Is the recent pullback in commodities a sign of things to come?
As you can see from the chart below, commodities are the only major asset class that’s in the red over the past month, through August 29. Although commodities are still up on the year, they trail most of the other asset classes. Only inflation-indexed Treasuries and U.S. bonds have delivered lower year-to-date gains than commodities.

Asset class proxies: Vanguard REIT ETF, iShares Russell 2000, iShares MSCI Emerging Markets, iShares MSCI EAFE, S&P 500 SPDR, Vanguard High-Yield Corporate, PIMCO EM Bond, Morningstar Ultra-Short Gov’t Bond Category, PIMCO Foreign Bond, iShares Lehman Aggregate Bond, Vanguard Inflation Protected Securities Fund, Credit Suisse Commodity Return Strategy Fund.
Predicting turning points in investment cycles is difficult, if not impossible, and quite often dangerous if investors go to extremes based on their expectations about the future. The risk of bailing out of an asset class completely has been on display recently by way of REITs. Some pundits (including yours truly) have worried that the REIT bull market is long in the tooth, and so a correction of some duration and magnitude looked probable. But as the record shows, REITs haven’t suffered much of a correction, at least nothing that comes close to looking like a sustained bear market.
If fact, REITs have continued to make new highs. So much for predictions.
Deciding if commodities will continue to deliver stellar gains, or something less isn’t any easier than forecasting when (or if) REITs will hit the wall. Such is life in the prediction game.
But while we hold no illusions about our (or anybody else’s) ability to discern what’s coming, that doesn’t stop us from making calculated bets in adjusting our asset allocation from time to time. And that includes paring back on asset classes that have run up while adding to those that have fallen on hard times.
To be sure, an enlightened approach to diversification is a bit more complicated. Valuation and macroeconomic factors should play role in rebalancing decisions too. But the analysis starts with comparing performance over a variety of time frames. By that standard, we’re inclined to pare back on REITs and emerging market stocks. Alas, the game gets tougher for deciding where to redeploy the capital. Having no good choices (i.e., compelling valuations are in short supply at the moment) at our disposal, we’re forced to make the least worst decision, which for us has been one of taking some money out of cash and putting it into short- and medium-term bonds and equivalent funds.
No, we’re not smitten with bonds. In fact, we’re not smitten with any of the major asset classes. That doesn’t stop us from owning some of each. But better days surely lay ahead for asset allocation opportunities. One or more of the asset classes, we expect, will emerge as convincing buys. We’re not sure when that will happen, or which asset classes will make the grade. But the opportunities may come sooner than many expect. And it is that rationale that continues to convince us to hold an overweight in cash.

As messages from the bond market go, yesterday’s trading session was fairly distinctive. It may even be accurate.
For much of the trading yesterday, sellers were in control, based on transactions in the benchmark 10-year Treasury Note. The yield climbed steadily as the hours passed, reaching upward to nearly 4.84% just after 1 p.m., New York time, the highest since last Wednesday. For the next hour, all was calm, and the yield level more or less held. Then at 2 p.m., the buyers rushed in and the yield on the 10-year dropped like a rock, as the chart below shows. The result: the yield tumbled back to 4.78% by the close–roughly the lowest since March and virtually unchanged from Tuesday.

What happened at 2 p.m.? The release of the minutes from the Fed’s August 8 FOMC meeting, of course. The perception-altering news of the minutes, or so traders decided, was that the central bank wasn’t quite as hawkish on interest rates as had been assumed earlier in the day. Thus, the repricing of risk, namely, the nominal yield on the 10-year Treasury, which, of course, is susceptible to future inflation (and the next story to hit the wires).
But inflation, the fixed-income set resolved, isn’t going to be much of a threat. That, at least, was the message of yesterday’s bond-market action. But the casual observer can be forgiven for confessing confusion. Indeed, yesterday’s FOMC minutes made it clear that the debate on August 8 (which marked the Fed’s first pause in hiking rates after 17 previous elevations) was hardly decisive one way or the other. As the minutes advised, “In view of the elevated readings on costs and prices, many members thought that the decision to keep policy unchanged at this meeting was a close call and noted that additional firming could well be needed.”
Nonetheless, most voting members of the FOMC voted to pause on August 8, apparently concluding that inflation is fading as a material threat. Of course, it’s also true that while there was but one dissenting vote at the last meeting, the minutes reveal that several members who voted to cease and desist were less than 100% confident in the accuracy of their decision. Again quoting the minutes: “In view of the elevated readings on costs and prices, many members thought that the decision to keep policy unchanged at this meeting was a close call and noted that additional firming could well be needed.”
Holy data confusion, Batman! Is the outlook really that muddled?
Fed Chairman Bernanke has said that the Fed’s forecast of a slowing economy will pare inflation’s upward momentum of late. And in fact, the economy has been slowing, although it remains to be seen if that will translate into a sustained fall in the core rate of inflation. A minor setback, if we can call it that, on that front comes in this morning’s latest estimate on second-quarter GDP. As it turns out, the economy grew slightly faster than previously calculated, according to the Bureau of Economic Analysis. GDP advanced at an annual rate of 2.9% during April through June, which is moderately faster than the 2.5% estimate previously disclosed. By itself, that doesn’t change much. Then again, we’ll have to wait and see what Friday’s employment report for August says before coming to any fast and furious conclusions.

