic move this time around, courtesy of the widely publicized data that show the diversification power of adding commodities to a portfolio of stocks and bonds.
But some worry that the diversification value of commodities may fade over time as more and more investors climb on the bandwagon. One way to monitor that diversification value is by watching the correlations of returns between commodities and other asset classes, primarily stocks and bonds. On that front, there’s reason to wonder if the price of popularity is starting to take a toll.
Consider that the rolling 36-month correlations between stocks and commodities have been rising sharply for more than a year, as the chart below illustrates. The correlations between commodities and bonds have been rising recently too, albeit with less drama.

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David Kotok, chief investment officer of Cumberland Advisors, a Vineland, N.J. shop with $800 million under management, is preparing for bird flu, which he thinks may come to the United States. Should you be doing the same? Or is the fear unjustified?
Kotok’s view is one of erring on the side of caution. In an email to clients last Friday, he warned that bird flu “must be taken very seriously.” He’s doing no less, as our conversation with him yesterday reveals.
It’s hard to know if Kotok’s money-management counterparts across America share his concern, although anecdotal evidence suggests that worrying about bird flu is not yet in season. That may change, and perhaps quickly. But for the moment, Kotok appears to be in the minority within the financial community.
If you’re interested in how the minority thinks on this matter, Kotok’s your man. Although he’s an investment professional, he’s well-read on the subject of bird flu, and has talked to various officials about what may be coming. He also has definite thoughts about what bird flu means when it comes to an investment portfolio. In sum, he says that raising cash will become increasingly warranted if and when the danger signs start to rise. If the virus becomes serious enough, he thinks selling equities completely will become prudent.
For the moment, however, bird flu is still very much a foreign hazard, and so cash-only portfolios remain the stuff of disaster planning in paper form only. Time will tell if it stays that way, although the flu seems to have some momentum, as the chart below suggests. The death toll among humans, although still tiny, is growing, as is the number of countries with avian flu in animals.

Source: US Health & Human Services Dept.
Meanwhile, with the approaching migratory season of Asian birds flying to North America there’s reason to worry anew, or so Kotok tells us in the following interview, which we conducted by phone yesterday, March 20. In fact, U.S. Interior Secretary Gale Norton said as much yesterday. “It is increasingly likely that we will detect a highly pathogenic H5N1 strain of avian flu in birds within the U.S. borders, possibly as early as this year,” the Secretary warned, according to McClatchy News Service via Detroit Free Press.
(If you’re interested in getting the government’s current spin on bird flu, take a look at PandemicFlu.gov. For news reports, Google has the usual surfeit of updates. Meanwhile, sleep with one eye open, and cast a wary eye on strange ducks in your backyard.)

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Diversifying across asset classes (otherwise known as asset allocation) is the foundation on which prudent, long-term successful investment strategies are built. One of the essential issues for allocating among the various asset classes is carefully choosing those pieces that will offer the most diversification bang for the buck, and then weighting the asset accordingly. Modern portfolio theory advises that there are three primary variables that feed into this decision: volatility of returns, expected returns for each asset, and the correlation of returns among the assets.
Focusing on the latter for the moment reveals several interesting trends for the strategically minded investor. (We’ll be publishing more on correlations going forward, but for the moment here’s a taste of what we’re tracking.) Let’s start with the classic stock/bond mix, for which we crunched the data based on rolling 36-month trailing correlations for monthly total returns between the Russell 3000 and the Lehman Aggregate Bond Index, plotted monthly, starting in January 2001 and running through last month.
As the chart below reveals, the sharply negative correlation that defined equities and fixed-income in recent years is giving way to something less. To be sure, stocks and bonds still post slightly negative correlation, and so the diversification factor remains potent for owning both asset classes. But if the trend in recent years keeps up, investors may want to re-examine diversification expectations for the classic stock/bond mix. (Note: 1.0 indicates perfect correlation, 0 is no correlation, and -1.0 is perfect negative correlation).

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