The first rule in the money game is recognizing that there are no silver bullets. Asset pricing is a black box. It’s become somewhat less of a black box after a half century of analysis by financial economists, but what we don’t know about how markets work still dominates by far.
Much of what we do know has come from reverse-engineering the system’s output. We can see prices and we can measure their fluctuations and linkages in countless ways. The trouble is that the financial gods forgot to give us the code that produces the output. That leaves us with the thankless ask of predicting returns indirectly. But even then we’re working with imperfect information. Ours is a world of ex post data. We know the past, but that’s a poor window into the future. We have the output but we’re forever debating the input. As a result, the link between ex post and ex ante data is shaky. That doesn’t mean we should ignore the historical record, but it should only be one of several layers of analysis for developing capital market assumptions.
Much of what we discuss on the pages of The Beta Investment Report is focused on developing equilibrium risk premiums and then integrating those long-range forecasts with our near-term outlook. To the extent there’s a divergence of some magnitude, and we’re reasonably confident in our assumptions, we have some basis for adjusting the asset allocation for the market portfolio, which we define broadly, as per finance theory. A global value-weighted mix of stocks, bonds, commodities and REITs is a reasonable definition, a.k.a. our proprietary Global Market Index.
Author Archives: James Picerno
THE RETURN OF MIXED RESULTS
A month ago, we surveyed the latest numbers for the major asset classes and wondered how long everything could continue rising. A month later, we have our answer. As our table below shows, divergence has returned to the world’s capital and commodity markets.
The switch to a wider array of results was inevitable. As we’ve been discussing for some time, the great snap-back period of 2009 was destined to be a temporary fling. When it became clear earlier this year that the world would not end, assets were repriced accordingly. But the first hint that something other than uniformity will prevail in performance trends arrived in October’s tally of asset class results.
POST-GDP WAKE-UP CALL
Today’s income and spending report for September takes the shine off of yesterday’s glowing GDP news. A closer look at what unfolded in the third quarter has now arrived in terms of the impact on consumer sentiment and the ongoing pain from the labor market. The upward momentum that was all the rage in August, which provided potent aid in the bullish Q3 GDP trend, took a turn for the worse in last month of the quarter. The fear is that the negative sentiment will roll on into the final months of the year.
The government today reports that real disposable personal income retreated by 0.1% last month and personal consumption expenditures tumbled 0.6%. We noted yesterday that the Q3 GDP report, encouraging though it is, would be succeeded by a war for growth and today’s numbers only bolster the forecast.
On the income side, we can sum up the challenge with the news that government payments were the only positive contribution to employee compensation in September. No wonder, then, that spending momentum is fading as the government’s stimulus efforts recede. Consumer spending isn’t necessarily headed for a persistent decline, but neither can we assume that it’s set to regain territory lost over the past year.
Q3 GDP IS UP, BUT THE WAR FOR GROWTH HAS ONLY JUST BEGUN
It’s official: the U.S. economy expanded by 3.5% in the third quarter, the Bureau of Economic Analysis reports today. Encouraging as that is, it’s neither a surprise nor anything near to closure for the financial and economic hurricane of the last year or so. But it is a step in the right direct, albeit a tentative and not-yet fully confirming step that the walk ahead will be equally brisk.
Nonetheless, good news is worthy of celebration at this point, if only for a moment. After four straight quarters of retreat, a gain in GDP is no trivial change. All the more so when we dive into the numbers and learn that the expansion was broad based. All the major categories that factor into the final GDP calculation posted healthy gains in Q3. That is, personal consumption expenditures, gross private domestic investment, exports and government spending were higher during the three months through September. That compares with red ink on those ledgers in past quarters, save for government spending and a mild rise in consumer spending in Q1 2009.
THE CHALLENGE AHEAD
Today’s update on new orders for durable goods reminds that the slash-and-burn of the Great Recession is over, replaced by the tedious business of rebuilding what’s been lost.
Once again, the news is encouraging, if only because the deep pain of the recent past fades as an imminent threat. And so the crowd can look with somewhat less-anxious eyes to the 1.0% rise in new durable goods orders and find a measure of comfort. As our chart below shows, the orders are rising off the bottom that formed in the first half of this year. But as anyone can also see, the work of rebuilding what’s been lost has only just begun and climbing this hill will take time, in part because the recovery is susceptible to the usual hazards that loom in every post-crash period. True for durable goods, and for many other measures of economic activity.
