There are many questions on the investment horizon, but it’s clear that 2006 has been a good year for U.S. stocks. Through yesterday’s close, the S&P 500 has risen by 10.3%. By historical standards, that’s pretty good. In fact, over the long haul, the stock market has delivered roughly an annualized 10%. It’s anyone’s guess if that will hold true in the years ahead, but it’s a safe bet that investors would be more than happy if it did.
We can’t tell you what’s coming, but we’re crystal clear on what’s already rolled by. Perhaps there’s even a kernel of insight about the future based on studying the past. In any case, we took a closer look at the sector drivers behind this year’s ascent in the S&P and compared that with last year’s tally. Among the immediate conclusions: What a difference a year makes.
This year, through October 30, the leading sector is telecom services, charging ahead by 27.2%, as our table below reveals. That’s an impressive recovery from 2005, when telecom was dead last in the year-to-date tally in 2005 through October 31, courtesy of a 10% stumble.
Some things haven’t changed though, at least not much. Energy was red hot in 2005 through the end of October, climbing by nearly 27%. The bull market in energy stocks has cooled considerably, but not completely and so the sector’s still up by 14.2% this year through last night’s close.
In third place so far this year is consumer discretionary. As with telecom, consumer discretionary stocks have bounced back in 2006 from an ugly stretch last year as of this point.
Meanwhile, even the S&P 500’s tech sector is showing life again. Although it’s still in last place in 2006 through yesterday, as it was at this time last year, the difference is that dead last doesn’t mean red ink this time.
That brings us to our next point: picking sectors in 2006 has been about as tough as shooting fish in the proverbial barrel. In other words, all of the S&P 500 sectors are up so far this year. In fact, seven of the ten sectors have scored gains above and beyond the market overall, as measured by the S&P 500.
Return and value aren’t necessarily synonymous, of course. In fact, when we profile the S&P 500 sectors by price-earnings ratio, the view changes more than a little. Seven of the ten sectors carry estimated p/e ratios above the benchmark. And when it comes to telecom stocks, the last in performance shall be the first in p/e, as our table below shows.
Curiously, energy has the lowest p/e of sector neighbors. In fact, energy’s p/e of 10 is well below the market’s 15.89, and a world below tech’s 23. We know what Mr. Market thinks of the future when it comes to sectors. Care to join the bandwagon?
Monthly Archives: October 2006
MORE INCOME, LESS FILLING
In absolute terms, personal income and spending for September didn’t change all that much from August. But little things sometimes mean a lot at a point when the debate is still fierce about whether the economy’s headed for recession or just a slower rate of growth.
On that note, the bulls will find something to chew on with the latest trend in personal income, which rose 0.5% in September, up from 0.4% previously. September’s income rise was the fastest since June, the government reported.
But while Joe Sixpack’s earning more in recent months, his spending ways are falling behind in relative terms, or so the this morning’s release documents. Personal consumption expenditures edged higher by just 0.1%–the lowest since November 2005.
If the trend of slower spending relative to income has legs, the economy may weaken further. As most readers know, consumer spending represents about 70% of gross domestic product. The lesson: there’s no growth of magnitude without Joe’s full faith and compliance.
It’s an open debate as to why Joe’s becoming increasingly thrifty of late, or even if it’ll last. Perhaps he’s been reading the news and analysis that warns of a consumer crackup by way of deteriorating household finances.
But even if Joe’s tilting marginally (emphasis on marginally) toward thrift of late, it’s important to maintain perspective. Indeed, the biggest portion of personal consumption expenditures (60%) is tied to services. Unlike purchases of durable and non-durable goods (which account for the remaining 40% of consumer spending), services spending is less prone to cyclical passions of the moment, or so economists advise. If so, there’s reason to find the trend in services-related spending encouraging, if only slightly.
Personal consumption expenditures advanced by 0.5% last month, matching the monthly rise for August. The 0.5% rate is the fastest since May; it’s also middling: 0.5% has been the average 12-month rate of increase for services-related PCEs for some time.
