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How had the market performed during prior Fed-tightening cycles? Is 'Measured Tightening' what the economy and the markets need? What will the 10-year note yield in the near future? Can I cushion the blow that rising rates could do to my portfolio? Will rising earnings outweigh the possibility of falling P/Es? The focus this month is investing in a rising rate environment. I sought articles that provide some answers [sometimes conflicting answers] to logical questions that this change brings, along with the usual postings of anything of interest I bumped into.
Short interest is particularly high among ETFs that invest in bonds or financial stocks, which tend to see their prices fall when rates go up. For example, in mid-May, short interest on the $698.5 million iShares Lehman 20+ Year Treasury Bond Fund was 180% -- but that's still down from a high of 697% in March. Short interest on the $858.9 million Financial Select Sector SPDR stood at 132% on May 14. ETFs make sense as a friend of the shorts: For the same commission an investor would pay to short a stock, an ETF offers a broad portfolio of securities. So the short can bet against a big chunk of the market rather than an individual stock whose daily moves are harder to predict. "Shorting isn't suddenly safe with ETFs," says Chris Traulsen, a fund analyst who covers ETFs for Chicago investment researcher Morningstar, "but it's less risky than shorting a single stock." There are other sweeteners for short-sellers. Securities law prevents selling a stock short unless its last trade was up in price -- the "uptick rule." The same doesn't go for ETFs, so a short seller can short at will. And ETFs' breadth, with more than 100 broad and focused choices, offers more and subtler tools for short sellers than they can find in the derivatives market. More ETF News/Info Tara Siegel Bernard, WSJ 5-30 Barclays Global Investors, which offers ETFs under the iShares brand, collected $17.4 billion in net new investments through the first four months of this year, surpassing its total net inflows of $16 billion for all of last year. There are about 134 ETFs to choose from, 87 of which are offered by Barclays. The average domestic equity ETF has an annual expense ratio of roughly 0.36% of assets, compared with 0.87% for the average domestic equity index fund and 1.53% for the average domestic equity mutual fund, Morningstar says.
Now former Vanguard Group Chairman John C. Bogle, a frequent critic of mutual funds, is calling for more scrutiny of the way IPO shares are handled by fund companies. "It must be obvious that the generator of the buying power must be the beneficiary, rather than, say, private pension accounts or small funds served by the advisers, where the trafficking in IPOs would have a larger impact," Mr. Bogle said in a recent speech. Indeed, Massachusetts Financial Services, which settled fraud charges with state and federal regulators related to improper trading of its funds and has changed many of its practices, has taken steps in that direction. Last month, it banned its smallest funds -- those with under $20 million in assets -- from receiving IPO shares, to minimize the chance that IPOs will distort the funds' performance. "The concern is that even a minimal IPO allocation has a chance to skew performance," says MFS spokesman John Reilly. "We view it as a common-sense restriction." The focus on how mutual funds handle IPOs comes as the IPO market is showing signs of life again, with 64 deals that generated $10.72 billion so far this year, compared with seven deals that generated $745.8 million through the end of May last year, according to Thomson Financial. In February, Nevis Capital Management's top two officers paid $150,000 each and the firm was ordered to pay $1.7 million to settle SEC fraud charges for claiming they distributed IPOs among their clients when they actually steered all of their IPO allocations in 1999 to their small Nevis Fund and just one other account they managed. The IPOs enabled the fund to post returns of 155% from its inception in June 1998 to Sept. 31, 1999, and nearly fourfold from its inception to the end of 1999. According to the SEC, those numbers would have been a 5.3% loss and 39% gain, respectively, if first-day IPO gains were subtracted. In 1999, Van Kampen Investments, now a unit of Morgan Stanley, paid $125,000 to settle SEC charges that it hadn't properly revealed the role of IPO gains in the returns of one of its funds. In 2000, Dreyfus Funds paid $2.6 million to resolve similar charges. The SEC said that during certain periods, IPOs were responsible for more than half of the gains posted by Van Kampen Growth and Dreyfus Aggressive Growth. Funds Duck Regulatory Bullet Chet Currier, Bloomberg 5-21 At this week's ICI meeting Matthew Fink, the retiring president of the ICI, told of a recent conversation with a congressional staffer who asked him how the fund industry would be affected by rule changes that were up for consideration. `Nothing right away,' Fink recalls replying. `But over time entrepreneurs will stop entering the business, many good managers will leave, and you will dumb down and commoditize the whole business.' According to Fink, the staffer replied, `That's exactly what we want to do.' The fund industry could have faced draconian reforms from Congress, which drafted a barrage of bills. But at this point it looks like there will not be legislation this year. The funds are much happier to be awaiting their ration of new rules from the SEC, where they feel their point of view is at least understood, than from a less sympathetic Congress.
It depends on what number you believe. The Federal Reserve's estimates of manufacturing-capacity utilization -- a gauge of how much productive muscle is being used -- stood at 75.7% in April. The Institute for Supply Management, which does its own biannual report on capacity utilization, put it at 85.6% in April, up from 80.1% in December. Which one is a truer figure is critical for several reasons. If factories and machines are operating at only three-quarters of their potential capacity, companies have little incentive to increase capacity, because they can meet rising demand by putting existing plants and equipment to fuller use. That, in turn, translates into little money being spent to buy new machines, build new plants and hire people to man them. If much, or nearly all, of the available production is being used, then prices could continue to rise, with the increases more likely to hit consumers, and companies likely will spend more to add capacity to keep up with strong demand. Mark Zandi, chief economist of Economy.com, says capacity utilization is clearly higher than the Fed figure suggests, and he points to rising prices as proof. Prices are rising in a wide range of manufactured goods, which typically doesn't happen until capacity utilization edges above 80%. The Federal Reserve's 75.7% figure, economists warn, may be too low. They note that the Fed is slow in removing obsolete -- or "dead" -- capacity from its calculations, which means its figures include capacity that companies already have written off because the machinery or production process is outdated. Philadelphia Fed President Anthony M. Santomero said earlier this month that, "it is important to recognize the possibility that rapid technological change may be undermining the reliability of these measures as indicators of the degree of slack in the economy." Technology is advancing so quickly a disproportionately large share of capacity may be obsolete. Moreover, the recent downturn was so prolonged and the outlook so uncertain that many companies postponed purchasing new equipment for longer than usual, which means an even greater share of their capacity has become outdated. Indeed, while the Institute for Supply Management's number is traditionally higher than the Fed's, the gap between the two has become particularly pronounced since 2001 for two main reasons: the length of the recent recession and the rapidity of technological advances. The ISM calculation, economists say, doesn't track the Fed figure because -- besides being quicker to expunge obsolete capacity -- it is based on a survey of a narrower group of companies. And the industries that dominate the ISM survey tend to have higher rates of utilization even in normal times. Mr. Zandi adds that the downturn in manufacturing has meant also that the ISM has lost some manufacturers that it formerly included in its surveys. "The guys who remain will be the more competitive ones, operating at higher rates of utilization," he says. "The reason pricing is holding up so well," says Mr. Zandi, "is that the supply side hasn't kicked in the way you'd think it would, given the very strong pricing that exists today." Although he says companies are starting to add to their overall capacity, they remain inordinately cautious about it. Many remain skeptical about the current climate of stronger pricing, worrying that it won't hold up, he says. They're worried also about global capacity coming on line in China and elsewhere. Dean Maki, an economist at J.P. Morgan Chase, notes that manufacturers outside the high-tech sector cut capacity steadily for much of the past two years. However, in recent months these capacity cutbacks have slowed, and capacity in nonhigh-tech areas is growing slightly. "There's still excess capacity, but the gap is closing," says Mr. Maki. Investment in new equipment has risen since the beginning of the year, which is a sign that capacity is poised to grow. However, much of that new equipment is replacing outmoded machines, rather than filling additional plants. New ways of organizing factory floors -- notably so-called lean techniques, which usually result in companies producing as much or more product in far less floor space -- means that companies don't need to build new factories to expand. Plus, it takes far longer to build a new plant than to add equipment to existing ones. Daniel Meckstroth, an economist at Manufacturers Alliance/MAPI, notes that the lead time to build a new factory and have it up and running is up to two years. New machines can be added at an existing facility within weeks or months, which means capacity can be added more quickly, making it hard to monitor.
Boomers are conservative investors, says the report. They want good returns, but they are worried about losing their capital. Hartford Financial (HIG) "may have stumbled onto a 'killer app' for the financial needs of today's boomers," write the Citigroup authors. It's called a Guaranteed Minimum Withdrawal Benefit (GMWB), a new kind of variable annuity. The deal is that, for a cost of a half-percentage point a year, you can invest in a range of financial assets, including stocks, with a guarantee that your entire principal will be returned to you -- provided that the principal is not withdrawn at a rate greater than 7% annually. I have no view on the GMWB itself, but there's no doubt that annuities -- especially if their fees come down -- should be enormously appealing to baby boomers. Other financial firms with GMWBs, recognized as "well-positioned" by the Citigroup study, include Lincoln National (LNC) and Prudential Financial (PRU).
