Feb 17th
Idaho Business Matters, a short daily radio feature broadcast on Boise State Public Radio recorded by Boise State University’s Dr. Nancy Napier, recently focused on QE2. Professor Napier’s scripts were written by Harmonic’s Kenn Lamson.
Recordings of the commentaries can be heard by clicking on the links below.
Feb 08th
While we don’t use the trading software made by the folks at AlphaScanner, I found their graphic of the typical stock price performance interesting. The graphic focuses on the technical aspects of stock performance while basically ignoring things that we spend quite a bit of time on: Earnings, management acumen, product/service competitiveness and so on. That said, much of stocks’ behavior can be explained by the information on the illustration.
The rally that began September 1st 2010 continued its run higher more-or-less uninterrupted through year-end. The Russell 3000, a broad US stock market index, rose +11.6% during 4Q10 and has continued to move higher through the first three weeks of January. As we noted in our previous newsletter (and in the Economic Insight segment of this one), stocks have been the beneficiary of the Fed’s initiation of bond purchases, also known as QE2. Oddly though, Treasury bond prices have fallen during this same period, contradicting what one would expect to be the normal reaction when there’s a large and continuous buyer in the market. Other types of bonds continued to perform well and commodity prices joined stocks on their rise.
STOCKS
While the “quality” of the market action is questionable given our belief that the latest round of Fed bond purchases won’t much help the economy, stock investors jumped on the proverbial bandwagon and the market continued to roar higher. The uncertainty represented by the election is out of the way, giving stocks clearer sailing. That the fourth quarter of the year typically has the best performance was also not lost on stock investors. Foreign stocks also benefitted, although the aimless performance of the US$ hasn’t been as great a tailwind for domestic investors as in previous periods.
Relative performance of largecap stocks (Russell 1000 – white), smallcap stocks (Russell 2000 – green) and developed market foreign stocks (MSCI EAFE – red); 11/15/10 to 1/25/11, indexed to 11/15/10 value {GRAPH: BLOOMBERG}
The stock market has had several things going for it during recent weeks: First, the third year of the four year Presidential election cycle has traditionally been the strongest for stock market performance. The usual explanation for this phenomenon is that the sitting Administration, often aided by the Federal Reserve, pulls out the stops to try to curry voters’ favor for the upcoming election. Some anticipation of this phenomenon probably accounts for the surge through year-end and so far in 2011.
Second, the fourth and first quarters historically comprise the strongest half of the year.
{CHART: CXO ADVISORY GROUP}
Third, corporate earnings have been quite strong for several quarters now, beating consensus estimates and giving bulls more fundamental support for their case.
Finally, the aforementioned QE2 has for all intents and purposes flashed a green light to investors in risk assets like stocks and commodities. As we mention in this month’s Economic Insight, QE2 probably won’t do much for unemployment or house prices but it has done wonders for stocks and commodities.
US Trade Weighted $ (white solid), Lehman Brothers Aggregate Bond Index (yellow dashed), Case-Shiller monthly 20-city home price index (blue dotted), S&P500 (red dotted), S&P Goldman Sachs Commodity Index (green dashed) –daily 8/24/10 to 1/25/10, normalized as of 8/24/10 {GRAPH: BLOOMBERG}
The consensus among market watchers is that stocks are overextended and due to pause in the near-term. That said, we’re learned the hard way that, according to John Maynard Keynes, “The market can remain irrational longer than you can stay solvent,” so we’re remaining vigilant.
We noted in the last newsletter that we were looking for financial stocks to confirm any rally and have been pleased to note that the financial sector has been one of the leading sectors of late.
S&P500 Sector Performance relative to the S&P500 {CHART: STOCKCHARTS.COM}
The consensus among stock market forecasters is that the market will end 2011 higher. Most argue that higher sales volumes and wider margins will left earnings and that P/E multiples will expand as the economy regains its composure. We tend to disagree; earnings are currently strong but may fade in 2H11, margins are near all-time highs and P/E multiples are, we believe, on a multi-year contractionary phase.
