It’s official: the economic contraction slowed dramatically in the second quarter. By that standard, the government can claim a victory. But now comes the hard part, and progress won’t come easily or quickly.
For the moment, however, there’s reason to cheer. The annual real change in GDP in this year’s second quarter was a relatively mild fall of 1.0%, the Bureau of Economic Analysis reports today. That’s a massively improved number from the first quarter’s huge 6.4% tumble.
The sharp slowdown in the rate of contraction isn’t necessarily surprising. As we’ve been discussing for months, a number of economic clues have been suggesting that the recession may be coming to a technical end. At the same time, we’ve also been warning that the official end of the recession—as defined by NBER—isn’t likely to lead to a rebound of any strength any time soon. Instead, we’re looking at an extended period of flat to perhaps modestly negative GDP reports between the technical end of the recession and the start of the recovery. In that sense, the business cycle is different this time, and the risk of a double-dip recession is therefore higher than normal as well.

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Today’s update on initial jobless claims reminds that the threat of economic contraction isn’t vanquished. There’s been progress, but the dark forces of decline are still lurking.
For the week ending July 25, the advance figure for seasonally adjusted initial claims was 584,000, an increase of 25,000 from the previous week’s revised figure of 559,000. A rise in new fillings for unemployment benefits is unsettling at this precarious stage in the economic cycle. Still, there’s nothing in today’s numbers that convinces us to alter our view that the technical end of the recession is near. For the moment, last week’s jump looks like statistical noise.

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There’s been some good news lately, including the encouraging signs in real estate. New home sales rose last month, posting the third straight monthly increase. For some, the writing is now on the wall. “Recession is over, economy is recovering,” declared John Silvia, Wells Fargo’s chief economist, in a research note, according to The New York Times.
We’re of a mind to agree with the first part of the statement, but not the second, at least not yet. As we’ve been discussing for some time, the technical conclusion of the recession is near or perhaps already here. We began considering the end back in March, when we examined the business cycle forecasting powers of the trend in initial jobless claims. In the months since, the reasoning grew stronger for anticipating that the recession’s end was approaching. News such as yesterday’s pop in new home sales only strengthens the case. But as we’ve said many times in recent months, the end of the recession this time is likely to be followed by an unusually long period of stagnation before economic growth returns in earnest.

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Your conventionally minded editor isn’t used to seeing a Federal Reserve chairman take his monetary policy show on the road. Then again, we’re from the old school, and we’re not used to seeing pigs fly either. But we’re obviously out of touch in the 21st century.
Ours is a world where formality gives way to “transparency,” which comes in an ever-widening rainbow of colors. Fed chairman Ben Bernanke’s “publicity tour” is certainly something new in the bag of central banking tricks. We thought that participating in so-called town hall forums and taking questions from the audience was an art reserved for politicians and talk-show hosts. We’re wrong. It’s also now just another tool in the otherwise dull business of managing money supply.
The old veneer of banking ceremony is fading, giving way to a penchant for empathy and personality tours. Imagine our surprise when we discovered that Mr. Bernanke was “disgusted” by some of the Fed’s recent actions, as he explained to an inquiring member of the audience in yesterday’s PBS television episode. Speaking of the various bailouts last fall, the Fed head confessed: “Nothing made me more angry than having to intervene, particularly in a few cases where companies took wild bets.” Perhaps he might have simply said that the devil made him do it. Personally, we’d have like to see some tears to make the confession more convincing.

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Investing is complicated, but it begins rather simply. How it ends is the question.
There are infinite possibilities for reassembling the major asset classes. The challenge is finding the one that satisfies your particular set of expectations, risk tolerance and financial situation. The basic choices boil down to choosing some combination of stocks, bonds, REITs and commodities. We can further subdivide those broad categories and we can also employ any number of asset allocation strategies to manage the mix through time. That includes leaving out one or more asset classes, holding some cash, selecting individual securities and venturing into the shadowy realm of alternative betas.
How should we begin? We can start by considering a government bond. The benchmark 10-year Treasury Note offered a 3.72% yield as of yesterday. That’s a good place to launch our analysis because we have a high degree of confidence—a virtual certainty, in fact—that we’ll receive a 3.72% total return from a 10-year Note if we buy and hold till maturity. Deciding if the rate du jour will suffice depends on various factors, starting with a strong estimate of one’s future liabilities.

