The tactical is vastly more interesting than the strategic when it comes to investing, but the latter is vastly more important for determining results. Unfortunately, coming up with reliable numbers is a challenge, and even in the best of circumstances the estimates are only guesses. Ideally, they’re informed guesses, but guesses nonetheless.
No matter, as guesses are all we’ve got for strategic portfolio design. The three building blocks in the endeavor of building efficient portfolios (i.e., portfolios that maximize return for a given level of risk) are expected returns, volatility (standard deviation) and correlations for the major asset classes. The latter two tend to be relatively easy to project based on a careful sampling of history. Expected returns, however, are another animal, and this is where the challenge lies. Simply put, projecting returns far into the future is at once immensely critical for long-term portfolio design, and immensely difficult. The reason: history is of limited value in determining performance in the years ahead.
That said, we’re more than a little interested when a respected research team brings fresh numbers to the genre of strategic projections. On that score, we refer you to EnnisKnupp. The Chicago-based institutional investment consultant last month updated its Capital Markets Modeling Assumptions, with an eye on assessing the outlook for returns, correlations and volatility among the major asset classes. Strategically minded investors would do well to give the research paper a read and consider the implications for portfolio design. Granted, the paper dispenses estimates, but robust ones nonetheless. As a result, the numbers offer a starting point for deciding how to structure a portfolio. As a preview, here’s a sampling from the paper’s statistical offerings:
Asset Class Expected Long-Term Compound Return
US Equity 7.5%
Non-US Equity 7.2
US Bonds 5.6
Real Estate 6.5
Historical Asset Class Standard Deviation (1978-2005)
US Equity 16.7
Non-US Equity 18.7
US Bonds 6.6
Real Estate 11.3
Historical Asset Class Correlations (1978-2005)*
Relative to US Equity:
US Equity 1.00
Non-US Equity 0.71
US Bonds 0.20
Real Estate 0.59
Relative to Non-US Equity:
US Equity 0.71
Non-US Equity 1.00
US Bonds 0.20
Real Estate 0.63
Relative to US Bonds:
US Equity 0.20
Non-US Equity 0.20
US Bonds 1.00
Real Estate 0.58
* 1.0 is perfect positive correlation; 0.0 is no correlation
We’re fairly confident that the standard deviations and the correlations will prove reliable, if not perfect benchmarks for the future for the simple reason that history is a fairly good guide for such measures. Expected returns, of course, are another matter, requiring more than a little suspicion as to their accuracy relative to what the future brings.
That said, one thing stands out in the numbers: the low correlation of bonds relative to equities. In fact, that’s consistent with history. The no-brainer diversification decision has long been one of adding bonds to a stock portfolio. If nothing else, the EnnisKnupp numbers reaffirm that the strategic does in fact trump the tactical as a vital issue for investing success. We can debate what the Fed will do next, and whether inflation is rising, falling or standing still. Exciting as all this is, it pales in importance next the recognition that bonds are likely to remain excellent diversification tools for equities. This, at least, is one paradigm that looks set in stone.

After yesterday’s surprisingly encouraging news on producer prices, investors were looking for a clear and unambiguous repeat performance with this morning’s report on consumer prices for July. But the financial gods delivered something else. Something else, but it will suffice, or so early signs from the bond market reveal.
Today’s CPI release is a poster child for mixed messages. Top-line CPI advanced by a seasonally adjusted 0.4% last month, the Labor Department reported. That’s twice as high as June’s 0.2% pace, and near the highest levels on a 12-month rolling basis for recent history. As a result, consumer prices jumped by 4.2% for the year through last month–a rate that lends no comfort for thinking that inflation is a receding force.
But investors are focused elsewhere, namely, the core rate of inflation (which ignores food and energy prices), and this gauge offers a more promising trend. Core CPI rose by 0.2% in July, down from the 0.3% in the previous month. But any optimism that springs from this good news is tempered by the fact that core inflation on a 12-month basis remains at the June level of 2.7%, which is the fastest 12-month change since 2001, as the chart below shows.
12-month rolling % change in core CPI, through July 2006

It all boils down to a consumer price report for July that’s less encouraging than yesterday’s producer price report. The bond market was no doubt expecting something more clarifying, or so yesterday’s buying spree in the trading pits of the 10-year Treasury suggest. Indeed, the bulls aggressively snapped up the benchmark 10-year on Tuesday,
pushing the yield down to 4.93% by the session’s end–or seven points lower than the previous close on Monday. As votes of confidence go, Tuesday’s trading spoke loud and clear on expecting the PPI’s-inspired cheer to continue today.
Cheering, however, is a fragile state of mind these days when dissecting the future path of inflation. Or is it? As we write this morning, the 10-year’s yield has continued to inch lower, dipping to 4.87% more than one hour after the CPI data hit the streets.
The message on inflation may be still be a bit murky, but Mr. Market’s prediction couldn’t be clearer: the Fed’s pause will continue. The interest-rate-setting FOMC convenes next on September 20. But while a lot can happen between now and then, bond traders are growing more convinced that the future of monetary policy is no longer a mystery.