Mr. Raich certainly thinks so. "I think it's just starting to steamroll," he says. Following Q4-03, in which year-over-year earnings growth was a better-than-expected 24%, analysts' early growth forecasts were fairly modest for Q1, just 16%, he says. Instead, he projects earnings growth for Q1 will come in at 32%, once all the results are in. The extent to which companies outperformed expectations "was a surprise even to the smart money," he says. However, based on current consensus estimates, earnings will grow at a slower pace, if only because companies face tougher comparisons to last year's improving numbers. Earnings are expected to rise 18% in Q2, 12% in Q3 and 14% in Q4. But the key is how much those estimates grow as the year progresses. Already, Q2 estimates have risen from 13% at the beginning of February. Mr. Raich believes it will ultimately wind up above 20%. When earnings expectations continue to rise, as they have for the past year, at some point you have to begin asking, "Is this as good as it gets?" It may well be, says Tobias Levkovich, chief market strategist at Smith Barney. He tracks the rate at which analysts' earnings forecasts change. His latest reading shows that in May, analysts' 12-month earnings forecasts have risen 37.3% on an annualized basis. That's the highest rate of change recorded during the 16 years Smith Barney has been tracking the measure. Anything above 30% is "extremely worrisome," he says. "The risk is mounting that you can't sustain these levels, and the news going forward is going to be less positive," he says. He notes that corporations' pretax profit margins are already at their highest point in 35 years. Further improvement will be difficult to achieve as more and more workers are hired and labor costs tick up. Yes, the growing economy may well allow firms to raise prices and otherwise improve their revenues, but chances are interest rates will rise as well. The higher rates tend to reduce the price investors are willing to pay for stocks. "Therefore, they wouldn't get the benefit of better earnings," Mr. Levkovich says. The assumption that a good economy plus rising earnings equal a strong stock market doesn't always hold, he says. In 1994, for example, S&P 500 earnings were up more than 20% and the economy was growing at a 4.2% annual pace (the same rate of growth as in this year's first quarter), yet the market indexes lost ground for the year in the face of sharply rising interest rates. Mr. Levkovich agrees that earnings aren't foremost in investors' minds right now. But "if the market is in trouble in an environment where there is positive earnings revision momentum, what happens when it starts to slide?" he asks. Barring unforeseen shocks, he doesn't envision the kind of upheaval that took place from 2000 through 2002. "But that doesn't mean markets can't pull back 10%," he says. Consensus Forecasts Jonathan Fuergringer, NY Times 5-21 The consensus among Wall Street analysts is that earnings will increase 13.5% for the companies in the Standard & Poor's 500 index in the second half of the year, compared with a year earlier. That would be a decline from the 22.7% increase forecast for the first half of this year by Thomson Financial. The average forecast of 53 economists is that the GDP, adjusted for inflation, will grow at an annual rate of 4.2% in Q3 and 4% in Q4, down from a 4.9% pace in the 12 months ended in March, according to Blue Chip Economic Indicators. On a year over year basis, growth is forecast to slow to a 3.8% rate next year, from 4.6% this year. Lower P/Es And a Rising Market? E.S. Browning, WSJ 5-17 Richard Steinberg, president of money-management firm Steinberg Global Asset Management, notes that the S&P's 500-stock index trades at roughly 21 times its companies' earnings for the past 12 months; the historic average is about 15. In the future, because of rising interest rates, investors could well become more demanding, agreeing to pay, say, only 17 times earnings. That could mean rocky days in the short term. Mr. Steinberg forecasts that the S&P stocks will earn around $71 a share next year, meaning that, even at 17 times earnings, it should hit 1200 some time next year. That would be a gain of almost 10% from Friday's close of 1095.70. If rate increases are less egregious and the market assigns a price-earnings ratio of 18, the S&P would hit 1278, a gain of nearly 17%, not including dividends. The Third Year Hex The Bank Credit Analyst via The Washington Post 5-23 Even if equities are not in a long-run bear market, the upside in prices seems relatively limited on a cyclical basis. . . . The S&P 500's 34% gain in the 12 months following its October 2002 low matched the average first-year rise of previous rallies. The average gain in the second year was 11%, and the market has already risen by as much as that in the six months since October 2003. The average third-year rise in prices has been a measly 3%. The key difference in the current cycle is that short-term interest rates have stayed lower for longer, and the prospect is for only a gradual rise in the coming year. This should provide significant near-term support for stocks. There is still a huge amount of cash sitting on the sidelines that can be put to work in the market if investors are feeling more confident about the economy. . . . The bottom line is that the cyclical rally is advanced, but it is premature to rule out further increases in prices. History Dan Sullivan, The Chartist Mutual Fund Letter via The Washington Post 5-30 The odds certainly favor a continuation of the bull market after the first hike in the discount rate, but not always. Who can forget the 1987 meltdown? The Fed raised the discount rate on Sept. 4 of that year, and the market crashed on Oct. 19, losing more than 20 percent in a single session. As Michael Murphy, editor of Technology Investors, recently pointed out: 'Since 1917, the Fed has raised interest rates 22 times after a series of declines, and, in 16 of those, went on to raise a second time. After the first increase, on average, stocks were higher one, three, six, nine and 12 months later. After the second increase, stocks were slightly down one and three months later, but higher six, nine and 12 months later.'
Some analysts are urging patience, reminding investors that junk bonds usually perform well when short-term rates are rising. "There is no good reason to reduce high-yield exposure in anticipation of a rise in the fed-funds rate," independent bond analyst Martin Fridson wrote in a recent report to clients. Mr. Fridson said that junk bonds have usually beaten Treasury bonds and investment-grade corporate debt during cycles of Fed tightening since 1980, mainly because the Fed acts when the economy is strengthening and the business outlook is improving for junk-bond issuers. The scenario junk-bond investors fear most is that rapid rate increases will hurt companies depending on lower interest rates to help pay off their debts, ultimately leading to bankruptcies. For now, no one is predicting that. But some companies are saying it's too expensive to raise cash by selling bonds now. In the first half of the month, 60% of the junk-bond deals were priced at more expensive terms for the company than anticipated, and a third of the companies decided to reduce the size of their offerings, according to J.P. Morgan. From Michael Weilheimer, manager of the high-yield Eaton Vance Income Fund, Barrons 5-18: High-yield bonds are a lot less risky than stocks, period. And the default rates are continuing to fall because of the economic recovery. Moody's is expecting the default rate [of high-yield bonds to] go down to the 3% level in 2004. The worst return year in the last ten years for high yield bonds was in the year 2000, and even then the high-yield bond market was off only 5%.
Wien and Weinstein also believe that "conditions are ripe for companies to increase (or declare) dividends." The reasons are simple: First, there is over $2 trillion in cash on the balance sheets of S&P 500 companies; that's 21% of their market capitalizations, on average, compared with 16% since 1990. Second, the dividend yield is still low (1.6 percent, compared with a 20-year average of 2.6%), and the payout ratio -- that is, the proportion of earnings sent to investors as dividends -- is just 33%, again well below the average for the past two decades. And, third, taxes have been cut, so gross dividends become more valuable to shareholders.
Higher quality means companies that have a solid record of increasing earnings and dividends, are adept at producing enough cash flow to sustain themselves and give a bit back to investors. Chalupnik uses the proprietary rankings published by Standard & Poor's as a guide. Last year, U.S. Bancorp Asset Management increased its holdings of technology stocks as part of its "risk will have its reward" investment theme. "Typically in the early part of an economic recovery, low-quality, near-bankrupt companies do extremely well, because credit is cheap and available and the economy starts expanding so there's less chance of bankruptcy," Chalupnik said. True to form, last year the S&P 500 stocks that rated A- (above average) and higher returned 24.4%, while those rated C (lowest) gained 49.4%. Low quality continued to outperform high quality until the blockbuster job report for March started the interest rate rally. "That's where high quality really started to kick in for the first time since this bull market began," Chalupnik said. "It's one month, but we think this trend certainly will continue, especially as the Fed starts raising rates." Economic conditions are about to get tougher for companies that depend on the debt markets to finance their still-growing operations. "The [lower quality] companies sooner or later have to refinance their debt, and they won't have very favorable rates any more," said Massimo Santicchia, a senior investment officer and equity analyst at Standard & Poor's. "Large, high-quality companies like GE can issue commercial paper and borrow for 1%, but a small technology or consumer discretionary company probably has to borrow at a much higher rate, and the interest costs become an important part of the equation." While Q1 corporate earnings grew more than 25%, that rate is expected to slow in coming quarters, also favoring high-quality issues. "When there is a deceleration in earnings, the interest cost burden becomes a higher percentage of the earnings," Santicchia said. Higher interest rates disproportionately hurt faster-growing companies, because of the way interest rates factor into valuations. "Typically a lot of these low-quality stocks are one-product, potential home run, rolling-the-dice kind of stocks that are in the initial stages of getting up and running and growing that business," Chalupnik said. "If you start throwing in a higher cost of capital ... it hurts them a lot more than the larger companies that are growing at 7 to 10%." Yet another reason to favor high-quality stocks lies in their current valuations. The average price-to-earnings ratio on high-quality stocks is less than that on lower-quality stocks for only the second time in the past 20 years. The last time was in 1992-93. "That actually peaked when the Fed started to increase interest rates, by the way, and in the following three years high quality outperformed significantly," Santicchia said. With the trend apparently now in place, it could last awhile. "Historically it would go on for at least two years as we move through the economic cycle," Chalupnik said. "We're looking for a good economy this year, a decent economy in '05 and maybe not good in '06. After we're in another slow-growth, somewhat of a recession environment, that's when high-quality's outperformance will peak. So I'd say the trend probably will be here for the next three years." Quality Part II Opdyke & Simon, WSJ 5-18 "Last year, risk won. The more risk you took, the more money you made," says Doug Sandler, chief equity strategist for Wachovia Securities. Now, the firm is advising investors across asset classes to "upgrade the quality" of their portfolios. For stocks, that means more recognizable names. In bonds, it means moving to higher-quality issues. One apparent sign of the growing aversion to risk: Investors pumped $16.7 billion into low-yielding money-market funds during the week ended May 12, according to AMG Data Services. This represents the highest inflows since January. In recent weeks, investors had been pulling money out of such funds.
