Asset allocation has regained its rightful place as the only game in town for strategic-minded investors, as January’s tally of performance among the major asset classes reminds.

The range of returns was a robust 14.1 percentage points last month among the major asset classes. On top: foreign developed market bonds, which posted a 5.2% total return in January, by way of our proxy, the PIMCO Foreign Bond (Unhedged) D mutual fund. At the bottom was emerging market stocks, which shed 8.9%, as per iShares MSCI Emerging Markets ETF.
Long gone are the days when everything went up, which meant that the stakes tied to asset allocation and rebalancing were minimal. In 2008, the reverse is true and rising volatility and falling correlations among the major asset classes are the reasons. We expect no less going forward.
As the economic cycle turns, risk is reassessed and repriced on a case-by-case basis. Investors will become increasingly selective in weighing the potential outlook of bonds vs. stocks, domestic vs. foreign, commodities vs. equities, and so on. Such discriminating behavior fell on hard times during 2002-2007. But the fog is thicker than usual for gazing into the future, and investors are becoming more discerning.

It’s too soon to say if the bond market will stay on board with the Fed’s new world order. From 10 miles up, however, all looks fine, as our chart below suggests. Rates and spreads have both dropped considerably, delivering an upward sloping yield curve along the way. Mr. Bernanke’s big adventure, in short, appears to be on track.

After yesterday’s cut, Fed funds are now at 3.0%, well below the benchmark 10-year Treasury’s 3.78%, as of last night’s close. The decline and fall of the 10-year yield has been fairly steep and swift. Indeed, the yield at one point last June reached as high as 5.23%. After a subsequent loss of nearly 150 basis points, it’s safe to say that a lot’s changed.
Surely no one can misread the central bank’s new strategy of reflating. That may or may not be the ideal prescription, but a hefty dosage is comine just the same. The rate on Fed funds rarely crumbles this far this quickly. And it’s not clear that we’re done. The May ’08 Fed funds futures contract is priced in anticipation of another 50-basis-point cut, which would bring us down to 2.5%.
So far, the bond market has been happy to tag along with the prevailing monetary winds. This is no small point. One can only imagine the chaos that might erupt if the Fed’s aggressive cutting was scaring the heck out of bond investors. In fact, just the opposite has been the norm. One example of the bond market’s vote of support can be seen in the 2.8% rise in the iShares Lehman 7-10 Year Treasury ETF (IEF) this month alone. Since last June, this ETF is up about nearly 15%, which, of course, is an extraordinary run for what’s essentially a risk-free asset if–a big if–in a world where inflation is largely mute.

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Today’s first guess at fourth-quarter GDP revealed what everyone already knew: the economy slowed sharply in the last three months of 2007 to a 0.6% annual pace in real (inflation-adjusted) terms, the Bureau of Economic Analysis reported. That’s a world or two below the third quarter’s 4.9% surge.
What’s the source of the downshift? Real estate–residential real estate, to be precise, as the table below shows. Spending on construction of new houses, apartment buildings and all the associated products and services took another hit in the fourth quarter, tumbling nearly 24%. Even worse, that follows a 20.5% tumble in the third quarter. In fact, you have to go back to the fourth quarter of 2005 to find a positive number in the residential real estate investment column in GDP reports. Since then, the sector’s been mired in red for each and every quarter and the toll has grown on the overall economy. The only difference this time: the 23.9% slump in housing investment in last year’s fourth quarter is the deepest yet for this cycle, and the mounting pressure is obvious via the weak economic growth generally.

The good news is that the pain is still largely contained to real estate, at least it was in the fourth quarter. That may or may not continue this year, but as we write consumer spending, while slower in 2007’s last three months relative to the previous quarter, still appears to be rising. Alas, the 2.0% rise in consumer spending is unimpressive relative to the past few years, but beggars can’t be choosy. With that in mind, we note that Joe Sixpack’s spending pace comfortably exceeded the economy’s growth rate as of late last year. Perhaps we should all be thankful for small (and increasingly precarious?) favors.