This morning’s update on producer prices for July was surprisingly low, which bodes well for tomorrow’s release of consumer prices. The producer price index (PPI) rose just 0.1% for last month, the least threatening report for wholesale prices since February’s anomalous 1.2% decline. The consensus forecast anticipated a 0.3% rise, according to TheStreet.com. Core PPI (less food and energy) was even more benevolent, posting a 0.3% fall in July, vs. a consensus prediction of 0.2%.
If tomorrow’s dispatch on consumer prices for July echoes today’s PPI news, Fed Chairman Ben Bernanke’s big gamble, as we recently labeled his monetary policy inclinations, will enjoy a resurgence of respect. One month a trend does not make, but the hawks may be forced to snack on a little crow come the end of the week.
Indeed, the 12-month core PPI certainly appears on its way to being tamed. Having advanced by 1.3% for the year through July, the pace has now fallen dramatically from the pace of recent history, as the chart below illustrates.
12-month rolling % change in core PPI, through July 2006

For investors looking for another excuse to turn optimistic, there’s also the news that oil prices are again on the retreat, which if it continues has the power to take more than a little of the inflationary pressures out of the system. The immediate trigger for the selloff is the tentative ceasefire announced in the Israel-Lebanon conflict. Such things are tenuous in that corner of the world, but for the moment there’s reason to at least be somewhat less pessimistic for the remainder of the summer.
As we noted a few weeks back, the fundamentals of crude suggest that prices should be lower, at least for the foreseeable future. The complicating factor has been fear, which has kept oil prices higher than economics alone imply. If fear takes a respite, if only briefly, and the latest warm and fuzzy aura on prices holds steady with tomorrow’s CPI report, the bulls may regain control of the stock and bond markets this week and perhaps this month.
Hope in August…it’s the new new thing.

Former New York Mayor Ed Koch loved to ask his constituents “How am I doing?” One can only speculate as to an answer if Federal Reserve Chairman Ben Bernanke posed a comparable question on matters of monetary policy to his constituency of dollar holders.
A clue as to our thinking on a provisional answer can be found in the following analysis. The first displays the yield curve at two points in time: Friday’s close, and a previous manifestation from a year earlier, August 11, 2005. As the chart illustrates, the arc of money’s price has become slightly inverted relative to the upward-sloping curve of 12 months previous. On Friday, the yield in a 30-day Treasury bill (a proxy for “cash”) was 10 basis points higher than a 10-year Treasury Note. That’s in sharp contrast to a year ago, when a 10-year Treasury commanded a 100-basis-point premium over a 30-day T-bill. Progress may be elusive, but change is incessant.

Now consider the trend in the core rate of inflation, which is computed by excluding the prices of energy and food. A year ago, for the 12 months through June 2005, core CPI rose by 2.0%. A year on, core CPI advanced by 2.6% during the past year through June 2006. That may not mean much to the man in the street, but in central banking terms the upward shift is dramatic and signals that pricing pressures are mounting.
In other words, the central bank has been raising interest rates, but without a material impact on slowing inflation’s rise. Bernanke and company realize that their attempts at prevailing has proved insufficient on altering core CPI’s course, and have admitted as much in FOMC statements this year. Plan B is telling the world that while the rate hikes haven’t put a ceiling on core CPI, elevating the price of money will still prevail because it will slow the economy, which in turn will do what rate hikes have not yet accomplished: end if not reverse core CPI’s upward momentum.
The slightly negative yield curve does in fact suggest that economic growth will slow. The question is whether slower growth will produce the proverbial rabbit from the Fed’s hat in the form of core CPI that no longer rises or declines? Getting from here to there remains an open debate, and history provides at best a mixed message.
The next clue in this all-important sage comes on Wednesday, when the Labor Department publishes July’s consumer price indices. The consensus forecast, according to TheStreet.com, is that core CPI will remain elevated by unchanged from June at 0.3%. If accurate, that would be better than 0.4%, although it will hardly reduce the pressure on the Fed to convince an increasingly skeptical Wall Street that it’s still in control of inflation trends. The best-case scenario would be a fall in core CPI, in which case Bernanke’s credibility goes up a notch, if only until the next monthly inflation update.
Alas, the Fed’s power (which is primarily one of managing expectations) now hinges on each new data point. This is a setback for the central bank, and for investors generally. To be sure, the markets are far more concerned these days with geopolitical events, which dominate the daily news. Watching the evolution of monetary policy is comparatively a sleepy sport that’s comparable to watching glaciers melt.
Nonetheless, keeping an eye on a small drip can pay off in the long run. Another drop comes tomorrow. And so, our glass is out, although we’re still not sure if it’s half full or half empty. Clarity invariably quenches our thirst, but the slaking takes time.

