Yesterday we wrote that the trend is your friend. We misspoke. To clarify, sometimes it’s your friend, sometimes not. It depends on the trend, the context, and the end result. When it comes to deficit spending in the government of these United States, we know the trend, we know the context; only the end result is in question. Even so, we have our suspicions of what financial fate may have in store for us, and so does everyone else. But they are only suspicions.
Before we pontificate on the matter of red ink (again), let’s identify the $781 billion in question. Indeed, there are so many billions earmarked for this and that in the halls of Congress these days that one can’t assume much when it comes to referencing large pots of money headed for a government spending program. It’s easy to get confused. As such, we’re talking of yesterday’s vote in the Senate to elevate the ceiling on federal debt by a cool $781 billion.
In some circles, $781 billion is a lot of money. How much is a lot? Seven-hundred-eighty-one billion buys a bit more than 39 billion copies of the paperback edition of Ben Graham’s Intelligent Investor, more than 24 million of this year’s Lexus ES300s model, and nearly 2.68 million homes at the average U.S. price in January, according to Census Bureau data. But when it comes to budgetary issues in Washington, $781 billion is a drop in the bucket. To be exact, $781 billion is less than 9% of total government debt, which rounds out to $9 trillion–that’s with a “t.”

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Today’s encouraging report on consumer prices for February can only embolden those who say that inflation’s under control. With the news from the Labor Department that prices for consumers rose only 0.1% last month–down from a soaring 0.7% in January, you could almost hear a collective sigh of relief on Wall Street. The core rate (less food and energy) also advanced by a quiet 0.1% in February.
Meanwhile, housing starts slowed in February, falling 3.2%, the Commerce Department reports.
The Federal Reserve, at least for the moment, is being congratulated on keeping a lid on inflation while slowing the housing market. Arguably, housing is in dire need of some cooling if only to compensate for the boom of recent years that some say the central bank mistakenly engineered by keeping interest rates artificially low.
In any case, the pessimists are again on the defensive in the capital markets. Even the bond market is regaining the urge to buy again, with the benchmark 10-year yield at 4.66% as we write, well down from the near 4.80% mark of a few days ago.
Contained inflation, slowing but not crashing housing, and any number of economic reports in recent weeks giving statistical aid and comfort to the general notion that the economy’s humming along quite nicely. It’s not nirvana, but it smells like it, albeit in a new mild and not necessarily permanent packaging.
No wonder that risk continues to be rewarded quite nicely in the stock market so far this year. Small-cap stocks have run ahead of large caps at twice the pace in 2006 through last night’s close. Looking at the S&P 500 and S&P 600 on a sector basis reveals even bigger gains in some corners; meanwhile, there are no sign of losses this year, as the charts below reveal.
In the large cap space, telecom services has climbed nearly 14% through March 15. Over in small caps, materials are up almost 18% year to date. Momentum may not work as a long-term proposition, but if you’re arguing with the trend these days it’s been a costly quarrel so far.

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The U.S. current account trade deficit jumped to an all-time record high in the fourth quarter, rising to $225 billion–up 21% from the third quarter the Bureau of Economic Analysis reported yesterday. With the latest numbers, the tally for 2005 is in, and the red ink for last year has pushed higher to another unprecedented level. Indeed, last year’s deficit was a record in both absolute-dollar and relative terms (as a % of the economy).
If you thought any of this would cast a pall over the mood of bond traders by suggesting higher interest rates, think again. In fact, the fixed-income set found reason for hope (such as it is from the view of a bond trader). As a result, buying was in evidence on Tuesday, and so the benchmark 10-year Treasury yield retreated sharply yesterday, falling to just under 4.70% from nearly 4.78% the day before.
One might argue that yesterday’s decline in yield was merely a temporary pullback in an otherwise rising trend in the price of money for long-dated bonds of late. The 10-year yield was under 4.3% at one point in January, but as of Monday it was threatening to break above 4.80%.

