The price of money is going up, and so it seems is everything else, including security and stability.
The Bank of Japan, the last major holdout in the monetary universe for dispensing cheap money, threw in the towel today on its long-standing tolerance for zero-percent financing. The BOJ’s policy board unanimously voted to raise the key overnight call money rate to 0.25% from zero.
While Japanese interest rates move off the floor, oil prices keep rising through the ceiling. The August crude oil futures contract briefly moved above $78 a barrel in New York yesterday, another all-time high. The immediate catalyst is the threat of a new regional war in the Middle East as Israel responded to cross-border raids by fighters of the Lebanon-based militant group Hezbollah. Oil supplies per se weren’t threatened, but it doesn’t take a Ph.D. in diplomacy to realize that new Israeli military campaign in Lebanon, which included attacking Beirut’s international airport and imposing a naval blockade on Lebanon, risks a wider conflict involving Syria and Iran.
Oil is nominally an economic commodity, but it also serves as an unofficial gauge of global tensions. No wonder, then, that the price of the world’s most valuable commodity continues to soar.
Helping fuel the latest run in oil prices is Israel’s reassertions that Syria and ultimately Iran are behind Hezbollah’s attacks. As a result, there are fears anew that Israel may attack Syria. Among those who think this is a possibility is Iran’s president, who reportedly felt compelled to respond to the perceived threat. “If the Zionist regime commits another stupid move and attacks Syria, this will be considered like attacking the whole Islamic world and this regime will receive a very fierce response,” Iran’s President Ahmadinejad was quoted as saying in a telephone conversation with Syrian President Bashar Assad, according to YnetNews.com.
The threat of a new war near and about the heart of the world’s largest oil reserves may still be a remote possibility, but traders are taking no chances. Given the history in the Persian Gulf region in the 21st century, no one should be surprised to learn that the pricing of oil is a business of erring on the side of caution.
The inclination to bid up oil on the first sign of trouble represents something of an evolution in the Mr. Market’s thinking in recent years. After the terrorist attacks of 9/11, the price of crude fell sharply in the remaining months of 2001. There was also a drop in oil prices after the start of the Iraq war in 2003. Don’t expect a repeat performance anytime soon. Oil supplies have since become pinched and global security appears more vulnerable.

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Are there any bargains left in the world’s equity markets? Or has the bull market of the last few years dispensed with such alluring concepts as relative value?
Easy to ask, tough to answer. Beauty, as always, is in the eye of the beholder when it comes to putting a fair value on stocks. The challenge is even tougher when you consider that valuing securities isn’t an end unto itself, but a means of divining the future path of stocks.
The assumption by many is that low valuations equals above average returns going forward. There is, in fact, quite a bit of truth to that notion, albeit one that can be risky when dissecting individual companies. Relative valuation offers a bit more comfort when comparing equity markets among the planet’s various regions. Regional equity markets, after all, don’t go out of business or get sideswiped by the ill-advised actions of a rogue CFO.
With that in mind, we dive into the performance statistics from the S&P/Citigroup Global Equity Indices, with the results listed in the table immediately below. With the usual caveats lurking, we nevertheless turn up a few intriguing profiles of what’s going on in equity markets around the world. But first, let’s go to the horse race, looking at total returns so far this year, through July 12, 2006 (see the table below).

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The trade deficit has been larger than May’s pot of red ink, but not by much.
The Commerce Department
announced today that total May imports exceeded exports by $63.8 billion. That amounts to $500 million deeper in the red from April’s trade tally. On the other hand, May’s deficit is below the all-time monthly low of $66.6 billion of last October.
Most of the trade deficit can be traced to the state of business in goods, such as industrial supplies, consumer goods, agricultural products and automobiles, as the chart below illustrates. The dollar-value of exports of these and other items in the aggregate have in fact been growing over time. For the 12 months through May, for instance, U.S. exports of goods rose by 12.9%. Impressive as that is, it falls short of the 13.4% increase in goods imports into America over those 12 months.

It’s a different story with services, a catch-all label that includes an array of items that the government labels business, professional and technical services, for instance. Whatever you call it, exports of services expanded by 9.8% for the 12 months through May, comfortably above the 8.8% rise in services imports.
But while the U.S. does a booming business in selling services overseas, it’s a relatively small part of the trade ledger, or so the Commerce Department tells us. The business of importing and exporting goods is several times larger, measured by dollar value, and so the U.S. posts a trade deficit.
These trends have prevailed for years, and so America continues to report a deficit in trade that, over time, continues to descend. Today’s trade report isn’t likely to change this secular trend. If anything, questions about what the ongoing trade deficit means for the U.S. economy will only loom larger after perusing today’s numbers.
Chief among the queries: What lies ahead for the dollar if the trade deficit continues to deepen? Billions of dollars hang in the balance, not to mention the U.S. economy and its financial system, depending on the answer.