And any stock declines within these six episodes were relatively small, when calculated from the starting point. The biggest came during that 1986-89 period, which includes the 1987 crash: a fall of 9.8% in the S&P500 from November 1986 to December 1987. The average was 4.7%. The last Fed tightening began in June 1999 and ended in May 2000, as the technology bubble was bursting. The S&P500 rose 13.2% over all for that period, although the bear market began in March 2000. But the rate increases contributed only a little to the damage that followed. Of the two rate-tightening episodes that had overall stock-market declines, the first was during the 1973-75 recession. With inflation rising at double-digit annual rates, the S&P500 plunged 26.6% into a bear market. In the other period, from December 1976 to March 1980, the Fed raised its benchmark rate to 20 percent. The S&P500 was down 15.8% by March 1978, but recovered enough to reduce its overall decline for the period to 2.4%. 1994 was not as bad for stocks as some memories might suggest. From February 1994 to February 1995, the Fed funds rate doubled, to 6 percent. Treasuries lost 3.3% in 1994, the worst return in the last 25 years. The S&P 500, however, was down only 6% at its low and had a gain of 4% for the cycle. More History & Expectations Greg Ip, WSJ 5-16 Ed Keon, strategist at Prudential Equity Group, studied past periods of Fed rate increases, he found stocks did best in the 1950s and 1960s, when inflation was low and stayed low, but worse in the 1970s, 1980s and 1990s when inflation was rising over the course of the rate-boost cycle. Keon says inflation encourages companies to boost profits through dubious means, such as bigger inventories, or delaying payment to suppliers. That sort of activity doesn't boost long-term growth. Also, history shows that high inflation produces more boom-bust cycles, which makes investors less willing to hold risky assets such as stocks. Financial companies tend to do poorly when rates rise for three reasons, says Vadim Zlotnikov, equity strategist at Sanford C. Bernstein. First, banks' loans are usually longer-term than their deposits, so rising rates boost funding costs more than interest income. Second, falling interest rates trigger a lot of profitable bond trading and underwriting, which dries up when rates reverse course. Third, rising rates can slow the economy and increase the number of bad loans. The high sensitivity of financial stocks to interest rates could be a serious problem for the entire stock market now because, thanks to the prolonged period of low interest rates, financial companies account for a third of all the profits generated in the stock market. Furthermore, analysts assume profit margins will keep growing. But this will be hard, Mr. Zlotnikov notes, given that profits are near record levels. The risk, he says, is that as employment expands, productivity will slow and profit margins will narrow just as the Fed is raising rates -- a double negative for stocks. Expect Surprises Charles Stein, Boston Globe 5-18 When rates are rising, no one can ever be sure how high they will go or what problems those elevated rates might cause. "You never know where the fault lines are until they get exposed," said Mark Zandi, the chief economist at Economy.com.
You see, it's all about me. We take fuel prices personally. It's one of the areas where economic data hits home. Rising gas prices affect me right away; hiring in the manufacturing sector doesn't. Even rising food prices aren't as noticeable, as there are so many different items in a grocery cart and the shopping list changes so much week by week. Clothing costs? Well, I don't buy clothes often enough to remember what I paid last time. After a few months, $2 gas will have a noticeable effect on many household budgets. Mine already has needed some adjustment because of the whopping heating oil costs of the last winter. Persistently high gasoline and oil costs could have a disproportionate effect on Americans' sense of economic well-being. Recent polls suggest that Americans have yet to be convinced the economy has turned the corner, and high fuel prices will only reinforce voters' sense that the economy is troubled, weakening the President's claim to have engineered a recovery.
The SEC study, written by staff economist Lori Walsh, comes down squarely on the side of the critics, saying the fees don't accomplish their original intent and aren't an appropriate substitute for clearly defined sales commissions. "Fund advisers use shareholder money to pay for asset growth from which the adviser is the primary beneficiary through the collection of higher fees," the report said. "This result validates the concerns raised by opponents of 12b-1 plans about the conflicts of interest created by these plans." Funds charging 12b-1 fees attract more new investments than funds without the fees, the paper found, but "shareholders do not obtain any of the benefits from the asset growth" spurred on by the fees. In fact, the study found that funds charging such fees have lower returns and greater volatility in money flowing in and out of them. The clearest benefit is to the fund management company, which earns more money in management fees from the increase in assets, the study said. "These results highlight the significance of the conflict of interest that 12b-1 plans create," the study concluded. The study comes as the agency is seriously considering an alternative to the fees that would allow funds to deduct distribution-related costs from shareholder accounts rather than from fund assets. Today, about 67% of all funds charge the fees, according to Morningstar. Studies have found that 12b-1 fees average just shy of the maximum 1% allowed by the SEC, but they vary widely and roughly one-third charge less than 0.25%, Morningstar says.
1. An all-stock portfolio earned a 13% annualized gain and a top one-year gain of more than 37% in 1995. An all-stock portfolio fell more than 22% in its worst year, 2002. 2. 75% Stocks / 25% Bonds dropped the worst one-year decline from more than 22% to 14%, while earning only slightly less [the article did not give the total return figure]. 3. 50% Stocks / 50% Bonds averaged a healthy 12% gain over this 20-year stretch. The portfolio's worst one-year fall in that period was a 5.9% drop in 2002. 4. 25% Stocks / 75% Bonds earned you a 10.5% annualized return with worst-calendar year and calendar quarter losses of 1.9% and 3.2%, respectively. 5. Being 100% in bonds earned a 9.4% annualized gain. That's about one percentage point less than the 25%-stock, 75%-bond portfolio. In it's worst year, 1994, this allocation fell almost 3%. The last twenty years has been a period of falling interest rates, which mean they have been a very good period to have invested in bonds. I believe these figures on portfolio mix are somewhat atypical - and may not be a service in chosing your allocation mix. But that is based on my presumption that falling rates have helped bonds more than stocks. It could be the case that they were equally aided - because the rise in P/E ratios over that time period should also be a one-time event.
Closed-end fund offerings during Q1-04 focused almost exclusively on generating current income through sectors like REIT's, utilities, preferred stocks and bonds. More than $12 billion in income-oriented funds came to market in the first three months of the year, more than has ever been raised in one quarter for closed-end funds of any type, said Donald Cassidy, senior research analyst at Lipper. And the largest closed-end offering, Mr. Cassidy said, came to market in February - for the ING Clarion Global Real Estate Income fund, which raised more than $2.5 billion. Generally, whenever Wall Street successfully markets a sector of closed-end funds, that sector is already grossly overvalued and on its way down. And in the first three months of this year, there was a record dollar amount of closed-end offerings that aim to generate high current income. The marketing gurus of Wall Street typically do not even try to sell a new closed-end fund unless it belongs to a sector that investors are already wild about. In other words, the stocks or bonds in these funds are likely to be overvalued. Yale finance professor Owen Lamont says that these skewed valuations are one reason that the popular sectors in which most new closed-end funds are issued tend to lag behind the market.
Six months ago, astride the great Nasdaq rally of 2003, just a handful of analysts raised their voices to express concern about the dangers of a stock market driven forward far more by highly simulative government tax and monetary policy than by fundamental business conditions. One was Michael Belkin, an elite independent researcher based in Bainbridge Island, Wash. In an interview published then, the former Salomon Brothers analyst argued that the 2003 advance would end in a Q4-03 skid mark, as 'bubble fuel' was drained from the system in an 'involuntary de-leveraging' process. Its main victims, he predicted, would be technology and housing-complex stocks. For the next three months, Belkin was dead wrong. The market continued to shoot straight up. Now, with the passage of time, his views are alive and right. The recent setback is nothing, however, compared with what’s coming, he says now. In an update interview this week, he said his research suggests that the market will revisit its October 2002 lows, and he is sticking to his prediction of a 'high-volatility dislocation' -- you might call it a crash -- en route. He still singles out semiconductors as likely victims, but has now added emerging markets to a long list of investment areas he expects to get clobbered; meanwhile, he still likes consumer products companies and energy as potential hedges, though he doubts they will provide positive absolute return. The dawn of the ‘real’ bear market His most interesting assertion is that it turned out that March 2000 was not the peak of the bull market that began in 1982: It was only the peak for the S&P 500, Dow Jones Industrials and Nasdaq. The agonizing bear phase that followed in those groups over the ensuing 2.5 years was counterbalanced by a steadfast rise in small-cap and midcap stocks, particularly ones categorized as value plays. In other words, agile money managers were able to sidestep the big-cap growth bear market by switching to, or hedging with, small-cap and midcap value plays. When the S&P Smallcap 600 and S&P Midcap 400 indices reached historic highs in October last year and continued to make new highs through March of this year, bulls asserted that their success showed the bear market had ended and a new secular bull market had begun. But Belkin’s view is that the real bear market is only now set to begin, with all market capitalization, sector and style groups -- not to mention foreign markets -- pushed to extreme valuations by an imprudent monetary policy that set interest rates far below the inflation rate. By allowing the official overnight federal funds rate to lag well behind the inflation rate, he says, the Federal Reserve made the worst of all possible central bank mistakes -- encouraging as much unproductive speculation in the past year as it did in 1999, when it flooded the world with dollars in anticipation of trouble from the Y2K bug. For this handiwork, he labels the men around the Fed board table 'worse than the board of Enron' for their obsequious obedience to Chairman Alan Greenspan. Belkin fears that emerging markets have the furthest to fall, because they attracted the most excess capital during the past two years. 'When capital is fearless, when investors feel bulletproof, they put money into the riskiest areas,' he said. 'That has pushed emerging markets into the worst extremes in my experience of about 20 years, including the periods preceding the big collapses in the ‘90s of Russia, Latin America and Asia. The Fed has essentially bubble-ized the whole world.' He estimates that the Nasdaq, S&P 500 and German DAX have about 42%, 30% and 45%, respectively, to fall to revisit their 2002 lows. Belkin's model sees all markets as big expansion and regression machines, always moving to extremes in one direction and then contracting to a baseline and shifting to the opposite extreme. His data show that the appetite for U.S. equities 'has been rotting from inside all year,' despite tremendous inflows of cash into mutual funds from investors earlier in the year. The peaks of inflow came in the first few weeks of the year, then tapered off, then hit a crescendo again the first week of April, and have since tapered down back to lows. His view is that when the market can’t make progress after that much fuel, investors inevitably get frustrated and slow or halt their contributions. And then the real trouble comes when fund outflows begin. 'The declines after bubbles are more violent and pronounced the more people are positioned wrongly, and I've never seen so many people on the wrong side of everything -- bonds, emerging markets, small-cap stocks, and techs -- just as inflation and interest rates are getting ready to explode,' he said.
