No one expected good news, and the expectations were met.
Today’s update on 2008’s fourth-quarter GDP was ugly, the ugliest in 25 years, in fact. The economy contracted by 6.2% at a real, annualized seasonally adjusted pace in the last three months of 2008. That’s much deeper than the 3.8% decline originally estimated by the government.
Painful, but no one should be shocked, given the general economic and financial climate. But let’s be clear: the embedded message in today’s revised numbers from the Bureau of Economic Analysis is sobering. The principal reason it’s sobering is that the main driver of economic activity has stumbled and the prospect for a quick turnaround is about as likely as waking up on the surface of Neptune tomorrow.

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The first priority for repairing the economy, or at least for stopping the bleeding is returning prices to something approximating equilibrium. There’s still more work to do, as suggested in the inflation forecast embedded in the spread between the nominal and inflation-indexed 10-year Treasuries.
As our chart below reminds, the market is far from convinced that the deflationary risk has passed. It’s open to the idea…maybe. But not convincingly, at least not yet.

As of last night’s close, the Treasury market is forecasting inflation of just under 1% for the decade ahead. That’s higher than the near-zero inflation expected at last year’s close and into early January, and so by that meager standard the outlook has improved. But relative to a normal state of affairs, the trend of late suggests there are worries anew that pricing pressure is set for another burst of deflationary wind.

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Next month, your editor will visit the City of Brotherly Love to discuss a few topics that will be familiar to readers of these digital pages: asset allocation and rebalancing.
On March 19, at 11 a.m., I’ll be speaking in Philadelphia on strategic portfolio issues large and small at the local NAPFA study group. The meeting will be hosted by the gracious folks at Wescott Financial Advisory Group, 30 South 17th Street, Philadelphia.
For more information about the meeting, including the cost for attending, please contact the study group leader: Chip Addis of Addis & Hill Financial Advisors. He can be reached at:
caddis-at-addishill.com
Among the subjects on the agenda:
* Comparing passive and active asset allocation strategies
* Reviewing the lessons for asset allocation after the bear market of 2008
* Analyzing rebalancing strategies as they relate to managing asset allocation
* Contrasting tactical asset allocation with rebalancing
* Using ETFs and index mutual funds for implementing asset allocation strategies
* The importance of seeing investing as a risk-management strategy rather than a return-chasing exercise
As an added incentive to join the fun, all attendees will receive a complimentary copy of the March issue of The Beta Investment Report. Hope to see some of you there!

Bear markets are painful, but they’re also educational. It’s debatable if the crowd ever learns anything in the money game, but the lessons are there just the same.
One of the lessons from the recent and current correction is that portfolios that appeared diversified were in fact far more concentrated than casual observation implied. There are many ways to measure, analyze, design and manage portfolios so as to maximize diversification’s benefits across asset classes. For the moment, we’ll briefly consider one in particular—so-called risk budgeting or risk allocation. The March issue of The Beta Investment Report will go into more detail on risk allocation, but here’s a brief overview of why the subject is relevant for strategic-minded investors.
In essence, the core insight of risk allocation is that there’s more than one way to define multi-asset class diversification. The most popular, alas, may be the most vulnerable to erroneous signals. Vulnerable or not, looking at portfolio allocations based on the capital mix is widely used. For example, a $100,000 portfolio with 60% of the dollars in stocks and 40% in bonds reflects a 60/40 asset allocation in capital terms. But capital allocation is only one measure of asset allocation. What’s more, it’s often a misleading measure if taken at face value without the benefit of broader analytical context.

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Target date funds have become popular in recent years because they offer one-stop shopping for managing the asset allocation challenge. If you’re retiring in, say, 2030, you can buy a target date fund to oversee your asset allocation with your retirement date in mind.
But as today’s episode of The Inside View reminds, not all target date funds are created equal and so there’s design risk to consider when choosing among these products. The critical variable in target date funds is the underlying index that governs the fund’s strategy. As such, the design and management of the benchmark determines much of the success, or failure, for any given target date fund.
Today’s guest, veteran investment consultant Ron Surz, knows a thing or two about how to build and analyze investment indices. His firm PPCA Inc. designs and sells a sophisticated suite of software tools for analyzing portfolios and investment indices. Ron is also president of Target Date Analytics, a consulting and research firm that designs target date fund indices, which are used by the SMART Funds Target Date Series.
As Ron explains in today’s episode of The Inside View, index design is fate for target date funds. Unfortunately, not every target date fund is looking at a rosy future. One problem, he says, is a lack of a sound methodology for some target date benchmarks…

Please visit CapitalSpectator.podbean.com for additional options with episodes of The Inside View.

