Buying Mr. Market in all his various asset class flavors is easy these days, thanks to the proliferation of ETFs and mutual funds that mine all the major (and increasingly minor) niches in the capital and commodity markets. But what is Mr. Market offering exactly? And what does his track record look like?
That’s a crucial question for strategic-minded investors, if only to catch a glimpse of the true global market benchmark, which by definition is diversification in full. Alas, there’s no off-the-shelf index for the global portfolio, at least none that we’ve come across. The vacuum inspired your editor to put one together, and so today we unveil the Capital Spectator Global Market Portfolio Index (GMP), which is an approximation of the global capital and commodity markets and weighted as per Mr. Market’s valuation. We’ll be using the index in future posts to compare and contrast various trends in the financial markets.
The methodology behind the benchmark in discussed in some detail below, but first let’s address the obvious question: how has GMP performed? The quick answer is in the chart below, which shows the relative total return performance of GMP against the S&P 500. As you can see, GMP handily beat the S&P 500, from the end of 2001 through March 31, 2008.
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Looking at the trailing performance numbers, the GMP index generated a 13.4% annualized total return for the five years through the end of last month vs. 11.3% for the S&P 500. In addition to outrunning the S&P, the GMP index did so at about three-quarters of the S&P’s volatility over those five years (measured by annualized standard deviation of monthly total returns). The practical evidence of this smoother ride is evident in recent history. From the S&P’s peak back in October 2007, the stock market suffered a -13.8% tumble through the end of last month, vs. a mild -3.2% loss for GMP.

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Alternative investing is hot. But you already knew that. Assets under management in hedge funds, private equity, venture capital and other formerly obscure realms have been exploding for the better part of a decade now. Slightly less obvious in the financial universe is the trend’s influence on the conventional money management business. For several years now, more and more investment shops are offering something a bit different, which generally means indulging in portfolio engineering of one kind or another. One quick measure of the trend can be found in the growing list of mutual funds and ETFs for which the underlying strategy can’t be described in 10 seconds or less.

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Another day, another symptom of recession to digest.
Today’s statistical confirmation is brought to you by the monthly change in nonfarm payrolls, which lost ground in March, reports the U.S. Labor Department. Meanwhile, unemployment popped up to 5.1% last month from 4.8% previous, pushing the jobless rate to its highest since May 2005.
The loss of 80,000 jobs last month was only slightly worse than the 76,000 slippage the month before. More troubling is the fact that the economy has suffered job destruction for three months running, a stretch of red ink that hasn’t occurred in this data series since 2003. As economic signals go, the triple-month slip is quite robust. Any one month is subject to revisions, of course, but the general trend can’t be denied for such a crucial economic indicator as payroll changes.
“Strong relationships exist between the employment data and virtually every other economic indicator,” advises Richard Yamarone, director of economic research at Argus Research, in his book The Trader’s Guide to Key Economic Indicators. “The growth rate of nonfarm payrolls, for instance, is strongly correlated with the growth rate of GDP, industrial production and capacity utilization, consumer confidence, spending, income–even with Federal Reserve activity. If it’s relevant to economic activity, it will have links with the payrolls data.”
Alas, as you can see from our chart below, the trend in nonfarm employment has turned decisively down. Meanwhile, today’s news only corroborates the negative signal in yesterday’s update on weekly jobless claims,
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It’s easy to jump to conclusions and assume that the Fed will now cut interest rates again in the wake of the employment picture. Perhaps, but it’s not yet obvious in Fed funds futures prices. The Fed funds rate currently stands at 2.25%, down from 3.0% previously after a hefty cut at the March 18 FOMC meeting. The next scheduled confab is April 29 and 30. Judging by the futures market, however, the jury’s still out on whether another cut is imminent, suggesting that the central bank has already dispensed its monetary medicine for this cycle.
Indeed, if the current downturn proves to be short and shallow, one could argue that the Fed’s pre-emptive liquidity injections will suffice. All the more so if one is worried (as is your editor) about the inflation outlook. Of course, all bets are off if upcoming economic reports show a worse-than-expected economic contraction is unfolding. Unfortunately, it’ll be a month or two at least before the downturn’s true nature will begin to emerge. The future is as cloudy as ever no matter where we are in the cycle. Worrying and nail-biting, of course, roll on with full transparency in real time.

