Veteran investors–otherwise known as anyone who’s gotten burned at least once in the capital markets–are rightly skeptical when someone comes along and says they’ve got the money game figured out. Someone says that, or its equivalent, about once every three seconds these days.
The reasons for staying skeptical are no less legion. Suffice to say, the proof is in the pudding and so it’s no accident that there’s a huge spread between the number of people who claim to have the secret investing sauce and those who can point to some real-world evidence. With that in mind, you may want to take the following with a grain of salt as well. Your editor too is a card-carrying member of the mere mortals club.
We say that because even a judicious, enlightened approach to investment strategy (which, we humbly believe, is a label that applies to our approach to portfolio design) is laden with risks, both known and unknown. It’s the latter that potentially pose the biggest dangers.
As an example, first consider a known risk, such as shunning diversification. Whether it’s a particular asset class or a broad asset-allocation strategy, everyone knows (or should know) that concentration risk is easily avoided and so anyone who suffers at the hands of this particular demon probably hasn’t been paying attention to the last 50 years of financial research. That’s not to say that one should never, under any circumstances, move away from complete diversification. But at the very least, know what you’re getting into before jumping off the cliff.
Meanwhile, it’s the unknown risks that keep us awake at night. By definition, this class of hazards is mysterious, of course, although we have some clues about how they materialize. Exhibit A is the evolving nature of markets, including the relationships between asset classes. It’s all too easy to look back on history and draw tidy conclusions about how the capital and commodity markets interact with one another. But finance is not physics, and so yesterday’s iron laws can and do turn into something less, something more or something entirely unfamiliar by yesterday’s standards.
Two quick examples: 1) the relationship between the 10-year Treasury yield and commodities; and 2) the extraordinary jump in spreads between the overnight inter-bank lending rate and the Libor rate.

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It’s called the Great Moderation, and it’s roughly 20 years old, give or take. The burning question: will it get any older.
The moderation is a reference to the fall in macroeconomic risk in the U.S. since the mid-1980s. GDP volatility has fallen dramatically since the roller coaster ride of the 1970s and early 1980s. The primary catalyst: shorter, shallower recessions that occur less frequently. In short, economic nirvana. But what’s behind the fading of recession risk?
Among the various theories for why the angels of moderation have graced the U.S. economy: the Federal Reserve has learned a thing or two over the decades in how to dispense monetary policy that’s not too hot, not too cold. The rise of the services economy, which tends to be less cyclical, is a factor too.
But is the Great Moderation now living on borrowed time? It’s a timely question for a number of reasons, starting with the fact that the U.S. economy is probably already in a recession, as we’ve discussed. Will this one be short and shallow too?

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For five months running, the annual pace of consumer price inflation has been running at 4%-plus, the Bureau of Labor Statistics reports in today’s CPI update. That hasn’t happened since 1991. (As of last month, CPI is up 4.0% for the past 12 months.)
Core CPI inflation (which excludes food and energy) has been running at the 2%-plus level on an annual basis consistently since September 2004! (The latest numbers show that core CPI rose by 2.4% for the 12 months through last month.) The Fed is widely said to be concerned whenever core inflation is running above 2% with any consistency.
It would seem that inflation generally has jumped a few notches to a higher plateau. The idea that inflation will soon return to lower levels now looks increasingly unlikely. To be fair, headline inflation at 4% and core inflation in the mid-2% range is hardly the apocalypse. We’re still a long way from the inflationary troubles of the 1970s.
But make no mistake: inflation has moved higher to a level that looks likely to endure short of a more hawkish monetary policy. That’s not to say that the Fed’s going to start hiking rates anytime soon, although we’re inclined to think that the days of cutting are just about over. Even so, leaving Fed funds at 2.25% while headline inflation’s at 4%-plus looks like a state of affairs that’s asking for trouble.
It’s important to recognize that history reminds that higher inflation tends to come gradually, almost imperceptibly over time. No one puts out a press release warning that the new inflationary era began last Tuesday at 3:45pm. Rather, the process of transitioning from contained inflation to something less contained unfolds slowly, in fits and starts. Only with hindsight is it obvious that pricing pressures have increased by more than a little.
In 2008, the crowd’s hoping that the cooling economy will take the wind out of inflation’s sails. That’s possible, although so far the idea of waiting for macroeconomic salvation for managing pricing pressures has a discouraging track record. Perhaps that’s about to change, or not. But given the data so far, one could argue that waiting and hoping seems like an increasingly dangerous strategy when it comes to monetary policy these days. But for the moment, that’s the plan and the Fed is sticking to it. But for how long?