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For all the tension in the world, stock markets around the globe have shown no trouble climbing. Call it well-founded optimism or a blatant disregard for risk, but whatever the correct the label it’s clear that 2006 is proving to be a good year for equities. Whether the trend continues remains to be seen, but it’s hard to argue with the results so far. Indeed, it’s only March and many investors are sitting on tidy gains already.
The 29 regional/world benchmarks in the S&P/Citigroup Global Equity Indices series, for example, all show increases this year through March 13. That’s on top of robust advances last year. Although there’s a fair amount variation in the total returns, depending on the market, it’s been hard to lose money by spreading assets around the world.
The best performer this year in dollar-based terms through March 13 among the regional/world indices from S&P/Citigroup is European Emerging, soaring 17.32% on a total return basis so far. The bottom performer is Asia Pacific, although it’s still in the black year-to-date by 1.64%.

There may be room to run further in global equity markets, to judge by some of the more optimistic commentators of late. Indeed, the fear of the moment in the bond market is that economic growth may be stronger than the fixed-income set expected–news that, in contrast, tends to inspire buying among equity investors.
Nonetheless, with everything bubbling in stocks in broad terms, now seems like an opportune moment to find out which corners of the globe look pricey, and which ones are in the running for offering a bit more value. As always, that’s a tricky call, and subject to a wide variety of misleading conclusions. Indeed, there’s no sure-fire method for deciding if stocks are priced to run, crash or tread water. What’s more, the immediate future is vulnerable to so-called exogenous threats, which is to say that something out of left field that no one expected, and that has no relevance in financial analysis, could throw a wrench in the machine.

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Data junkies will be going through withdrawal symptoms today. With no economic releases of relevance scheduled, there’s a vacuum to be filled. As it happens, the Federal Reserve’s quarterly Flow of Funds report was updated for the fourth quarter and released last Thursday. As always, there are enough numbers here to satisfy even the biggest data addicts. In an effort to help soothe the numerical DTs, we present sliver of the report via the following chart:

At a moment when anxiety seems to be on the rise in the bond market, we note that consumers’ inclination to dig ever deeper into debt took a chill pill in the fourth quarter. Consumer credit contracted for the first time in many a moon in last year’s fourth quarter, while the growth rate in home mortgage credit slowed a notch. Is Joe Sixpack rethinking his spending habits? If so, is there reason to think the recent strength in the economy will soon fade?
The question is laden with all the usual risks, and then some in light of the fact that the fixed-income set appears to be responding to the query with a resounding “no.” Indeed, the yield on the benchmark 10-year Treasury is just under 4.80% as we write this morning, the highest in 20 months.
The Flow of Funds report, of course, is a rear-view mirror. It’s the future that captures Mr. Market’s attention. On that front, there’s reason to think that the pullback in consumer credit was an aberration, or so the consensus seems to be saying. Judging by the futures market, the Fed is expected to raise Fed funds by 50 basis points to 5.0% by June. If so, the current yield of nearly 4.80% on the ten year looks a bit light.
Therein lies the dilemma for the bond market: Should the recent yield-curve inversion be maintained, or is that very much yesterday’s news? Before you answer, consider too that rates around the globe are on the rise of late. Nothing dramatic, but the change of direction for the moment speaks louder than the magnitude of the adjustment. Notably, the European Central Bank now looks set for a course of tightening, albeit in small doses. Ditto for the Bank of Japan, which has been the focus of much chatter over the past week with speculation that deflation is finally dead and buried in the Land of the Rising Sun.
Rising yields around the world and in the U.S. too. Meanwhile, the week ahead offers a hefty dose of new numbers to confirm or deny what lurks in the hearts and minds of traders. That includes tomorrow’s release of retail sales for February; followed on Wednesday with last month’s change in import prices; the latest on consumer prices dispensed on Thursday; and industrial production on Friday. If nothing else, this week will not suffer for lack of drama.