Meanwhile, the PCE measure of core inflation inched down a notch last month, rising 2.4% in September, or slightly less than 2.5% in August. The generous interpretation is that inflation’s threat has peaked, thereby leaving the Federal Reserve more opportunity to lower interest rates and convince Joe to elevate spending once more.
Overall, there’s room to be optimistic, sort of. That’s another way of saying that there’s room to be pessimistic. It’s a new week with the same old debate.
WARNING: SLOWDOWN IN PROGRESS
The optimists will have their hands full after digesting this morning’s news on the third-quarter GDP.
The economy grew by a real annualized pace of just 1.6% during the July-through-September stretch–down from 2.6% in the second quarter, and a few light years below the first quarter’s 5.6% sizzle. Third quarter growth, as a result, was the slowest in more than three years, as you can see from the chart below.
The debate on what the fourth quarter will bring officially starts now.
Meanwhile, the big surprise in today’s GDP report was the 17.4% drop in residential fixed investment (which includes spending on housing). Not only is that the biggest quarterly decline since 1991, it’s the third stumble this year on a quarterly basis. Each new number’s been negative, and each time it’s bigger than its predecessor. It’s already clear that the housing market has been correcting, and today’s GDP report only adds confirmation of the trend.
Overall, the debate about what comes next may remain as passionate as ever, but there’s no question that the economy has slowed so far in 2006. “The deceleration in real GDP growth in the third quarter,” the Bureau of Economic’s advised in a press release, “primarily reflected an acceleration in imports, a downturn in private inventory investment, a larger decrease in residential fixed investment, and decelerations in PCE for services and in state and local government spending that were partly offset by upturns in PCE for durable goods, in equipment and software, and in federal government spending.”
The good news is that the core and top-line rates of inflation, as per the personal consumption expenditures index, moderated in the third quarter. Core PCE rose at an annualized 2.3% real rate, down from 2.7% previously. Fed Chairman Bernanke’s stature and influence goes up a notch thanks to the trend. Bernanke, of course, has been promising that a slowing economy will take the edge off core inflation. We haven’t really seen that in the core consumer price index, but the idea finds aid and comfort in today’s update on third-quarter PCE.
Nonetheless, the economy has little room for further “deceleration” without triggering the “R” word. But if the odds of a recession are rising, it’s not yet a done deal, or the latest number from consumer spending implies. Joe Sixpack maintained his shopping instincts in the third quarter. Although the economy slowed during July through September, Joe’s spending pace increased. Real annualized personal consumption expenditures advanced by 3.1% in the third quarter, up from 2.6% previously, today’s GDP report revealed.
The economic outlook may be fuzzy and the data in question, but our consumer hero so far hasn’t been swayed from buying one more digital camera, SUV and plasma TV. Some things, at least, remain intact, at least for today.
A CONTRARIAN THINKS HIGHER RATES ARE COMING
The Federal Reserve left Fed funds unchanged at 5.25% in yesterday’s FOMC meeting, although the spectre of inflation still haunted the accompanying statement. The FOMC “judges that some inflation risks remain,” the central bank advised. “The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”
That evolution, by one analyst’s reading, all but assures more rate hikes are coming. Charles Dumas, an economist in London at Lombard Street Research, expects a fresh round of monetary tightening. The crowd thinks otherwise, but Dumas is steadfast in his contrarian view. His reasoning: “there’s excess demand [in the economy,] which tends to create inflation pressure,” he told CS on Tuesday.
Dumas explained that the unemployment rate is “below trend” at 4.6%, which is almost a full percentage point lower than is consistent with noninflationary growth. He added: “The [relatively low] rate of unemployment now will produce 1% more wage growth per year than will be offset by productivity.” Simply put, a jobless rate that’s nearly a percentage point below trend tends to produce faster wage growth, which he predicts will lead to higher inflation. The Fed, as a result, will be forced to raise interest rates to nip the trend in the bud.
