Winter’s coming and oil prices have been falling. That makes OPEC anxious. A quick remedy is an “emergency” meeting of the cartel’s members, with a goal of hammering out an agreement on a production cut.
Easier said than done. Oh, sure, there’ll be an announcement from the meeting in Qatar later this week. The message for consumption from the confab, which starts on Wednesday, will no doubt be a one-million-barrel-a-day reduction promised (threatened?) by various sources. Algerian Energy Minister Chehib Khelil yesterday said that OPEC will officially unveil such a cut. Meanwhile, Qatar Energy Minister Abdullah bin Hamad al-Attiyah said that OPEC will discuss “the possibility of reducing total oil output by one million barrels a day (b/d) to stop any further decline in prices.”
So far, Mr. Market isn’t overly impressed. The November crude futures contract in early New York trading today was largely unchanged from its Friday close of $58.57. That doesn’t mean that OPEC won’t be able to talk up the price this week, or even over the coming weeks and months. With the onset of winter buying, demand is likely to become increasingly robust.
That said, consensus is easier for cartels when prices are rising. It’s a whole other ball game when selling dominates. Indeed, OPEC’s history is more than a little blemished when it comes to keeping member promises intact on the matter of cutting production in the face of lower prices.
The challenge is hardly unique to OPEC. Human nature being what it is, profit maximizing actions invariably overshadow those that emphasize a group over the individual Adam Smith is always happy to explain the concept in more detail for those who’re interested. Suffice to say, past experience suggests that maintaining quotas on new production cuts will be a bit like keeping water from following downhill.

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Oil prices have been trading under $60 a barrel for much of October, the first time that the commodity’s been that “cheap” since February. Some bulls say that the mid-$50 range represents a floor for the foreseeable future, while the bears say that even lower prices are coming.
But while the future for a barrel of crude is hotly debated, the past at least is crystal clear, and from that history we can draw some fairly basic conclusions. To wit, the fundamental drivers that have brought us to the present state of energy pricing remain intact, as the latest Energy Information Administration data suggest. With the publication earlier this week of EIA’s Petroleum Supply Annual for 2005, the government has started finalizing its annual energy data for 2005, and the various trends embedded in those numbers look all too familiar and none too pretty.
As the chart below illustrates, which graphs EIA data with the newly dispensed 2005 numbers through the end of last year, not much has changed in the American economy when it comes to the big-picture analysis of oil when viewed from 10,000 feet. To summarize: domestic production keeps falling and domestic consumption keeps rising. Filling the gap is the old standby of imports, which continue to run higher.

Short-term analysis, by contrast, leaves room for hope. Quixotic hope, perhaps, but hope nonetheless. Consider the monthly data for 2006. Domestic production was up 7.5% in July 2006 vs. December 2005, while imports climbed just 2.1% over that span. Meanwhile, consumption slipped by more than 4% in July from the previous December.
In fact, a slowing economy will pare consumption every time. As such, if the slowdown has legs, overall consumption is likely to fall–temporarily. As the chart above reminds, temporary blips don’t change the secular trend. Domestic oil production has been generally falling since the 1970s, and that’s not likely to change. That’s not to say that secular trends can’t be redirected, subverted or even abolished, but it’s highly unlikely that such a change will come by way of major discoveries on U.S. territory. Meanwhile, it’ll take more than even a recession can muster to alter the basic facts of life for energy in these United States, which has is basically one of consume more, import more.
But the trend is starting to attract attention–even in Washington. President Bush is warning against energy complacency now that oil prices have fallen from all-time highs of late. “My worry is … that a low price of gasoline will make us complacent about our future when it comes to energy, because I fully understand that energy is going to help determine whether or not this nation remains the economic leader in the world,” he said yesterday. “We envision a day in which light and powerful batteries will become available in the marketplace so that you can drive the first 40 miles on electricity, on batteries, and your car won’t have to look like a golf cart.”
Such hopeful comments about alternative energy will inevitably be dismissed by some as just another instance of politicking. Maybe so, but sometimes reality intrudes even into the inner sanctum of politics.
Supply and demand, in short, will dictate the future when it comes to oil and energy in general. That future may not arrive next month, but it’s coming, and we’re pretty sure what it’ll look like. Only the timing and magnitude of the transition is in doubt.