There’s less than two weeks of life left for the Fed’s M3 series, the broadest measure of money supply. On March 23, the central bank plans to end publishing the data. But if one Congressman has his way, M3 will live on. It’s an uphill battle, to be sure, but Ron Paul, a Republican who represents the 14th Congressional district of Texas, has sponsored legislation (H.R. 4892) to keep the data coming. (For the latest version of the legislation, visit Thomas at the Library of Congress and browse under Rep. Paul’s bills.)

CAN THIS MAN SAVE M3?

M3 is arguably all the more relevant these days since its rate of growth has been roughly twice as high as M2, a narrower gauge of money supply. The Fed claims that there’s not a lot of difference between the two, although the numbers as reported suggest otherwise. (For previous CS posts on M3, see our February 28 article, with additional links for background information.)
Paul’s attempt to keep M3 alive and kicking may be quixotic, but he’s not giving up the fight, as becomes clear in an interview we conducted with the Congressman yesterday by phone. Here are some excerpts:
What’s the goal of your M3 bill?
My legislation would require that the Fed continue to report M3. It’s no more complicated than that.
So you think M3 is valuable as a measure of money supply?
I realize the shortcomings of some of these numbers, and M3 isn’t an answer to all the information that we would like. But it’s better than not having it. I think it does represent a reflection of Federal Reserve policy. For them to quit reporting it you have to ask, why?
Ok–we’ll bite. Why?
I don’t know exactly why, but the Fed gives answers. They claim that it costs too much money and they don’t use M3 any more. My argument to [Fed Chairman] Bernanke the other day was: some of us like M3, and Congress has a right to this type of information. There are still a few people in the country that think money supply’s important, and M3 is a reflection of money supply. I mentioned that there are a few economic schools of thought that are still concerned about M3, although some deny it has any value.
The most interesting thing was when he said it cost too much to collect [the data for compiling M3]. I kid the Fed about that, and say, I don’t why you should be concerned about it. If you need to spend money you just print it.
Somehow we can’t imagine the folks at the central bank laughing.
Well, the Fed makes a lot of money on interest, and of course it creates a lot of credit in order to buy Treasuries. So, I think the notion that it’s costly is preposterous. In fact, the Fed probably has most of the numbers right there anyway.
What’s the bigger picture here? What’s your thinking on what the impending demise of M3 suggests, if anything, in a broader context when it comes to the Fed?
I think back to what Mises talked about in Human Action: he writes that there’s always a deliberate attempt to deflect concern about the money supply so that the common person thinks that inflation is caused by other things.

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Energy’s supply/demand outlook makes it a no-brainer for maintaining exposure to oil and oil-related assets over the long haul. But what about the short term? At the moment, there’s reason to wonder, in part because oil and oil stocks have had such an extraordinary run in recent years.
The performance of the Energy Spider (Amex: XLE), which represents the energy stocks in the S&P 500, towers over the stock market for last three years through yesterday, according to Morningstar. XLE posts 33.7% annualized return as of March 8. That’s nearly double the S&P 500’s advance. Meanwhile, the relative market cap of energy keeps climbing in the S&P 500. The energy sector currently represents about 9.5% of S&P 500 market cap–a rise of about one-third from a year ago, which is by far the biggest increase among the ten sectors.
What’s driving XLE? Surging oil prices, of course. A barrel of crude oil currently changes hands at about $60, or more than twice the price of three years ago.
The case for projecting higher oil prices for the years to come has merit, but expecting crude to keep up the pace of the last three years may be asking too much. Indeed, even the super oil bulls don’t think crude will double in price every three years going forward. A few analysts think $100 a barrel is possible in the near future, but that would represent a 66% gain from current levels. And once we’re at $100 a barrel, then what? Two hundred bucks? Don’t hold your breath unless you’re thinking in terms of five, ten and 20 years.
True, anything’s possible when it comes to the world’s most valuable commodity. One “event” could change everything. But waiting for the world to end is questionable as prudent investing strategy. Then again, even in the best of times crude oil is priced by its own strange rules, which are influenced by any number of variables that don’t otherwise pervade commodity pricing.
In sum, oil prices may have reached a permanently higher plateau, but further increases from this point may be more measured, not to mention widely anticipated. In fact, there’s reason to at least consider scaling back one’s expectations for earnings performance in oil stocks. In fact, that seems to be happening, at least when it comes to analysts’ estimates.
Analysts’ projections for earnings in energy sector of the S&P 500 tell the story, as the chart below illustrates. After enjoying a long stretch of 40%, 50%, and even higher year-over-year comparisons in earnings increases, the energy sector’s outlook is one of moderating optimism. And to the extent one wants to believe the projections, analysts predict that energy earnings in the fourth quarter of 2006 will post their first decline relative to the previous year’s quarter for the first time in recent memory.