S&P500 P/E ratio, weekly, 1/2/70 – 1/27/11 {GRAPH: BLOOMBERG}
US stock mutual funds have only recently begun to see inflows, coming largely at the expense of bond funds. Those flows are noteworthy because they reverse a multi-year trend of individual investors moving money away from stocks. Historically, individual investors were a great contrary indicator for smart money, as individuals tend to be last to jump on the bandwagon. We wonder if they collectively bought bonds at the lowest interest rates in a generation only to move their funds into stocks as equities turn lower.
BONDS
The key lesson from Macroeconomics 101 is that increasing the demand for something will, leaving all other things unchanged, raise the price. Therefore we and most market participants expected the Fed’s ongoing purchases under the banner of QE2 to depress US Treasury yields. Treasury bond yields have risen, however, since our last note. Confusing the issuer further is that the yields of UK, German, Eurozone, Japanese and other countries’ bonds have risen alongside US Treasuries. We’ve read research suggesting that this head-scratcher is due to the above-mentioned shift of mutual fund investors from bonds to stocks or that it could be large investors like sovereign wealth funds decreasing global bond holdings in anticipation of potential inflation and concerns about sovereign debt risk. Regardless of the reason, we’re glad we sidestepped some of the punishment by tactically lightening clients’ bond holdings.
US Treasury (orange), UK Gilt (white), German Bund (red) and Japanese JGB (yellow) 10 yr bond yields, 1 year(daily) ending 1/27/11 {GRAPH: BLOOMBERG}
Yield spreads between Treasuries and the highest risk bonds – aka “junk” – have continued to contract while spreads on higher quality bonds have remained fairly stable. Spreads indicate the additional yield investors require to accept the risk of holding a non-Treasury bond, so contraction suggests less risk aversion. It remains to be seen whether risk aversion or risk seeking will win the race.
“B”-rated (light blue), “BBB”-rated (yellow) and “A”-rated (dark blue) 10-year corporate bond yields, 3-months ending 1/27/11 (daily) {GRAPH: BLOOMBERG}
As one would expect given the inflation-creating potential of an additional $900 billion sloshing around in the economy, inflation expectations have risen since Bernanke’s speech. Those expectations are easiest measured by the spread between inflation-protected bonds and nominal bonds. The bond market seems to think inflation is more likely to come sooner than later: Since their late August low spreads on bonds that mature in 2 years and 10 years have risen about 1.00% and 0.72% respectively.
Yield difference between 2 Year (orange) and 10 year (yellow) maturity TIPS and nominal Treasury bonds, daily 8/24/10 to 1/28/11 {GRAPH: BLOOMBERG}
The market for municipal bonds, a usually staid corner of interest mostly to wealthy individuals, has seen more than its usual share of activity lately. The selloff in the muni market was first linked, we think, to that in Treasuries, discussed above. However, municipal bonds were further pummeled as commentators speculated on the number and magnitude of potential municipal defaults.
TOP: Generic municipal bond yield curve 10/28/10 (orange) & 1/28/11 (green)
BOTTOM: yield change in basis points
{GRAPH: BLOOMBERG}
It’s clear that state and local governments are under tremendous pressure as tax and other revenue sources decline while, in some areas at least, the demand for public services increases. We think that the selloff is in part based on the potential for additional supply and an overreaction to rather alarmist media reports.
The bonds used in our clients’ portfolios have been carefully chosen based on their credit quality, geography, repayment source and other factors. Obviously we’ll continue to monitor developments in state and local government finances and will make adjustments to client portfolios if necessary.
COMMODITIES
As mentioned at the beginning of this commentary commodity prices have been one of the star performers since the Federal Open Market Committee announced QE2. Not all commodities have reacted alike however.
Anyone who’s purchased gasoline in the last few months is aware of the latest spike in energy prices. Oil has dropped back to the high $80s after hitting its most recent high above $91. As noted in this month’s Economic Insight food commodity prices have risen sharply as well.