No one should be surprised by this morning’s discouraging news on weekly jobless claims, which surged to 407,000 last week–the highest since the anomalous but temporary spike in September 2005 directly after Hurricane Katrina. The warning signs have been bubbling for months, as CS and others have pointed out. And so, this time, the rise in new filings for unemployment insurance is a reflection of a weak economy rather than a one-time weather event. In short, there will be no sudden and sharp drop in new claims this time, as there was in 2005.
As our chart below reminds, the rise in jobless claims has been unfolding since late last year. The message in the graph is clearly that the tide has shifted in no uncertain terms. No one can say that jobless claims are still in a range that reflects a healthy economy. Those days are over. The front line of optimism now turns to looking for light at the end of the tunnel. As we discussed last Friday, the recession is here and the debate necessarily moves to the questions: how long, how deep?
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Fed Chairman Bernanke set the official tone yesterday, when he said “recession is possible” in testimony on Capitol Hill. By this editor’s reckoning, Bernanke was being charitable. As the above chart suggests, the odds of sidestepping economic contraction look virtually nil. Yes, anything’s possible. But if we look at a broad range of economic indicators in addition to today’s jobless claims report, it’s hard to miss the obvious trend.
It’ll take time to get a handle on how short and shallow (or long and deep) the recession will be. Given the lag in economic data, the coming weeks and months are likely to provide ongoing confirmation of what’s already obvious. As a result, the focus turns to the various leading economic indicators for clues about where the cyclical trough lies and what will spark an eventual upturn. But let’s not strain our eyes at this point; it’s too early for that. For the moment, patience and prudence, along with a modest dose of opportunistic buying sprees here and there are still a strategic-minded investor’s best friends.

It comes as no surprise to learn that volatility in the capital and commodity markets has been rising of late. Confusion and uncertainty (both of which have been in surplus in recent months with regards to economics and finance) typically sow the seeds of wider trading ranges. Monitoring volatility is no short cut to easy profits, of course, but as we’ve discussed from time to time, the ebb and flow of volatility sometimes offers strategic-minded investors some valuable clues about investment cycles.
With that in mind, below we present a freshly updated chart of rolling 36-month volatility over time for several major asset classes, with data through March 31, 2008. Consider that volatility looked unusually low in ’06 and ’07, which we now know was a prelude to a reversal. Note too that trailing returns back in ’06 and the first half of ’07 looked exceptionally strong across the major asset classes. The two trends looked long in the tooth, suggesting that the cycle was poised to turn. And turn it did. But now that it’s turned, what’s next?
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That’s always a relevant question and it’s forever unclear in real time. To the extent that strategic-minded investors can generate informed guesses about the future, tracking volatility cycles is one among many factors to survey on a regular basis. For the moment, there are no obvious signals springing from volatility, at least nothing comparable to the signs of ’06 and ’07. As such, volatility remains one more metric we watch and will continue watching, always in context with other factors, starting with valuation.
Meantime, volatility has been rising and returns have been falling. But that too will end…at some point. Cycles, in short, remain very much alive and kicking.

Whipsawed is the best way to describe recent action in the major asset classes. What was down is up; what was up is down.
Consider the horse race for March, as per our table below. Commodities were the bottom performer, posting a total return loss of -6.5%. A month earlier, commodities were the leading asset class, posting a 12.2% gain in February. Meanwhile, REITs were the big winner in March, completely reversing their last-place status the month before.