Standard deviation is on the defensive these days as a valued risk measure. Although it’s been a staple in modern portfolio theory and for quantifying risk generally by way of price volatility for securities and asset classes, there’s a concerted effort of late to attack, diminish and otherwise banish the venerable metric.
A leading complaint is that standard deviation doesn’t reflect the true risk that threatens investors. The woman investing for retirement 20 years on faces a variety of risks, starting with the possibility that she will spend all of her savings before dying. Standard deviation, as a result, is of no consequence to someone trying to avoid outliving her savings.
There are technical complaints as well. The basic calculation of standard deviation assumes a normal distribution. Normal distributions work great in physics and general statistics, but are flawed when it comes to picking up the tendency of investment returns to suffer distributions that are less than normal. The so-called fat tails distribution forever haunts the world of investing, a risk that effectively means that dramatic events can and do happen every once in a while, and that risk isn’t captured in a normal distribution world that defines the basic concept of standard deviation.
True enough. Standard deviation isn’t a real-world risk in saving for retirement, and it doesn’t fully reflect what happens in the capital markets in terms of how returns are distributed around the mean. But after accepting the wisdom of the observation, the analysis shouldn’t end there. Standard deviation, or the volatility of prices around the mean, still offers a reasonably valuable tool for comparing one type of risk (although hardly the only type) among various asset classes. It’s less than perfect; in fact it’s flawed. But it’s still useful for getting a general sense of the risks that loom.
Should investors use standard deviation exclusively and ignore all other measures and definitions of risk? Absolutely not. But neither should one dispose of standard deviation simply by recognizing that the metric can’t be all things to all investors at all times. If that’s the bar by which risk measures must reach, then nothing would suffice. Something, we submit, is better than nothing. In fact, the imperfections of the real world demand that we use a collection of flawed risk measures to piece together an outline of the overall risk that looms.
Here now begins our admittedly underdog attempt at defending and, perhaps, partially restoring standard deviation’s once-good name in the world of risk analytics. The effort consists of simply showing that price volatility, while flawed, is nonetheless valuable still for assessing the nature of a particular asset class relative to another.
Exhibit A is the table below, which ranks the major asset classes by their respective 3-year annualized standard deviation, based on monthly total returns through last month. Note that the asset classes that rank highest in volatility are indeed, by most accounts, the riskier of the bunch. Meanwhile, those at the bottom, including cash, are the least risky by this measure.

To restate the obvious, there’s a world of difference with the low risk of cash to the high risk of emerging market stocks. High risk isn’t inherently bad, nor is low risk inherently good. In fact, mixing risks together with a strategic purpose is the only way to fly. But we digress.
The pairing of standard deviation against trailing 3-year annualized total return shows that the relationship between the two is eminently logical. Consider the graph below, which plots the trailing 3-year returns for each of the asset classes listed above against their respective standard deviation. The key revelation is that returns generally rise along with risk, even when the risk is measured as standard deviation. There is no free lunch, as the graph reminds. This iron law of the investment universe is sometimes thrown out of whack in the short run, but as a long-term proposition it’s virtually impervious to change.

Obviously, standard deviation is only one risk measure in an ever-expanding sea of competing metrics, both quantitative and qualitative. No single measure fully encompasses the concept of “risk” in all its nuance and variety. An accurate profile of the risk that inhabits the investment landscape requires more than crunching the numbers by any one gauge.
But for our money, we begin with standard deviation, and do so regularly. Price volatility, after all, ebbs and flows, just as returns do. The ongoing shifting sands of return and risk warrant keeping a close eye on the relationship between the two. The moral of the story: Enlightenment in the investment game comes one metric at a time.

Federal Reserve Bank of Dallas President Richard Fisher thinks inflation is “too high.” Nonetheless, he’s “comfortable” with the current Fed funds rate, he said yesterday at a conference. But he noted too that the Fed is prepared to hike rates if the central bank’s strategy doesn’t show results in paring the upward move in inflation of late.
This strategy includes expecting that a slowing economy will take the edge off of inflationary momentum (a notion that monetarists dispute). Still, Fed Chairman Ben Bernanke has said as much, and Fisher reiterated the notion yesterday. Of course, nothing is perfect when it comes to monetary policy, and the risk of error is always lurking.
Since the Fed’s birth in 1913, the institution has made more than a few mistakes in misjudging inflation and its capacity for circumventing the best-laid plans of central bankers. But the bad old days are gone, we’re told; the Fed is a far-more enlightened entity in the 21st century.
Let’s hope so, as the stakes aren’t getting any smaller, at least not yet. As last month’s World Economic Outlook from the IMF reminds, it’s not yet clear that inflation has lost its penchant for rising, albeit from unusually low levels from a few years back.
Consider two charts from the IMF report, republished below. The first one reminds that while inflation overall is still low relative to the past 20 years, by 21st century standards pricing pressure is moving up. Labor costs are beginning to move upward too. Will the combination force the Fed to begin raising rates again? Perhaps. It all depends on the data, of course.

