The biggest challenge in strategic-minded investing lies within. The high-yield bond market of late offers a telling example.
Trailing yields on junk bonds have soared recently, as our chart below shows. The risk premium on junk over 10-year Treasury Notes exploded skyward to close yesterday at nearly 15%. That’s the highest since the early 1990s and, one could argue, it looks enticing.

The human mind, meanwhile, is a complicated organ. What looks like far better values today relative to, say, June 12, 2007 isn’t necessarily obvious or compelling to homo economicus. We cite June 12 of last year because that was the trough for the junk/Treasury yield spread, as per Citigroup High Yield Index.
Not long after, we remained suspicious that the spread was sufficiently high to compensate for the risks ahead, as per our post in late summer 2007. As it turned out, we weren’t wary enough, not by a long shot. We did, however, say that even though the risk premium had risen to a bit over 4% in August 2007, “we’re not yet convinced that strategic opportunities are convincing in the highest-risk spectrum of assets.” In fact, we should have told everyone to run for the hills and put everything in cash. Hindsight, as always, tells us exactly what we should have done.
As it turned out, the crowd had other ideas, which is to say bullish ideas. Indeed, the late summer of 2007 was a strong period for the junk bond market. The iShares iBoxx $ High Yield Corporate Bond ETF (HYG), for instance, had a run higher in August and September of that year, reaching an all-time high of $104.70 on September 25, 2007. The ETF closed yesterday at $71.40.
Having been crushed, the high-yield bond market now offers its highest trailing yield in a generation. We’re guessing, but it seems as though there are few takers, if any. Yes, there’s reason to shun junk bonds, starting with the high odds that a painful and lengthy recession awaits. If so, defaults on junk will rise. Understandably, that scares off the bulls. And for all we know, staying scared may be the only logical decision at this point. An economy that takes a beating will treat the lower-grade tier of securities harshly, even after the harsh treatment to date.

Continue reading →

There are no short cuts to easy profits, but sometimes Mr. Market throws us a bone (or two) in our quest for strategic insight. Two examples, though hardly the only ones, come by way of reviewing correlation and volatility histories. We surveyed correlations last week, and today we revisit volatility, as per our chart below, which graphs rolling three-year volatilities of monthly total returns back to September 1994.

The obvious trend is that there is one, or so it appears. Lulls in vol tend to be followed by surges, and then lulls, and round and round we go. It’s all obvious in hindsight, of course, but dissecting where we are in real time and how long it will last (or not) is always more obscure.
Meanwhile, we’re constantly fighting our own biases. That’s partly because the mind likes to extrapolate recent activity far into the future. Back in the late-1990s, the calm in volatility readings was thought to be the dawn of a new era in smooth and high returns in stocks and other risky assets. Such thinking prevailed right up until the idea was beheaded in the crash of 2000-2002, a reversal of fortunes that was accompanied by a spike in vol.
Something similar unfolded during 2003-2007, when returns generally were strong and standard deviations were low. Once again, it was all too easy to believe that the trend would last. It didn’t, leading to a collapse in returns and a swelling in vol.
It’s always hazardous to speculate on when a current cycle will end and a new one will begin. Nonetheless, we can and should observe cycles for what they are: finite. The one that now has the world by the neck may appear set to roll on indefinitely, but that is an illusion. This too shall pass, although the timing, as always, is unclear.

Continue reading →

By now the routine is familiar–and increasingly painful. The government updates the state of the housing market and a bevy of negative numbers fly by. Today’s news on this front is, alas, more of the same, reminding that the primary source of the current economic and financial ills is still correcting and therefore throwing off bearish shock waves in all directions.
New housing starts dropped 6.3% in September from the previous month, the Census Bureau reports. That’s a lesser decline than August’s 8% drop, although as our chart below reminds that’s cold comfort given the persistent declines that have been battering this sector almost nonstop since early 2006.

It’s no better for new housing permits issued, and that casts a pall on the future. As our second graph below shows, this forward-looking measure remains under enormous strain too, virtually assuring that housing construction and related activity will continue to shrink for the foreseeable future. The 8.3% drop last month in new permits is steep and only slightly below August’s 8.5% tumble, suggesting that the negative momentum has still got its foot on the industry’s neck.

The best we can hope for at the moment is that a bottom in the housing market is near. Forget about a rebound–that’s probably a year or two off at the earliest. At this point a material slowdown if not an end to the bleeding is housing is priority one. It’s unclear what policies will bring that about other than to let the excess in the housing market unwind naturally. Suffice to say, government intervention with an eye on moderating the pain will be ongoing on several fronts, but getting some traction relief remains a trial-and-error effort still.