Given its historical role as a hedge against uncertainty, gold is perhaps the ultimate asset for risk adverse investors. The spot price of gold climbed along with other commodities through November; however, since then it has traded sideways, somewhat contradicting the inflation concerns suggested by inflation-protected bonds.
Spot gold (white solid), light sweet crude oil (orange dotted) and Bloomberg Food & Fiber commodity index (purple solid), daily 8/24/10 to 1/28/11
{CHART: BLOOMBERG}
REAL ESTATE
Harmonic gives clients exposure to the commercial real estate market via real estate investment trusts. One advantage of using real estate in an investment portfolio is that the real estate cycle is somewhat different than the stock and bond cycles. However, since REITs are a type of common stock they have a moderate correlation with the stock market. That, and the fact that REITs usually offer a relatively high yield, has pulled them higher in recent months.
Dow Jones US REIT Index (white solid) & S&P500 (orange dotted), daily 8/24/10 to 1/28/11, indexed to 8/24/10 {GRAPH: BLOOMBERG}
POSITIONING
We’re positioned to take advantage of the rally, having shifted client assets towards stocks and commodities while lightening up on bonds when it became clear the Fed intended to put its money where Bernanke’s mouth was. However, given the “low quality” of the rally we’re focusing on high quality stocks rather than more speculative ones. Also, we took some profits in longer-term bond holdings that benefited from the QE2-inspired rally and increased clients’ inflation hedge by adding to Treasury Inflation Protected bond positions.
As noted earlier we continue to think it’s likely that the US stock market “trades sideways” with higher than normal volatility for the next several years, suggesting that investors should become more tactical in their approach rather than pursuing a buy-and-hold strategy.
Jan 28th
I’ve noted in several research pieces that I believe that the US stock markets entered a secular bear market in March 2000 that will probably end sometime 2014-2016. The chart below helps provide a bit of the background for that assertion.
The chart is of the price of the S&P Composite that has been adjusted for inflation and placed on a logarithmic scale. The Composite includes more stocks than the largecap S&P500 so is a better sample of the total stock market; since inflation erodes the value of any investment it’s good to know the real spending power of that investment; and the log scale helps smooth the parabolic curve evident in the typical long-term stock market graph, making linear analysis easier.
The graph also shows a regression line that indicates an approximate annual price return of 1.7%. Add dividends (about 4.9%) and inflation (about 2.3%) to get the “nominal” annualized return of 8.9% with which we’re more familiar.
The red line segments are periods when the market traded lower – secular bear markets.
{hat tip: DShort.com. Doug Short’s website has become one of my favorites for excellent graphical analysis of economic and market subjects.)
Dec 20th
It’s UK-centric, but this graphic from the website Money.co.UK does a great job of reviewing the financial collapse, subsequent recession and the tepid growth seen in its aftermath. Needless to say, the picture in the US hasn’t been much different than “across the pond.”
View the full graphic here.
hat tip: Ritholtz.com
Dec 08th
The title of this post is also that of a recent book by Gordon Murray, a former bond salesman turned index fund investing acolyte. The thing that sets Mr. Murray apart, beyond his privileged East Coast upbringing, is that he’s used his final months to write the tome, having ceased treatment for a form of brain cancer.
We are proud to note that Mr. Murray’s recommendations, based on his experience as a consultant for Dimensional Fund Advisors, very closely mimic Harmonic’s strategy.
The story, originally published in New York Times, is here.
Nov 01th
Today’s morning reading included two interesting pieces handicapping tomorrow’s national elections. The first, from the New York Times’ election blog, FiveThirtyEight, which apparently did a fine job of picking the winners in the 2008 elections, gives us some great data (and excellent charts to go with it) on tomorrow’s national and statewide elections. A couple of examples:
The bottom line is that Republicans are likely to pick up a substantial number of Senate seats, although not the majority, and are likely to gain a significant majority in the House. (hat tip – Ritholtz.com).