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For the second day running, the yield on the 10-year Treasury yesterday closed under 4.8%. That hasn’t happened since March.
Traders of government bonds have become increasingly optimistic that inflation isn’t half the threat it was perceived to be in weeks past. In concert with that forecast, the 10-year’s yield has dropped roughly 20 basis points from the 5.0% level of August 14. Although many disagree with the trend and instead fear that inflation will continue to harass the economy, for now the fixed-income set is convinced that it knows what’s coming, and the world can either follow or get out of the way.
No matter what you think of the decline in yield, the trend is being felt elsewhere in the capital markets. That includes the market for high-yield debt securities, otherwise known as junk bonds.
Among the byproducts of the falling bond yields is a rise in the spread of junk yields over the 10-year’s. The KDP High Yield Index currently carries an 8.0% yield, which translates into a spread of roughly 3.2% over the 10-year Treasury. The spread is highest since the second half of 2005, and up about 70 basis points from earlier this year, according to KDP Advisor.
The rise in the junk spread is encouraging for those looking at high yield bonds. But encouraging does not yet convince us to buy, even if we’re finding more incentive to look. Indeed, a 320-basis-point spread is the richest so far this year. Alas, it still pales next to levels from recent history. In the first half of 2005, for instance, the spread touched ~400 basis points, based on the KDP High Yield Index, as the chart below shows (courtesy of KDPAdvisor.com) And back in 2002, an astonishing spread of nearly 900 basis points could be had, albeit for a brief and fleeting moment.
KDP High Yield Index Spread over 10-Yr Treasury

Source: KDP Advisor
Of course, no one should expect a 900-basis-point spread to return any time soon. The monetary and economic climate has changed drastically since then, all but insuring that far-more modest spreads are likely to prevail for the foreseeable future.
Nonetheless, for those smart enough to dive in junk bonds in mid-2002, the subsequent returns have been remarkable, as the trailing returns remind. For the past five years through yesterday, for instance, the Merrill Lynch U.S. High Yield Master II Index has earned an annualized total return of 8.3%, or more than double the S&P 500’s rise over that span, according to Morningstar.com. Bonds overall, as measured by the Lehman Bros. Aggregate, have also trailed, posting an annualized total return of 4.85% for the five years through yesterday.

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Is this as good as it gets? Has perfection in corporate profits come and gone? Anxious investors with above-average allocations to domestic equities can be forgiven for asking such questions these days. Perfection, after all, has nowhere to go but down.
As The New York Times observed in a front-page story today, corporate profits as a share of the economy, at 10.3% in this year’s first quarter, are the highest since the mid-1960s. The story quoted UBS research, which termed the recent level of corporate profits as “the golden era of profitability.”
Can a golden era remain golden indefinitely? Or is the natural course one that will turn gold into lead? These are the questions that weigh on equity investors, who are sitting on tidy gains generated since the stock market collapse of 2000-2002. For those who were lucky enough to time the subsequent rebound in stocks just right, the ensuing gains have been sweet. The S&P 500 boasts a torrid 15% annualized total return from March 1, 2003 through July 31, 2006. That’s about 50% higher than the stock market’s long-term average performance. Small-cap stocks have enjoyed even stronger performance. The Russell 2000’s total return over the same stretch is nearly 23% a year.
Bull markets for stocks, in other words, don’t get much better than the previous three years or so. But with clarity on economic and political issues receding by the day, a bit more caution on the future may be just the thing to calm one’s nerves.
Don’t misunderstand. We like stocks. We like them a lot. Some of our favorite portfolio holdings are equities. In fact, we’re committed to holding equities as a long-term proposition, come hell or high water. But we’re also inclined to think that the last three years may be anomalous compared to what’s coming for U.S. stocks overall, i.e., a stretch of mediocrity. In turn, our expectations (flawed though they may be) inform our thoughts on equity allocations, which for the moment we prefer to ratchet down.
Trimming back on equities for some may look premature. The rear-view mirror is nothing if not impressive, casting a bullish aura for those who like to extrapolate the past into the future, no questions asked. Earnings, after all, have been the great power that’s elevated stock prices in recent years, and on that measure there’s much to celebrate by looking back. The Federal Reserve saw fit for several years prior to June 2004 to lower interest rates to levels that, with the benefit of hindsight, were excessively low. And even once the Fed started raising rates, it did so slowly, allowing cheap money to endure. Corporate America, being a for-profit group, took advantage of the situation and proceeded to repair balance sheets to a degree that was as dramatic as it was quick.
Consider that in 2001, income before taxes for nonfinancial businesses fell more than 5% from the previous year to $1.15 trillion, according to date from the Fed’s current Flow of Funds Accounts of the United States. However, as the chart below shows, corporate income has been climbing ever since. In fact, last year, income advanced nearly 23% over 2004, making the year one of the more remarkable 12-month stretches in corporate history.