Continue reading →

As expected, inflation is now retreating in the face of financial turmoil and economic contraction.
Consumer prices were flat last month, following a 0.1% decline in August, the Labor Department reports. Of the eight major components of the consumer price index, three posted declines (housing, apparel and transportation prices) last month. Among those that posted increases, food and beverage prices led the way with a 0.6% rise. Core CPI (which excludes food and energy prices) rose 0.1%.
The data doesn’t yet confirm that inflation has faded from the economic landscape, but that future’s coming. CPI’s 12-month change dropped to 4.9% last month, down from 5.4% in August. It’s likely that the annual pace of consumer inflation will show further drops in the months to come, courtesy of the slowing economy that’s probably headed for contraction if it isn’t already shrinking.
Looking for lower inflation is hardly a dangerous forecast these days. Commodity prices have continued falling in October, with crude oil prices falling under $75 a barrel yesterday in New York futures trading for the first time in more than a year. A number of other key commodities are under selling pressure as well.
The big unwinding of the last five years is underway and it’ll roll on for a bit. It’s an across-the-board correction and it’s driven by fundamentals and fear. The U-turn doesn’t surprise us since there was a bull market in virtually everything for several years running. If one trend’s possible, so is the other. Cycles are as old as civilization, although it’s the degree of the rotation that’s so shocking this time, although the shock is directly related to our capacity for focusing primarily on the recent past and thinking that’s true perspective.

Continue reading →

This morning’s retail sales report will surprise no one who’s been watching the economy this year, but the trend is still disturbing.
Estimated monthly sales for retail and food services on a seasonally adjusted basis slumped 1.2% last month, the biggest monthly percentage decline in more than three years, the U.S. Census Bureau reports. On a 12-month basis, retail sales are 1% below the year-ago figures. As our chart below reminds, the trend looks ugly, and it’s virtually certain that there’s more of the same and worse on tap for the coming months.

Considering the U.S. economy’s high dependence on consumer spending (roughly 70% of GDP comes from personal consumption expenditures), today’s retail numbers speak loud and clear that the recession is here, and it probably has been for some weeks or month, and that the general economic downturn will deepen for the remainder of the year and quite possibly continue through early next year. Your editor was at a press conference with money managers in New York yesterday and one especially pessimistic chap talked of quarterly GDP falling by an annualized 5% at some point in this year’s second half. We’re not sure the pain will get that bad, but one can’t rule out much these days in light of all the negative surprises in recent weeks.

Continue reading →

Single-day rallies of 900 points or more in the Dow Jones Industrials tend to get our attention, in part because they’re the unicorn of market action: Often imagined but never seen. Well, we saw a unicorn yesterday.
In fact, we’ve seen a lot of things lately that just a few months ago were the stuff of dreams–or nightmares. No wonder, then, that this reporter is at risk of losing perspective amid all the chaos. But let’s try to sober up and reassess where we’re at in the economic cycle. Maybe, just maybe, we can cut through the extreme volatility and venture a guess as to what’s coming. It’s a long shot, but let’s go through the motions anyway.
We begin by speculating that all the government’s efforts at stabilizing the financial industry don’t really change the underlying economic conditions that brought us to this point. The government’s intervention was about stopping the bleeding and shoring up the system to avoid implosion. Perhaps it’s time to label that effort successful, although no one quite knows just yet. As for the real economy, the question mark is much bigger. Indeed, the financial crisis over the past year has only recently been making a mark on Main Street, and it’s our guess that the trend has quite a few more months to run, at the least.
We’re talking here of real estate bubbles and the associated fallout. It didn’t start overnight, nor will it end suddenly. No, we still can’t see the future any better today than yesterday or last year. Regardless, we’re not convinced that the cycle gods are done playing with mortals.
We could cite any number of economic numbers to support our still-cautious outlook, but we’ll start by looking at our proprietary measure of economic activity–CS Economic Index. As our chart below shows, momentum still looks biased to the downside, as it has been for some time. This is hardly news. Your editor has been pointing this out for some time now, along with many others observers of the economic scene. For quite a while, we were premature in calling for a material weakening of the general economy, as in this post from last March. So it goes in forecasting generally: you’re either early or late. A few lucky souls enjoy perfect timing, of course, but repeat performances by the same people are rare, and rest assured that yours truly isn’t likely to ever join that celebrated club.

As for the economy, the above chart strongly suggests that there’s more weakness coming. Economic weakness tends to beget more of the same. Until it stops. Even then, recovery may be preceded by lengthy stretches of treading water. Distinguishing one from the other is as much art as science, of course, and on that note it’s every forecaster for himself.

Continue reading →

The extreme in finance and economics is by definition rare, and that makes it valuable for study.
The crisis of late is no exception. It’s one thing to analyze markets when everything is running smoothly, but sunny days don’t offer much, if any insight about what to expect during hurricanes.
On the matter of diversification benefits, or lack thereof, one might wonder how the volatility and selling have impacted correlations among the major asset classes. With that in mind, we ran the numbers for trailing 36-month correlations through September 30, 2008, which delivers the chart below.

As usual, correlations are a mixed bag, at least as we calculate them. (Our definition of correlations here is based on the trailing 36 months of monthly total returns. In all cases above, the correlations are in relation to U.S. stocks, as defined by the Russell 3000. The assumption is that investors are looking for opportunities to diversify their equity holdings, which tends to be the dominant risk asset.)
Unsurprisingly, stocks the world over have moved in tighter lockstep recently. In financial panics, all equities look the same, which is to say that investors want now, today, this minute. No wonder, then, that correlations have gone up from already high levels between U.S. stocks (Russell 3000) and stocks in mature foreign markets (MSCI EAFE) and emerging markets (MSCI EM).