Source: IMF World Economic Outlook, Sep 2006
In fact, Fisher reminded that while the housing market is cooling, the rest of the economy appears to be doing just fine. “With a decline in housing market activity, you will dent but not destroy consumer confidence,” he said, via The Wall Street Journal. “I don’t think it will lead to a recession.” For those who subscribe to the Fed’s belief that a slowing economy will nip inflation in the bud, Fisher’s outlook raises questions about the future for monetary policy.
In any case, bond traders have started rethinking (again) the yield on the benchmark 10-year Treasury. Selling in the last two trading sessions has boosted the 10-year’s yield to around 4.75% at yesterday’s close, up from last Thursday’s 4.57%.
But if there’s any fear of another rate hike at the next FOMC meeting on October 24/25, it’s not showing up in Fed funds futures. Trading in the November contract remains placid, anticipating Fed funds will remain unchanged at 5.25% at the monetary confab later this month.
Overall, optimism and tranquility reign supreme on the monetary front. Even stock market volatility, measured by the VIX, is near its lowest levels of recent years. Betting on whether the serenity continues or not is the great wager du jour. Speaking of which, what’s the old saw about the calm before the storm?

Jim Cramer, writing in an op-ed in yesterday’s Wall Street Journal, disparaged the notion that there was anything to fear when it comes to the outlook for consumer spending.
“In 25 years of trading stocks,” Cramer wrote, “I’ve read the consumer’s obituary more times than I care to imagine; each time the facts have proven the obit premature.” He went on to explain, “We are seeing numbers from the major retailers — both high-end and low, mass and teen — so strong that the consumer is not only not dead, but he’s at the peak of health.”
There is no question that Joe and his counterparts across the country are as intent on spending as ever, or so it seems. And while we agree with Cramer that the consumer isn’t dead, that doesn’t mean there are no worries regarding Joe’s spendthrift ways. Indeed, Cramer failed to mention that consumer spending, while it may be eternal, does suffer cycles. Joe’s spending habits, in other words, wax and wane, and the resulting impact on the economy is more than trivial.
History tells the story. Inflation-adjusted personal consumption expenditures (PCE) in the first quarter of 1991, for instance, dropped by 0.4% from the year-earlier level, according to data from the Bureau of Economic Analysis. It’s no accident that the decline accompanied a recession at the time. First-quarter GDP in 1991 was off 1% from a year earlier.
A recovery ensued, and by the late-1990s the PCE in some quarters was advancing at 5% or more over the year-earlier quarter. Again, no one should be surprised to learn that the return of relatively robust spending paralleled an extraordinary period of economic boom.
PCE’s pace has been more middling of late, compared with the highs of the late-1990s. Still, the 3% jump in PCE in this year’s second quarter over the same period in 2005 is nothing to sneeze at.
The point is that while consumer spending is alive and well for the moment, its level and rate of change isn’t written in stone. As the chart below details, the pace of growth in consumer spending continues to fluctuate. And that is the real issue. The reason: consumer spending drives the economy. As a result, a slowdown in consumer spending to, say, 1% in future quarters relative to year-earlier levels may trigger a sharp slowdown in GDP growth, perhaps even bringing recession. And as the chart suggests, such a future isn’t exactly beyond the pale.

Yes, we can all agree that the consumer isn’t dead, nor is he likely to expire anytime soon, if ever. But that’s a false topic of discussion.

