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It may be silly to worry that history will repeat itself. But for the record, based on performance since 1945, there is about a two-thirds chance that the Dow Jones industrial average and the Standard & Poor's 500-stock index will be down for the year if each one declines in January. If you are not going to worry about that, it makes sense to examine the current market environment to see whether conditions favor a rally. Unfortunately, the answer is not clear. Investor optimism has been in retreat since the end of 2004. That is a positive sign. Bullish sentiment often serves as a good contrarian indicator, so a decline from a relatively high level could mean that the market is less vulnerable to further declines. The two-week average of the bullish sentiment index of the American Association of Individual Investors was 44.7 on Friday, well below the 76.7 at the end of last year and the ninth-lowest reading since the beginning of 2003. The average between the election and the end of the year was 70.3. Another indicator, which measures the ratio of advancing and declining stocks and the trading volume in these stocks, is still giving a buy signal, according to Ned Davis Research. Price-to-earnings ratios, one valuation measure, are way below the peak reached in 2001, the firm found. The P/E for the S.& P. 500 at the end of last week, using reported earnings, was 20.3. That is above the average for the last 25 years but nowhere near the peak of 46.5 in December 2001. The so-called Fed model, which weighs the value of stocks compared with bonds, is also giving a positive reading. When interest rates are low, this model says stocks are more attractive. At the moment, it says that the S.& P. 500 is 31.3 percent undervalued. That is more undervalued - cheaper - than at the end of last year, when the model's undervaluation was 26.8%. But interest rates are expected to rise this year, as Federal Reserve policy makers increase their benchmark short-term interest rate to keep inflation in check. (The policy makers meet again this week.) With higher rates, P/E valuations will look a little more costly, and the attractiveness of stocks under the Fed model will decline. In fact, one reason that stocks seem cheaper now under the Fed model than they did at the end of 2004 is that the yield on the Treasury's 10-year note has fallen. The S.& P. 500 is not so inexpensive by this measure as it was before the post-election rally. In late October the undervaluation was as much as 37.7%, the most attractive since June 2003. Several indicators suggest that the demand for stocks is waning. The number of stocks hitting new highs has fallen, while the number hitting new lows has climbed. During the post-election rally, the number of daily new highs on the New York Stock Exchange was 279, on average, compared with 10 new daily lows. Through Friday, the average number of daily new highs had dropped to 89 for the year while new lows had risen to 20. The flagging of investor demand shows up in the flow of money in and out of equity mutual funds. January is usually a good month for inflows, but that is not the case this year, according to AMG Data Services. Through Wednesday, there was actually a net outflow of $229 million from all equity mutual funds. The big outflow, $4.4 billion, was from funds that invest in American stocks. While the month is not over - and flows from some big mutual funds that report monthly are not included - it is possible that January will register the first negative outflow for domestic stock funds since AMG began gathering data in 1992. These barometers - which, really, are no more than the market's bones and tea leaves - can be good measures of the current climate. At the moment, they predict neither sunny nor stormy weather. Still, Mr. McManus of Banc of America Securities says there is a good side to a down January: a lot of bad news has already been discounted by the stock market. So, he said, "if things turn out to be better than investors think now, stocks are likely to go higher."
Investors profited by steering more of their money into mutual funds that concentrate on foreign companies. Global funds rose 18.5% in value, on average, last year, according to Morningstar Inc. That compares with a 12.2% rise in value for U.S. funds, down from their 32% jump in 2003. "Investors were aware that the U.S. market was flattening out and that the dollar was continuing to weaken," said Andrew Clark, senior analyst at Lipper Inc. "The sentiment is that there is more money to be made overseas." The institute's report said investors put $67 billion more into global funds than they took out in redemptions, a 186% increase over 2003. The larger category of domestic funds took in a net $110.5 billion, down 14% in 2003. Bond funds had a net inflow of $10.3 billion last year, down from $31 billion, the institute said. Net inflow is the amount moving into a fund after redemptions. Balanced funds, which hold a mix of stocks and bonds, had a net inflow of $42.6 billion, versus $32.6 billion in 2003. The trade group said stock funds had a net inflow of $10 billion in December, down from $21.4 billion in November. Nearly 80% of December's inflow went to global funds. Although January figures are not yet available, two independent estimates suggest that investors have cooled toward U.S. stock funds. TrimTabs Investment Research estimated a net inflow of $187 million for stock funds through Wednesday. AMG Data Services estimated a net outflow of $229 million for the same span. Last year, by contrast, stock funds reaped a $43-billion inflow in January, the Investment Company Institute said. Typically, January brings strong inflows for stock funds as investors launch 401(k)s or otherwise put cash to work. "It's sort of shocking," said Carl Wittnebert, research director at TrimTabs. "The percentage play is that January is a good month." AMG and TrimTabs said domestic funds were hit by net outflows of more than $3.3 billion for the month so far. Those redemptions were somewhat offset by money pouring into global funds. Investors may be reacting to the U.S. market's weak start this year, but analysts said the flows could be adding to the downdraft by providing fund managers little new cash to deploy. For the second straight year, American Funds was the top-selling fund family, according to a report issued this week by Financial Research Corp. American Funds' stock and bond funds took in a combined $83.7 billion last year, the report said, on the heels of a $64.5-billion net inflow in 2003. American Funds, a unit of Los Angeles-based Capital Group Cos., had the five best-selling individual funds. Index giant Vanguard Group of Valley Forge, Pa., was No. 2 in sales, with a $51.3-billion inflow. Growing interest in exchange-traded funds lifted San Francisco-based Barclays Global Investors to the third spot with an inflow of $43.8 billion. Exchange-traded funds, or ETFs, hold baskets of stocks or bonds but trade throughout the day at updated prices like individual stocks. Assets in these funds rose to $226.2 billion, from $151 billion a year earlier, the institute said.
As with many stereotypes, of course, this one has the germ of truth. Jim Rogers, perhaps the most famous champion of commodity investing, is probably even better known as the guy whose idea of investment research is motorcycling around the world. He no doubt would find life as a stock or bond analyst intolerably boring. But the stereotypical view of commodity investing is also wrong in almost all major respects. And it's important to discard it, especially if the next several years prove to be as difficult for the stock and bond markets as many currently suspect it will be. In that event, commodities may be the one asset class that provides attractive returns. Consider a study completed last year by two finance professors: Gary Gorton of the University of Pennsylvania and K. Geert Rouwenhorst of Yale. Entitled "Facts and Fantasies about Commodity Futures," the professors paint a picture about commodities that is significantly at odds with the stereotype. Let's start with the notion that commodities are risky. This is just not true, according to the professors, who constructed a comprehensive index of commodity futures contracts covering the period from mid 1959 through March 2004. As judged by the volatility of this index's returns, commodities over this 45-year period were some 19 percent less risky than the S&P 500). The professors also found that there were significant differences in the kind of volatilities experienced by these two asset classes. For example, a disproportionate amount of stocks' volatility came from months in which they lost big, while an outsized portion of commodities' volatility came from months in which they scored big gains. As a result, the professors conclude that stocks have greater downside risk than commodities. On a related subject, the professors found that commodities are negatively correlated with stocks. So diversifying a stock portfolio into commodities has the potential to reduce risk by a large amount. The bottom line: Commodities are not inherently risky. The source of commodity futures' much-vaunted risk therefore is not the commodities themselves, but the ability to invest in them on very little margin. What about the notion that commodities produce better returns than other asset classes? The professors say that this is not so. Over the last 45 years, their commodity index produced returns that were almost identical to that of the S&P 500. To be sure, it's impressive that commodities were able to match equities' returns while nevertheless reducing risk by 19 percent. As a result, they outperformed stocks by a significant margin on a risk-adjusted basis. Still, this result is a far cry from some of the claims made on commodities' behalf. Fellow MarketWatch columnist Marshall Loeb recently quoted Rogers as saying that "you would have made more money in the last 45 years in commodities than in stocks and bonds." The professors' research shows that this is accurate about bonds but not about stocks. (Read Loeb's column below.) What if you become convinced that commodities deserve a place in your portfolio? Can you just as well invest in the stocks of companies that are involved in the production of commodities? Many think that you can. Loeb, for example, quotes the manager of the T. Rowe Price New Era Fund (PRNEX), Charles Ober, as recommending commodities equities.But the professors found that commodity futures have provided far superior returns than such stocks. Over the last four decades, their commodity futures index more than tripled the cumulative performance of the average stock involved in the production of those commodities. The professors conclude: "an investment in commodity company stocks has not been a close substitute for an investment in commodity futures." Any way you approach it, therefore, it looks as though commodities deserve a prominent place in your portfolio.