As Dumas wrote in a research report published the day before our conversation (the report that initially inspired us to call):
…the “neutral” rate of unemployment is 5-1/2%: on my analysis of past trends, this is the rate that leads to real hourly compensation growth of 2 to 2-1/4%, i.e., the rate that matches hourly output growth in the economy. But current unemployment of 4.6% is nearly 1% below this level [see graph below]. And a deviation from neutral of 1% for unemployment generally implies 2 to 2-1/2% for output, as profits rather than labor absorb much of the effects of fluctuations in output and incomes. Yet the output gap [in the economy] we measure is zero.
Source: Charles Dumas, Lombard Street Research
An output gap of zero implies that inflation will be contained. But Dumas thinks the jobless rate will nonetheless dominate going forward for two reasons. One, core CPI consumer price inflation is now running at nearly 3% in the U.S. Second, hourly compensation has been “heavily revised upward,” he wrote in his research note. He went on to explain:
The latest quarterly number for hourly compensation is up 7-3/4% from the year before – an obviously ridiculous number as it implies unit labor cost gains of 5% or more, and yet much lower prices increases have not stopped profits booming. But even if
the eventual number is half-way back to the pre-revision rate of only 3%, such a 5-to-6% gain in hourly pay is consistent with 3% or so for unit labor costs – in other words, higher core inflation is being “baked in.”
Perhaps, although the crowd isn’t worried at the moment. Or so it appears based on Fed funds futures this morning. The next FOMC comes on December 12; judging by the December contract, the consensus remains convinced that Fed funds will remain unchanged at 5.25% once the dust clears from the next meeting in December.
In fact, there’s no shortage of economists predicting that the economy will continue to soften and that the rationale for holding rates steady, if not cutting, grows stronger over time.
Nonetheless, there’s more than enough conflicting data to keep the debate alive in some corners. The future’s always unclear, and arguably it remains a little more so than usual.
THE HOUSING FACTOR
Keep your eye on real estate prices if you want to know what the Fed’s planning these days.
The advice was dispensed this morning by Wayne Angell, a former Federal Reserve governor who spoke at a press conference today at the United Nations for the launch of a new set of Dow Jones Wilshire global indices. Responding to a question by your editor on the future of monetary policy, Angell said that the Fed’s monetary response will unfold based largely on what happens to housing prices in the coming months. Intrigued, yours truly pressed the former chief economist at Bear Stearns on the matter.
In particular, we wondered how the Fed might balance the fact that housing prices can change quickly (up and down) while monetary policy and its effects arrive at a relatively glacial pace. Arguably, the rise in core inflation of late is a reflection of the loose monetary bias of several years ago, when the central bank was consumed with fighting deflation. Angell, in fact, said as much. As to what’s coming in monetary policy vis a vis housing, he responded first by posing some questions:
Will the annual rate of decline in housing prices stay at negative 2 percent? Or is it more likely to go to negative 15%? Or negative 30%? The answer will dictate the Federal Reserve’s next move
Angell went on to say that there’s a risk that the Fed remains too focused on the recent past. The rise in core inflation is in fact a lagging indicator. As he pointed out, the jump in core CPI was baked into the system 24 months ago. The challenge, as always, for the Fed is balancing lagging indicators with monetary decisions today–decisions that will have an impact over the next 24 months or so. To the extent the Fed stumbles with finding the right balance, the result can be recession, he noted.
Angell was also asked by another journalist if he’d cut interest rates now. His answer was “no.” He reasoned that the “Fed must prepare the markets” before a cut, which he suggested will come in the first quarter. The preparation will come through communications by Fed Chairman Bernanke and other representatives of the central bank. Perhaps a fresh clue will come in today’s FOMC announcement, due in a few hours as we write.
Meanwhile, speaking of housing prices, the national median price for single-family homes dropped 2.5% in September 2006 vs. the year-earlier figure, the National Association of Realtors announced today. That’s the largest decline on record. The good news, such as it is: we’re still a long way from a 15% or 30% decline.
RETHINKING EMERGING MARKETS
Emerging markets have been a staple for at least a decade among investors who value portfolio diversification. The asset class went mainstream in the mid-1990s with the launch of a variety of mutual funds targeting the stock markets in the developing world.