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The economic report du jour can be dramatic, it may spawn a sea of commentary and it may move markets. The latest numerical update sometimes reflects the larger trend in the data series, too. But one has to remember that statistical noise all too often clouds the true story.
That’s worth considering in the wake of today’s encouraging report on durable goods orders. We can’t say for sure if the data’s pulling a fast one on investors today or if the upturn is the real deal. For that matter, we can’t ever be sure until the passage of time delivers its always flawless dose of clarity. So, what’s a strategic-minded investor to do? Waiting a year isn’t practical, but neither is rushing to judgment based on the last number to hit the Street. The middle ground is taking a longer term view of the cycle in the here and now. True, the future is still unclear regardless, but at the very least it pays to have solid insight about where we’ve been and how the latest report fits in with the trend as it’s unfolded so far.
With that in mind we offer the following chart, which graphs the 12-month rolling percentage change in new orders for manufactured durable goods right up through today’s December 2007 update. First, take note that new durable goods orders last month posted a strong 5.2% rise from the previous month. In fact, December’s jump was the highest since July. In addition, a monthly gain north of 5% is fairly rare, occurring only 10% of the time over the past 10 years. Clearly, one shouldn’t undervalue the potential significance in last month’s report. In addition, December’s gain marks the second straight monthly gain in new durable goods orders, which is considered a gauge of future economic activity.

But the bullish aura described above is tempered when you put last month’s gain in broader context with durable goods orders over the years. As the above chart reminds, the strength in December’s report doesn’t reverse the overall trend of the past two years, which is unmistakably down. Smoothing the volatile durable goods orders reports by comparing annual changes over time reveals a slowdown that appears to have momentum. The good news is that the slide remains mild, so far, compared to the previous slump in 2000 and 2001, when new orders for durable goods routinely shrunk by 5% to 20% on an annual basis.

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Sometimes it’s best to let the numbers do the talking. Without further adieu, we offer the following statistical recap on the 10-year Treasury yield, its counterpart in the 10-year real yield a.k.a. TIPS, and the spread between the two.

As always, minds will differ as to the implications of the above chart, and so what follows is your editor’s view, which may or may not be relevant for the foreseeable future. That caveat aside, consider the persistent decline in 10-year yields in both nominal and real measures since last July. On this point, at least, all can agree: the bond market’s become increasingly giddy, bidding up the price of government debt, which, of course, results in pushing yields down.
The 10-year Treasury’s nominal yield was comfortably north of 5.0% midway in 2007; at last night’s close it was 3.68%.
For the 10-year TIPS, a similar story has been unfolding, albeit at lower rates, which is typical for real relative to nominal. Back in June 2007, the 10-year TIPS yield was as high as 2.83% at one point; now it’s 1.44%.
Meanwhile, consider the spread between yields on nominal Treasuries and TIPs, a gap that’s considered a measure (albeit not the only one or necessarily an infallible one) of Mr. Market’s inflation outlook. As such, the two Treasury markets are priced in anticipation of inflation of 2.24%, defined as the current 10-year yield (3.68%) less the current 10-year TIPS yield (1.44%). Oh, and by the way, the spread has remained fairly constant for the past six months or so, as the chart above reminds. The implication: the inflation outlook hasn’t change much, if at all since last summer.
Ah, but here’s where it gets interesting, or frightening, depending on your perspective. The latest Consumer Price Index numbers, which are widely accepted (tolerated?) as the U.S. inflation rate reveals prices rising by 4.1% for 2007. That’s far above the 2.24% inflation rate implied by the spread in nominal and real Treasury yields.

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No one knows if the Fed’s aggressive 75-basis-point cut in interest rates yesterday will soothe the markets and stabilize the economy. But slicing the price of money so deeply in one fell swoop rearranges risk, creating new opportunities and new pitfalls in the process.
Let’s start with the suspicion that the central bank’s latest easing was motivated by the tumble in stock markets around the world. The case looks fairly compelling. With only a week before the regularly scheduled FOMC meeting, when a rate cut was widely expected, the Fed lowered its key Fed funds rate early and deeply. Was the move solely about shoring up a weakening economy? Partly, although there’s more to the story. Otherwise, why didn’t the Fed cut last week? Was there some new economic news moving to Fed to action? No, but stocks around the world were collapsing and so the central bank decided to minimize the damage yesterday, the first day of U.S. trading since Friday.
No central bank can afford to ignore the signals emanating from financial markets. But there’s a fine line between ignoring and pandering. Only history will decide if the Fed is deploying monetary policy judiciously in pursuit of balancing its dual mandate of maximizing economic growth and minimizing inflation. Meantime, it’s hard to shake the suspicion that the Fed’s reacting to Wall Street rather than Main Street. Correct or not, the central bank can’t afford to let such a perception take root without creating a bull market in expectations that the Fed ultimately can’t satisfy.
Ill-conceived or not, the Fed cut is reality, and when you slash rates that much that fast the action reorders risk. One example is REITs, which popped yesterday amid falling stock prices. The Vanguard REIT Index ETF (VNQ) on Tuesday jumped 2.3%. Not bad on a day when U.S. stocks fell more than 1%. Why were REITs a safe harbor yesterday? Some of it has to do with the fact that real estate securities have been declining for some time. Perhaps more important is that the relatively rich yields in REITs suddenly look that much more alluring in the wake of a massive rate cut.