In many ways, it is not the most logical or convenient time for the Fed to be raising interest rates. After all, there are more than 500,000 fewer private-sector jobs today than there were at the recession's end in November 2001. The headlines are filled with stories about outsourcing of jobs to Asia, while others reflect fears that interest-rate hikes could undermine the housing market. To top it off, a heated presidential race is under way and, well, it's largely about the economy. Don't worry. The Fed's not going to hike rates unless the economy is poised for sustained above-trend growth. Moreover, inflation is not going to force its hand. After all, the policy-making Federal Open Market Committee yesterday characterized the risks to price stability as balanced, and found inflation expectations to be benign. If Fed officials seem less "patient" after yesterday, it's not because growth thus far provides a compelling case for tightening. Although the U.S. economy has been growing for the past two and a half years -- and since mid-2003 at an annual pace of more than 5% -- doubts had lingered about the expansion's speed and durability. For example, consensus estimates currently anticipate GDP growth in this year's second half at an annual pace of 4%, slowing to 3.5% annual pace by next year's second half. As most Fed officials consider a 4% growth pace to be sustainable in current circumstances, it hasn't been clear why the Fed would be expected to hike rates if growth was expected to slow soon to a below- trend pace. Investors implicitly anticipate a sharp shift in the outlook. In particular, current prices are consistent with a 25 basis point hike in the funds rate target at the FOMC's Aug. 10 meeting. Moreover, the structure of rates today points to a series of Fed rate hikes that would put the funds rate -- currently 1% -- at about 3.5% by the end of next year. If job gains accelerate to a monthly average pace of 200,000 or more in the coming quarters -- as seems highly plausible -- it is reasonable to expect that 2004 growth forecasts will be raised to more than 5%, while 2005 growth forecasts will rise into a 4% to 5% range. With growth firmly above trend, the case for monetary policy tightening will be compelling, even in the absence of heightened inflation pressures. A series of Fed rate hikes beginning in August would seem appropriate, with the Funds rate hitting around 4% by the end of next year. Investors already anticipate an eventual return of consumer price inflation to at least a 2.5% annual rate. However, it is likely that inflation will continue to fall short of consensus worries. It is difficult to envision a significant acceleration in inflation with unit labor costs stable or falling. The moderate recent rise in the Employment Cost Index, and the wide gap between current job totals and the pre-2001 employment peak, suggests that unit costs are not likely to accelerate quickly. The Fed may be tightening as the Democrats and Republicans gather for their national conventions in Boston and New York late this summer. But before that happens, the economy and job market are going to demonstrate more strength than we've seen to date.
Fed officials' forecast that the combination of unemployment, unused industrial capacity and rapid growth in productivity would keep inflation very low for another year or two. Fed officials, though not ready to abandon the forecast, acknowledge that their primary concern has shifted to rising prices. Mr. Bernanke said that's because inflation should be restrained by the gap between the economy's actual output and what it could produce at full employment. That gap moderates workers' ability to get wage increases and businesses' ability to raise prices. But "No one can measure the output gap very precisely, and one inflation risk looking ahead is that the gap may be narrower than many believe," Chicago Fed President Michael Moskow noted in a speech this week. Mr. Bernanke also cited other inflation-restraining factors: brisk growth in productivity, or output per hour, which allows businesses to raise wages without raising prices; and an apparent end to the dollar's decline and to the rise in commodity prices -- except, of course, for oil. Inflation, excluding volatile food and energy prices, is "likely to remain in the zone of price stability during the remainder of 2004 and 2005." Some private analysts are questioning how long the Fed can say it's pace of Fed Fund increases will be "measured." "Odds of the Fed moving from a measured pace of tightening to a more-aggressive pace by late this year or early next are rising," Peter Hooper, chief U.S. economist at Deutsche Bank, warned in a recent report; he predicted that the federal-funds rate would hit 2% by the end of this year and 4% by the end of 2005. In recent quarters, unit labor costs have begun rising, albeit slowly. With fat profit margins, Mr. Greenspan has noted, companies can absorb higher labor costs without raising prices. But if companies retain their pricing power, job growth remains strong and productivity growth slows, Mr. Greenspan is likely to be more worried about inflation. The Fed has less cushion for inflation surprises than it thought just a few months ago. Al Broaddus, the Richmond Fed president, noted in a speech this week that "the inflation picture has changed significantly." The surge in oil prices is a wild card for the Fed. In recent years, big jumps in oil prices have tended to be a temporary reflection of geopolitical tension. They sapped consumer spending power in the short term, but the Fed didn't expect them to have a lasting impact on inflation. That's one reason Fed officials typically focus on core, rather than overall, inflation. This time appears different. Mr. Greenspan recently noted that markets believe this rise in oil prices will be longlasting. That increases the risk that it will feed into continuing inflation. More on the Bernanke Speech Agnes Crane, WSJ 5-21 Bernanke argued that the backup in bond yields, the muted response of stocks to strong earnings reports and the recent strengthening of the dollar will help counter inflationary pressures. "These developments -- the sort of 'front-loading' of monetary tightening predicted by our analysis of gradualism -- will reduce the financial impetus being provided to the economy and thus provide some check to nascent inflationary pressures," he said. But he added that "at some point" the Fed "will have to validate the general expectation of rising short-term rates." Responding to questions, Mr. Bernanke said a neutral fed funds target rate -- one which would neither stimulate nor restrict economic activity -- would be in the range of 3.7% to 4.7%. John Spinello, bond market strategist at Merrill Lynch, said "I think he leaves the door open for them to do anything." Fed Speak Primer Steve Liesman, WSJ 5-07 In the four months between August 2003 and December 2003, the Fed suggested it would keep short-term interest rates low for "a considerable period." Then in January 2004, the Fed explained it could be "patient" before starting to boost rates. This past week, we moved into "measured pace". The measured-pace concept is a direct attempt to avoid the financial fallout in the bond market from the 1994 rate cycle, when the Fed doubled interest rates to 6% from 3% over the course of about a year. This could keep the bond market happy, but as earnings forecasts have increased, stock markets have declined. That follows the same pattern of 1994, when price-earnings multiples declined while the Fed was boosting rates. Some in the stock market want the rate increases over and done with so they can move on. A Survey on the 10 Yr's Yield Carloine Baum, Bloomberg 4-26 The Treasury 10-year note is expected to yield 4.7% by the end of the year, according to a Bloomberg News survey of 72 economists conducted from March 26 to April 5. Note: The 10-year ended 5-14 at 4.77% after ending March at 3.83% and starting the year at 4.4%. Updated 10 Yr's Yield Expectations Greg Ip, WSJ 5-16 Investors expect the Fed's first increase to come at the end of June and that the rate will reach 5% by September of 2006 says Gerard MacDonell, an economist at J.P. Morgan Fleming Asset anagement. He figures the yield on the 10-year Treasury note ought to be about 6% in an economy that's growing at a normal pace. The market now thinks it will hit that level at the end of 2006. Updated Fed Funds Expectations Edmund Andrews, NY Times 5-17 The big question is how much the Federal Reserve will raise short-term rates before it decides that monetary policy is no longer encouraging inflation. Robert T. Parry, president of the Federal Reserve Bank of San Francisco, noted recently that the federal funds rate had averaged some 2.7 percentage points above the rate of inflation. If inflation settles around 2% a year, that would imply that the benchmark short-term rate would eventually have to reach nearly 5% - a huge increase from 1 percent now. The Contrarian's View Scott Patterson, SmartMoney 5-12 Bill Nyren, portfolio manager of the $6 billion Oakmark fund, says "I find it amazing what a consensus there is that rates are going to rise. The bond market already incorporates somewhere between a 75 basis-point and 100 basis-point increase by the Federal Reserve. As we go through these next Fed meetings, if we find that rates have in total been raised that much, the bond market has already discounted that, and there's no need for long-term interest rates to rise if that's the extent of what the Fed has to do. People are acting as if it's a foregone conclusion that rates are going to rise significantly from their current level, and that belief is so uniform that the contrarian in me thinks there's a pretty good chance that they won't be right." The Contrarian's View II Monica Rivituso, SmartMoney 5-14 Whereas the market is reacting to the threat of inflation, there's very little evidence of