The last several years have been especially sweet for the asset class, delivering double-digit gains for three years in a row through 2005. This year doesn’t look too shabby either. Despite the correction in the MSCI Emerging Markets Index earlier this year, the stocks are up nearly 14% so far in 2006 through yesterday.
Adding luster to the asset class is the growing stack of research that sings a familiar song: emerging markets stocks are a valuable diversification tool for conventional domestic stock/bond portfolios. A familiar argument is of a type found in an essay by George Hoguet, the emerging markets investment strategist at State Street Global Advisors. Diversification, return enhancement and a general expansion of the so-called investable opportunity set are the main benefits, he wrote. In the long term, Houget counseled, “adding emerging markets to your portfolio can both increase return and lead to diversification.”
Houget’s far from alone in promoting emerging markets of late. That’s the nature of bull markets. But while the crowd loves the asset class these days, Jeff Troutner has another view, namely: emerging markets haven’t lived up to expectations and so it’s time look elsewhere for diversification benefits.
ANOTHER LOOK BACK
In a year when positive returns are widespread, the job of rebalancing is a thankless task. It’s also an increasingly burdensome one. Your editor, as a result, pines for the past.
Take 1998, for example. Now that was a year of variety. U.S. stocks, measured by the Russell 3000, enjoyed a robust 24.1% total return that year–the best among the major, broad asset classes. On the opposite extreme: emerging markets, which shed nearly 30%, as per the MSCI Emerging Markets Index. There was also a wide dispersion among the other asset classes. REITs, for instance, were down 17% in 1998 while U.S. bonds added 9.7%. Ah, yes, those were the days.
This year, by contrast, is a study is relative consistency. Save for the recently battered commodities, everything is up, as our table below reminds. And on a three-year trailing basis, even commodities show a gain, and a healthy one to boot. And who knows? Maybe OPEC will gain more respect when it comes to production cuts, helping elevate commodities’ performance into the black for 2006 after all.
Ours is not to question why, ours is but to rebalance or die (apologies to Tennyson). Unfortunately, the low-hanging fruit that availed itself in ’98 (or ’00 through ’02, for that matter) looks sparse by comparison.
To be sure, we’re not so naive as to think that a sizable loss in a given calendar year for an asset class invariably leads to a gain the next. There’s plenty of history to suggest that such a one-factor world doesn’t exist. And so we’re forced to seek out value in asset classes as well.
And we’re also mindful that momentum is a potent force too. Indeed, except for 1999, emerging markets posted losses for each an every year from 1998 through 2002. Meanwhile, REITs are on track again this year to post a gain, as they’ve done consistently for each full calendar year so far in the 21st century.
True enlightenment for the necessary task of rebalancing doesn’t come easy. Nor does it fit nicely into little tables. But past performance, while no guarantee of future return, is at least a start.
THE FUTURE ACCORDING TO GITLITZ
David Gitlitz has been predicting for some time now that the economy will stay robust and that inflation’s still a problem. The bond market may be forecasting recession and falling inflation, but that’s a bet that will be proven wrong, says the chief economist for TrendMacrolytics.
A few weeks back, Gitlitz’s view looked mistaken. In late September, the yield on the 10-year Treasury dropped to under 4.6%–the lowest since February. With Fed funds at 5.25%, a 4.6% 10-year yield created an inverted yield curve in no uncertain terms. Recession, in other words, was coming, the fixed-income set predicted, and inflation was winding down.
But in the wake of yesterday’s report on consumer prices for September, investors are again wondering if inflation is still a threat. Yes, top-line CPI fell 0.5% last month, and the yield curve’s still inverted. But the 10-year’s yield has been rising of late, and so is core inflation. In fact, core CPI advanced 2.9% for the year through September–the highest in nearly a decade.
With the latest inflation report hot off the government’s press, we thought it was a timely moment to chat with Gitlitz and get the details on his latest thinking. What follows is an edited transcript of our phone conversation from late-yesterday afternoon.
Q: What’s your take on the consumer price report for September? The top-line measure of CPI fell, but CPI ex-food and energy advanced by 2.9% for the year through last month, the fastest pace since 1996.