The second is a piece by the Strategy research team at Royal Bank of Scotland (seems a little odd I know, but remember that RBS owns the stockbrokerage Dain Raucher and other US properties). Their expectation is similar to NYT – Republican House, (barely) Democratic Senate. The RBS piece further postulates that little economic or investor benefit should be expected since the Democratic party really hasn’t “moved the ball forward” since they lost their 60-vote majority in the Senate. In other words, gridlock will reign. To the extent that’s the case, they argue (and for what it’s worth, I agree) that the political lines will probably harden, not soften, after the elections and passing badly needed legislation regarding job creation, straightening out the housing crisis (and related issues involving foreclosures) and fiscal measures to support the anticipated “QE2″ will become even more difficult. The RBS resesearch is here: RBS – US elections. (hat tip – FT.com)
Harmonic uses Exchange-traded Funds (ETFs) heavily in its construction of asset allocation-driven portfolios for our clients. Because of this fact we felt compelled to comment on a recent tempest-in-a-teapot:
CNBC reported on Wednesday 22 September about a Bogan Associates research piece that suggested that ETFs can collapse if they’re subject to heavy naked short selling. Unfortunately, CNBC suggested this frightening possibility without actually verifying its accuracy, as such an outcome is basically impossible.
Two pieces, one from fund analyst Morningstar and the other from online index fund blog IndexUniverse.com, do a good job of explaining why: In short, if the shares are lent out (to a short-seller), they won’t be redeemed by the ETF provider. That language is included in the legal documents that create the ETF (the Statement of Additional Information).
Aug 27th
In our recent client letter and e-newsletter we stated our expectation of a rocky third quarter for the stock markets. Courtesy of Chart Of The Day comes a graph that supports that view from a historical perspective.
Mar 18th
Economic Insight: Harmonic Notes e-Newsletter, March 2011
Author: Kenn Lamson
Comments: 0
On balance it could be said that we’ve seen a continuation of improving but uneven growth in the US economy since our last Harmonic Notes e-newsletter in mid-January, with one rather large wrinkle: Inflation concerns are back in the headlines.
DATA OVERVIEW
- The major negative factor facing consumers remains, of course, stubbornly high un- and underemployment levels. True, the headline unemployment rate fell to 8.9% in February but recent declines have come in part because the “participation rate” fell. Also, while home sales have recently been mixed, with sales of new homes flat but sales of existing homes rebounding, home prices as measured by the Case-Shiller Home Price Index resumed their decline. A recent reading of consumer sentiment came in sharply lower than expected, presumably a reaction to the recent surge in fuel prices.
+ The broadest measure of un- and underemployment fell to 15.9% in February, its third consecutive monthly decline. Despite the still-elevated monthly unemployment rate, weekly unemployment claims have recently fallen below the critical 400K level, suggesting a downward bias to the rate in coming months. Probably influenced by this gradual improvement, retail sales and other measures of consumer spending rose (although the latest readings were taken prior to the recent spike in oil product price spikes). Also, February’s Consumer Price Index showed a moderate +1.4% YoY increase; concerning, however, was the index’s +0.4% month-over-month spike. More on the CPI and other inflation measures below.
- Participation in the recovery by small businesses continues to be a sore spot; while the NFIB Small Business Optimism Index ticked up in February to a 3-year high, the index remains at very low levels. Also, January’s Industrial Production report came in lower than expected but the weakness may be short-lived because warmer than expected weather temporarily cut demand from utilities.
+ The ISM Manufacturing and Service Indices, surveys of mostly large businesses, both continued to surge higher and both remain solidly in expansionary territory.
- Imports rose more than exports in January, widening the trade gap. Import growth was driven dominantly by energy prices.
+ The +2.8% revised reading on fourth quarter GDP growth was an improvement from +2.6% in 3Q10 but a drop from the initial estimate of +3.2%. The report showed the strongest consumer spending since 4Q06 and received a huge boost from exports. Meanwhile, our favorite coincident macroeconomic indicator, the Chicago Fed National Economic Activity Index, continues to wobble around the neutral mark. And our favorite leading indicator, the ECRI Weekly Leading Indicator, has continued its gradual improvement; after a precipitous decline for about nine months beginning late 2009, it’s risen back into expansionary territory.