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The age of self-managed retirement funds can be imagined as a wonderful world, one in which enlightened citizens invest their assets wisely over time so as to live out their golden years in comfort and style. Or so one could theorize. In practice, it may turn out to be something less. How much less depends on any number of factors, starting with the particular skills of the individual.
Alas, those skills, such as they are, may fall short of the minimum required to produce even modest results. Indeed, a new academic study throws more than a little skepticism on the notion that the masses are up to the challenge of managing their 401(k)s as a long-term proposition. The evidence for holding this pessimistic outlook comes from a testing of the most-basic of investing skills: picking the best S&P 500 index fund from a list of four choices, i.e., the fund with the lowest cost.
As tasks in financial decisions go, this one is arguably the easiest. There is, after all, just one factor for selecting the best portfolio: expense ratios. Since S&P 500 index funds are commodities in the true sense of the word, the only differentiating factor is one of price. A simpler methodology for picking mutual funds could hardly be imagined. As such, one could reason that if there’s any hope of advancing one’s investment station in life, success would reveal itself by investors mastering this important, but ridiculously easy investment hurdle.
Unfortunately, the participants in the study inspire anything but confidence as individuals continue to take control of their retirement assets. Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds, a paper authored by professors from Yale, Harvard and the Wharton School, asks Wharton MBA and Harvard College students to allocate an imaginary pot of $10,000 across four S&P 500 index funds with varying expense ratios and commissions of more than a little significance. In the first experiment, the only related literature the students are given to make an informed decision is the prospectus for each fund. The result? To quote the study authors, “Over 95% of control group subjects fail to minimize fees.” In other words, only 5% made the correct decision of choosing the lowest-cost index fund.
In a second test, the students are asked to choose from the same index mutual funds but this time they’re given the associated prospectus and a one-page summary that highlights the expense ratios of the four index funds. The results are slightly better, but barely. A still-high 80% of the students still failed to pick the lowest-cost index fund.
But wait–it gets worse. This time, students are handed a prospectus for each fund and a summary sheet that shows each index fund’s annualized performance since inception. The professors throw a small curve ball to the students here, if only to test the complexity of life in the real world. That is, the performance summaries represent different time periods. No apples-to-apples comparisons here. But in fact, it’s all a trick question. “Because each fund’s inception date differs,” the professors write, “this information should be ignored when predicting across-fund variation in future fund returns. In fact, we construct our fund menu so that annualized returns since inception are positively correlated with fees; chasing past returns since inception lowers expected future returns. Nevertheless, this is what our subjects do.”

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The stock market’s been a yawn this year, but the sport of water treading that dominates the broad indices masks the price volatility that lurks below.
The S&P 500 has climbed 1.4% through July 7, but this drowsy performance profile is hardly common within the ten sectors that comprise the broad market. As the chart below shows, the range of returns within the market index has been wide this year. At the head of the horse race is energy–still. Rising by more than 13% year-to-date, the ongoing bull market in all things energy related stands in stark contrast to equities generally. Ditto for the bottom-performing sector in 2006, albeit in reverse. The tech slice of the S&P 500 has been no wallflower when it comes to dispensing red ink: the tech stocks have shed nearly 8% this year.

Between those two extremes lie the various shades of gray that add up to a mixed market and building blocks that, in theory, can lead to besting beta with superior equity selection skills. Success in stock picking requires choosing the right sectors more so than usual this year–advice that’s born out in the outlook for sector earnings. As Zacks reported last week, the median firm in the S&P 500 is expected to report earnings growth of 8.1% for the second quarter. But far-greater drama resides in the sector-specific tally, as the table below reveals (courtesy of Zacks.com). Energy is on top with anticipated earning growth of 40% for the second quarter; on the opposite extreme is consumer staples, with is projected to post a mere 4.0% rise in earnings.

Such variation in price returns and earnings expectations should give traders just what they need to prove their worth in doing something other than holding the index. But as veteran investors know, opportunity doesn’t easily translate into results. Bashing beta is a perennial habit, but leaving it in the dust is still the bane of most active managers.