A: The suggestion that somehow…there’s nothing to worry about [regarding inflation] is off the mark.
Q: Why?
A: Because a 2.9% annual core inflation rate…can hardly be considered benign. The top end of the Fed’s comfort zone [for core inflation] is 2.0%.
Q: We’re way above the Fed’s comfort zone.
A: That’s right. I think it’s likely to get worse before it gets better.
Q: Why?
A: Because the price pressures that are embedded in the system, as a result of the Fed being as easy as it’s been for as long as it’s been, are feeding through. Within the next year there’s a very good chance that we’ll be running something like a 3.5% core. And that’s just based on what the Fed’s already done. There’s basically nothing they can do to reverse that. The only thing they can do is get to an equilibrium posture so that they don’t continue to make it worse. And from everything we monitor, they’re still not [at equilibrium]. So we think the Fed will be raising rates.
A TALE OF TWO PRICE INDICES
Today’s update on consumer prices for September looks like a poster child for biopolar disorder.
On the one hand, top-line inflation is conspicuous in its absence. Consumer prices actually dropped last month, posting a sizable -0.5% loss for September. Monthly plummets of this magnitude are rare for CPI, with only a handful arriving in the past generation on a month-to-month basis. But while top line inflation has, for the moment, vanished, core inflation (which excludes the volatile food and energy sectors) shows every indication of staying put.
Core consumer prices rose 0.2% last month, matching the pace in the previous two months. More ominously, the annual rate of core prices edged up to 2.9% in September vs. the year-earlier month, up from 2.8% in August. In short, core inflation is now running at the highest annual rate since 1996, as the graph below shows.
STILL CLIMBING
Rolling 12-month % change in core CPI
Source: Bureau of Labor Statistics
The reason for the divergence between top-line and core prices is an energy story. The sharp correction in oil and gasoline prices last month dragged down the broad CPI index. Energy prices dropped a hefty -7.2% last month, a tumble that helped pare transportation prices by -4.1% in September.
Alas, this kind of relief is probably as ephemeral as political promises in an election year. Energy prices have suffered big corrections relative to past months, but at some point a price floor will be reached, and we’re a lot closer to that floor today than we were a month or two back. Anything’s possible in the 21st century, but $20-a-barrel-oil exists at the outer edge of possibilities.
The inflation problem, in other words, isn’t going away. With core CPI continuing to inch higher, the Fed needs to prove that it can control price momentum. So far, that proof is lacking. Declining energy prices are no substitute for muscular monetary policy. For the moment, the distinction is lost on Mr. Market. But if core CPI continues to creep up in coming months, the markets will be forced to reprice risk.
The dilemma, of course, is that getting tough with inflation is risky at this point in the economic cycle. If the economy continues to slow, Bernanke and company will be faced with the thankless task of choosing between containing inflation and keeping the economy bubbling. It’s been said that central banks can have both, simultaneously. The record, however, is mixed, at best.
Mr. Bernanke’s big adventure has only just begun. The consensus believes that he’ll be able to pull a monetary rabbit out of the hat. Giving him the benefit of the doubt has been easy of late, thanks to declining energy prices. When that support fades, as it soon will, the crowd is likely to become less forgiving. The clock is ticking.
LOOSE CHANGE
Are rare coins a good investment? It certainly looks that way if you consider the past 10 years of the PCGS 3000, a price benchmark for a variety of rare coins that’s exploded skyward. But for newcomers, investing in rare coins can be tricky, not to mention dangerous to one’s net worth. That’s true of any asset class, and doubly so for rare coins and other collectibles. Nonetheless, the stellar returns in recent years have attracted growing interest in coins. In our “day job,” we recently interviewed an expert on the subject. Robert Brown, chief investment officer of Genworth Financial, has studied rare coins as an asset class and written several papers on the subject. In the September issue of Wealth Manager, your editor asked him to share some of his findings. For the details, read on. To find the article (“Minting Money,” Sep 2006), scroll down to the bottom of the WM archive page.