There has been a bull market in commodities for several years now. So, Rogers insists, "people who have always ignored and scoffed at commodities can no longer afford to do so." That is because the supply of many key commodities is declining, while demand continues to grow as the economies of China, India and many other nations continue to expand. Whenever supply and demand get out of whack, says Rogers, prices move to the extremes. This has happened so many times since 1960 that "you would have made more money in the last 45 years in commodities than in stocks and bonds," he says. "You would have had less risk and a better inflation hedge." You may challenge his reckoning for the long term, but it's hard to dispute Rogers in the immediate and short term. As Fortune magazine recently reported, "Nobody has gotten it more right lately than Rogers. Just look at the Rogers International Commodities Index. Since Aug. 1, 1998, when Rogers launched a private futures fund to track the index he created, the RICI has produced a total return of 194 percent, making it the top-performing investment index in the world over the past six years, according to Barclay Trading Group." Among the commodities Rogers likes now are cotton (47.90 cents per pound), orange juice (81.80 cents per pound of frozen concentrate) and soybeans (517.50 cents per bushel). But he wouldn't buy lead because its price has gone up too rapidly of late. As for oil, he believes the price will go higher for many more years, because demand has been rising so strongly and supply is so questionable. "Where's the oil coming from that is going to drive the price down?" he asks. "There has been no important oil discovery in the last 35 years. Producers have been caught flat-footed and do not have surplus capacity available." Investors can put their money into either commodities -- the actual "stuff " -- or the stocks of the oil, mining, metals, agricultural and other companies that produce commodities. Charles Ober, manager of the T. Rowe Price New Era Fund, (PRNEX: news, chart, profile) which invests broadly in companies that produce commodities, unsurprisingly recommends that individual investors put 3 to 5 percent of their assets in funds that invest in those commodity equities. Among individual stocks, he favors: Iron ore: Vale do Rio Doce. This company (RIOWI: news, chart, profile) has a vast supply of ore in the midst of its native Brazil, and can produce significantly more tonnage for the voracious Chinese. Nickel: Norilsk. This Russian company (NILSY: news, chart, profile) is successfully expanding its cash flow from its nickel operations into increasing its gold production. Potash: Potash Corporation of Saskatchewan. (POT: news, chart, profile) Prices for this fertilizer have hovered around $100 a ton for the past 10 years, but lately have climbed to $140. A main reason is that so many Chinese farmers have left the land and fled to higher-paying jobs in the cities that there is a serious shortage of farmers. People in agricultural areas now will have to plant fencerow to fencerow to make up for the shortage, and to do that, they will need much more fertilizer. Gold: It has come off its recent, 16-year high of $458 an ounce to $421.80 because of a rally of sorts in the dollar, a move that Ober believes it is only a bear-market rally, meaning gold would rise again. A primary beneficiary would be Newmont Mining Corporation, (NEM: news, chart, profile) a U.S. company whose fortunes ride on the price of gold. Surveying the entire commodities field, and reckoning that the global economy is likely to keep right on growing, Ober says, "We still have a pretty good cycle ahead of us."
The Mechanics of an Investment in Commodity Futures A commodity futures contract is an agreement to buy (or sell) a specified quantity of a commodity at a future date, at a price agreed upon when entering into the contract – the futures price. The futures price is different from the value of a futures contract. Upon entering a futures contract, no cash changes hands between buyers and sellers – and hence the value of the contract is zero at its inception. How then is the futures price determined? In determining the fair futures price, market participants will compare the current futures price to the spot price that can be expected to prevail at the maturity of the futures contract. In other words, futures markets are forward looking and the futures price will embed expectations about the future spot price. If spot prices are expected to be much higher at the maturity of the futures contract than they are today, the current futures price will be set at a high level relative to the current spot price. Lower expected spot prices in the future will be reflected in a low current futures price. Because foreseeable trends in spot markets are taken into account when the futures prices is set, expected movements in the spot price are not a source of return to an investor in futures. Futures investors will benefit when the spot price at maturity turns out to be higher than expected when they entered into the contract, and lose when the spot price is lower than anticipated. What then is the return that an investor in futures can expect to earn if he does not benefit from expected spot price movements, and is unable to outsmart the market? The answer is the risk premium: the difference between the current futures price and the expected future spot price. If today’s futures price is set below the expected future spot price, a purchaser of futures will on average earn money. Are there any theoretical reasons for the risk premium to accrue to either buyers or sellers of futures contracts? John Keynes [in A Treatise on Money 1930] theory of normal backwardation postulated that the risk premium would accrue to the buyers of futures. He envisioned a world in which producers of commodities would seek to hedge the price risk of their output. For example, a producer of grain would sell grain futures to lock in the future price of his crops and obtain insurance against the price risk of grain at harvest time. Speculators would provide this insurance and buy futures, but demand a futures price which is below the spot price that could be expected to prevail at the maturity of the futures contract. By “backwardating” the futures price relative to the expected future spot price, speculators would receive a risk premium from producers for assuming the risk of future price fluctuations. To further illustrate these points, consider a stylized example, adapted from Stefan Weiser [in “The Strategic Case for Commodities in Portfolio Diversification” 2003] . Assume that the spot price of oil is $30 a barrel and that market participants expect the price of oil to be $27 in three months. In order to entice investors into the market, the futures price is set at $25, which is a discount to the expected future spot price. The difference between the futures price and the expected future spot price, or $2, is the risk premium that the investor expects to earn for assuming short-term price risk. Now suppose that at the time the contract expires, oil is trading at the expected price of $27. An investor in physical commodities, who cares about the direction of spot prices, has just lost $3 (i.e., $30 - $27). An investor in the futures contract, however, would have gained the difference between the final spot price of $27 and the initial futures price of $25, or $2. Gathering the Data - Making a Commodity Index At the beginning of this section, we explained that the value of a futures contract is zero at origination, and does not require any cash outlay for either the long or the short position. In practice, both the long and short position will have to post collateral that can be used to settle gains and losses on the futures position over time. The collateral is typically only a fraction of the notional value of the futures position, which implies that a futures position can involve substantial leverage. In order to draw a meaningful comparison between the performance of futures and other asset classes, we need to control for leverage when calculating futures returns. We make the assumption that futures positions will be fully collateralized. When an investor buys a contract with a futures price of $25, we will assume that the investor simultaneously invests $25 in T-bills. The total return earned by the investor over a given time period, will therefore be the change in the futures price and the interest on the $25 (calculated daily), scaled by the $25 initial investment. The performance index is computed as follows: at the beginning of each month we hold one dollar in each commodity futures contract. (If the futures price is $25, we hold 1/25th of a contract). At the same time we purchase $1 in T-bills for every contract that the index invests in. The index is therefore “fully collateralized” by a position of T-bills. The contracts are held until the end of the month, at which time we rebalance the index to equal weights. The Data Shows: 1. Over the last 43 years, the average annualized return to a collateralized investment in commodity futures has been comparable to the return on the SP500 [at around 11%] Both outperformed corporate bonds [which returned around 8%]. 