Confusion, terrorism and risk in general hang heavy over the global economy, but Mr. Market is getting used to the noise.
Measured by year-to-date returns, the broad stock market continues to post returns firmly in the black. The Russell 3000 Index, for instance, has climbed 2.6% so far this year, through August 10, as the table below shows.

But lest we get too excited, it’s worth mentioning that 2.6% is less than spectacular in a world where a low-cost money market fund offers a yield nearly twice as high. Risk, in short, just isn’t paying off like it used to.
In addition, much of the rise in the stock market this year comes on the back of value stocks. The Russell 3000 Value has risen nearly 8.8% year to date. By contrast, the Russell 3000 Growth is down more than 3%.
In fact, all measures of growth are in the red so far this year across the large-, mid- and small-cap equity spectrum for U.S. stocks, as you can see from the graph below.

Equity investors are in a defensive mood this year, a notion supported by looking at the ten major sectors in the S&P 500, where cyclically sensitive stocks have tumbled so far in 2006. Info tech stocks have suffered the most, falling by more than 9% this year. Meanwhile, consumer staples, utilities and energy continue to shine.

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The Federal Reserve’s decision on Tuesday to stop raising interest rates marks the start of a new phase for monetary policy. Only time will tell if this new phase is enlightened or something less. But no matter what comes next, ending the two-year campaign of rate hikes harbors a fair amount of risk at a time when inflationary momentum is picking up.
Bernanke is betting that an economic slowdown will cool inflation. The underlying assumption is that inflationary threats are self correcting. Unfortunately, history is less than clear when it comes to finding hard data to back up the assumption. In fact, recent history suggests the opposite. As we noted back on August 1, rate of increase in core inflation (as measured by personal consumption expenditures) has picked up recently just as the pace of personal consumption expenditures has turned lower. In other words, the primary engine of the economy (consumer spending) is softening at a time of rising inflation.
The Fed’s effectively arguing that it can now take a hands-off approach to managing inflation because economic growth will do the job. The issue is whether the Fed’s monetary policy in the recent past is partly or wholly responsible for the rise in core inflation in the here and now. If the central bank’s actions are accountable to a degree for the higher core inflation now, then it follows that the Fed must be proactive in bringing that inflation down (or preventing it from rising further).
Adding to the Fed’s burden is the fact that productivity in the American labor force slowed sharply in the second quarter while labor costs jumped, according to yesterday’s update from the Labor Department on productivity and costs. Labor costs increased at an annual rate of 4.2% during March through June, the fastest rate since 2004’s fourth quarter, and sharply higher than the 2.5% pace in this year’s first three months.
The rise in labor costs is “a warning shot across the Fed’s bow,” Joel Naroff, president of Naroff Economic Advisors in Holland, Pa., told U.S. News & World Report. “The Fed is facing a very difficult situation” between containing inflation and spurring growth, Naroff said. “It may not change the decision [to halt rising rates], but it puts pressure on them to make comments about how they are monitoring inflation.”

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It promises to be a hot week for financial news, but The Capital Spectator is taking a cool vacation in the North. We’re on ice through Wednesday, August 9, returning to the heat on Thursday, August 10, with another hot essay. Till then, stay cool, and thanks for reading!

This morning’s employment report for July gives the bond bulls one more reason to buy.
The unemployment rate rose to 4.8% last month, the highest since February, the Bureau of Labor Statistics announced. Meanwhile, the economy added only 113,000 new jobs, based on the nonfarm employment survey–the smallest increase since April’s 112,000 rise.
“The uniformity of the evidence of softer labor market conditions should make the FOMC decision next week easy,” writes David Resler, chief economist at Nomura Securities in New York, this morning in a note to clients. “With virtually all the recent reports confirming the FOMC’s [view] that the economy is now on track for the forecasted ‘moderating growth,’ and with market interest rates possibly suggesting that the slowdown is more severe than desired, the prudent course for policymakers is to maintain current policy until a clearer picture of the outlook develops.”
But while the payroll trend continues to show continued weakness, the related inflation tied to wages continues to inspire caution on matters related to turning the handle on the monetary-sausage machine. The widely monitored average hourly earnings for the private sector rose by 0.4% last month, unchanged from June’s pace but still in the upper range of monthly advances for the past several years. On a 12-month rolling basis, July’s jump in hourly earnings was 3.8% higher compared to July 2005, which is also in the upper range posted in recent years, as the chart below illustrates. To the extent that wage pressures are helping elevate inflationary momentum, today’s report won’t do much to assuage such fears.

