Today’s update on personal income and spending corroborates yesterday’s GDP report, which told us clearly that the consumer is wary and is cutting back sharply on consumption.
The smoking gun today is that while disposable personal income rose 0.2% in September, personal consumption spending dropped 0.3%. It’s not the first time that income rose and spending slipped in the same month, although it’s rare. Indeed, news of a spending decline generally is rare. Until now.
In the current climate, everyone will recognize that lower spending has legs, and that the trend will take a toll on an economy that relies so heavily on it for growth. Meanwhile, let’s not assume that income will keep rising in the coming months and quarters, which is far from certain. Yes, a new fiscal stimulus is reportedly coming, but the inclination will be strong to bank another round of checks from the government. No wonder that some policymakers are talking of FDR-type infrastructure projects to bypass consumers in a bid to boost demand in the economy. As for Joe Sixpack’s sentiment, much depends on how the labor market fares going forward, and for the moment that outlook isn’t encouraging.

On the spending side, last month’s drop is the biggest monthly decline in four years. What makes this news so discouraging is that it doesn’t yet reflect the deteriorating consumer sentiment for October or the ongoing economic and financial pain that we think is coming for the remainder of this year into 2009. It’s hard to imagine that spending reports in the coming months will somehow avoid further deterioration, and that news will weigh heavily on everything from the stock market to employment reports. More immediately, to state what now’s surely obvious: the holiday retail season looks set to disappoint.
As we said yesterday, the age of consumption is over, at least as we’ve known it in recent years and for the foreseeable future. Spending is out, saving is in, and the revival has only just begun. Yes, Virginia, cycles are still alive and kicking.

This morning’s news that third-quarter GDP retreated by 0.3% should surprise no one. This slump is arguably one of most anticipated contractions in recent memory. In any case, the recession is here, although officially the label won’t be applied until NBER gets around to reporting what’s already obvious. But barring an extraordinary turn of events in Q4–an unlikely event if ever there was one–the recession is here, as we speculated it would be as early as this past March.

Granted, the government will update Q3 GDP two more times before a final print. But there’s no reason to think that the revisions won’t reveal even bigger pools of red ink.
As for what the Bureau of Economic Analysis reports today, the numbers on their face are humbling. The bad news is grounded in the overwhelmingly dominant piece of GDP: consumer spending, which accounts for roughly 70% of gross domestic product. The point now is plain: Joe Sixpack has finally cut back, and by more than a little. The great engine of the U.S. economy has shifted into reverse in a big way, as our chart below shows, with personal consumption expenditures dropping 3.1% in 2008’s Q3 (on a seasonally and inflation-adjusted annualized basis, as per the norm). That’s the steepest quarterly decline since 1980’s Q2, although 1990’s Q4 came close to reaching the latest drop.
There’s just no way to sugarcoat this reversal of spending. It’s steep and given the general economic and financial backdrop, along with the generally high indebtedness of Americans, it suggests more declines are coming. A generation or more of consuming at any price appears to be at an end, at least for the foreseeable future. Indeed, the chart below suggests the great boom in consumption has, for a time, ended. No, consumers aren’t going away. But the extreme consumer age has ended, due for replacement initially by saving and then a more modest strategy for visits to the mall. It’ll take time for the American economy to adjust. Ditto for the global economy. The sky-is-the-limit spending mandate of Joe is on hold till further notice. Retrenchment is never easy, but gravity has its way eventually.