“Energy is expected to lose earnings share in 2007, as growth is forecast to be lower than that of the overall market,” writes Dirk Van Dijk of Zacks.
One could argue that oil stocks will need a large bump in energy prices in the near term to maintain the stellar record of increases that oil stocks have posted of late. But what if $60 a barrel remains the norm for some time? “Absent further large increases, energy stocks have probably lost at least one powerful driver of performance,” writes Michael Krause of AltaVista Independent Research, in a research report published yesterday.
Meanwhile, volatility in the Energy Spider has been on rise lately, with the standard deviation of the ETF’s price more than doubling from 2003. The implication: XLE faces the prospect of slower earnings growth amid rising price volatility. “Because XLE now appears more reasonably valued based on current fundamentals, the machination of politics in oil exporting countries has taken on increased importance since the daily fluctuation in the price of oil now has more impact on value investors assign to energy profits,” Krause writes.
Yes, the case for energy-related investments still looks good for the long term, but getting there first requires surviving the short term.

There goes the swagger. Sure, the bond market’s attitude (or was it misplaced nonchalance?) of late has evaporated amid the roar of selling the benchmark 10-year Treasury Note in recent days. As such, the yield on the 10-year jumped to as high as 4.78% at one point yesterday, up from around 4.50% at the end of February.
Yesterday’s closing yield was the highest in nearly two years for the 10-year Note. What’s up? The economy, one could argue. A number of reports of late leave the impression that economic growth remains sufficiently potent to keep the Federal Reserve on track for raising short-term interest rates. To be sure, the Fed’s been doing just that for almost two years, and the bond market has more or less yawned. Why is the fixed-income set taking note now?