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There are many ways to model expected returns. Unfortunately, not one is even close to being foolproof, which inspires looking at multiple measures of market activity. That includes monitoring relative returns through time among the major asset classes, one of several analytical tools employed in the search for strategic perspective in each issue of The Beta Investment Report.
As a basic example, consider the chart below, which graphs differences in rolling 3-year annualized total returns between U.S. stocks (Russell 3000) and U.S. bonds (Barclays Aggregate), foreign stocks (MSCI EAFE) and REITs (Wilshire REITs). For instance, for the three years through the end of June 2009, the Russell 3000 suffers an annualized 8.3% loss vs. a gain of 6.4% for the Barclays U.S. Aggregate Bond Index. The result is that equities are under water by nearly 15 percentage points relative to bonds (red line). By comparison, stocks have bested REITs over the past three years, with a positive spread of more than 11 points (green line). Domestic vs. foreign stocks, meanwhile, are generally neck and neck as of the past three years through last month (black line).

What’s the point of looking at returns in this fashion? It offers some perspective on return on a relative basis. No, it’s not a silver bullet, nor does it offer a quick road to easy money. It is, however, valuable when considered in context with other variables.

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The ascent in the yield on the 10-year Treasury Note during this past spring took a breather after rising to nearly 4.0% by mid-June. That prompted some to claim that the underlying source for the rise—worries about future inflation—were overbaked.
Perhaps, but we beg to differ, and have for some time. Even when the crisis of last fall was exploding with all its ignominious power, we were of a mind to expect a return of inflation at some point. The CPI report last week suggests that such expectations are still valid.
To be sure, the risk an imminent surge in inflation to lofty levels still looks low. Although deflationary forces are fading, the blowback from the financial crisis and the lingering effects of the current recession will reverberate for some time and so pricing pressures are still muted. Nonetheless, it’s always been clear that the Federal Reserve’s primary goal was to return the system to an inflationary bias. A mild one, if possible, but inflationary just the same. We never doubted the Fed’s capacity for success on that front, and neither it seems does the bond market. The question is whether the central bank can let the genie out of the bottle just a little?

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It’s been a long-time coming, but my upcoming book—Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor (Bloomberg Press) is now available for pre ordering on Amazon.com. The scheduled release date is February 2010.
We’ll be discussing the book in more detail in the coming weeks and months. Meanwhile, for more information about purchasing a copy, click on the link below…

We’ve been there before only to end up disappointed. Could this time be different?
One day the recession will end and we’ll put a floor on the economy’s deterioration. Are we there yet? This week offered several reasons to cautiously answer “yes,” or perhaps it’s better to say “maybe.”
Today’s news certainly offers one more reason to think that stability may be returning. Both new housing starts and new building permits issued rose again last month, the U.S. Census Bureau reports today. For the second month running, both series scored respectable gains.

Save for Wednesday’s news that industrial production continues to slide, this was a modestly good week for dispensing numbers in favor of the idea that a trough in the business cycle may be near if it hasn’t already arrived.

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Another update on new filings for jobless claims, another reason to keep the faith.
The Labor Department reports today that initial jobless claims fell 47,000 for the week through July 11 to 522,000, the lowest since early January. The decline is all the more encouraging because it suggests that the hefty fall for the holiday week through July 4 wasn’t a fluke.

We’ve been writing since March that jobless claims have a long history of peaking just ahead of or concurrently with the end of recessions (for some background, see here and here). But we’ve also been careful to note that this time may be a bit different in terms of what it implies for the period ahead.

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