2. Stock [with a standard deviation of 15%] and Commodity Futures [with a standard deviation of 12%] have experienced higher volatility than Bonds [with a standard deviation of 8%]. 3. Commodity Futures outperformed Stocks during the 1970s, but this performance was reversed during the 1990s. 4. The volatility of the equally-weighted Commodity Futures total return is slightly below volatility of the S&P 500. So, the Sharpe Ratio has been slightly higher for Commodity Futures than for Stocks. 5. Financial returns are not completely characterized by the mean return and the standard deviation of returns. This is because, as is well known, the returns on financial securities are not normally distributed, but rather have “fat tails” compared to the Normal Distribution. This is also true of commodity futures. Commodity futures returns are positively skewed; stock returns are negatively skewed. Zvi Bodie and Victor Rosansky [ in “Risk and Return in Commodity Futures” 1980] , and others, also note that commodity futures returns are considerably positively skewed compared to stock returns. Correlations: 1. Over all horizons – except monthly – the equally-weighted Commodity Futures total return is negatively correlated with the return on the SP500 and long-term bonds. This suggests that Commodity Futures are effective in diversifying equity and bond portfolios. 2. The negative correlation between Stocks and Bonds tends to increase with the holding period. This suggests that the diversification benefits of Commodity Futures tend to be larger at longer horizons. 3. Commodity Futures returns are positively correlated with inflation, and the correlation is larger at longer horizons. Because Commodity Future returns are volatile relative to inflation, longer-term correlations better capture the inflationproperties of a commodity investment. The correlations of stocks, bonds, and commodities with inflation. 1. Commodity Futures have an opposite exposure to inflation compared to Stocks and Bonds. Stocks and Bonds are negatively correlated with inflation, while the correlation of Commodity Futures with inflation is positive at all horizons. 2. In absolute magnitude, inflation correlations tend to increase with the holding period. The negative inflation correlation of Stocks and Bonds and the positive inflation correlation of Commodity Futures are larger at return intervals of 1 and 5 years than at the monthly or quarterly frequency. Commodity Futures have opposite exposures to unexpected inflation from Stocks and Bonds. 1. The negative sensitivities of Stocks and Bonds to inflation stem mainly from sensitivities to unexpected inflation. The correlations with unexpected inflation exceed the raw inflation correlations. 2. Commodity Futures are also more sensitive to unexpected inflation, but (again) in the opposite direction. The correlations of stocks and commodities with the business cycle. Weiser (2003) reports that commodity futures returns vary with the stage of the business cycle. In particular commodity futures perform well in the early stages of a recession, a time when stock returns generally disappoint. In later stages of recessions, commodity returns fall off, but this is generally a very good time for equities. 1. Over the period July 1959 through March 2004, average monthly annualized returns on the S&P and the equally-weighted commodity futures total return are remarkably similar, 10.8% and 10.5%, respectively. 2. They are also remarkably similar over expansions, 12.8% on the S&P and 12.9% on the equally weighted commodity futures. Over recessions, the average monthly annualized returns for the S&P and the equally weighted commodity futures are 1.7% and 0.5%. 3. During the Early Recession phase the returns on both stocks and bonds are negative, -15.5% and –2.9% respectively. But, the return on commodity futures is a positive 3.5%. During the Late Recession phase the signs of the returns reverse, stocks and bonds are positive, while commodity futures are negative. 4. The diversification effect is not limited to the early stages of recessions. Whenever stock and bond returns are below their overall average, in the Late Expansion and Early Recession phases, commodity returns are positive and commodities outperform both stocks and bonds. Many researchers argue that oil shocks disrupt economic activity. That is, unexpected increases in oil prices are associated with declines in the macroeconomy, as measured by output or employment. For example, see Hamilton (2003, 1983). Essentially what happens during the Early Recession phase, generally speaking, is that oil and energy-related prices unexpectedly increase, causing a windfall gain to long futures investors. Commodity Future Returns & Backwardation The degree of backwardation – defined as the difference between the current futures price and the current spot price – carries no information about the relative attractiveness of investment in commodity futures. To reiterate, none of this is surprising if futures markets are efficient, as it should not be possible to profitably trade on the basis of public information. Commodity Future Returns & Commodity Company Stock Returns [We also examined] difference between the average return of commodity futures and investment in commodity company stocks. Over the 41-year period between 1962 and 2003 the cumulative performance of futures has been triple the cumulative performance of “matching” equities. A plot of the same indices on a logarithmic scale indicates that the two investments have limited correlation as well – the full-sample average monthly correlation is 0.38. The conclusion of Figure 18 is that an investment in commodity company stocks has not been a close substitute for an investment in commodity futures.
FED CRED: Some 20-plus years of successfully fighting inflation has convinced bond investors that the Fed will do what it takes to keep price pressures in check. What's more, Greenspan & Co. enhanced their credibility by patiently yet persistently raising rates last year despite a temporary summer soft spot in the economy in the midst of a heated Presidential election campaign. "They've built up a lot of goodwill in the marketplace," says Anthony J. Crescenzi, chief bond market strategist at institutional broker Miller Tabak & Co. A SURFEIT OF SAVINGS: It's not only in the U.S. that bond yields are low. Europe's are as well and have fallen below those of the U.S. That has led former Fed Governor Lawrence B. Lindsey to speculate that a global glut of savings may be holding down long-term rates worldwide. Lackluster economic growth in Europe means hordes of aging baby boomers there have limited investment options for their retirement caches. Some of that money is coming to the U.S., helping to hold down rates here. ASIAN APPETITES: Led by Japan and China, Asian central banks were big buyers of dollars last year. Their goal: protect their exports by keeping their money from appreciating against the greenback. A quarter of a trillion dollars or more of that money was invested in U.S. bonds, particularly Treasury securities. Fed staffers reckon that lowered U.S. yields by 0.25 to 0.5 percentage points. STRUCTURAL SLOWDOWN: Some bond investors are convinced that the U.S. economy is a lot more fragile than the Fed believes. Among the troubles they see: heavily indebted U.S. consumers, a federal government awash in red ink, and an overheated housing market. They're buying bonds and bond futures now in a bet that those structural drags will stunt growth this year, pushing yields down further. Does the rate mismatch matter? If the bond markets are just riding on a wave of Fed cred or retirement cash, probably not. But Asian currency manipulation or drags on U.S. growth could be setting the market and the economy up for an abrupt adjustment. Unfortunately, not even the Fed knows for sure which causes dominate -- or how they'll play out.