Looking closer at consumer spending reveals that the greatest damage came in durable goods, which sunk by a huge 14.1% in Q3. Nondurable goods spending fared better, as you would expect, but only in relative terms. But let’s be clear: the 6.4% drop in nondurable goods is troubling since these items include such staples as food, clothing and energy. The fact that nondurable expenditures dropped so precipitously reminds that the extreme negativity in consumer sentiment is taking a toll in the real world.
The other big slice of consumer expenditures–services–managed to eke out a gain in Q3, rising 0.6%. But this is a paltry outing for a sector that’s thought to be the most immune to cyclical pain, since it includes such resilient spending sources as medical care and housing. All the more so if you consider that growth in services spending averages more than 2.0% for the last 10 quarters. By that standard, the Q3 reading sends a clear and humbling message of how the average American is thinking these days.
Exports, the great redeeming corner of the economy this year, is still growing, posting a 5.9% jump in Q3. But that’s down sharply from Q2’s 12.3% surge and is at the lower range of gains in recent years. It’s debatable if export growth can hold up in the face of rising economic and financial anxiety in foreign markets. Meanwhile, the dollar has rebounded in the forex markets amid the global rush for the safety of Treasuries, thereby undercutting some of the fuel for exports growth.
No one should be surprised at the GDP numbers today. One could argue, as many do, that the current ills have been years, even decades in the making. But it’s the future that matters, and today’s GDP report is just another reminder that the economic blowback from the financial crises of the past year has only just begun.

A small ray of sunshine on the economic front greets us today in the update for durable goods orders. Alas, it’s not the sign of a turning point. Not even close.
New order for durable goods rose 0.8% last month vs. August, the Census Bureau reports. But September’s bump doesn’t change the fact that new orders are down 4.7% from July’s tally and 3.6% below the year-earlier level. Last month notwithstanding, the trend is still down.
If we strip out defense-related items, new orders fell 0.6% last month. No matter, since the market will be looking for positive signs and the top-line number for durable goods orders will satisfy the demand for something sweet. But the economic challenges have barely begun and investors should refrain from reading too much into any one number this early in the cycle.
The real pressure will come in consumer related numbers. It will take months for the full brunt of the financial hurricane of September and October to fully work into the consumer readings. A grim glimpse of things arrived in yesterday’s update on consumer sentiment from the Conference Board, which advises that Joe Sixpack’s as pessimistic as he’s ever been since this index was first calculated in 1967. “Consumers are extremely pessimistic,” observes Lynn Franco, director of the Conference Board’s Consumer Research Center via AP. “This news does not bode well for retailers who are already bracing for what is shaping up to be a very challenging holiday season.”
It’s a virtual certainty that consumer-related economic reports will be discouraging in the months ahead, to say the least. The only questions: How much pain and how long will it last? In any case, brace yourself. The monsters are coming, and it won’t end on Halloween.

It’s been known for some time–decades, really–that relatively high dividend yields tend to precede relatively high returns in subsequent years. Graham and Dodd’s Security Analysis suggests as much about the relationship between valuation and return. More rigorous studies of the valuation phenomenon (of which dividends are only one measure) arrived in the 1980s, when a number of new research efforts found a strong relationship between relatively undervalued equities and higher prospective return.
One review of the possibilities came in a 1984 Journal of Portfolio Management article: “Dividend yields are equity risk premiums,” by Michael Rozeff. He explains that “the evidence dictates” that dividend yields can be used to time purchases. He warns against reading too much from specific dividend levels for establishing absolute buy and sell signals. He also counsels readers away from trying to profit from dividend-yield signals in the short term. Nonetheless, the basic premise, if not exactly original, reflects economic common sense, Rozeff argues:
My evidence indicates that returns increase continuously and monotonically as dividend yield in the prior year increases. My theory that the dividend yield is a measure of the ex ante risk premium explains why this is so. High returns tend to occur when the environment is perceived to be so risky that investors demand a high premium for holding stocks. Low returns tend to occur when the environment is perceived to hold such little risk that investors demand a low risk premium for holding stocks.
Subsequent studies lend support to the idea that valuation overall matters. For example, Robert Shiller, in Irrational Exuberance, argues in favor of return predictability based on valuation parameters. One example comes by way of a diagram in the book that plots price-earnings ratios against subsequent 10-year returns based on buying the S&P Composite Index (a proxy for U.S. stocks) at a given p/e ratio. The relationship, which draws on more than 100 years of market history through 1989, shows a “moderately strong” link between low p/e ratios and relatively high returns, and vice versa, according to Shiller.