an inflation problem, says Sung Won Sohn, chief economist at Wells Fargo. Wages are increasing ever so slowly, and capacity utilization rates, while improving, are still low. Employment is recovering, but hasn't reached a robust level yet. And while commodity prices have risen smartly, Sohn thinks those have peaked and will soften amid China's efforts to cool down its economy. "I don't think we have a serious inflation problem, even though we are beginning to see some inflationary pressure percolating up thru the CPI," says Sohn. "The demand has risen, commodity prices have jumped, and energy costs have gone up significantly. These things are percolating up thru the CPI chain. However, if you look at the fundamentals of inflation, such as wages, productivity and capacity utilization, which came out this morning, they all point to pretty benign inflationary pressure." Sohn's year-end federal-funds-rate forecast of 1.5% is lower than many market watchers expect. His take is that Greenspan sees the recent uptick in inflation as confirmation that there's less need to worry about disinflation, not as a harbinger of more inflation to come. "We all know that inflation is headed up, but I don't think we are looking at massive amounts of inflation in the future," says Sohn. "So that kind of limits how high interest rates can go." Inflation Update Meg Richards, Associated Press 5-09 The Institute for Supply Management's monthly survey of purchasing managers showed many were seeing higher prices in the goods they bought. The institute's purchasing-managers index hit 88 last month, its highest reading since November 1979. Pricing pressure also reflected in Q1's employee benefit expense, which soared 2.4%, the fastest pace in two decades. More Comments Aaron Lucchetti, WSJ 5-11 All types of corporate bonds, government agency bonds and foreign bonds, especially in emerging markets, have sold off even more sharply than Treasurys in recent days, a worrying sign for those who predicted the corporate bond market would digest interest-rate hikes with few problems. If inflation continues to rise and the economy continues to add jobs at a rapid pace, the bond market may tumble further. Bond bears point out that once the economy starts to gather steam, it usually keeps its momentum until the Fed steps in to interrupt the party with rate hikes. They note that the Fed isn't always successful at first in cooling things down. The bond market "has gotten out in front of the Fed," says William Hornbarger, fixed-income strategist at A.G. Edwards. He predicts that the 10-year Treasury note will end 2004 yielding around 5%, just a shade higher than its 4 p.m. yield yesterday of 4.788%. One way to illustrate the difference between this bond market and [crash of] 1994 is the steepness of the yield curve, or the difference in yields between longer-term bonds and shorter-term notes. A steep yield curve like today's indicates that bond investors expect the economy to strengthen and for short-term rates to eventually move higher. When that happens, long-term bond yields usually stabilize as investors buy bonds in the expectation that the Fed's medicine will slow down the economy and stamp out the chances for future inflation. Fed History Offers Warnings David Wessel, WSJ 4-22 The last time the Federal Reserve ended a long period of ultra-low interest rates was in 1994. The U.S. economy took it well and performed impressively for the rest of the decade. But the rate increases set off a bond-market tidal wave. By the time the Fed raised rates in February 1994, officials thought they had prepared markets adequately. They hadn't. "We had a far greater impact than we anticipated," Mr. Greenspan admitted to colleagues on Feb. 28, 1994, Fed transcripts record. "Markets ... clearly have been shocked." By May, the Fed had moved its short-term rate by 1.25 percentage points. But the bond market, where investors set the longer-term rates that influence mortgage and business borrowing, had pushed up the yield on 10-year Treasury notes even more -- from 5.7% to nearly 7.5%. By November, these rates peaked at above 8%, a sign that investors anticipated more inflation, and more significant Fed rate increases, than Fed officials were expecting. The turmoil whacked businesses, governments and individual investors, who weren't prepared for such swings. Trade tensions between the U.S. and Japan and the German central bank's reluctance to cut interest rates (some things don't change) roiled markets. The dollar sank even as the Fed raised rates, confounding experts and exacerbating inflation jitters. The Fed kept raising rates until the federal-funds rate reached 6% in February 1995. It's easy to argue that the Fed, the bond market and Wall Street won't make the same miscalculations that they made in 1994. But that doesn't guarantee the next year or two will be placid. But what if the Fed begins to raise rates at the same moment that foreigners decide not to send quite so much money to the U.S. and markets decide that [large federal government's] deficits aren't so benign after all? Expect a Rally After the Raise Amey Stone, BusinessWeek 5-19 "I'm of the view that if the Fed tightened more, it might actually be better," says Jason Trennert, chief investment strategist at International Strategy & Investment. He thinks it would signal greater confidence in the strength of the underlying economy. Plus, by acting quickly, the Fed "might allay some of the fears about how aggressive it might have to be," Trennert adds. He admits, however, that a half-point hike "is very unlikely." The first increase will be reassuring to investors on two levels. For one thing, a 25 basis-point move would prove that the Fed is following through on its plan for "measured" tightening and doesn't intend to make any jarring changes, like the series of aggressive hikes in 1994 that wreaked havoc on bonds. History shows that the market almost always rallies after the first in a series of rate hikes, says Trennert. "The only instance where that wasn't the case right away was in 1994, when the first Fed tightening was a surprise," he says.
U.S. households started nudging up their inflation expectations last summer, according to the University of Michigan, which polls 500 households every month about their expectations. Stung by rising health bills and soaring school-tuition costs, they didn't really buy into the fears of price deflation. By April, expected inflation among households had risen to 3.2%, its highest level since May 2001, and up notably from 1.7% in July 2003. Ian Morris, an HSBC economist, says such inflation expectations of typical consumers will be an important indicator to watch in the months ahead to determine just how much inflation picks up. "The expectation of higher inflation may now be generating higher actual inflation in a self-fulfilling manner," says Morris. That is because companies have an easier time making price increases "stick" when consumers begin to expect such increases to come. Right now, few economists expect a large pickup in inflation. That could change with a few more months like January, February and March, when the CPI rose at an annual rate of 5.1%. What is shaping household perceptions about inflation? Households often don't view inflation the way economists or financial markets view it. Richard Curtin, the director of consumer surveys at Michigan, says rising gasoline prices have been the most important factor driving up inflation expectations in the past few months. While economists often dismiss changes in gas prices as too volatile, households have a much different take. "People buy gas frequently. They notice the change in the price of gasoline because it reduces the amount of their discretionary income. It has an immediate and highly visible impact on their views," he says. The same holds true for everyday food prices that have been rising sharply, such as the prices of butter or pork chops. Household perceptions about inflation also are being shaped by factors that aren't even measured in the government's gauge of inflation, such as home prices. U.S. home prices increased 8% in 2003. The Labor Department doesn't include that [directly] in its measure of CPI. Instead, it uses a complex formula to track the rental equivalent of a homeowner's monthly expenditures. That measure rose by a much smaller 2% last year, held down in 2003 by a soft rental market. Real people don't make such fine distinctions when gauging their cost of living. Moreover, this measure of housing inflation accelerated in Q1 to a 2.5% growth rate. Now a whole new set of factors appears to be coming into play in household perceptions about inflation. Last year, many households could take some solace from the fact that while prices for services such as education and health care were rising, prices for many goods were falling. That is changing. Prices in several categories that had been falling last year [household furnishings, cars and apparel] turned upward in Q1. For example, prices of girl's clothes rose 3.1% in the 12 months through March, after falling 4% in the 12 months through December. Prices for living-room furniture edged up 0.1% in the year through March, after falling 2.3% through December. The unwinding of goods deflation is probably the result of strong economic growth, which has boosted demand for products such as cars and clothes, allowing producers to hold the line on price cuts. Moreover, the weak U.S. dollar is raising the price of imports and reducing pressure on domestic producers to cut prices to keep their customers. Many economists believe there still is so much spare capacity in the global economy, and competition still is so intense, that companies won't have much leeway in the months ahead to raise goods prices very aggressively. But Morris says "From Joe Blow's perspective, they're seeing everyday items rising and that is raising their inflation expectations."