In fact, what little postive-return consistency there was in February and March among the major asset classes was concentrated in cash and foreign bonds.
The back and forth is hardly surprising. The unfolding drama in finance and the wider economy leaves investors jumpy as they ponder where the next shoe will drop. We’re already up to our necks in fallen footwear and few pundits (including this one) are prepared to say it’s over.
Yesterday was a perfect example. It’s not every day that the U.S. Treasury Secretary gives press conferences outlining ambitious proposals for overhauling financial regulation in the U.S. and dramatically expanding the powers of the Federal Reserve. Yes, the plan may be dead on arrival in Congress, as has been widely reported. But it’s clear that the turmoil on Wall Street continues to reverberate throughout the wider economy and the government.
Meantime, large financial institutions keep announcing the price tag of previously believing that bull markets last forever. The Swiss banking giant UBS announced yesterday that its first-quarter loss would top $12 billion, thanks largely to mounting troubles from the subprime mess.
If investors are skittish in such an atmosphere of uncertainty, no one should be shocked. Strategic-minded investors, however, should be looking to take advantage of the volatility when opportunity arises. For equities in particular, there’s a recession premium associated with buying when the crowd wants cash. The catch: the recession premium probably won’t pay off for years and the only way to boost the odds of success are buying at lower prices and extending one’s investment horizon.
These are extraordinary times and markets are likely to be whipsawed for the foreseeable future, interrupted by periods of calm that give way to a fresh round of drama. Once the economic outlook stabilizes will something approaching a more normal state return to the risk/reward profile of the major asset classes. But for the moment, ours is a fluid period. As Wall Street and Main Street grapple with the prospect of recession, prices will be volatile. So it goes when uncertainty comes in larger-than-usual doses.

It’s been tempting to think that maybe, just maybe, the U.S. could avoid recession. Perhaps some divine financial power might intervene and pull the economic coals out of the fire. But such hope, however remote in the first place, should now be packaged away in the file cabinet that holds all forlorn desires.
The recession, by our reading, is confirmed. That will come as old news to readers of these digital pages and anyone else who follows the economic news. Any number of warning signs have been flashing for months, some of which we’ve discussed. Economic models, by contrast, often dispense robust signals with lags. That’s in part due to the fact that economic data is released with a lag. In addition, economic measurements that digest multiple data series are prone to false signals and a fair amount of volatility in the short term. The practical solution is to be patient and wait for a relatively high degree of confidence that the model’s warning is more than statistical noise. As such, our own home-grown index has just issued what we think is a valid signal after we updated the last bit of selected February data (personal spending and income). Yes, we’ve suspected contraction all along, but now we’re that much more confident.
Granted, absolute clarity in the dismal science is forever elusive–except in hindsight, when all the data’s been revised and economists have scrubbed and rescrubbed the numbers so that the only remaining debate centers on what size font to use for writing the definitive history. That day is still a ways off. Meanwhile, back here in real-time economics, replete with all the usual caveats, the cake looks pretty much baked by this editor’s reckoning. It’s now time to move on and debate, among other things, how long the recession will last, how deep it will be and what it all means for strategic-minded portfolio design.