Continue reading →

The current 1.5% Fed funds rate isn’t long for this world. The Federal Reserve, perhaps in coordination once again with other central banks around the world, will cut interest rates, and soon.
That, at least, is the market’s view. The November ’08 Fed funds futures contract has all but priced in a 50-basis-point cut to 1%.
The announcement of a cut, whatever it is, will come as a shock to no one, given the events of late. Indeed, money supply has been rising at extraordinarily high rates in reaction to the extraordinarily dire state of affairs in finance and increasingly on the economic front. M1 money supply (the narrowest measure) surged more than 19% on a seasonally adjusted annualized basis for the three months through September 2008, the Fed reports. A year ago, M1 was up a mere 0.8% over the same time frame.
Such an aggressive creation of liquidity will be met with lower interest rates…again. But we’re coming to the end of this road, and the dangers (psychological as well as economic) are growing. It’s no longer beyond the pale to consider the possibility that the Fed will drop rates to zero, depending on how the turmoil unfolds in the coming weeks and months. What happens when Fed funds have sunk to nothing remains an open debate, but this future appears to be rushing toward us.

Continue reading →

Seeing the world as chaos, devoid of rules or logic when the capital and commodity markets go into a tailspin and the economic outlook is grim is a potent temptation. But it’s a mistake to think that order has run off the rails.
The problem has been hubris—an excess of hubris. The comeuppance is now upon us, and the process of a return to modesty, humility and a healthy respect for risk in money management is in full swing. This comes as a great shock to many investors. But to say this is something new is to ignore history.
Financial calamity is always lurking. As Kindleberger put it, financial crisis is a “hardy perennial.” Sometimes it’s kept at bay for years, even decades, but eventually the beast returns. Painful as this recurring truth is for those who must live through it and watch hard-earned savings wither, there can be no other path.
Don’t misunderstand. The pursuit of progress in economics and portfolio management must continue, and will continue. We’re not doomed to sit on our hands and let the financial gods do what they will with us. We can and will advance the cause of intelligence on these fronts. Indeed, we’ve learned much over the past 100 years. Yet greed and fear are immune to knowledge and wisdom, much as the common cold is resistant to the miracle that is medical science.

Continue reading →

It’s no surprise to learn that inflation expectations have been pounded downward in the wake of the financial crisis, although the magnitude of the drop may still turn a few heads.
Consider the outlook for consumer prices embedded in the spread between the nominal and inflation-indexed Treasury, as per our chart below. Mr. Market is now anticipating that consumer prices will rise a mere 1% a year for the next decade, down from nearly 2.6% as recently as this past July.

The source of this massive and sudden change of heart needs no explanation other than to point to the events of the past two months. Meanwhile, amid all the turmoil and fading of inflation worries an investor can, as of last night’s close, buy a 10-year inflation-indexed Treasury at a real yield of 2.59%, as our second chart below shows. That’s shy of the October 14 close of 3.05%, although it’s still high by recent standards. At one point during this past March, the 10-year TIPS yielded a scant 90 basis points.

The opportunity to lock in a real yield of 3%, or something close to it, shouldn’t be dismissed lightly. Indeed, a nominal 10-year Treasury currently yields 3.65%, a mere 106 basis points over its TIPS counterpart.
Inflation, of course, is a dead issue at the moment, or so the crowd believes. No wonder, since there’s a persuasive case for thinking that it’ll probably be some time, perhaps several years, before pricing pressures return with any great force. Disinflation, or worse, is upon us, courtesy of the economic challenges that await.
All of which only goes to remind that the best deals in the investing game typically come joined at the hip with frightening headlines and gloomy expectations for the assets in question. Some things never change.
Prices, by contrast, are always in flux. The only task, then, is figuring out if the going rate is attractive, and that starts by comparing it with what the crowd was accepting in the past.

The biggest challenge in strategic-minded investing lies within. The high-yield bond market of late offers a telling example.
Trailing yields on junk bonds have soared recently, as our chart below shows. The risk premium on junk over 10-year Treasury Notes exploded skyward to close yesterday at nearly 15%. That’s the highest since the early 1990s and, one could argue, it looks enticing.