No one will find encouragement in today’s update on wholesale prices, which posted a troubling 1.1% rise last month. So far, however, the Fed funds futures market is still inclined to see another rate cut when the FOMC meets again on April 29 and 30.
Perhaps, although the time has passed for swashbuckling 75-basis-point slashes in the Fed funds. The hour is late when it comes to nipping pricing momentum in the bud. Today’s producer price report is just one more clue that it’s time for the central bank to pay more attention to pricing pressures bubbling. This idea is all the more compelling when you consider that while the Fed can’t do much more at this point to juice the economy via broad changes in interest rates, but it can still act as the defender of last resort when it comes to inflation.

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At long last a bit of good news: retail sales rose last month by 0.2%, reversing February’s stumble and bringing hope to the dwindling number of optimists who think economic growth will remain intact. But while Wall Street may be inclined to jump on the news as a reason to buy, the bigger trend in retail sales can’t be denied.
Indeed, as our chart below reminds, the cycle in consumer spending is still clear, which is to say: down. Over the past year through March 2008, advance estimates of U.S. retail and food services sales rose 2.3%, or near the lowest annual pace since the previous down cycle of 2001-2003.

What’s more, other than the positive sign that precedes the number, last month’s rise in retail sales isn’t all that impressive as increases in this data series go. In fact, March’s gain of 0.2% (0.15% if you carry it out to two decimal points) could hardly be more frugal relative to past monthly reports of recent vintage, as our second chart below shows.

So, yes, monthly data is filled with statistical noise, tempting false impressions for those looking for broader trends. As such, no one should be surprised to see a month or two of relatively large gains in the near future. But that by itself doesn’t change the fact that the economy’s slowing and probably is set to contract for at least a time this year. No, it’s not the end of the world, nor is the contraction doomed to run on for anything longer than what passes for a normal stretch. Of course, no one really knows and so the guessing game rolls on.

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Today’s update on import prices once again paints a troubling picture on pricing pressures.
Import prices jumped 2.8% last month, the U.S. Labor Department reports. That’s the highest since last December’s unnerving 3.2% spike. More troubling is the fact that the 2.8% rise in March is in the upper range for monthly changes going back to the 1980s. Adding insult to injury, import prices soared 14.8% measured over the 12 months through last month, as our chart below shows. That’s the highest 12-month rate in the Labor Department’s archives, which goes back to 1982 as per the web site.

The “good news,” if we can call it that, is that much of the rise in import prices was due to higher energy costs. And energy prices can’t rise forever–we hope. In any case, the 14.8% surge in import prices over the past year falls to 5.4% after stripping out energy. But the lesser rise in non-petroleum import prices is hollow comfort once you recognize that the 5.4% annual pace is the highest since the 1980s. The basic trend, in short, is not in doubt, no matter how you slice the import-price pie.
How troubling is a 5.4% rise in non-petroleum imports? In search of an answer, consider that inflation generally in the U.S. is climbing by 4.0%, based on the annual rise in consumer prices through February. And the nominal (pre-inflation adjusted) annualized pace of economic expansion in 2007’s fourth quarter was 3.0%. In other words:
* non-petroleum import prices are advancing at a roughly 33% faster rate than general inflation
* non-petroleum import prices are rising 80% faster than the nominal growth of GDP
And if we add energy back to the mix, import prices are, well, let’s just say they’re skyrocketing.

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Global economic growth is slowing, the International Monetary Fund announced yesterday in its new World Economic Outlook (WEO).
“The global expansion is losing speed in the face of a major financial crisis,” WEO advises. The leading offender is the U.S., the report says, thanks to the correction in the housing market. “The emerging and developing economies have so far been less affected by financial market turbulence and have continued to grow at a rapid pace, led by China and India, although activity is beginning to moderate in some countries.”

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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.