The January reprieve is now official. Deciding if it’s also enduring is the question. For now, beggars can’t be choosy. Inflation at this juncture, however spare, is good news.
Wholesale and consumer prices rose last month, as we expected they would. The deflation war isn’t over, but there’s reason to think that it can be won. Even so, winning will take time and setbacks are likely.
For now, let’s recognize that consumer prices rose last month, just as they did for wholesale prices. The reason, as we explained yesterday for the pop in producer prices, was the rebound in energy.

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Producer prices rose last month. That’s good news in the war on deflation.
The news wasn’t totally unexpected, as we discussed on Tuesday. The partial rebound in energy last month—heating oil and gasoline—is a key reason for the return of inflation to wholesale prices in January. The same forces suggest that tomorrow’s update on consumer prices will also post a mild gain for last month.
Producer prices rose 0.8% in January on a seasonally adjusted basis, the Labor Department reported this morning. That’s the biggest gain since July—in fact, it’s the only gain since July. From August to December, wholesale prices fell in each and every month. That makes today’s news of higher prices welcome since it suggests that price stability may be near. It’s too soon to be sure, but for today, at least, there’s fresh reason for hope.

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Market watching in the 21st century features real-time analysis to a degree that was the stuff of dreams even 10 years ago. The problem is that economic crises aren’t likely to be resolved any faster today than they were 50 or 100 years ago.
Any one sitting in their bedroom can get institutional-quality quotes on securities these days. Meanwhile, an array of software-based financial analytical models with extraordinary power and depth can be deployed at affordable prices. But while we’re all working on 21st century terms, the economic mess we’re in is still likely to unwind at a 20th century pace. It’s worth noting too that the factors that got us into this pickle were also familiar staples in the economic crises of yore.

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Deflation still haunts the American landscape and until the threat subsides there will be no rest for anxious investors. But maybe, just maybe, the anxiety level will drop a notch or two with this Friday’s update on consumer prices.
As we’ve discussed in recent months, including here, the perils of falling prices is upon us. In December, the CPI posted its first annual decline since 1955. Nipping the deflationary problem in the bud is second to none as a national economic priority and the Federal Reserve, Congress and the White House are on the job of trying to stabilize if not lift prices. Helping the cause is the mixed pricing trend in energy last month.

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Central bankers aren’t gods, even if a few of them sometimes think otherwise. For proof of their mortal status one need only survey the various errors linked to this group in the 21st century. Yes, many central bankers made good, even superb decisions. But there were also some rather large lapses in judgment in matters of monetary policy and related matters in recent years. Arguably the ill-advised decisions overwhelmed the brilliant ones. A number of central bankers tell us so.
Of course, the private sector made more than a few errors too. In sum, the blame for the current troubles stretches far and wide. But when it comes to concentrated power, and the capacity for generating pain or pleasure, central bankers are second to none. They’re an influential lot—influential on a grand scale. For that reason alone, listening to what they say is productive, or shocking—especially when they’re deconstructing what went wrong in the run-up to the crisis now pummeling the global economy.
With that in mind, here are a few choice quotes (courtesy of The Bank for International Settlements) from recent speeches by members of world’s most elite and potent financial club. We don’t necessarily agree with all that follows, although much of what follows certainly rings true. In any case, we’re listening closely.
Mario Draghi, governor, Bank of Italy, 16 December 2008
One striking aspect of the crisis is precisely how its unfolding has continued to catch both policy makers and private sector players by surprise. It started with defaults in a marginal segment of the financial services industry, then quickly spread to virtually all assets. From being a US-only event, it has become global, and in fact it is forcing and accelerating the redressing of world macro imbalances that have been with us for 15 years. The current recession is the result.

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