Curiously, the stock market reacted rather sheepishly, with the S&P 500 climbing only 4.9% last year. Perhaps it’s not so curious after all. The stock market is widely credited with looking ahead. Sometimes it sees things that don’t materialize, but in 2003 and 2004 its powers of prognostication were prescient, or so the S&P’s 29% and 11% total return for each of those years, respectively, suggests.
Indeed, earnings continue to impress relative to the past. But the fuel that powers those earnings–rising corporate income–is showing signs of slowing. For this year’s first quarter, corporate income slowed considerably relative to the year-earlier quarter, rising by 13%, as the chart above reveals.
Granted, there’s a big difference between slower rates of growth and outright declines. But for those who think strategically, the signs of income growth turning sluggish are a warning.
No, it’s not time to write off equities and go to cash. Far from it. But pulling back, taking some profits seems eminently reasonable at the moment. Asset classes never go bankrupt, but they do fluctuate. Exploiting those fluctuations and redeploying profits is the only way to fly.

Inflation fears are on the rise lately, courtesy of the upward momentum in the pace of the core consumer price index, which extracts food and energy from the mix. But judging by the market’s outlook on inflation, derived from inflation-indexed Treasuries (or TIPS, as they’re known), not much has changed this year. Mr. Market, it seems, isn’t worried about inflation. And perhaps that’s as it should be. The Fed tells us that a slowing economy will do the dirty work of cutting any inflation surprise off at the knee, and it’s becoming clearer that the economy is in fact slowing.
Nonetheless, core CPI advanced by 2.7% for the year through July–that’s up from 2.2% in 2005 and the fastest annual pace since 2001. A sign of things to come? Maybe, but the market-based outlook for inflation has been calm, cool and largely inert this year. Consider that at the close of 2005, the TIPS-based inflation projection (calculated by difference in yield between the nominal 10-year Treasury and the 10-year TIPS) was 2.33%, which inched up to just 2.53% as of yesterday, as our chart below illustrates.

As warning signs of future inflation go, the one emanating from TIPS is a fairly tepid animal. Indeed, the current 2.53% forecast is well below both the latest reading on the annual change in core inflation (2.7%) and top-line inflation (4.1%).
Some may take comfort in the fact that the market thinks there’s no bull market in inflation, but a number of skeptics say that TIPS are less than a reliable forecasting mechanism when it comes to pricing trends. In fact, the subject of inflation and TIPS became a topical, if hotly debated subject yesterday after commentary from Arthur Laffer. Writing in The Wall Street Journal in a piece called “The Flawless Fed”, he invoked the securities and announced that a reading of the yield spread between nominal Treasuries and TIPS indicates that “over the past three years there has been no upswing in the market’s expectations of inflation.”
The blogosphere reacted, warning that reading the tea leaves from TIPS offers no special insight into the future, and perhaps a whole lot less than some assume. Bret Swanson at the Discovery Institute was speaking for some, including Don Luskin, when he wrote “Dr. Laffer says expected inflation gleaned from TIPS bonds is the best predictor of inflation, but in fact TIPS have not been very good at all at predicting inflation.” Macroblog weighed in as well, sparking a debate on Laffer’s assumptions.
For others, Laffer’s op-ed was swallowed hook, line and sinker. This blogger, for instance, cited Laffer’s commentary on low inflation expectations by way of TIPS to gush,