As the Federal Reserve Board steadily hiked its benchmark interest rate from 1% to 2.5%, the rate on adjustable-rate mortgages correspondingly rose. But the long end of the market didn't behave as widely anticipated. Instead of rising -- the typical reaction whenever the Fed initiates a tighter money policy -- the yield on the traditional 30-year fixed-rate mortgage fell last year. DORMANT INFLATION. In the new year, Wall Street commentary is once again singing the same tune: Long-term interest rates are heading higher. Yet the decline in fixed-rate mortgages has continued in 2005, with the rate currently hovering around 5.25%. The odds are that mortgage rates will stay where they are or even trend irregularly lower this year. And this continued low level suggests the housing market's coming slowdown will be modest rather than cataclysmic in 2005. Why should long-term mortgage rates come down? The expected rate of inflation plays a large role in setting long-term market rates. The more investors anticipate inflation, the higher the interest rate they demand to compensate them for the risk that a debauched currency will ravage the value of their fixed-income investment -- and vice versa. But inflation isn't about to stir. The Federal Reserve Board is waging an open campaign to stem any resurgence in inflation by raising its benchmark interest rate. And consumers rebel whenever retailers try to raise prices. BUBBLE DEBATE. Take the recent holiday season. Wal-Mart (which accounts for about 10% of the nation's retail sales) tried to avoid offering shoppers special promotions. And what did buyers do? They went elsewhere to find deals. Wal-Mart got the message and quickly reversed course, whipping out the markdown pen. Delta Airlines' new low-fare strategy is wreaking havoc on its competitors. The Japanese auto makers are taking market share from the Big Three with generous incentives. With so little evidence of inflation, investors have reduced the yield on the benchmark 10-year Treasury bond from around 4.6% in June to about 4.2%. With inflation heading lower this year -- and the Fed continuing to raise its benchmark interest rate -- there's additional room for further decline in bond yields and mortgage rates. "When the Fed says it wants low inflation and that it's willing to further tighten monetary conditions, the record suggests it should be taken at its word," bond mavens Van R. Hoisington and Lacy H. Hunt of Hoisington Investment Management Company wrote in their fourth-quarter 2004 outlook. What impact will continued low rates have on the housing market? The residential market has been on a tear, and home prices adjusted for inflation are up about 36% since 1995. That's roughly double the increase of previous home-price booms in the 1970s and 1980s. Many analysts believe the housing market is developing a massive bubble that will soon burst, erasing much of the gain of recent years. Still, after a careful review of the residential real estate market and the bubble literature, economists Jonathan McCarthy and Richard W. Peach of the Federal Reserve Bank of New York conclude that the "most widely cited evidence of a bubble is not persuasive." RISKS OF OPTIMISM. Indeed, homes remain affordable on average (assuming you don't live in New York, Los Angeles, or a few other high-cost cities) -- largely because of low rates. For instance, McCarthy and Peach compute a simple home-price-to-income ratio. The figure is between annual interest and principal payments at prevailing 30-year mortgage rates on a new single-family home (assuming a 20% down payment), and median family income. By this definition, 15% of family income is going toward housing costs on average. The number has been stable for the past several years and is as low as it has been in 25 years -- in sharp contrast to the conditions of the 1970s and 1980s when high home prices and high interest rates combined to erode cash-flow affordability. True, there's anecdotal evidence that the housing market is losing steam in many areas of the country, especially in tony neighborhoods. But stagnation is a far cry from a catastrophic plunge reminiscent of the dot-com bust of 2000. Still, these optimistic calculations could be upended by any number of economic crises in 2005. Foreign investors could go on strike, refusing to buy any more U.S. government debt, scared away by the twin federal budget and current account deficits. If the Administration succeeds in creating private accounts for Social Security, the transition cost will likely require $1 trillion to $2 trillion in additional government debt. The risk exists that the U.S. dollar's slide on foreign exchange markets turns into a stomach-churning rout. BONDS GET NO RESPECT. These financial dangers are well known. Yet, some bearish money mangers and high-profile observers, frustrated that long-term interest rates have come down over the past year, argue that investors are willfully overlooking these potential pitfalls. Still, that's a tough argument to buy. Almost no Wall Street commentator and public policy maven likes bonds these days because the rates are too low. Like Rodney Dangerfield, bonds get no respect. Big mistake. If the Fed succeeds in its stated mission and brings the inflation rate down, long-term interest rates aren't about to go up -- and that includes mortgage rates.
What's fueling those concerns? The minutes -- which don't identify the worrywarts -- point to the return of corporate pricing power, a weak dollar, still-elevated energy costs, and slowing productivity growth as signs that price hikes could soon accelerate. And in the financial markets, Fed officials cited low corporate bond yields and recent pickups in initial public offerings and mergers and acquisitions as indications that easy money is fueling speculation. So it's not surprising that some policymakers are uneasy with the repeated assertions that rate hikes will be measured. They are warning that the Fed may need to be more aggressive. "At some point the measured language will come out of the Fed statement," Federal Reserve Bank of St. Louis President William Poole told reporters after a Jan. 13 speech. "There would be a pretty vigorous reaction [by the Fed] should we see [inflation] threaten to move to a sustainably higher rate." HAPPY MARKETS But those concerns don't seem to have fazed the man atop the Fed. Associates say the chairman has shown no signs of panic and appears content with the strategy of small, slow rate hikes -- one-quarter of a percentage point at each meeting. By more than doubling the short-term rates it controls, from 1% last June to 2.25% today, the Fed has already drained much of the stimulus it pumped into the economy after the stock market bubble burst and terrorists attacked on September 11. Indeed, with another quarter-point hike expected at the Feb. 1-2 meeting, short-term rates will be inching closer to levels where some Fed officials might even consider taking a break from their rate-hiking campaign. "Interest rates clearly are not at restrictive levels," Minneapolis Federal Reserve Bank President Gary H. Stern said in a speech on Jan. 18. But, he added, "if we keep inflation low, I don't see any reason why interest rates should reach particularly high levels." Buttressing Greenspan's view: Despite the steady rise in short-term rates, financial markets have stayed calm. Stock prices have risen, and bond yields are actually lower than when the Fed started raising rates in June. In previous expansions, falling long-bond rates often signaled the market's concern that the economy might be weakening. That's unlikely to be the case this time. The economy, in fact, looks pretty good. Business has shrugged off a jump in oil prices, and gross domestic product looks set to grow 3.5% to 4% in 2005, Fed officials say. Although inflation has crept up some, it remains well-contained. Excluding volatile food and energy costs, core consumer prices rose just 2.2% in 2004. "We haven't seen any worrying rise in inflation at this point," Fed Governor Edward M. Gramlich told reporters on Jan. 12. While there are differences at the Fed over the risks of inflation, central bank officials insist that it would be wrong to exaggerate them. Most of the Dec. 14 meeting was in fact spent discussing the Fed's growing confidence in the durability of the economic upswing. But that conclusion caused little divergence among policymakers and was given short shrift in the minutes. As a result, more of those were devoted to the discussion of inflation, magnifying the importance of those differences. That emphasis may also have led some investors to conclude that the Fed is more worried about a rise in