Sometimes the data enlightens, sometimes it frightens. And sometimes it simply tortures Mr. Market. The latter seems to be the operative theme with today’s release of the June employment report.
If anyone was expecting a clear signal from this morning’s update from the Bureau of Labor Statistics to lift the fog harassing the economic outlook, the numbers were something of a letdown. On the one hand, there’s fresh reason to think that inflationary pressures are still bubbling, as per the uptick in average hourly earnings, which posted a 3.9% rise last month over the year-earlier rate–the highest in five years. Score another point for thinking the Fed may still raise the price of money.
But the analysis is getting trickier by the day. Indeed, the job-creation machine continues to sputter, or so it seems, perhaps to the point of offsetting the inflationary worry that currently resides in the minds of the Fed governors. Consider that a Reuters poll called for a gain of 185,000 in today’s update on nonfarm job growth, based on the median estimate. What was dispersed was a number significantly lower than the crowd’s best guess. The government advised that 121,000 new nonfarm jobs were created last month, slightly ahead of May’s rise, but only slightly.
As the chart below illustrates, plotting monthly payroll changes on a rolling 12-month percentage basis shows that for the moment we’re going nowhere fast. Nonfarm payrolls rose by 1.4% last month over June 2005–the same rate of change that prevailed in April and May.

What’s more, June’s payroll advance was even closer to April’s 112,000 tally of new jobs. As signals go, the one being dispensed by the employment report has become a yawn of late. Even the jobless rate remained unchanged for June. What’s more, at 4.6%, last month’s unemployment rate has barely budged at all in 2006, remaining in a tight range of 4.6% to 4.8% in the first half of this year.
Expectations were primed for so much more, or at least something materially different after Wednesday’s dose of stats. In particular, that was the day when the National Employment Report from Automatic Data Processing (ADP) advised that private sector jobs exploded upward by 368,000 in June–the highest monthly rise in the five-year history of the somewhat obscure data series. The news attracted more than passing interest from the bond market, which reasoned that the Labor Department’s tally would follow suit, thereby setting the stage for more interest-rate hikes at the hand of the Federal Reserve. But the anxiety will no doubt wane for the moment after the anticlimactic news dispensed by the Labor Department today.
The divergence between the ADP report and the Labor Department’s survey raises more than a few questions, of course. Some of it has to do with variations in methodology, and we can already hear the grapevine buzzing with debate about which employment series captures the true essence of the economic trend.
In the meantime, Fed Chairman Bernanke and associates look poised to continue to stew in their statistical juices. The central bank has counseled recently that incoming data would play an increasingly important role in monetary policy going forward. As today’s report reminds, however, that heightened role isn’t guaranteed to be dramatically enlightening on any given day. Perhaps next week’s data will prove more enlightening.

The spot price of oil touched a new high yesterday, running above $75 a barrel. The world’s most valuable commodity may be vulnerable to a correction if U.S. economic growth downshifts in the months ahead, but for the moment oil traders can only say buy. Some of that has to do with geopolitical tension, of which there is no shortage these days.
Alas, separating the fundamental from the political is no easy task when it comes to analyzing crude. Nonetheless, the oil giant BP recently updated its annual review of all things energy, once again making a valiant effort to emphasize the quantitative over the qualitative via its 2006 Statistical Review of World Energy.
Poring over the data, we found an array of profiles and trends, ranging from the expected to the surprising. Here’s a sampling:
Perhaps the most predictable item in crunching energy numbers is the recurring theme of Saudi Arabia as the world’s leading repository of proved oil reserves, or so official statistics tell us. Equally unsurprising is the fact that the top-five nations for proven oil reserves are also in the Middle East. Who says the oil business is always unpredictable?

Moving over to the not-so-obvious category we discovered that India and Brazil post the biggest percentage gains in proven oil reserves last year over 2004. The biggest loser, in percentage terms, was Mexico–a country that just happens to be one of the main suppliers to the energy-hungry United States. For perspective, the global change in proven reserves was 0.6% last year. It’s worth noting that proven reserves can be manipulated, depending on the country in question. In fact, it’s a safe bet that politics has more than a little influence in many countries regarding the numbers dispensed for public consumption.

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One doesn’t need to remind the capital markets that risk is in the air. A cursory glance at the horse race for the past month among the major asset classes tells the story, which is predominantly one of espousing caution.
On the extreme ends of performance for the past month, through July 3, as the graph below illustrates, REITs continue to lead the way, racking up an impressive 3.6% rise, as per the Vanguard REIT Index Fund. On the losing end of the spectrum: commodities, which lost 3.8% over the past month, based on results from the PIMCO Commodity Real Return Strategy A Fund.