There won't necessarily be trouble this time, but "if you look back at history, whenever the Federal Reserve starts a cycle of raising interest rates, somebody blows up," says Michael Cheah, portfolio manager at AIG SunAmerica Asset Management. Mr. Cheah and other trouble hunters are focused on the private market for trading interest-rate derivatives, the financial instruments that sophisticated investors use to reduce their exposure to big moves in interest rates. That market is dominated by large banks such as J.P. Morgan Chase and Bank of America, which have sharply increased their sales of such instruments in recent years. In a March report, Credit Suisse First Boston analysts warned that three dealers -- J.P. Morgan, Citigroup Inc. and Bank of America -- "have substantial exposure to changes in the level and volatility of interest rates" as a result of huge positions in the market for interest-rate options. (These options are essentially contracts giving buyers the right but not the obligation to buy or sell securities such as Treasury bonds at a price that is based on interest rates.) The worst thing that can usually happen to a buyer is that the option expires and is worthless; he then loses the upfront fee, or premium, he has paid the seller. Sellers, on the other hand, can be exposed to cascading losses if interest rates move sharply against them and they haven't properly hedged their positions. The CSFB report points out that Wall Street dealers had exposure to $844 billion worth of interest-rate options they sold as of last June, up more than threefold since 1999. The overall level of derivatives held by these dealers has also soared. The analysts wonder about what might happen if one of the top dealers in this market has financial problems and is forced to stop buying and selling interest-rate options. As interest rates rise, "Will these markets remain sane and liquid?" asks James Bianco, head of Chicago research firm Bianco Research. "That's what nobody knows and what everyone is wondering." The housing market is largely responsible for the explosion in interest-rate options. As Americans raced to buy homes over the past decade, mortgages outpaced U.S. Treasury debt as the largest part of the $22 trillion bond market. Mortgage debt outstanding at the end of 2003 totaled $5.3 trillion, compared with $3.6 trillion in Treasurys. The largest players in the mortgage market -- Fannie and Freddie -- must hedge the unique risks that come with owning mortgages. In the U.S., most homeowners pay off their mortgages with a fixed interest rate that they have the option to refinance at any time. That refinancing option, which was tapped often in the low-interest rate environment of recent years, presents uncertainty to mortgage owners like Fannie or Freddie. So they turn to Wall Street to mitigate the risk. Wall Street, which generates fees for taking on Fannie and Freddie's risk, then hedges part or all of that risk by trading with hedge funds and other dealers. In other words, the risk doesn't go away; it gets passed around. It isn't always easy for Wall Street firms to lay off risk. While Fannie and Freddie often seek options that last for as long as five years, Wall Street firms usually hedge their own exposure with options that expire much sooner. Even some dealers say that caution is warranted. "It is a significant risk-management problem," says one major Wall Street dealer. "Options bought and options sold don't always match perfectly. Often we are long apples and short oranges." The turmoil in the bond market last summer suggests that concerns about Wall Street banks and brokers aren't overblown. When a surprisingly small rate cut by the Fed and a shift in hedges at mortgage firms sent bond yields soaring, dealers say some options desks on Wall Street briefly experienced paper losses of tens of millions of dollars. Risks are building elsewhere as well. In the last four years, Wall Street dealers have doubled the amount of money they are borrowing to about $790 billion, according to Mr. Bianco. Much of the money has gone toward leveraged trades such as the popular "carry" play, in which dealers borrow at low short-term rates and invest in higher-yielding instruments such as long-term Treasurys, corporate bonds and mortgages. The prospect of rising rates means that many banks, hedge funds and other investors may try to dump bonds and stocks to pour money into new fixed-income securities with higher yields. That could lead to rapid price drops, potentially inflicting damage on some players in the market. "We've seen this in 1994 and in 1998," recalls Mr. Bianco, referring to the bankruptcy of Orange County, Calif., and the near-collapse of Long-Term Capital Management. "The history of this type of thing is not good. People panic."
A similar result can be obtained, Kitces said, by selling short a fund known as iShares Lehman 20+ Year Treasury Bond Fund (TLT). The fund is based on a Lehman Brothers index of the same name and represents the long end of the Treasury market. When interest rates rise, long bonds fall the most.
RegentAtlantic Capital found that including alternative assets in a basic stock and bond portfolio increased returns and cut down on volatility from 1994 through 2003. Researchers compared two portfolios. The first held 60% of its assets in the S&P's 500-stock index and 40% in the Lehman Intermediate Government/Credit Bond index. The second kept a total of 20% of its assets in the Wilshire REIT index, the Dow Jones AIG Commodities index and the Credit Suisse First Boston Tremont Hedge Fund index, with the remaining 80% divided between the S&P 500 (48%) and the Lehman bond index (32%). The portfolio using the alternative assets would have returned 10.1% a year, versus 9.6% for the basic portfolio. Moreover, returns of the portfolio with alternatives were less volatile than those of the traditional one. None of the returns included costs of making the investments.
Should interest rates rise, bond prices will fall. There is a potential solution - convertible securities, which offer both income with equity market participation. Convertibles have historically provided higher returns than bonds, with marginal additional risk. In addition, they are typically less susceptible to rising interest rates, due to their conversion feature. Convertible securities may also offer upside potential when the underlying stock is increasing in value and downside protection when it experiences a decline. Convertibles generally capture 60% to 70% of the underlying equity’s upside, while assuming only 30% to 50% of the downside. Floating Rate Loans Information from Columbia Funds Unlike bonds that carry fixed interest payments, floating rate loans offer interest rates that float above prevailing market rates, such as the London Interbank Offered Rate (LIBOR). Because the interest rate is reset periodically to reflect changes in underlying interest rates, there is little duration risk in periods of rising interest rates. There are special risks associated with floating rate loans, including default and nonpayment of scheduled interest or principal payments by the issuer of the loan and prepayment of principal by borrowers that could result in a loan’s replacement with a lower yielding security. As well, floating rate loans may be less liquid than other investments. FYI - From Monica Rivituso, SmartMoney 5-19: "Since the early 1980s, periods of rising interest rates have lasted about 13 months, according to Merrill Lynch". In her article, Rivituso also mentioned market-neutral funds and funds that short bond benchmarks. Another alternative was investing in 'equipment leasing' companies. "Basically, certain companies, such as Atel Capital Group, hold large portfolios of equipment (planes, ships, tractors, among others) and lease them out to companies. Investors can buy stakes in the portfolio, and presumably benefit from leases that adjust for inflation."
If there is any time that this instruction manual is unlikely to work, it is now, however. Nothing was normal about the downturn, one in which consumers kept spending, companies hunkered down and interest rates were driven to lows unseen in decades. "The real money," Alson Capital's Neil Barsky wrote in his May letter to the investors in his hedge fund, "will not be made by reading from the mutual-fund manager playbook, but by taking advantage of those times the playbook does little more than describe history and not the future." The home builders, who usually have falling earning at this time in the economic cycle - but are forecasted to have slowing but growing earnings - could be a perfect example of this.
Other measures of inflation expectations have been pointing up as well. The spread between nominal and inflation-indexed Treasuries, a measure of expected inflation, has been widening. The University of Michigan Survey of Consumers reported average inflation expectations one year out at 3.4% in March. That's up from last year's low of 2.3% in July. Finally, businesses surveyed by the National Federation of Independent Business were more aggressive in raising prices in March than at any time since early 2000. So how do inflation expectations influence the inflation process? The process starts with an increase in aggregate demand as the central bank creates more money than the public wants to hold. Producers respond to increased demand for their product by raising their prices. If demand is strong enough, the increases will stick. If consumers expect prices to rise, they spend today rather than defer their purchases. Producers raise prices based on what they expect them to be in the future. The whole process gets accelerated. Pretty soon employees realize the increase in their nominal wage is being gobbled up by higher inflation. In order to preserve their real purchasing power, they demand a bigger increase. It's the Fed that provides the conditions -- the tinder, so to speak -- for inflation to take hold. After a brief decline late last year, broad money is growing strongly again. The M2 aggregate, which includes currency, demand deposits, savings deposits, small time deposits and retail money market accounts, rose 9.5% annualized in the 13 weeks ended April 12. There's another less obvious way that inflation expectations contribute to higher inflation. `If inflation expectations raise nominal interest rates and the Fed gives the impression that it will delay (raising overnight rates), then banks will create more money,' says Bob Laurent, professor of economics and finance at the Illinois Institute of Technology's Stuart School of Business. If banks believe their borrowing costs aren't going up anytime soon -- a message the Fed has been telegraphing loud and clear since August -- they will borrow and lend more, profiting from the spread. While Fed policy makers talk about inflation as if it's a function of the output gap, or the difference between actual and potential output, when pushed they all admit that in the long run inflation is a monetary phenomenon. If the Fed does nothing under such a scenario, ``it not only ratifies the inflation process, it makes it worse,'' says Laurent, one of a dying breed of monetarists. From Caroline Baum, Bloomberg 5-18: Median one-year inflation expectations rose to a nine-year high of 3.2% in April and early May, according to the University of Michigan Survey of Consumers. Median long-term inflation expectations have been locked in a 2.7% to 2.9% range since 1997, according to Richard Curtin, director of the Michigan Survey.
2. Sell a fund if its expenses are too high. 3. Sell shares in one or more funds, if necessary, in order to periodically rebalance your portfolio. Think of rebalancing as a mechanical way to force yourself to buy low and sell high. 4. Sell a fund if it's tax-inefficient. Sometimes very high turnover is a necessary part of a valid strategy, but it's always expensive. Tolerate high turnover only if it part of that strategy. 5. Consider selling a fund if its style is drifting away from the market capitalization or value-growth orientation that made you want to own this fund in the first place. A change in style isn't intrinsically bad. But if you're serious about asset allocation (and I think you should be), stick to funds that are committed to a particular niche. 6. Consider selling an actively managed fund if the manager changes. Usually a change in manager won't be enough to justify selling a fund. But if other factors on this list make you think you should sell, a manager change could be enough to tip the balance. 7. Consider selling a fund if you're making a gift to charity. If selling the shares would result in a taxable loss, you should sell and get the tax benefit from the loss. But if the sale would result in a gain, donate the shares directly. You'll never pay tax on the gain, but you'll be able to deduct the full value of shares as a contribution. 8. Consider selling a fund if it becomes so large that it's difficult or impossible for the manager to do what the fund is supposed to do. By definition, a small-cap fund can't keep pouring money into the same stocks forever without driving the prices up to prohibitive levels. 9. Consider selling a fund if it consistently underperforms its peers. This is tricky, because recent performance is not the right reason to either buy or sell a fund. If you own an index fund, this doesn't apply because your objective is to capture the market, not exceed it. But if you're paying for active management, there's no reason you must put up with extended subpar performance. 10. Consider selling a fund if your asset allocation needs change. 11. Sell a fund without a second thought if you are following a mechanical market timing system and you get a sell signal. This seems too obvious to have to mention, but this list wouldn't be complete without it.