inflation than appears to be the case, Fed insiders say. What's critical is what Greenspan thinks. While his influence may dim the closer he gets to stepping down next January, Fed insiders say he remains first among equals. Throughout his 18-year Fed career, Greenspan has focused like a laser on productivity growth, labor costs, and profit margins in trying to determine the outlook for inflation. Now is no different. The message from those key indicators? Inflationary pressures may be building, but gradually. Yes, productivity growth has slowed to a 1.8% annualized pace in the third quarter of last year, the latest period for which data are available. But that slowdown is from extremely strong levels that Greenspan long thought were unsustainable. Excluding farming, productivity grew at a 4.4% clip in 2002 and 2003, a pace that puts even the New Economy of the 1990s boom to shame. And sure, unit labor costs have turned up as productivity growth has slowed. But that's after costs fell in both 2002 and 2003, the first back-to-back yearly decline since the early 1960s. Labor compensation -- wages and benefits combined -- is growing steadily, at around 4% annually, and shows scant signs of accelerating. That's not a big surprise given the modest jobs growth so far in this recovery. Profit margins, meanwhile, look to be leveling off after sharp jumps last year. It was that rise in profit margins that Greenspan identified as the culprit behind last spring's pickup in inflation. But as execs gain confidence and become more aggressive, competition for market share will heat up. That will limit companies' ability to pass on their added costs to customers. The likely result: a squeeze on margins and a cap, at least temporarily, on inflation. And that seems to be the message from the monthly survey of small companies by the National Federation of Independent Business. It shows that pricing power peaked in June of last year. CLOSER TO EQUILIBRIUM Of course, inflation risks would look a lot different to Greenspan if the central bank hadn't already removed plenty of its monetary juice from the economy. When the Fed began tightening credit last June, policymakers said they wanted to raise ultralow interest rates back to equilibrium levels where monetary policy is neither stimulating nor holding back the economy. What exactly that level is, though, isn't clear. Greenspan has said he'll know it when when he gets there. But other policymakers have suggested that monetary policy will be in neutral when rates hit the range of 3.5% to 4.5%. If the Fed goes ahead and raises short-term rates to 2 1/2% on Feb. 2, it will be within hailing distance of that objective. "The Federal Reserve has already begun to make the transition from an accommodative policy stance to a neutral one," said Anthony M. Santomero, president of the Federal Reserve Bank of Philadelphia in a speech on Jan. 18. Yet even as the Fed has tightened its stance, financial conditions in the markets have turned looser. Long-term interest rates have fallen, stock prices have risen, and the dollar has ebbed. Together, that has given extra oomph to the economy, more than offsetting the impact of the Fed's rate moves, says Goldman, Sachs & Co. (GS ) chief economist William C. Dudley. That's why he and others in the markets argue that the Fed might need to raise rates further than planned. That argument is unlikely to sway Greenspan. Under his tutelage the Fed has always been reluctant to target any measure of financial conditions, says ex-Governor Laurence H. Meyer. Instead it focuses on why asset prices are moving and what impact they'll have on the economy. Stocks have risen over the past year on growing optimism about the economy. That heightened hopefulness has also boosted initial public offerings and mergers and acquisitions. Meanwhile, bond yields, including those on corporate debt, have fallen, in part in the belief that inflation will stay low. It's not clear why any of that should particularly concern the Fed as long as the economy looks healthy. Fed officials are paid to worry -- and Greenspan is no exception. But as he swings into his final year astride the world's economy, he appears to be about as relaxed as any central banker can be. Here's an interesting factoid: a rise of over 55% in the Goldman Sachs Commodity Index has never failed to produce a recession. The index has now risen by over 100% in the past 33 months. Here are the historical occurrences where the index has gained at least 55% over a 30 month period: May 1973, January 1980, September 1990, November 2000, and March 2004. More interesting, only one time before has the index rallied more than 100% and that was back in 1973 when the S&P 500 fell 16%. (The Kirk Report 10-12-04)
Having analyzed initial public offering statements since 1991, Ms. Killian has a long-term view of how governance is practiced at new companies and how those practices have changed. To be sure, the share of poorly governed companies from last year is lower than the 63 percent registered in 2002. But Ms. Killian is surprised by the fact that more than half of new companies last year seemed unconcerned about issues that many shareholders care deeply about. "What we see in our research is the quality of governance has deteriorated in I.P.O.'s," Ms. Killian said. "It's surprising to me, given the enactment of major legislation and all of the emphasis that has been placed on better corporate governance." Last year was a relative banner year for I.P.O.'s: there were some 216 new issues, up from 68 in 2003, though still down considerably from the 406 in 2000. Of course, assessing governance at public companies is part science, part art. Ms. Killian begins her analysis with a checklist she has developed. She looks, for example, at whether the proceeds from the I.P.O. go to the company (good) or to selling stockholders (less good); the degree to which management enriches itself with perquisites and pay; whether directors are really independent; and the size of the executives' stakes in the company. The most common governance problems cited by Ms. Killian in new issues are a dearth of truly independent directors keeping watch over the companies, meager stockholdings by top executives and big insider selling when the deal is done. That is different from previous eras, Ms. Killian said. "In the 1990's, for example, there used to be more odious insider transactions," she said, "or part-time chief executive officers who would have outside interests that conflicted with their running of the public company." The fact that after all these years directors at many of the companies going public are not wholly independent, at least by Ms. Killian's standards, is something of a surprise. Director independence has been a hallmark of reforms since the Enron and WorldCom debacles showed what could happen when boards were too cozy. In many cases, these directors would qualify as independent under rules instituted by the New York Stock Exchange or Nasdaq, Ms. Killian explained. "But when you look at it in a reasonable way, you'll see that they are buddies with management," she added. Many of the new issues scoring low in corporate governance are real estate investment trusts, Ms. Killian said. One reason is that many of them are set up to capture tax benefits and may not meet the same standards as other companies. For example, several recently formed REIT's had no outside directors, or were run by insiders with their own separate interests in the same properties held in the REIT. In some cases, executives at new REIT's had the distraction of outside interests in other properties, Ms. Killian said. REIT's have also been such top performers in recent years that shareholders who buy them as new issues may be willing to overlook governance shortfalls. Last year, REIT's returned 30.4 percent, on average. The Celanese Corporation, an industrial chemical company that issued 50 million shares in an I.P.O. last Thursday, is an example of a company whose officers and directors own a tiny stake in the company - less than 2 percent, according to Ms. Killian. The company, which had hoped to get $20 a share in the offering, had to settle for $16 when the deal closed. A spokesman declined to comment because of regulations limiting public statements immediately after a stock offering. As a practical matter, Ms. Killian said, shareholders should flex their muscle, rewarding companies with good corporate practices and penalizing those that fall short. "Over the long term, good governance at a company makes a difference in its performance," Ms. Killian said.And investors interested in exceptional performance have to be watchful, even now.