EMBERS OF ENCOURAGEMENT
Several anecdotal and quantitative pieces of data suggest the economic expansion is becoming self-sustaining1:
Unemployment rate (white, right scale); Average hourly earnings (orange, left scale); Average workweek (yellow, right scale) {GRAPH: BLOOMBERG}
ISM Manufacturing Index (orange) and ISM Service Index (white), 13 years ending February 2011 {GRAPH: BLOOMBERG}
Total Consumer Credit, 3/31/05 to 1/31/11 {GRAPH: BLOOMBERG}
DISTURBING DATA DEEP DIVE
Despite the overall improving data trend there remains plenty of things about which to worry; a partial list2:
Case-Shiller 20 City Home Price Index (not seasonally adjusted), January 2005 – December 2010 {GRAPH: BLOOMBERG}
{GRAPH: Bloomberg}
INFLATION
Maybe it’s biased by our information sources, but it seems like there’s been an increase in the chatter about inflation lately. We noticed an uptick last summer when Bernanke signaled the Fed’s intention to launch QE2 and it’s really caught the public’s attention since gasoline prices spiked higher. We thought it worthwhile to dedicate a portion of this newsletter to discussing what inflation is, what we’ve experienced in the past, the most recent readings and where we think we may head.
An online search for definitions of inflation will likely confuse a careful reader. Each school of economic thought offers its definition, the most well-known of which is probably Milton Friedman’s assertion that “inflation is always and everywhere a monetary phenomenon”. The difficulty of defining inflation naturally leads to disagreement over how to measure it, and thus whether the US is currently suffering from it. Rather than choosing a side, we’ll simply observe that inflation’s a widespread rise in the general price level in an economy; it’s NOT:
We’ll focus this discussion on inflation on consumer price inflation so we’ll leave aside a discussion of measures like the Producer Price Index.
The most widely known indicator of inflation is the CPI – the Consumer Price Index. The Bureau of Labor Statistics, which calculates and publishes the Index, reports the CPI with and without the impact of food and energy prices (aka the “core” CPI). It’s been said that the Fed prefers to look at the core rate since it’s a more stable reading of prices affecting consumers; that may be so, but I don’t know many people who don’t use energy or eat, so I tend to consider both.
Year-over-year change in CPI (orange), “core” CPI (yellow) and PCE deflator (white),
August 1980 to January 2011 {GRAPH: Bloomberg}
The CPI is well-known and broadly used by investors, economists and the media as a proxy for the overall level of inflation in the US economy. In fact, the US government uses the measure to adjust the value of Social Security and other transfer payments. Also, there’s a type of US Treasury bond (which will be discussed in some detail later) that has its principal value adjusted to reflect changes in CPI. However, problems with the calculation of the Index are widely known and include:
Another government-produced measure of consumer price inflation is the Personal Consumption Expenditure (PCE) deflator. It’s a broader measure than the CPI, capturing expenditures made by others on behalf of households. The PCE deflator’s composition changes from quarter to quarter, so it’s more up-to-date than the CPI. The CPI actually represents about 74% of the PCE deflator, with the balance consisting of other price indices. Because of these advantages it’s understood that the Fed prefers to watch the PCE deflator.
As one can easily observe from the graph above, the PCE, CPI and core CPI all currently are near their lows of the past 30 years. The year-over-year change in these measures was in the low single digits as of the most recent reading; at 1.1%, the core rate remains below the 1.75%-2.0% range indicated by the Fed as their target.