First, don't worry too much about price. In the first chapter of his book Fisher wrote, "Even in these earlier times [he's talking here about 1913], finding the really outstanding companies and staying with them through all the fluctuations of a gyrating market proved far more profitable to far more people than did the more colorful practice of trying to buy them cheap and sell them dear." In fretting about whether a stock is cheap or expensive, many investors miss out on owning great companies. My own rule is: quality first, price second. A good example is Starbucks Corp. (SBUX), the coffeehouse chain. In 1996, the price-to-earnings ratio of Starbucks averaged well over 50. Too high? Well, an investor who bought the stock then would have more than quintupled his money. Ever since it became a public company, Starbucks has sported P/E ratios in the forties and fifties (right now, it has a current P/E of 50 and a forward P/E, based on expected earnings for the next 12 months, of 36), but the firm has increased its earnings at a rate of more than 20 percent annually, so the price has risen sharply. Second, Fisher says that investors must ask, "Does the company have a management of unquestionable integrity?" If not, stay away from the stock. The same goes for mutual fund companies. There are too many choices out there to bother with companies that aren't run by honest, diligent folks. Finally, Fisher offered the best advice ever on selling stocks. "It is only occasionally that there is any reason for selling at all." Yes, but what are those occasions? They come down to this: Sell if a company has deteriorated in some important way. And I don't mean price! Like Buffett, but unlike most small investors, Fisher rarely got transfixed by the daily price, either high or low, of a stock he owned. Many investors sell because a stock has tumbled, getting out after they have lost, say, 20 percent of their stake; others sell because a stock has risen, hitting some kind of "target." Fisher's view, instead, is to look to the business -- the company itself, not the stock. Start with why you bought shares of the company in the first place (you can't know when to sell unless you know why you bought) -- perhaps because you liked the management and the products and because you thought demand would be strong and competition wouldn't be bothersome. Now determine whether something has changed for the worse. "When companies deteriorate, they usually do so for one of two reasons: Either there has been a deterioration of management, or the company no longer has the prospect of increasing the markets for its product in the way it formerly did." For example, as an owner of Starbucks, I would consider selling if the company decided to start opening fast-food hamburger shops or a pizza chain -- businesses in which Starbucks has little expertise. I would consider selling if a powerful competitor began to take market share away from the company. I would put Starbucks on my watch list for a sale if there were significant management changes, but wouldn't sell unless I saw a clear change for the worse. But I would hang on to Starbucks -- following the Fisher strategy -- if the stock price dropped 20 percent tomorrow. I might even buy more. A stock-price decline can be a key signal: "Pay attention! Something may be wrong!" But the decline alone would not prompt me to sell. Nor would a rise in price. Starbucks doubled between mid-1999 and mid-2000. Time to sell? If you did, you missed another doubling.
But it may be time for the big stocks to wake up. 'I'm a contrarian at heart, so I like large caps now more than ever,' said John Montgomery, manager of the Calvert Large Cap Growth fund. 'We've had a string of very strong small-cap years. That's going to unwind.' He expects large-caps to outperform small caps, on average, over the next three years. Larger companies may be better positioned to benefit from economic growth, said Stephen R. Petersen, who manages two Fidelity funds, Equity-Income and Puritan. "Smaller companies aren't as well diversified; they don't have as much excess capacity," Mr. Petersen said. "Larger companies have more opportunities to capitalize on an improving economy." Larger companies are more likely to outperform the market because they pay dividends and, as a result, tend to be more disciplined about corporate spending, said Stuart Schweitzer, global markets strategist at J. P. Morgan Fleming, the asset management arm of J. P. Morgan Chase. `We believe 2004 will mark the transition in stock-market leadership from speculative stocks to high-quality stocks,' says Richard Hoey, chief economist and investment strategist at Dreyfus. `We believe that a major theme over the next two years will be a trend towards quality.' `High-quality stocks will eventually regain market leadership. The timing of this shift is unclear, but it is inevitable in our view given wide valuation gaps between high- and low-quality stocks' say strategists at Putnam. Monthly Employment Stats
The new hiring extended to nearly every major industry in the economy, even manufacturing, which added 21,000 jobs, its third monthly gain in a row after 42 straight months of shedding jobs. Makers of machinery and semiconductors showed notable gains in April. Hotels, restaurants, trucking companies, movie studios, building-supply stores, insurance firms, and doctor's offices also added workers at a solid rate, according to the Labor Department's numbers. The breadth of gains caused Goldman Sachs economists to call the data "even stronger than March's," although March's increase -- revised upward today to 337,000, from 308,000 -- was larger than April's. The Labor Department also said that February's gain was 83,000, up from its earlier estimate of 46,000. More Employment Data Hourly earnings increased 0.3% (the consensus was 0.2%). The report's only part that was weaker than expected was the workweek, which remained at 33.7 hours (below the consensus expectation of 33.8). The solid increase in wages may mean both a stronger trajectory for job growth and earnings. Another surprise came from the manufacturing sector. Factory employment has been unexpectedly strong over the past three months, rising a revised 37,000 over the period. But the workweek posted a hefty drop, to 40.6 hours, from a peak of 41 in January and February, and overtime indicators declined as well. Apparently, employers are willing to meet expected output growth with more workers rather than more hours. The data translate to a fairly modest 0.4% industrial production gain in April, with weakness attributable to the sluggish workweek data. However, the solid earnings gain allows a bigger personal-income increase of 0.6%. This mix means industrial-production growth on a quarterly basis will actually moderate in Q2 to around 5% from 6.6% in the first, while disposable-income growth hovers at 7.5% in Q2 -- boosted by tax-law effects -- following a similarly aided 7.7% rate in the Q1. In total, the employment report will leave hours-worked growing at a 2.5% to 3% rate in q2, following 1.9% in both Q1 and Q4-03. (William Andrews, Action Economics via BW Online 5-07)
Between March 2001 and March 2004 (the latest available data), that employment number contracted by 1.96 million jobs. But here's the incredible statistic: The export-sensitive job contraction accounted for 1.56 million of the jobs lost -- or 79.9% of the total U.S. employment decline in that period. Yet export-sensitive jobs account for only about 5% of total payroll employment. Obviously, they have a disproportionate impact on the total job-loss number. The reason for the sluggish job-market growth is not that domestic growth isn't strong enough. It's that world growth isn't yet strong enough. Between the end of the U.S. business-cycle recession in November 2001 and March 2004, U.S. payroll employment jobs shrank by 323,000. However, in that same span, export-sensitive employment contracted by nearly three times that amount, 903,000 (gains in nonexport industries failed to make up export-sensitive industry declines), and it remains the primary drag on the labor markets. Today, the story is changing, although the export-employment situation still is very weak. In February and March 2004, export-sensitive employment posted small increases of 3,000 jobs each month. February's export-job upturn -- however slight -- was the first gain since October 2000. And the uptick in export employment in March brought the first back-to-back monthly increase since August 2000. There are some positive precursors of more sustained improvement for export jobs. In its latest global economic outlook, the IMF revised upward its expectations for real economic growth worldwide by about half a percentage a year for 2004 and 2005, to 4.6% and 4.4%, respectively. That's important, since global demand is the key driver of the U.S. export business. But can U.S. economic policy reverse the loss of nearly two million export jobs? This remains to be seen. These BLS data tell an important -- although largely overlooked -- economic story. They can help focus employment policy by making clear why the U.S. labor markets are restrained. George Bush, John Kerry and the investment community should all make sure to keep a close eye on those data.
"Demand has been so strong that they cannot produce enough simply through productivity," said Sung Won Sohn, economist with Wells Fargo. "In many service areas, where most of the jobs are coming from, productivity has limits." Some businesses may also have taken a half step back and become more willing to hire as a weaker dollar eases pressures from foreign competitors, said David Wyss, chief economist at Standard & Poor's. "But the main thing is, frankly, that the economy picked up," he said. "I think employers have become more confident about growth and thus they're more willing to add to their labor force." The increased demand for workers is not just strengthening, but spreading, economists said. That will certainly help people who are looking for work, but it may be a while before an improved job situation helps people already working, said Andrew Sum, director of the Center for Labor Market Studies at Northeastern. "The labor market has still got enough slack in it that I can hire anybody I want and I don't have to raise anybody's wages," he said. "The average worker is more likely to work, but is still not going to take any more (money) home." And from the same set of statistics come two voices that draw the opposite conclusion. From The Washington Post 5-09: There was an 0.5% increase in unit labor costs after a long period of steady decline -- an early sign that workers are beginning to demand and receive their share of the productivity spurt in the form of increases in inflation-adjusted wages and benefits. From Gene Epstein, Barrons 5-10: The decline in joblessness should have brought an accelerated rise in average hourly earnings -- the wage rate of the approximately 80% of workers called "nonsupervisory." And it has -- to an annual rate of increase of 2.6% over the past three months, from 2.1% in the past six months. Given the trends, "wage inflation" should continue to accelerate.