Asset class proxies: Vanguard REIT, iShares Russell 2000, iShares MSCI Emerging Markets, MSCI EAFE, S&P 500 SPDR, Vanguard High-Yield Corporate, PIMCO EM Bond, Morningstar Short Gov’t Category, PIMCO Foreign Bond, iShares Lehman Aggregate Bond, Vanguard Inflation Protected Securities, PIMCO Commodity Real Return.
After you chop off those two extremes, the range of performance among the remaining ten asset classes is quite narrow, suggesting a heightened sensitivity for embracing prudence. A mere 131 basis points separates the second-best performer (cash, as per the Morningstar Ultra Short-Term Bond Fund category) from the second-worst (TIPS).
Investors can be forgiven for expecting the proverbial second shoe to drop. With North Korean missiles flying over the Sea of Japan, threats of higher inflation lurking in the shadows, fears of slowing growth, and any number of other crises gurgling with potential, ours is a moment to reconsider the safety that comes by watching and waiting.

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The Declaration of Independence of the Thirteen Colonies
In CONGRESS, July 4, 1776
The unanimous Declaration of the thirteen united States of America,
When in the Course of human events, it becomes necessary for one people to dissolve the political bands which have connected them with another, and to assume among the powers of the earth, the separate and equal station to which the Laws of Nature and of Nature’s God entitle them, a decent respect to the opinions of mankind requires that they should declare the causes which impel them to the separation.
* * *
The Constitution of the United States of America
We the people of the United States, in order to form a more perfect union, establish justice, insure domestic tranquility, provide for the common defense, promote the general welfare, and secure the blessings of liberty to ourselves and our posterity, do ordain and establish this Constitution for the United States of America.

Yesterday’s 25-basis-point hike in the Fed funds rate–the 17th in a row–managed to surprise no one. But the accompanying FOMC statement was anything but routine this time around.
The central bank opted to keep the markets guessing a bit more with its latest prose. Let’s call it the high art of espousing neutrality with a touch more gusto. David Resler, chief economist at Nomura Securities in New York, yesterday wrote in a note to clients that the FOMC statement “suggests more strongly than in those of the past that the future course of policy is now wholly data dependent.” In other words, anything’s possible, depending on the number du jour.
In any case, the threat of inflation is now firmly embedded in Fed thinking, as per the FOMC’s advisory: “Readings on core inflation have been elevated in recent months.” As a result, the notion that 25-basis-point hikes will now arrive like clockwork at each and every FOMC meeting has all but passed into history. In its wake is something different, which is to say that the Federal Reserve is more likely to surprise Mr. Market in the future than at any time since the central bank began elevating the price of money back in June 2004. Granted, if the data permits, the Fed may take a pass on another rate hike. But if the surprises go the other way, something tougher may come in terms of responses, and perhaps faster than you think.
One economist we talked with thinks Bernanke and company believe it’s time to take off the kid gloves with the fixed-income set. In fact, the Fed is now prepared to adjust monetary policy to a degree and on a timetable that isn’t necessarily obvious to the bond traders who’ve come to anticipate only modesty and predictability from the central bank. So says Robert Dieli, president and founder of the economic consultancy RDLB Inc., a Lombard, Ill. shop that also runs Mr. Model, an economics web site. More to the point, Diele tells CS that the Fed, if it feels obliged, may hike rates by more than 25-basis-points, and perhaps on a day other than the regularly scheduled FOMC huddle.
“If we get a bad consumer price index report, for instance, the Fed might do something the next day,” Diele muses.
What convinces this 23-year veteran of dispatching economic forecasts that surprises may be the new new thing in monetary fashion this season? The data, in short, speaks to him, as he outlined in a report he penned last week titled Mr. Bernanke’s Dilemma. In the essay, Diele advises that the Fed’s hard-won respect on fighting inflation took the better part of a generation to acquire. It could be lost much quicker. Ideally, the state of monetary nirvana that characterizes the past decade or two comes when the Fed funds rate is sandwiched between the yield on long Treasuries above and core inflation, defined by the Personal Consumption Expenditures Index, excluding food and energy, below. No easy task, as the central bankers in the 1970s and early 1980s learned–the hard way.
Alas, this “comfort zone” that some thought had become the natural order of the universe is now in danger of evaporating, at least for the foreseeable future. The core PCE, in other words, appears intent on moving out and above this zone, as illustrated by a chart borrowed from Diele’s report, reprinted below.

Source: Robert Dieli, www.mrmodelonline.com

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