An interesting third, but by no means final, alternative inflation measure is one calculated by professors in MIT’s Applied Economics Group called the Billion Prices Project (BPP). The BPP conducts a daily online survey of about 5 million individual items across 70 countries that provide a nearly real-time measure of goods price inflation. Obvious weaknesses of the BPP are that it doesn’t include services and the surveys are conducted online only. However, given the breadth and depth of the survey, the BPP provides an interesting and potentially useful counterpoint to the government-collected statistics.
Each of the aforementioned price indices is retrospective and so is of limited value in estimating prospective inflation. As we build our outlook on the economy and financial markets, Harmonic reviews short-term estimates from several sources, including the Federal Reserve Bank of Philadelphia, CXO Advisory Group, and BMO Nesbitt Burns Capital Markets.
GRAPH: CXO Advisory Group LLC
The long-term inflation forecast we find most useful is one that’s derived from the financial markets themselves. We’re of the frank opinion that an investor who’s putting money behind their opinion is a more credible source than an economist who doesn’t. Treasury Inflation-protected Securities (TIPS) are a widely traded type of bond that offers a direct view into the market’s inflation forecast; subtracting the yield of a TIPS bond from a nominal (not inflation-adjusted) bond of same maturity provides an estimate of the average CPI for that upcoming period. For instance, the top panel of the graph below shows the 10-year nominal US Treasury note (orange) and corresponding TIPS yield (white); the lower panel shows the spread, equivalent to the market consensus forecast of the average CPI inflation for the next 10 years, at 2.33%.
{GRAPH: Bloomberg}
Understanding inflation is critical to gauging value in the financial markets and it has an obvious and immediate impact on the quality of life of those it touches. Wages that don’t rise enough to offset higher costs put consumers under greater pressure and may result in undesirable purchasing patterns. In its worst form, hyperinflation, consumers may be relegated to bringing large amounts of rapidly depreciating cash for their purchases.
Inflation also has a measurable impact on the level of interest rates. Since the coupon rate and principal of most bonds is fixed, the price an investor is willing to pay should change in direct negative proportion to anticipated changes in inflation; if inflation is expected to rise, the price of a fixed rate investment should decline to compensate investors for the loss of purchasing power of their securities. Since interest rates move in an opposite direction from bond prices, those price declines create rising market interest rates.
Inflation expectations affect stock prices in two ways: First, since the fair value of an investment is simply the present value of its expected cashflows, higher (lower) interest rates translate into higher (lower) discount rate and therefore lower (higher) estimated fair value. Second, from a fundamental perspective an increase in prices that can’t be passed on to consumers will be seen as pressuring companies’ margins. All other things equal, lower margins mean lower company earnings and lower stock prices.
As can be observed in the bottom panel of the graph above, next-10-year inflation expectations are within a rough “normal” zone of 1.30% to 2.65% despite recent spikes in energy and food prices and widespread concerns regarding the inflation-creating potential of monetary policies like QE2.
We believe that inflation pressures may be building. While velocity of the money supply remains quite low, suggesting that the flow-through of liquidity being pushed to the financial system by the Federal Reserve is being restrained from entering the real economy, velocity may be set to rise because, in part, consumers are no longer deleveraging.
{GRAPH: St. Louis Fed}
Current inflation levels and those short-term forecasts by market participants have risen from 2009 but on balance they appear moderate. We worry, though, that the Fed’s focus on the core rate of inflation, ignoring the affect of energy and food prices, causes the central bank to fail to see the larger picture and to maintain an easy-money policy longer than is necessary. The pressure on consumers caused by rising food and energy prices is a concern, as are rising rents. It’s worth remembering too that forecasting models don’t handle structural changes well, such as an increase in the Non-accelerating Inflation Rate of Unemployment (NAIRU) or changes driven by foreign economies, like we’ve seen with commodity demand from emerging markets.
1 SOURCES: Bureau of Labor Statistics, Cantor Fitzgerald, ISI Group, CIA World FactBook
2 SOURCES: Gluskin Sheff, Bureau of Labor Statistics, ISI Group, Global Macro Monitor, CXO Advisory Group, BMO Capital Markets, Federal Reserve, MIT Billion Prices Project,