Kim Jong Il is among the world’s most reclusive leaders, but he knows how to send a loud calling card.
The latest example came packaged in yesterday’s underground nuclear test, which North Korea announced on Sunday. The political reverberations came quick. “We expect the U.N. Security Council to take immediate actions to respond to this unprovoked act,” White House spokesman Tony Snow said. The new Japanese prime minister, Shinzo Abe, while in South Korea, declared “…that if North Korea’s nuclear test is confirmed, it would be a grave threat not only to Japan and South Korea and neighboring countries, but to international peace and security.”
While the world struggles with what to do next, there’s a report this morning that the chief of South Korea’s intelligence agency told lawmakers on Monday that Kim’s North Korea might unleash a second nuclear test.
As we write this morning, it’s too early to know how the markets will react, but we have our suspicions. Predictably, South Korean stocks dropped on the news while gold and oil prices jumped.
Market reaction, in fact, may continue for days and weeks. For starters, we would expect that when the bond market reopens tomorrow (it’s closed today in the U.S. for the Columbus Day holiday), a burst of fresh demand for the safety of Treasuries will push yields lower once more. Meanwhile, news from the Korean peninsula probably won’t do much to drive up the price of U.S. stocks any time soon.
Volatility, in sum, looks set for a rebound in several asset classes, courtesy of Kim’s big adventure in splitting atoms. It’s likely that the volatility won’t last, however. Mr. Market has become increasingly comfortable in learning to live with heightened risk in the global economy. That’s not to say that a crisis-induced selloff isn’t possible, although it’s less likely these days. Nonetheless, for the long-term strategic investor, volatility is good, even if it’s short-lived. The reason: volatility can deliver some temporary bargains.
Indeed, history shows that when the world gets nervous, spreads widen and riskier assets are disposed of with haste. It’s too early to say if a similar scenario awaits this time around, but we’ll be watching in case fresh opportunity avails itself. Cash is burning a hole in our pocket, as it has been for some time now. But while we’re not ready to part with a heavy overweight in the asset class just yet, we’re mindful that at some point a substantial rebalancing is necessary to fend off the performance drag that cash invariably delivers over time. Timing, of course, is the great variable that weighs on our decision, and that in turn will be driven by valuations, trailing returns and a number of other variables.
But let’s not minimize the challenge of finding value. As the table below reminds, screaming buys are an endangered species. Everything has rallied to one degree or another, and so nothing looks particularly compelling. Take note that negative returns are listed in red, and on that front there are only two instances, and both are in commodities, and both are of recent vintage. Of course, given today’s news, along with reports of OPEC’s efforts to reverse the drop in oil prices of late by paring output, the commodities-related red ink may soon turn black once again.

In which case, where will red numbers be most likely to appear next on our table? Inquiring, opportunistic and strategic-minded investors want to know.

Yesterday we said we were impressed by the labor market’s ability to hold up relatively well against what some said was an approaching recession. What a difference a day makes! Today, we’re far less impressed. In fact, we’re surprised by the sharp downturn in job creation last month. Score one more for those who think the Fed will soon begin cutting interest rates.
Meanwhile, we can ponder the implications of September’s meager rise of 51,000 in nonfarm payrolls. A lesser number on this front hasn’t been seen since October 2005’s 37,000 advance. Of course, one could write off the previous dip as the extraordinary fallout from Katrina, which temporarily threw the labor market off its stride in September and October of last year. Indeed, the slide was more than reversed in November 2005, when nonfarm payrolls soared by 354,000, followed by a string of lesser but still robust months of job creation.
Alas, that kind of rebound from last month’s dip looks remote this time. With the real estate market cooling and a number of other economic metrics softening, job creation is now taking it on the chin.
The sectors of the economy that posted outright declines in jobs were in the cyclical corners of goods producing, manufacturing and retail, collectively shedding 42,000 positions last month. As usual, the service portion of the economy came to the rescue by delivering the lion’s share of the gains: a total of 62,000, although that’s a bit thin by the service sector’s standards.
The other bit of encouraging news in today’s employment report is that August’s payrolls rose by 188,000, up significantly from the initial estimate of 128,000. Meanwhile, the national unemployment rate fell to 4.6% in September from August’s 4.7%. The implication: jobs are still growing faster than the population, wrote Charles Dumas of Lombard Street Research in a note to clients today.
There’s also some technical number-crunching going on related to so-called benchmark revisions. Reportedly, the annual revision will be unusually large, perhaps giving a new bullish aura to the past profile of job creation.
Hope springs eternal, even if it’s technical in nature. These days, the stock market bulls aren’t picky about where they get their inspiration. Regardless, it’s all about the future now, and the trend of slowdown increasingly looks baked into the economic cake. The bond market will cheer, as it has been doing for months. Until and if some new report changes the perception, we think we know what we’ll be getting for Christmas.
The key questions now: How can the stock market maintain its cheery outlook in the wake of this morning’s news? Also, now that the slowdown looks closer to fact rather than speculation, will it produce what the Fed desperately needs: a commensurate slowdown in core inflation?

Today’s addition to the WM library is an interview with Ross Miller, a professor of finance at the State University of New York at Albany and president of Miller Risk Advisors. In our chat, he discusses his active expense ratio with your editor in the October issue of Wealth Manager. Miller designed the quantitative measure to shine a light on the true cost of active management. As he sees it, his gauge offers much improvement over the gross expense ratio that’s typically used for comparing costs among mutual funds. The metric’s details are outlined in his original working paper, “Active Expense Ratios and Active Alphas,” which is available via a link on his web site and is forthcoming in the Journal of Investment Management.