Junk, or "high yield," corporate bonds, and emerging-market debt, have rallied for so long that their yields, which move in the opposite direction of their price, are near their lowest levels ever. The small-stock Russell 2000 index closed last year with repeated record highs, and overall stock-market volatility has been at its lowest levels since 1995. Emerging-market stocks soared 86% over the past two years. But so far this year, investors have turned more cautious. A Merrill Lynch survey this week of equity-fund managers showed a shift in sentiment away from riskier stocks. High-yield bond mutual funds suffered outflows of $265 million the week ending Jan. 12, the largest weekly total since July, according to AMG Data Services. Brazilian bonds led a selloff in emerging-market debt after the Federal Reserve minutes came out earlier this month, and small stocks and companies in the tech-heavy Nasdaq Composite Index have come under steep selling pressure. This may yet prove to be temporary profit taking before these riskier assets return to favor. Indeed, some fund managers argue that improving economic and corporate fundamentals justify the record recent gains -- and they argue that will lead to further gains in the year ahead. They point to better credit quality in the high-yield and emerging markets, healthier corporate balance sheets and sounder economies in the developing world. Yet some analysts warn that the risk premium -- the additional yield attached to more-speculative bets relative to risk-free U.S. Treasurys -- has come down so far that investors no longer are adequately compensated for their risk. Speculative assets would be the most vulnerable if the economy doesn't grow as much as expected, or if interest rates rise faster than anticipated or if another corporate blowup rattles investor confidence. In that case, investors would flock to safer assets such as Treasury or high-grade bonds and larger rather than smaller stocks. "I've been surprised how unconcerned people have been about what a global slowdown would mean for risk premiums and corporate profits," says David Bowers, chief global investment strategist for Merrill Lynch. "People know that the Fed is tightening, but they are underestimating what that means." Fed officials seem to have similar misgivings. In minutes from the U.S. central bank's last policy meeting, officials worried about "excessive risk taking" following a prolonged period of low interest rates as they wondered why corporate-bond yields weren't higher. Risk premiums shot up in the wake of the Sept. 11, 2001, terror attacks in the U.S., and many market observers predicted at the time that they would remain high for several years. The attacks not only aggravated the economy's existing weakness, but they also introduced numerous new geopolitical uncertainties that were seen disrupting business planning and weakening consumer confidence. By last year, however, in the absence of another major attack in the U.S. and continued high consumer confidence, risk appetite was clearly returning, especially after the presidential election ended without controversy. Some investors maintain risk premiums have been falling for good reason: These securities are less risky than before. As corporate balance sheets have improved, and as low interest rates have allowed companies to refinance debt at more-attractive levels, default rates among junk-bond issuers have come down. In emerging markets, about half of the debt in the benchmark index carries an investment-grade rating, compared with only 10% in 1998. Indeed, one reason why Brazil rebounded was because Moody's Investors Service raised the government's rating outlook to "positive" from "neutral." The U.S. economy also has been providing a favorable backdrop for more speculative assets. Consensus forecasts call for solid growth of about 3.5% in 2005, inflation remains tame and interest rates, though rising, are still at relatively low levels. Even some investors who believe that the market is underestimating risk say they aren't ready to turn completely defensive. "Risk premiums are lower than they should be, but there is still value out there," says Mohamed El-Erian, head of emerging markets for Pacific Investment Management Co., or Pimco. He points to government bonds from Russia and Brazil, which he believes can rally from probable credit upgrades even if risk premiums for the broader market move higher. Others are more worried. They argue that after long rallies, the riskier securities now are pricing near-perfect outcomes for the global economy. But if anything does go wrong, the more-speculative stocks and bonds would be hit the hardest. Because hedge funds and other speculators have been buying these securities, any initial selloff soon could be amplified as these short-term investors rush for the exits. The Fed clearly has signaled that interest rates are going higher, and some economists think even if inflation stays benign, the Fed will want to raise its key federal-funds interest-rate target back to a more neutral level -- say, between 4% and 5% -- from the current 2.25%, so that it has room to lower rates for the day when the economy slows. Higher interest rates would cause bond yields to rise and make investing in risk-free Treasurys more attractive, so other bond yields would need to rise to attract capital. A continued rally also depends on the economy expanding at a healthy rate. But last week, several economists rushed to revise downward their fourth-quarter estimates after the U.S. trade deficit in November proved wider than expected. Additional surprises such as this could temper future economic expectations, driving investors to sell riskier assets and seek safer ones. Some investors worry that any crack in the economy also could expose problems with some companies that have done well in recent good times. "Given that we haven't had a major corporate risk event since perhaps WorldCom, memories are short," says Dominic Freud, a fund manager with Oppenheimer Funds, referring to the telecommunications company that in 2002 disclosed fraudulent accounting. "But all it would take is one high-profile blowup to spark a selloff" in riskier assets. Andy Xie, a Morgan Stanley economist based in Hong Kong, believes the fate of risky assets is tied to the dollar. He argues that while emerging markets no longer are cheap, money continues to flow into them because institutional investors want to avoid dollar-denominated assets. "Global investors are ignoring risks in emerging markets as they're consumed by the fear of a crashing dollar," he wrote in a recent report. This "psychology is causing the risk premium on emerging markets to disappear. When the dollar bottoms, it will signal the peaking of all risk assets globally."
The past year's top defaults included Trump Atlantic City ($1.8 billion), RCN Corp. ($1.3 billion) and Pegasus Satellite ($800 million). For 2005, Fitch expects default rates to remain significantly below the long-term annual average of 5.5%. The outlook for 2006 and 2007, however, is less certain due to a multitude of factors. One, nearly $70 billion in high yield bonds is slated to mature over the next two years, compared to just $20 billion in 2005. Thus, the ability to refinance will be in the forefront amid an environment of potentially higher long-term rates and wider credit risk premiums . In addition, the market's enthusiasm for extending credit to high yield issuers may be damped by investment alternatives in less risky assets. Earlier this week Standard & Poor's warned that global corporate speculative-grade bond default rates will likely rise by year-end after declining slightly from their fourth-quarter low of 2.3%. Its average forecast for the next four quarters of 2.2% remains lower than the 3.8% historical average of the trailing four quarters, S&P said. But concerns for a more "material" increase in defaults in two to three years remain, the agency added. Last week, Moody's Investors Service said the global speculative-grade issuer-weighed default rate fell by 58% in the past year. In December, the rate was 2.2% - lower than 5.2% at the start of the year. The rate was down from its peak of 10.9%, which occurred in January 2002. In November, Moody's said the default rate was 2.54%. Moody's expects a default rate of 2.7% by the end of the year.
The rise in home-equity lending may reflect a more fundamental shift in consumer borrowing habits. "Home equity lending is displacing other forms of consumer credit," such as credit cards, mortgage insurance and first mortgages, Morgan Stanley analyst Kenneth Posner said in a recent report. Mr. Posner estimates that the home-equity market could grow by as much as 20% per year through 2010. For borrowers, the advantages include lower rates and tax-deductibility, but there are also fears that some homeowners may become overextended. As the number of home-equity loans has increased, so has the amount borrowed. The average size of a new home-equity line climbed to nearly $78,000 last year, up from roughly $57,000 in 2001, according to Benchmark Consulting International in Atlanta. The Federal Deposit Insurance Corp. says home-equity loans are the fastest-growing asset class on financial institutions' balance sheets. Home-equity loans and lines accounted for roughly 25% of the growth in mortgage debt in the third quarter of 2004, according to the Federal Reserve Board. Some homeowners use home-equity lines as a reserve fund to be tapped in an emergency. But utilization rates are increasing, with borrowers drawing down an average of nearly 51% of their credit line in October, up from 46% a year earlier, according to LoanPeformance, a San Francisco firm that tracks mortgages. As with credit cards, the cost of a home-equity line of credit goes up when the Federal Reserve Board raises short-term rates, which it has done five times since late June. The blow is softened, however, by the fact that loan balances tend to be relatively small. Someone who borrowed $50,000 using a 15-year home-equity line would pay roughly $370 a month if rates were 4%, the prime rate before the recent series of increases. The monthly payment jumps to $402 with a 5.25% rate and to $449 at 7%, according to SMR Research. As the Fed raises short-term rates, home-equity lines have lost some of their edge over fixed-rate home-equity loans, which have barely budged. The difference between loans and lines of credit now stands at just 1.37 percentage points, down from 2.37 points in June, according to HSH.