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If there’s any consensus in the business of managing money, diversification probably comes closest to the ideal of strategic agreement and accord. Diversification, after all, is your only friend in the long run. Timing the market and choosing securities is far more exciting, but who among us thinks such high arts can be sustained?
The alternative, of course, is the time-tested antidote of diversification, which is the only effective defense against the great unknown, otherwise known as tomorrow. Since no one really knows what’s coming, prudence dictates the embrace of diversification, at least for us mere mortals who have no chance at becoming the next George Soros or Warren Buffett.
To be sure, not all diversification is enlightened. Owning three tech-stock funds, for example, doesn’t come close to informed diversification.
Yes, it’s true that there’s no shortage of debate about what constitutes a prudent level of diversification. But there are some ground rules, starting with the fact that investors should have exposure to the various asset classes. We’re defining asset classes as those groups that exhibit relatively unique characteristics that distinguish them from other groups. Price correlation is one way to measure such characteristics.
Bonds and stocks, to cite the obvious example, post a sufficiently low correlation with each other over time so as to warrant embracing them as separate and distinct asset classes. What that means is that there’s a good chance that when one’s losing money, the other will be holding its own, if not posting gains. In fact, history shows just that. Owning bonds in 2000-2002, for instance, offered valuable ballast when the stock market was suffering.
But how do you protect a portfolio when bonds are under attack? Traditionally, stocks can help, although the record shows that stocks and bonds have been known to tank together at times–this limited form of diversification fades just when you need it most. Meanwhile, cash is an asset class in its own right, and always holds its value, at least in nominal terms, which makes it an essential candidate for diversification. But holding too much cash opens one to the inflation threat over time.
The true solution is embracing a broader array of asset classes. That’s not been easy for individual investors in the past, but as mutual funds and exchange traded funds bring formerly exotic asset classes to the masses, quite often in cost-efficient index-fund packages, the opportunity for greater diversification is here.
The question then becomes: is more diversification better? In search of an answer, or at least some perspective, we crunched the numbers on 10 asset classes (courtesy of Morningstar and Dow Jones) for the decade through the end of 2005 and compared three diversification strategies:
1) an equal mix of U.S. stocks, U.S. bonds and cash
2) an equal mix of 10 asset classes
3) a traditional pension-fund-inspired 60% U.S. stocks/40% U.S. bonds mix
The asset classes for the three strategies are based on returns from the following indices, most of which are available via index funds or an actively managed fund that serves as a proxy:
1. U.S. Stocks (Russell 3000)
2. U.S. bonds–Treasuries, corporates, mortgaged backed (Lehman Brothers Aggregate)
3. Cash (3 Month T-bill)
4. Emerging markets debt (Citigroup ESBI-Cap Brady, in dollars)
5. Foreign government bonds, developed countries (Citigroup Non-$ World Govt, in dollars)
6. U.S. high yield debt (CSFB High Yield)
7. Foreign developed markets stocks (MSCI EAFE, in dollars)
8. Foreign emerging markets stocks (MSCI EM, in dollars)
9. Real estate investment trusts (Wilshire REIT)
10. Commodities (DJ-AIG Index)

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Foreign stocks remain hot in 2006. The S&P 500 is up 3.5% on a total return basis through March 3, and the small-cap Russell 2000 has climbed 8.7%. But those are no great feats in terms of finding comparable performance in equity markets elsewhere on the planet. The “catch” is that much of the stellar flights in returns this year continuing coming by way of emerging markets.
We say “catch” because emerging markets have been on a tear since 2003. This being the fourth consecutive year (so far) of potent performance, the question necessarily arises: How long can the good times last in emerging markets? There’s no easy answer, if only because no one knows what the future holds. But at least we can study the past and digest whatever scraps of insight that task offers.
Nonetheless, there’s a risk of drawing too many (and arguably any) conclusions from history. Indeed, more than a few bears have been waiting for REITs to correct after a multi-year run. A similar sense of dread hangs over some when it comes to surveying bonds. But each of those markets has continued to confound and confuse by refusing to do the decent thing for bear-minded investors and take a dive.
To be sure, every market rises and falls. The timing is the great mystery. Still, we can’t help but consider the past. Maybe it offers context, maybe not. While you ponder such imponderables, here’s some graphics to pass the time.
First up is a look at developed markets, measured in broad terms. (All charts below are drawn from data published by MSCI for 2006 price returns through March 3.) The Nordic countries of Europe are clearly in the lead in the developed world, with Norwegian stocks jumping by more than 15% so far this year in dollar terms. The laggard is the developed markets in the Far East, with New Zealand taking a dive in 2006.


The real action in global equity markets is again in the emerging markets. MSCI Emerging Markets Index is up more than 11% in dollar terms, posting a rise so far in 2006 that’s twice as high relative to developed markets overall, as tracked by MSCI EAFE. Even the relatively lagging regions of emerging markets are in the black. So far in 2006, it’s been virtually impossible to lose money, a precedent that no doubt will prove easy to break at some point down the road and cause more than a few investors to draw the wrong conclusion in the here and now.

The top-performing emerging market this year is Venezuela, which has soared more than 39% in dollar terms, proving that President Chavez’s anti-Bush rhetoric hasn’t had much of a price when measured in local stock prices.