No one needs reminding that the housing market is softening; the data are doing just fine with that task, thank you very much. Nonetheless, Fed Chairman Ben Bernanke yesterday decided that the masses needed reminding, and he made his point clearly. Whether it was a productive point is debatable.
This much, at least, is clear, Bernanke told us: the housing market is now in “substantial correction,” and the result will be a drop in U.S. economic growth by around one percentage point in the second half of this year, reported USA Today. The effect will “probably” linger next year, taking a toll on growth in 2007, he added.
The message was clear enough. Or, so one might think. In fact, nothing’s what it seems these days when it comes to reading the economic tea leaves of numbers and commentary.
Equity traders listened to Bernanke speak and found reason to buy, driving stocks up. The S&P 500 delivered a robust 1.2% gain yesterday, one of its better days in recent memory. The bond market, meanwhile, was inspired to again drive the yield on the 10-year Treasury lower, to 4.565% by the close.
The fixed-income set heard Bernanke and took the hint by deciding that another rate hike looks unlikely. Holding Fed funds steady seems the path of least resistance for the moment, although some are talking about the prospect of a rate cut in the near future. All of which stirred bond traders to buy, and thereby lower the 10-year’s yield.
The stock market too found reason to cheer at the notion that the odds of another rate hike further receded into the financial woodwork. And, yes, chatter about a rate cut was present in the equity realm too, producing a giddy session yesterday that stirred some to visions of financial sugar plums.
In sum, the stock market offers a crisp counterpoint to the bond market. The former thinks the future economic scenario will favor equities, which is to say, growth. The bond market begs to differ. How long can this go on? Perhaps longer than reasonable minds think possible.
In the meantime, Bernanke’s outlook for a slowing economy is complicated by the fact that inflation remains higher than the Fed would prefer. Indeed, Bernanke said as much yesterday, explaining that inflation remains “above what we would consider price stability.”
Everywhere, it seems, there is a dualism, offering this on one hand, and that on the other. On Monday, we learned that construction spending last month bounced back unexpectedly. On the same day, however, news broke that manufacturing’s pace of growth continued to slow. The tea leaves turned even more ambiguous yesterday with the report that orders for manufactured goods in August were flat.
Meanwhile, this morning we learned that the labor market continues to hold up rather impressively. The number of people filing for new jobless claims fell to 302,000 last week–the lowest since July, and 20% below the year-earlier tally.
The data’s telling us many things, but that’s not making the job of predicting what comes next any easier.

It’s widely quoted, represents the face of the stock market to the masses, and closed at a new all-time high yesterday. But that doesn’t change the fact that the Dow Jones Industrial Average, for all its storied history, is irrelevant.
The observation is unchanged by yesterday’s news that it eclipsed its old high of 11,722.98 set on January 14, 2000 by settling at 11,727.34. Yes, the Dow makes for interesting copy in the newspapers, as a review of the media today reveals. Nonetheless, the hoopla is misplaced. Indeed, the Dow’s ascent into record territory stands alone today among the broad measures of U.S. stocks. Notably, the S&P 500 and the Russell 3000 remain well below their peaks of early 2000.
Ditto for the Nasdaq Composite, the fallen poster boy for tech stocks. In fact, a new high for the Nasdaq may have a long, long wait. Breaching the 5000 level briefly in March 2000, the Nasdaq is still more than 50% below that ancient summit.
The S&P 500 and Russell 3000 are much closer to their previous crests. Nonetheless, equities would have to rally long and hard from here to deliver a new high in these indices, both of which command far more respect and money in the institutional investor community than the Dow. In fact, no one in their right mind would consider using the Dow Industrials as the basis for an index fund for serious money, which is why there’s precious little money attached to the benchmark compared to the alternatives.
The value of the Dow, if one can call it that, is mainly that of an antique curiosity. The world’s first stock index, the Dow Industrials trace a history back to 1884, when Charles Dow began publishing a measure of market activity in the “Customer’s Afternoon Letter,” the forerunner to what would become The Wall Street Journal. In the 19th century, the limitations of technology demanded a relatively simple methodology for sampling equity price changes writ large. The Dow, as a result, is today a prisoner of those archaic confines.
The modern Dow Industrials is the world’s most recognized stock index, but the benchmark exists by virtue of its lengthy history as opposed to any compelling relevance. Looking at the Dow is like peering back into time. This, dear readers, is an index that is bottled in a methodological formaldehyde, preserved for the ages for no particular reason beyond the fact that it’s been around longer than its competitors. Even Dow Jones & Co., which owns the index, has long since recognized the obvious by publishing a modern suite of benchmarks of relevance.

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