But let’s revel in the good news, if only for a minute. That includes recognizing that orders rose at a healthy clip even after subtracting the standard noisemakers: transportation and defense. That tells us that the advance was broad based. And so it was, save for a few minor holdouts.
THE DATA DUMP FOR THE WEEK AHEAD
The next round of economic releases is about to commence, ushering in the next phase of the post-apocalyptic financial crisis. Although we’re likely to see a fresh batch of encouraging numbers, there’s plenty of reason to remain humble on expecting salvation is imminent for one simple reason: the labor market continues to bleed.
“While job losses will likely end early next year, robust job gains may still be several quarters away,” according to Christina Romer, the chair of President Obama’s Council of Economic Advisers, in testimony to Congress last week.
That’s a fairly stark assessment considering that it comes via the usual political spin that passes for debate in Washington. A cynic might argue that if the White House is preparing the nation for many more months of job destruction, the truth may be even harsher. Meantime, the next clue comes on November 6, with the monthly update on employment from the government.
A LITTLE CONTEXT GOES A LONG WAY
Twenty-first-century investing is all about predicting. But developing intuition about markets, asset classes and how they interact is too often overlooked if not ignored outright. That’s a mistake for strategic-minded investing, albeit a mistake that’s understandable in the crowd’s rush for quick and easy profits.
It’s hard to miss all the self-proclaimed seers running around espousing magic formulas and the three most-important investment gauges that insure big gains. Rarely do you hear of the dark side of these easy rules, such as the possibility that maybe, just possibly they’re byproducts of data snooping, survivorship bias and other gremlins that harass seemingly flawless assumptions.
It’s no surprise that limitations, blemishes and in some cases blatant fallacies are minimized/ignored in the three-minute talking-head interview or the personal finance column at your favorite financial publication. To be fair, some of this is simply an issue of time. Journalists and investment strategists can’t deliver a full accounting of prudent investing practices and concepts every time they opine on the subject du jour. As such, it’s easy to get a distorted view of investing by looking at any one post from, say, the CapitalSpectator.com and embracing it in isolation to my broader asset allocation analysis as outlined in my book and in my monthly newsletter.
MANAGING EXPECTATIONS
Yesterday’s news on housing starts wasn’t great, but neither was it bad. Perhaps we might label it a mildly positive yawn. More of the same is coming, we predict, in a range of economic indicators.
It’s fun to forecast extremes. It makes the headlines; people pay attention when you scream the world is coming to an end, or that the next great bull market will commence on Friday at 2:39 p.m. But projecting middling results rarely taps the zeitgeist du jour. Popular or not, that’s the future we see coming for some period in the U.S. Oh, sure, there will be volatility, surprises here and there, and even some mayhem in the economy and the capital markets at times. But for the most part, the future looks rather boring, at least compared with what’s passed over past 12 to 18 months.
THE FIRST STEP IS A GOOD PLACE TO START
Is the stock market overvalued? Wolfgang Münchau says it is in today’s FT. He cites some persuasive evidence, based on analysis by smart people: Professor Robert Shiller and Andrew Smithers. The U.S. stock market is overvalued by more than a third, we’re told.
Our own work suggests that caution looks increasingly prudent when it comes to risk exposures in asset allocation. But we’re not sure. To be precise, we’re not sure that a given quantitative profile of the market dispenses timely information about what returns will be in the immediate future. And neither does anyone else.
It’s tempting to thinking otherwise, but the future is always unclear. The good news is that the ambiguity oscillates with degrees of vagueness. But that alone isn’t enough. The challenge for investing is finding context and structure for managing asset allocation through thick and thin; through times when the future looks reasonably clear as well as during periods when the near term outlook for risk and return is murky.
The good news is that more than half a century of financial economics provides us with the tools and concepts for thinking clearly and productively about designing and managing asset allocation for the long haul, which arrives one day at a time. Different investors will come to different conclusions, but everyone should begin at a common point: the market portfolio.
INITIAL JOBLESS CLAIMS DIP AGAIN
The trend remains our friend in the land of initial jobless claims. The absolute level is still reflecting pain in the labor market, but there’s no denying that the general ebb and flow of new filings for unemployment benefits is favorable.
As our chart below shows, new filings dropped again last week, falling to a seasonally adjusted 514,000, below the previous week’s 524,000, the Labor Department reports. That puts the latest number at the lowest level since the week ended January 3, 2009.
Confirming the trend is the decline in continuing claims, which dropped below the six-million mark in the week through October 3 for the first time since March.