That is in large part because they are easily traded, inexpensive, tax-efficient and you know exactly what is inside -- unlike their traditional mutual-fund cousins. The average domestic-stock ETF has an expense ratio of roughly 0.36% of assets, compared with 0.88% for the average domestic stock-index fund and 1.50% for the average domestic stock-mutual fund, according to Morningstar. Traditional brokerage houses are increasingly adding ETF portfolio products to their fee-based programs. A.G. Edwards & Sons Inc. was a trailblazer, launching its Allocation Advisors program in late 2001, and now has 15 model ETF portfolios with plans to add six more within the next month. Meanwhile, Ryan Beck & Co., Janney Montgomery Scott, Morgan Keegan and Park Avenue Securities LLC, a unit of Guardian Life Insurance Co. of America, have all also recently instituted similar programs. Raymond James Financial plans to unveil its version this month, while Morgan Stanley hopes to have ETF portfolios available within its unified managed-account program this summer. "It's clear there is a lot of interest," said Jeff Holland, vice president of Raymond James' Consulting Services, its separately managed account program. "You have these 800-pound gorillas pushing and promoting the [ETF] product, and you are starting to see a lot of demand pulling from advisers and clients. So it made a lot of sense to put something together." The so-called gorillas are the two largest ETF providers -- Barclays Global Investors and State Street Global Advisors -- which together control 68% of the market. The online brokerage firms are also tapping into the rise of ETFs. Ameritrade Holding Corp. and Fidelity Investments launched ETF-focused portfolio services late last year, while ShareBuilder Securities Corp., an online brokerage house geared to younger, "emerging" investors, unveiled its service last week. "The customers told us they'd really like to have something that designs the whole portfolio, that takes good investing principles and fundamentals and tells [them] what to buy," says Jeff Seely, ShareBuilder's chairman and chief executive officer. ShareBuilder's PortfolioBuilder Plus tool gauges an investors' goals, risk tolerance and time horizon through a questionnaire, and then suggests one of 15 ETF portfolios. Depending on the amount being invested, the portfolio will include anywhere from two to about seven ETFs, which can be wrapped inside an IRA. The majority of ShareBuilder's customers make automatic investment contributions to their accounts each month, paying $1 to $4 per transaction. Since ETFs trade like stocks, investors must pay commissions when buying and selling shares. ShareBuilder keeps those costs much lower than its brokerage peers by bundling these automatic investors' transactions into one large block trade. Still, it doesn't always make sense for dollar-cost-averaging investors, those who invest a set amount of money at regular intervals. Any savings on the lower cost of ETFs can quickly be erased by commission costs, making mutual funds a better bet. Ameritrade's online-advisers service Amerivest, which helps investors choose an asset allocation of ETFs, has waived all ETF trading costs and instead charges a flat fee -- 0.50% of assets for portfolios south of $100,000 and 0.35% for larger portfolios. Investors also need to consider pricing when building a portfolio of ETFs through an adviser. "If they are putting a 2.5% wrap [fee] on a portfolio of ETFs, it defeats the purpose," says Dan Dolan, director of wealth management strategies for Select Sector SPDRs, a family of ETFs that divvy up the S&P 500-share index into nine sector index funds.
"The theme of 'stocks for the long term' sustained itself," Nachmany says. "Equity fund redemption activity overall is lower today than in the 1980s, partly due to the fact that over 60 percent of equity fund assets constitute retirement investments." That last point is key. Much of recent fund growth doesn't stem from some new appetite for investing, but rather a shift of money flows out of old-style institutionally managed pension plans into self-directed retirement accounts such as 401(k) plans. This is business the industry gained mostly by being in the right place at the right time, rather than from some unique management brilliance or special marketing genius.
But you must do that with a sense of control. For example, if you're impulsive, you should control your tendency to jump into an investment without having given it much thought. "You need a strategy that does take into account what's happening in the market that you will stick with, even though there may be times when your emotions will rear their ugly head," said Mr. Frankle, president of Wealth Resources Group. The basic emotions held by all investors are fear and greed. Fear can paralyze you to the point where you lose more money than necessary. An example is holding on to a stock when it's clear you should cut your losses. "Most investors are loss-averse," said Robert Weller, vice president of the J.P. Morgan Intrepid Funds and the JPMF U.S. Dynamic Fund. "Investors are 1.7 times more likely to sell a gain than a loss." Some get too greedy. "Some hold on and they end up going down the tubes," said Muriel Siebert, chief executive of Siebert Financial Corp. in New York and the first woman to hold a seat on the New York Stock Exchange. "It is the worst thing in the world to ride it up and down and go broke when you've had opportunities along the way. "Don't be a pig. Take half the profit and keep the rest, if you still believe in it." Using psychology Wall Street is well aware of how investors' personalities can sway their investment direction. J.P. Morgan Funds' has created Behavioral Finance Funds, which seek to take advantage of investor psychology to make money. "The human tendency to be overconfident in one's own abilities often leads individuals to make judgments based on inadequate information, to overestimate the accuracy of their predictions and to lull them into believing that they aren't prey to the same mistakes as everyone else," according to JPMorgan sales materials. "But overconfidence is good news for followers of behavioral finance. Repetition of the same mistakes leads to systematic anomalies in the stock market which offer significant profit-making opportunities." Investor personalities Merrill Lynch recently released a survey that found four distinct investor personalities: Measured investor: This person is very systematic, very methodical. "They are comfortable about their financial situation," said David Nethery, a vice president and financial adviser at Merrill Lynch's Global Private Client Group in Dallas. "The biggest mistake these people make is they're sometimes to the point of being stubborn with their methodology, and they seem not to know when to sell." Unprepared investor: This person hasn't saved or invested much typically because of overspending or because "they just feel so unknowledgeable about it they just don't want to deal with it," Mr. Nethery said. Reluctant investor: "They didn't start investing early enough and started too little too late," Mr. Nethery said. Reluctant investors don't particularly enjoy investing, preferring to spend as little time as possible managing their investments. At the same time, those investors tend not to hold losing investments too long, and few have over allocated into one investment. Competitive investor: "They look at investing almost as a sport," Mr. Nethery said. "They love the thrill." Although they're knowledgeable, competitive investors also trip up. "They hang on when they clearly should be selling," Mr. Nethery said. "They get that stubbornness confused with discipline." One Dallas investment adviser harnesses a client's personality to make the best recommendation. "If they spend everything they can get their hands on, I'm going to recommend some kind of an investment where they can't get their hands on it," said Dan Saur, president of D.R. Saur Financial Inc.