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The Fed’s current monetary policy looks reckless only for those who see inflation bubbling. The same monetary policy looks prudent, even prophetic for those who see deflation as the dominant risk.
Our bias, for what it’s worth, leans toward inflation, as our posts over time suggest, such as this one. And we’re not alone. That doesn’t make us right, and to the extent that the crowd’s on board with this idea gives us pause. Nonetheless, from what we can tell, inflation risk looks to be the bigger threat, although that view is contingent on a future of a fairly orderly downturn in the business cycle followed by a somewhat routine recovery in a timely manner.
As for the belief that the crowd’s thinking inflation: one clue is found in the rush into inflation-linked Treasuries. The iShares Lehman TIPS, for example, posts a 12.9% total return for the year through last night’s close, according to Morningstar.com. That’s far above the 7.6% total return for nominal bonds overall during that span, as per the iShares Lehman Aggregate Bond. Another sign that inflation expectations have deep roots: the bull market in commodities prices. The iPath Dow Jones-AIG Commodity ETN, for instance, boasts a total return of more than 25% for the past year.
One can surmise that inflation fears have the market’s attention, but it would be wrong to say that alternative views are absent or even misplaced. Indeed, some believe that deflation risk is relatively high and rising. Leading this charge is the deflation master-in-chief: Fed Chairman Ben Bernanke.
It certainly helps seeing Bernanke’s aggressive easing strategy in a prudent light if deflation is a real danger in the foreseeable future. If so, dropping interest rates quickly and dramatically looks like a reasonable strategy for minimizing the potency of the approaching deflationary forces.
Then again, if inflation is the bigger threat, Bernanke’s current game plan looks rash if not irresponsible.
Alas, no one knows what’s coming and so we’re all–central bankers included–reduced to guessing, a.k.a. forecasting, predicting, etc. Some guesses are better than others, perhaps because some guesses are better informed than others. Still, in real time it’s hard to tell one from the other absent the passage of time.

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Risk comes in two basic flavors in the realm of finance: the expected and the unexpected. There’s no obvious fix for the latter, other than remembering that a black swan can fly into your financial life without warning. That implies some basic preparation, like keeping a stash of cash. Expected risks, in theory, may be easier to grapple with. Single-security risk, for instance, is easily minimized with diversification. But other expected risks can be more problematic, as we’re reminded in a new paper that surveys financial crises over the centuries. Indeed, a recurring risk can be a tricky adversary if its reappearance schedule unfurls in s-l-o-w motion, in which case it’s easy to dismiss/ignore the threat potential as nonexistent.
“Major default episodes are typically spaced some years (or decades) apart, creating an illusion that ‘this time is different’ among policymakers and investors,” advises “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises,” a working paper by professors Carmen Reinhart (University of Maryland) and Ken Rogoff (Harvard).
The central message: the relative macroeconomic calm of the past generation isn’t necessarily written in stone. It’s easy to think otherwise, of course. So it goes for cycles that unfold over long stretches. Lulling otherwise prudent investors into a false sense of security is as old as markets, and so it should surprise no one that many look to the recent past and extrapolate that as fact for the future.
Readers of these digital pages know that your editor has a warm spot for studying cycles and looking for the historical perspective, such as our post back in 2006 that considered a research paper looking at the history of 20th century economic booms. Perspective is a valuable thing, or so we believe. But it can be akin to watching grass grow if you’re wondering what to do now, this minute. No, historical perspective won’t help much for day trading, but maybe, just maybe, the long view promotes a healthy respect for risk. And that respect may one day save your financial life.

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It’s probably too early to call a bottom in global equity markets, but the thought is tempting after looking at the past week and discovering that we’re still standing. Survival is always a confidence builder.
Still, this is no time to be a roaring bull, although some degree of optimism may be just the ticket.We’re oriented toward a contrary approach to portfolio strategy generally speaking, but that’s tempered by a healthy respect for risk and reward. And there’s still a lot of risk lurking in the global economy, and a fair amount of that continues bubbling within the U.S. In short, we still think the remainder of 2008 will be a challenging year on a number of fronts. That leads us to favor oppotunistic nibbling in asset classes where the margin of safety is relatively higher than, say, a year ago.
That said, it’s tempting to think that the point of maximum stress for the capital markets has come and gone this week. The Bear Stearns implosion a few days back promises to be the poster child for the current correction, much as Long Term Capital Management and Enron were for past purges.
Of course, there’s no way to say for sure if even greater hazards await. A number of economists we chat with regularly say that there’s still a risk that the current troubles in the U.S. could linger longer and cut deeper than the crowd expects. We’re told that the hangover from a generational accumulation of debt on the consumer level is one potential trouble spot for the years ahead.

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