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.
THE FOREST, THE TREES & ASSET ALLOCATION
Jason Zweig, one of the best financial journalists in the business, asks in his latest Wall Street Journal column: Can you make the risk of stocks go away just by owning them long enough?
This is a popular question and one that has been the focus of entire books, such as Jeremy Siegel’s Stocks for the Long Run. It’s also a useful question, but it’s important to recognize that it’s only one question for strategic-minded investors.
The reason, as Bob Litterman explained in Modern Investment Management, can be condensed to a single sentence: “The simplest and most practical insight from modern portfolio theory is that investors should avoid concentrated risk.”
ONE WAY OUT
Maybe it was Australia’s decision to hike rates last week, the first monetary tightening among the G20 nations since the financial crisis began. Or perhaps it’s just the recognition of economic fate. Whatever the catalyst, Fed chief Ben Bernanke is now talking openly of the “exit strategy.”
“My colleagues at the Federal Reserve and I believe that accommodative policies will likely be warranted for an extended period,” Bernanke said yesterday, based on prepared remarks published by the Fed. “At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road.”
INITIAL JOBLESS CLAIMS DIP AGAIN, BUT DON’T CHEER YET
This morning’s update on new filings for unemployment benefits suggests that the improving trend since the spring for this series remains intact. Initial claims for jobless benefits dropped 33,000 for the week through October 3, the Labor Department reports. That cuts initial claims to the lowest level since this past January, as our chart below shows.
More good news comes in the way of continuing claims, which dropped to 6.04 million, the lowest since April.
THE ALL-OR-NOTHING TRADE IS HISTORY
In case you were wondering, 2009 is on track to be among the best years in the annals of the stock market. There’s still nearly three months of trading left, of course, and so we shouldn’t write anything into stone just yet. But as we write, it doesn’t get much better than this. In fact, we don’t expect it to get any better and in relative terms, at least, it’s likely to get quite a bit worse. Or perhaps we should say less stellar.
Whatever label is appropriate, there’s just no way that equities can maintain the pace so far this year. As our chart below shows, it’s been nothing less than extraordinarily profitable in the land of equities, here and abroad. The bullish momentum may roll on, of course. In the short term, anything’s possible. But as a strategic matter, there’s reason to wonder.
This much is clear: The trailing returns of recent vintage won’t survive for the year or two ahead. No, that doesn’t mean that we’re headed for a new bear market, although no one can dismiss the idea entirely given the still-precarious nature of the economic revival. But equity performance is headed for a period of lesser results, if any, for the foreseeable future.
RAISING INTEREST RATES DOWN UNDER: THE NEW NEW THING?
Someone had to be first. It turns out that it’s Australia. The Reserve Bank of Australia raised its benchmark cash rate by 25 basis points to 3.25%. No longer are rates at a half-century low down under. And so the precedent has been set: the first central bank among the G20 nations has hiked rates.
“Economic conditions in Australia have been stronger than expected and measures of confidence have recovered,” RBA advised in a press release accompanying the rate hike. “Overall, growth [for Australia] through 2010 looks likely to be close to trend.” Nonetheless, the labor market in the country remains weak, the bank acknowledged. But as RBA reasoned, “With growth likely to be close to trend over the year ahead, inflation close to target and the risk of serious economic contraction in Australia now having passed, the Board’s view is that it is now prudent to begin gradually lessening the stimulus provided by monetary policy.”
There will be more reports of rate hikes in the coming months and years. But it starts here. The question now is timing and magnitude. How soon will rates rise and by what degree? And when will the big central banks in the global economy follow suit? And, of course, there’s the $64,000 question: What will be the impact on the global economy and markets?
Questions, questions, always more questions. The only constant: It’s always a different set of questions.
But for now, a milestone has been reached. The Great Decline in rates is over. We’ve known that was coming for some time, of course. Now begins the inevitable sequel.
Risk, in short, is a perennial, albeit in an ever-changing state.
[Note: In the original post, we wrote that the Reserve Bank of Australia was the first central bank to raise interest rates. In fact, as one commenter pointed out, the honor goes to the Bank of Israel. We should have clarified our commentary by noting that the Reserve Bank of Australia was the first central bank of a large economy–i.e., a member of the G20 nations–to hike rates. The oversight has since been corrected in our post above. Sorry ’bout that. –JP]
NONFARM PAYROLLS: STILL SLIPPING AND SLIDING
The news that nonfarm payrolls shrunk again last month by 263,000 is bad news, but a little perspective may help minimize the pain.
But first, let’s recognize that there’s just no way to sugarcoat the fact that the economy has been losing jobs each and every month since January 2008. The question is whether the upward tick in job losses last month vs. August is a turn for the worse or just statistical noise on the way toward zero and, at some point, an expansion in the labor market?
We don’t have a definitive answer, of course, but it’s worth pointing out that the reversal in the recovery trend also occurred in the June jobs update, and on a grander scale. But that was temporary and it soon gave way to more progress, albeit in relative terms by way of fewer losses. It’s also worth reminding that the reversal in June didn’t stop investors from bidding up asset prices in the ensuing months. This time, however, we may not be so lucky.
THE RETURNS OF SEPTEMBER
It’s becoming repetitive, but no one’s complaining. September witnessed across-the-board gains in all the major asset classes. Again.
With some minor exceptions, the world’s capital and commodity markets have been on a non-stop rebound since March. That’s not exactly surprising, given the depth of the previous losses in almost everything. When you stretch returns to extremes in a short period, a reversal in the opposite direction is typical. Deciding how long it will last is the trick.
In sum, the good times can’t last, at least not in terms of tidy gains as far as the eye can see. There’s a reason that diversifying across asset classes has merit, even if it’s not obvious these days. But correlations among the various subgroups of stocks, bonds, REITs and commodities are destined for a wider divergence. Designing and managing portfolios, as a result, will become more challenging in the years ahead.
But not today. For the moment, everyone’s a winner regardless of asset allocation. Enjoy it while it lasts.
HOPING FOR ABSOLUTE, BUT SETTLING FOR RELATIVE
It’s all about employment now. More of it would be better, although we may have to settle for losing it a slower pace for a bit longer.
The U.S. Labor Department will dispatch the official update for September nonfarm payrolls on Friday. Meantime, dismal scientists, pundits and fans of macabre labor stats are making estimates and crunching the numbers on hand.
Wanted Technologies, an employment analytics firm, expects that nonfarm payrolls will fade by 167,000 in September. If so, that would be an improvement over August’s loss of 216,000 jobs, albeit a relative improvement.