U.S. workers produced an annualized 3.5% more output for each hour they worked in Q1-04, compared with a 2.5% increase in Q4-03, the Labor Department reported yesterday. They were 5.4% more productive in the first quarter than in the same period a year earlier, high by historical standards but in line with the past two years. In 2003, the nation's output, or GDP, grew 3.1%. But productivity increased 4.4% [for the full year], meaning that efficiency gains were more than enough to meet higher demand and that the number of hours worked fell. That started to change in the first three months of 2004. The 3.5% productivity gain, while solid, wasn't enough to match growing demand for businesses' products. Total output increased 4.2%, and hours worked rose. Companies added 513,000 jobs to their payrolls in the first three months of the year, after cutting them in 2003.
Maury Harris, chief U.S. economist at UBS AG, said perhaps the most significant news in Friday's report was in the mix of jobs. Employment in professional and business services, from management consultants to engineers, rose by 123,000 following a gain of 54,000 in March. For the first four months, the category is up 214,000, or 1.3%. "There has been a major turnaround in high-wage job growth," says Mr. Harris. UBS economists broke down Friday's report by looking at job growth in industries with above-average pay and comparing it with job growth in industries with below-average pay. They found that low-paying industries began picking up employment last year and had been outpacing high-paying industries. But in the past few months, the gap has narrowed. In December, employment in high-wage industries was down 0.4% from a year earlier. Now it is up 0.6% from a year earlier, Mr. Harris says. The pickup in better-paying jobs could help explain why wage growth showed signs of accelerating in March and April after slowing in early 2004 even as the job market started to improve. Average hourly earnings were up 2.2% in April from a year earlier, compared with a 1.8% increase in March and a 1.6% increase in February. While the April increase was barely keeping pace with rising inflation, it did mark a turnaround in earnings power after a steady slowdown for two straight years. The employment-to-population ratio, a measure of the percentage of the population that is working, rose only slightly in April to 62.2% from 62.1% in March. Just the Facts The Hedge Fund Effect Remember when, after the Long-Term Capital fiasco, the investment banks said they would be more cautious in lending to hedge funds? A new survey by Greenwich Associates, a pension consultant, finds that brokers have loosened the purse strings. They are making bigger loans and imposing less stringent terms. Only now is it becoming clear just how much of the market froth of 2003 was based on what is known as the carry trade. Now some of what that money bought has been sold, alarming a lot of other investors. But there is no way to know just how much speculation was brought on by super-low interest rates. Nor is there any way to be sure how much of that leverage has now been unwound.(Floyd Norris, NY Times 5-23) Record Year for Dividends Companies in the S&P's 500-stock index are expected to pay out a record $183 billion in dividends this year [vs $167 billion in 2003]. The average annual yield of S&P 500 members stands around 1.7%. Of the companies in the S&P 500, 374, or 75%, of the members now pay dividends, the highest number since 1999. The current figure compares with 370 companies at the end of 2003, and 351 at the end of 2002. The biggest dividend payer in the S&P 500 is Citigroup, which pays out $8.27 billion based on its shares outstanding. Second is GE, which doles out $8.17 billion. The third biggest is Exxon-Mobil, paying $1.08 a share, or $7.06 billion. (Karen Talley, WSJ 5-19) Diminished Expectations Reminder Historically, earnings per share have grown two percentage points a year faster than inflation. If annual inflation runs at 3%, we are talking about 5% earnings growth. Assuming share prices climb along with earnings, you will get 5% annual share-price gains. Tack on a little under 2% for dividends, and you are looking at almost 7% a year. To be sure, there's a chance that earnings will grow faster than the historical average, so maybe we will get 8%. But suppose the price-earnings multiple on stocks drifts down over the next decade from today's 22 to the historical average of 15. That would knock four percentage points a year off the market's return, reducing our 7% annual return to just 3%. (Jonathan Clements, WSJ 4-16) Individual Bonds vs Bond Funds Bond-fund investors get a key benefit [over those who own bonds]. While it's tricky to reinvest the interest payments from an individual bond, it's a cinch with bond funds, which allow you to automatically reinvest your interest payments in additional shares. That reinvestment is critical to earning decent long-run returns. Let's say you invest $1,000 in a bond fund yielding 5%. If rates stay at 5% over the next 20 years, you will make $1,653. But almost 40% of that gain will come from reinvesting your interest payments and thereby earning additional interest. (Jonathan Clements, WSJ 5-12) Quick Facts, Stats & Opinions The economy is once again running into rather fierce headwinds. Last year's stimulants have been replaced by this year's drags. There's no tax cut this year, rising long-term rates have all but choked off the re-fi boom, housing is slowing, the dollar is up while the stock market is down, and higher energy costs are sapping buying power. (Irwin Kellner, CBS.MarketWatch 5-25) The spread between the nominal funds rate and nominal GDP is the widest since the late 1970s. Also for the first time since the late '70s, the rate of nominal GDP growth is higher than the yield on the 10-year Treasury note. (Caroline Baum, Bloomberg 5-21) With policy makers intent on producing suitable employment growth before taking their feet off the gas, investors and speculators have been borrowing short to buy everything and anything long: Treasuries, high-yield bonds, emerging markets debt, real estate, commodities, anything that trades. The result has been an increase in leverage to record levels, according to Jim Bianco, president of Bianco Research. Even after a 100 basis-point rise in 10-year Treasury yields in the past two months and a punishing sell-off in riskier bonds, `the bond market still has a record amount of leverage,' Bianco says. (Caroline Baum, Bloomberg 5-21) So what might ignite a stock rally? Some stock analysts say the spark will be evidence that the American economy is not heating up, but cooling down. While it sounds contrarian, a modest cooling off is what Fed policy makers will be aiming for when they raise their benchmark interest rate, as anticipated, in the months ahead. A cooling down would also curb fears of higher inflation, which has been accelerating this year and could push interest rates higher and unnerve stock investors. (Jonathan Fuergringer, NY Times 5-21) Every month, Merrill Lynch surveys global money managers about whether they are taking on more or less risk than they normally do. Back in January, they claimed to love risk. Now they say they are avoiding it. That survey also showed that managers had raised their cash positions rapidly as prices fell. The proportion with more cash than usual rose to its highest level since March 2003, just as many markets were hitting bottom.(Floyd Norris, NY Times 5-20) In a test going back to 1992, one of the most accurate predictors of stock performance is the ratio of a stock's price to its free cash flow per share (cash profit that doesn't have to be plowed back into capital expenditures to keep the business humming). (James Glassman, The Washington Post 5-23) For the 12 months ended in April, emerging-market mutual funds posted an average total return of 52.1%, according to Lipper. But during recent weeks, as emerging-market funds have dropped 14%, there has been an abrupt about-face. Investors yanked out $464 million during the week ended May 12, the largest outflow for the sector on record. This month overall, investors have pulled $875 million from the sector. (Opdyke & Simon, WSJ 5-18) It's our strong belief that investors are 'selling on the rumor' of the Fed raising rates and will 'buy on the news' of it actually doing so. The market has already done much of the work the Fed will ultimately do, with the 10-year note rising. . . We remain optimistic on the outlook for stocks. Small-cap stocks in particular are attractive, with favorable growth, valuable and multiple catalysts on the horizon. (Michael Moe, ThinkThoughts - ThinkEquity Partners via The Washington Post 5-16) If you're going to make a large purchase [on a credit card], time it so that you buy a day or two after the closing date of your card's billing cycle. (Michelle Singletary, The Washington Post 5-13) Mutual funds manage about $1.1 trillion in fixed-income investments, compared with almost $4 trillion of stocks. A typical bond fund would lose a little less than 4% of its value for every 1% increase in interest rates. That's based on weighted average investments in corporate and government bond funds, said John Benvenuto, director of research at Financial Research Corp. (Steven Syre, Boston Globe 5-13) "One of the great things Warren Buffett has brought to the body of knowledge of value investing is the idea of the circle of competence," says Bill Nyren, portfolio manager of the $6 billion Oakmark fund. "You can gain a competitive advantage if you limit the decisions you make to those that you feel you have a high enough competence to have a high probability of success." (Scott Patterson, SmartMoney 5-12) My suspicion is that we're in for a secular rise in interest rates because of the current account deficit and the federal budget deficit. The world also appears to be entering a period of rising inflation, which will initially be most noticeable in the U.S. The U.S., European, and Japanese central banks are pumping money like mad into their economies. (Dan Fuss, Managers Bond Fund, BusinessWeek 5-06) The McClelland Summation Index, which measures market breadth, starting to turn negative last week. (Jon Markman, StockTactics Advisor via MSN Money 5-05) Higher interest rates are coming, but contrary to the sell-offs that have occurred since April 2, this will not be the end of the world for stocks in the financial sector, home builders, mortgage lenders, REITs, or even for fixed-income investments. . . . I would wait until after the second Federal Funds rate increase [by the Federal Reserve Board] before adding to positions in banking, and only then in money-center institutions like our longtime favorite Citigroup. (Roger M. Tweed, The Tweed Update via The Washington Post 5-02) The recent [economic] gains have been particularly noteworthy in the retail sector, where the latest report showed very strong demand for autos, clothing, building materials, and furniture. . . . Such strength suggests that GDP growth will comfortably exceed 4% for the year as a whole. . . . The news from overseas is less uplifting, especially from Iraq. . . . The nod still goes to the bulls, however. That's because, most global events aside, the path that the stock market normally takes is a function of earnings trends, interest rates and the economy. (Selection & Opinion, The Value Line Investment Survey via The Washington Post 5-02) Between 1901 and 2003, the Dow gained on average 12.5% in pre-election years, 9.3% in election years, 5.2% in post-election years and 3.2% in midterm years. (Andrew Blackman, WSJ 3-07) Home Page Previous Factoid Top Sites
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