Continue reading →

It all looks so easy on paper, but in real time, using real money, making strategic investment choices is hard. Especially during a banking crisis that threatens the broader global economy.
Each January, we offer an historical chart of how the major asset classes fared on a calendar year basis, starting with the recently ended year and going back several years. Here’s what we published this past January–see table at end of post. Looking at this history leaves the impression that one can easily sidestep danger and favor the winners over time. In fact, looking at the past and managing portfolios in real time are equivalent only in the sense that both are focused on investing. But one and only one is immensely difficult, and the reason has as much to do with managing emotions as it does with informed financial analysis.
There are many ways to manage the various pieces of the global market portfolio. We can exclude certain pieces, load up in others or own everything, either in a passive market-value-based mix or by way of an alternative methodology, i.e., active management. But no matter how we manage our portfolios, we must make decisions, all the more so at extreme points in the cycle. At the very least, rebalancing the mix, according to some preplanned strategy, is critical. The exception is building a passively weighted portfolio that self adjusts, thereby remaining weighted as per Mr. Market’s portfolio and effectively putting the rebalancing on auto pilot. But even there, we must decide how much cash to hold, if any, in relation to owning the passively managed global portfolio and how that cash/risk portfolio mix should change over time.
The point is that decisions must be made at times. Invariably, some of those decisions will be wrong. But doing nothing solely because of fear, when reasoned analysis suggests action, is a mistake. A strategic mistake, and perhaps one that will forever haunt us.
Indeed, the only thing worse than watching one’s portfolio get crushed is doing nothing during or afterwards, once prices have dropped sharply. No, we don’t know where the bottom is, or when it will arrive. Our leap of faith is that a rebound will one day come. Could be on Monday, or several years from now. We simply don’t know, but we can’t risk assuming it’s never coming or that it’s so far off in the future that there’s nothing left to do but sit idly for years.

Continue reading →

If not the decade, depending on how all this plays out. In any case, Carl Weinberg, chief economist at High Frequency Economics, cuts through the fog and goes right to the heart of the challenge, in a quote from today’s New York Times:
“The core problem is that the smart people are realizing that the banking system is broken. Nobody knows who is holding the tainted assets, how much they have and how it affects their balance sheets. So nobody is willing to believe that anybody else isn’t insolvent, until it’s proven otherwise.”
And until there’s some reasonable degree of certainty as to where the bodies are buried–and not buried–the pain will go on. Here’s one naive idea for a step in the right direction: All banks and financial institutions publish a list of their holdings on their web sites so everything body can see who holds what. Yes, for some institutions this is going to be a complicated list. Accountants, bloggers and everyone else can then start weighing in. Some of the holdings are already widely known, of course, particuarly among publicly traded institutions. But there’s still a fair amount of mystery out there, and mystery is exactly what we don’t need at this point. More transparency–complete transparency is needed. Urgently needed. Granted, that’s just step one in a thousand mile journey, and it’s no silver bullet. But it would help. And it won’t cost $700 billion either.

The classic conundrum in strategic investing is that relative bargains in the stock market tend to arrive when buyers go on strike. There’s no mystery as to underlying cause, as current events remind.
Consider our chart below, which shows month-end trailing equity dividend yields for the major regions of the developed economies. The trend of late is clear: yields are rising, dramatically so in recent months. European yields lead the pack at 4.93% at last month’s close, based on S&P Global Equity Indices. The U.S., Asia Pacific and the developed world-ex-US are also posting substantially higher dividend yields compared to recent years. For reasons that need no explanation, however, investors are reluctant to avail themselves of these higher yields. For comparison, the yield on the benchmark 10-year Treasury Note closed out September 2008 at 3.85%.

Perhaps avoiding equities (broadly defined) with relatively high yields is prudent at the moment, perhaps not. Yield, after all, is but one component of total return for equities. The other key variables are capital gains and changes in valuation. All three are ultimately speculative in ex ante terms. But if today’s higher yields are unappealing, one might ask why the relatively skimpy yields of 2003-2007 deterred almost no one from owning equities? Was it that the outlook for capital gains were so bright that yields did not matter? If so, were expectations for capital gains reasonable or something less? Tackling such questions is as much a job for a psychologist as it is for a financial analyst. In any case, we’re better at asking questions than providing definitive answers, in part because we see the past so clearly and are forever fuzzy about what’s coming.
Rest assured that the true answers reduce down to the age-old explanation of fear and greed. The duo is always at work, of course, although at times one or the other dominates to the extent that the other is overlooked, dismissed if not left for dead. Until, that is, the cycle changes. The process, we’re sure, will endure, along with weather patterns and sunspots.
In short, dividend yields and other fundamental measures will remain in a constant state of flux, which implies (but doesn’t guarantee) that prospective returns vary through time as well.
That’s meaningless information if you’re looking to turn a quick buck over the next month or even year. But what about investors with time horizons of five years or more? The possibilities–maybe, perhaps–aren’t quite as dire as the headlines suggest.