But if the Fed must make a choice between juicing the economy so as to avoid a recession vs. nipping any mounting inflationary pressure in the bud, the former is getting the bond market’s vote of late. The yield on the 10-year Treasury fell again yesterday, settling at 4.951%–the lowest since mid-April. Meanwhile, in the wake of the July employment report comes a burst of buying in the August Fed funds futures contract in early trading today, which reflects the strengthening sentiment that the central bank will take a pass on another rate hike at next Tuesday’s FOMC. If so, that would be the first pause in two years of elevating the price of money.
But while the consensus is now predicting the Fed will take a breather, it’s worth remembering that there’s a complicating factor overhanging Treasury pricing and the associated signals on inflation expectations that spring from current yields. Fear, it seems, is no trivial force driving money into government bonds, and thereby lower yields. That decline in the price of money, in other words, isn’t wholly a reflection that inflation’s a waning threat. With the Middle East ravaged by war in more than a few locales, anxious deployers of capital the world over are finding fresh incentives to park money in what is still regarded as the safest paper obligations on the planet.
Of course, even the mighty Treasuries have competition when it comes to stores of value. Perhaps that’s why gold is again moving higher, having jumped by around $100 an ounce over the last two months.
The Fed has a very simple and one-dimensional tool for addressing a very complicated world with a myriad of economic and geopolitical cross currents. Up, down or hold are the choices for monetary policy. If only the real world were that simple.

The Federal Reserve may be set to put its rate hikes on hold, but the European Central Bank’s tightening phase is in full swing.
The ECB today raised its key interest rate by 25 basis points to 3.0%–the fourth rise in eight months. The Bank of England also elevated the price of money today, bumping up its key rate by a quarter of a point to 4.75%. The BoE’s decision was unexpected, and is the first rate hike for the bank in two years.
In both cases, the common denominators were economic growth and rising inflation. Although neither looks poised for a radical break out on the upside any time soon, the upward momentum of late is worrisome for the central bankers.
Back in America, the buzz (again) is that the Fed is set to pause in its two-year-old campaign to raise interest rates. Anticipating as much, bond traders chased the benchmark 10-year Treasury to the extent that its current yield fell to 4.96% by the close of yesterday’s session, the lowest since June 13.
The official word from the Fed on interest rates comes next Tuesday. Between now and then, precious little new data will be released, excepting for tomorrow’s update from the Labor Department on July’s employment status. Judging by the consensus outlook, as per Briefing.com, not much will change. June’s jobless rate of 4.6% is forecast to remain the same for July, while the widely monitored nonfarm payrolls number for last month is expected to rise only marginally.
But in the spirit of the times, there’s still reason to keep an open mind about what comes next. Case in point: yesterday’s July update of the controversial ADP National Employment gave traders an excuse to wonder if tomorrow’s government employment update for July will be weaker than expected, in which case the bond bulls will be beside themselves with celebration. The ADP report showed a sharp decline last month in the growth of private employment in the U.S. July added only 99,000 new jobs to the economy, according to ADP, down from 368,000 in June.
By ADP’s standard, the Fed will find more than enough statistical ammunition to call off the rate-tightening dogs next week. But there’s a debate about how accurate the ADP numbers are relative to the government’s survey of payroll trends. David Resler, chief economist at Nomura Securities in New York, advised in a note to clients today that in the brief three month history of the ADP employment report, “it has not proven to be a very reliable indicator of the change in nonfarm payrolls as estimated by the BLS, so I suspect few forecasters will change their estimate of nonfarm payrolls.”
Ed Yardeni, chief investment strategist for Oak Associates, also notes that ADP’s numbers may be suspect. In an email to clients this morning, Yardeni summarized some of the issues at stake in the dispute:

Yesterday’s ADP employment report, which is based on actual paychecks, showed an increase of only 99,000 in private sector jobs in July, following a gain of 368,000 in June. The official June headcount conducted by the Bureau of Labor Statistics showed nonfarm payrolls rose 121,000 and 90,000 with and without government employment. June’s household employment survey showed a very impressive gain of 387,000. The ADP series starts in December 2000 and has tracked the official numbers closely. That’s why [I’m] sticking with 180,000 to 200,000 for Friday’s payroll number, well above the consensus of 140,000. We figure the divergence with the ADP report should be narrowed, and that the economy is still creating plenty of jobs. In any event, the payroll numbers will most likely determine whether the Fed raises the federal funds rate one more time next week and then pauses, or pauses next week.