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Panic, fear, and an emergency 75-basis-point cut in the Fed funds rate. Yes, dear readers, it’s time to start nibbling at asset classes that have fallen on hard times.
But let’s not go crazy. We’re not in the business of calling market bottoms, or tops. Nobody knows how long the selling will last. It could be over tomorrow, unless a protracted bear market extends the pain for months or years.
This much, at least, looks clear: strategic-minded investors with long horizons should be taking advantage of the selling. Timing, of course, will be critical. Alas, there’s no definitive bell-ringing ceremony at the bottom of bear markets. Clarity only arrives with hindsight. Nonetheless, waiting for clarity is sure to come with an opportunity cost. Once it’s obvious that the trough is past, market’s may have already bounced higher.
Overall, the risk of waiting too long to exploit a cyclical repricing of securities is balanced by the risk of pulling the trigger too early. In a perfect world, investors would buy at the bottom and sell at the top. In the universe we all inhabit, however, imprecision rules and so returns suffer relative to the ideal, albeit in varying degrees depending on the investor.
Despite the risk of buying too early or too late, few can afford to stand still and watch the world pass by. Lower prices equate with higher prospective returns. And so, after five straight years of bull markets in just about everything, the cycle has turned, risk has been reshuffled and a new deck of prospective returns has been dealt. We don’t pretend to have the answer as to when it’s time to buy. On the other hand, we’re reasonably sure that the year ahead will offer compelling opportunities for rebalancing among the major asset classes. The source of this new opportunity: the churning of economic and financial risk.

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Lately, we’ve been thinking a lot about alpha, a.k.a. investing talent. That includes the ever popular question: How much alpha’s available? The standard answer is that alpha’s limited, meaning that for every investor who beats a benchmark, the win must be offset with someone who trails the index. Alpha, in other words, is a zero sum game. That’s a widely accepted view, although much depends on how you define your terms, as discussed in a pair of articles penned by this reporter in the January issue of Wealth Manager.

The Federal Reserve doesn’t need another excuse to cut interest rates, but the economic report du jour brought a fresh reason anyway.
New housing starts continued tumbling last month, the Census Bureau advised this morning. Privately-owned housing starts fell 14% in December to levels last seen in 1991. Building permits crumbled again last month, too. Since permits are considered a measure of future activity, the ongoing slide here casts a pall over the outlook for housing.

“These figures confirm that the housing recession continues to deepen,” Mike Larson, a real estate analyst for Weiss Research, told CNNMoney.com. “Slumping consumer confidence and tighter lending standards have already taken their toll on demand, and the broader economic slowdown we’re starting to see unfold now threatens to make a bad situation worse.”

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The Bernanke Fed caught a break this morning.
The December report on consumer prices shows that inflation returned to something approximating a manageable level. After November’s eye-popping 0.8% surge in CPI, December’s 0.3% looks like a gift, and a timely one. No, inflation hasn’t evaporated as a clear and present danger, but pricing pressures retreated enough in December to give the central bank a green light to drop interest rates by 50 basis points at the end of the month, when the FOMC meets.
The market expects no less. As we write, the February ’08 Fed funds contract is priced in anticipation of a 50-basis-point cut.
It’s clear that the economy’s slowing and may even be contracting. By that standard, slashing interest rates looks sensible. And thanks to this morning’s CPI report, inflation doesn’t appear to be an imminent threat, giving the Fed a clear path for firing up the printing presses at a higher rate in the hope that such action will head off a recession, or at least dull the economic pain.

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