The human mind, meanwhile, is a complicated organ. What looks like far better values today relative to, say, June 12, 2007 isn’t necessarily obvious or compelling to homo economicus. We cite June 12 of last year because that was the trough for the junk/Treasury yield spread, as per Citigroup High Yield Index.
Not long after, we remained suspicious that the spread was sufficiently high to compensate for the risks ahead, as per our post in late summer 2007. As it turned out, we weren’t wary enough, not by a long shot. We did, however, say that even though the risk premium had risen to a bit over 4% in August 2007, “we’re not yet convinced that strategic opportunities are convincing in the highest-risk spectrum of assets.” In fact, we should have told everyone to run for the hills and put everything in cash. Hindsight, as always, tells us exactly what we should have done.
As it turned out, the crowd had other ideas, which is to say bullish ideas. Indeed, the late summer of 2007 was a strong period for the junk bond market. The iShares iBoxx $ High Yield Corporate Bond ETF (HYG), for instance, had a run higher in August and September of that year, reaching an all-time high of $104.70 on September 25, 2007. The ETF closed yesterday at $71.40.
Having been crushed, the high-yield bond market now offers its highest trailing yield in a generation. We’re guessing, but it seems as though there are few takers, if any. Yes, there’s reason to shun junk bonds, starting with the high odds that a painful and lengthy recession awaits. If so, defaults on junk will rise. Understandably, that scares off the bulls. And for all we know, staying scared may be the only logical decision at this point. An economy that takes a beating will treat the lower-grade tier of securities harshly, even after the harsh treatment to date.

Continue reading →

There are no short cuts to easy profits, but sometimes Mr. Market throws us a bone (or two) in our quest for strategic insight. Two examples, though hardly the only ones, come by way of reviewing correlation and volatility histories. We surveyed correlations last week, and today we revisit volatility, as per our chart below, which graphs rolling three-year volatilities of monthly total returns back to September 1994.

The obvious trend is that there is one, or so it appears. Lulls in vol tend to be followed by surges, and then lulls, and round and round we go. It’s all obvious in hindsight, of course, but dissecting where we are in real time and how long it will last (or not) is always more obscure.
Meanwhile, we’re constantly fighting our own biases. That’s partly because the mind likes to extrapolate recent activity far into the future. Back in the late-1990s, the calm in volatility readings was thought to be the dawn of a new era in smooth and high returns in stocks and other risky assets. Such thinking prevailed right up until the idea was beheaded in the crash of 2000-2002, a reversal of fortunes that was accompanied by a spike in vol.
Something similar unfolded during 2003-2007, when returns generally were strong and standard deviations were low. Once again, it was all too easy to believe that the trend would last. It didn’t, leading to a collapse in returns and a swelling in vol.
It’s always hazardous to speculate on when a current cycle will end and a new one will begin. Nonetheless, we can and should observe cycles for what they are: finite. The one that now has the world by the neck may appear set to roll on indefinitely, but that is an illusion. This too shall pass, although the timing, as always, is unclear.

Continue reading →

By now the routine is familiar–and increasingly painful. The government updates the state of the housing market and a bevy of negative numbers fly by. Today’s news on this front is, alas, more of the same, reminding that the primary source of the current economic and financial ills is still correcting and therefore throwing off bearish shock waves in all directions.
New housing starts dropped 6.3% in September from the previous month, the Census Bureau reports. That’s a lesser decline than August’s 8% drop, although as our chart below reminds that’s cold comfort given the persistent declines that have been battering this sector almost nonstop since early 2006.

It’s no better for new housing permits issued, and that casts a pall on the future. As our second graph below shows, this forward-looking measure remains under enormous strain too, virtually assuring that housing construction and related activity will continue to shrink for the foreseeable future. The 8.3% drop last month in new permits is steep and only slightly below August’s 8.5% tumble, suggesting that the negative momentum has still got its foot on the industry’s neck.

The best we can hope for at the moment is that a bottom in the housing market is near. Forget about a rebound–that’s probably a year or two off at the earliest. At this point a material slowdown if not an end to the bleeding is housing is priority one. It’s unclear what policies will bring that about other than to let the excess in the housing market unwind naturally. Suffice to say, government intervention with an eye on moderating the pain will be ongoing on several fronts, but getting some traction relief remains a trial-and-error effort still.

Continue reading →