Investors have heard warnings about the weary consumer for years, but even in 2004 spending didn't falter. The differences in 2005: Consumers now have all but drained their savings, consumer interest rates are rising, and there are no more tax cuts to augment income. "I just don't see where the ammunition for consumer spending is going to come from," said Brett Gallagher, head of U.S. equities at Julius Baer Investment Management. "Ultimately, businesses are not going to spend if their end clients cannot spend." After years of tax cuts and mortgage refinancings, disposable income growth has fallen back in line with overall income growth. "The income that drives the consumer no longer has any kick to it," Mr. Gallagher said. "You've lost that leverage effect the tax cuts gave you, and what you make is now what you have." This root source of uncertainty has most strategists predicting a second year of respectable, but not stellar, gains in the stock market. Most predict returns on the Standard & Poor's 500 will come in around 8% to 10%, equaling the expected growth in corporate profit for the year. Donald Straszheim, president of Straszheim Global Advisors, is among the more pessimistic. "If investors don't pick well, it's going to be a tough year," he said. "One thing is for sure, we're not going back to 1982 and an indexer's market." Beyond index funds Putting money in an index fund and forgetting about it has become a regular practice for many investors. Some say now's the time to be more flexible. "The critical thing you have to do as an investor is to rethink your portfolio and know that you can't fall in love with a particular theme," said Tobias Levkovich, chief strategist at Citigroup Smith Barney. Mr. Levkovich said such flexibility helped him uncover the next source of upside for stocks. Until recently, he was pessimistic about stocks' prospects, but now he says 8% gains in the S&P 500 are achievable this year. Here's why: Unlike consumers, whose balance sheets deteriorated further in 2004, businesses continued in their cleanup efforts. Today, the debt ratio on corporate balance sheets is very strong. The Good News Excluding the financial services industry, companies' debt, minus their cash, stands at 33% of market capitalization, down from 48% 15 years ago. "Rather than focus on earnings growth that's going to slow, look at what you're paying for corporate America's balance sheet," Mr. Levkovich said. "You pay more for companies with lower debt, and that's one of the most underappreciated aspects of the investment landscape today." Mr. Levkovich is advising his firm's clients to avoid sectors that depend on discretionary consumer spending such as retailing. Instead, he's steering them to companies that sell consumer staples, pharmaceuticals and health care, and to the beaten-down media companies that will benefit from an increase in these companies' ad spending as they compete for consumers' dollars. The Bad News Part One Though Julius Baer's Mr. Gallagher said he also will advise investors to be "anti-consumer," he's not quite as constructive on the prospects for stocks. He said he would not be surprised to see stocks end 2005 down 5% to 10%. Debt in corporate balance sheets is his focus as well, though in a different way. In 1985, debt-to-sales ratios stood at 30%. Today that number has ballooned to 80%. "I'm not saying that companies are in trouble, but I'm not convinced things are all that great today," Mr. Gallagher said. "The quality of earnings on balance sheets is worse than it's ever been. In order to generate the same level of sales, companies have had to take on a lot more debt." The Bad News Part Two Adding to the intrigue is the return of the "special item," a one-time gain or charge against earnings, said Howard Silverblatt, market equity analyst at Standard & Poor's. Though special items are just now back to the normal to high end of their historic range, he warns investors: "The dog can only eat your homework once." "If those numbers get any worse, it will speak directly to the quality of earnings deteriorating, and that's what investors have to watch for," Mr. Silverblatt said. "All companies will have them every once in a while; the problem starts when they have them every quarter." Good, bad or in between, most analysts are expecting corporate earnings growth to slow to about 10% or less in 2005, still strong but about half the rate investors enjoyed in 2004. Interest rates Also to Pressure Margins Analysts cite interest rates as one of the pressures on profit margins, just as they're one of the pressures on consumers. Economists say the Federal Reserve is caught in a classic Catch-22. As the central bank raises its short-term interest rates to try to keep inflation in check, it must be delicate in its approach to avoid triggering a dramatic pullback by debt-laden consumers. But it also must keep in mind foreign investors, whose purchases of U.S. debt enabled American consumers to keep spending. Further complicating matters is the flatness of the yield curve. The yield on long-term bonds is not much more than the yield on short-term bonds. "Inflation rose pretty sharply last year, and the Fed raised rates a lot, and guess what?" asked Mark Kiesel, portfolio manager at PIMCO. "The yield on the 10-year Treasury didn't move. That was shocking." As a result, borrowing costs remain, for now, at ultra-accommodative levels for consumers and businesses alike. Bond Yields Too Low But investors looking for yield in the bond market have not been so lucky. "Investors are not being compensated for holding longer maturities," Mr. Kiesel said. Traditionally, he said, investors can expect at least a 3% after-inflation return on the 10-year benchmark Treasury. But with the yield on the 10-year hovering near 4.25% and core inflation at about 2.2%, investors are scarcely getting a 2% "real" yield. "Rational investors wouldn't be buyers at these levels," Mr. Kiesel added. A growing concern is that foreign investors agree with that assertion. The dollar enters the year near a nine-year low against a basket of currencies. Some worry that a further slide in the greenback will push interest rates up, as foreign investors demand a higher return on their bond holdings in exchange for what they are losing in currency deterioration. The futures market is factoring in a federal funds rate of 3.25 percent at the end of 2005, implying the Fed will raise interest rates by another full percentage point. Mr. Kiesel and others at PIMCO, the nation's largest bond fund manager, disagree. "We'll get a quarter-point hike in February, but after that future decisions are going to be driven primarily by payroll growth, unit labor costs, productivity and core inflation," Mr. Kiesel said. Though many economists are forecasting that inflationary pressures will mount throughout the year, a few have ventured to say inflation will end the year close to where it is now. "I think low bond yields are saying that inflation will remain well-contained, but also that growth is poised to slow and that the Fed may be overdoing it," said Kathleen Bostjancic, senior economist at Merrill Lynch. Those predictions are predicated on the theory that consumers will be forced to save more and spend less in 2005. Merrill is predicting that gross domestic product growth will slow to 3 percent, accompanied by average monthly payroll gains of about 150,000. That's more pessimistic than the majority of economists, who are forecasting GDP growth of 3.5% this year. Exports & Payrolls "I don't think we can continue to rely on the consumer doing more than their fair share with the savings rate effectively at zero," said Mark Zandi, chief economist at Economy.com and one of the more optimistic prognosticators. "That's led us to believe we are in the early stages of a transition from a consumer-driven economy to one that is more balanced." Some of the growth that will fill the void caused by consumers retrenching could well come from growth in exports, especially given the recent weakness in the dollar, which makes U.S. manufacturers more competitive abroad. This pickup in business activity, Mr. Zandi said, should help support his forecast that average monthly payroll gains will come in closer to 200,000. If payrolls consistently hit that mark, it could indeed be another good year for stock investors. Rising wages, after all, are the soundest source of permanent growth in household income. For the last three years, investors have faced geopolitical worries, along with economic. In late 2004, those concerns all but disappeared from market chatter, as stocks enjoyed a smart end-of-year rally. With elections in Iraq due in January, some are warning against too much complacency. "We think stocks are going to go higher, though we're a bit concerned about the beginning of the year," Mr. Levkovich said. "We will have a pullback at some point."
But focusing on the year's losers distracts from what were many winners, said Tim Hayes, equity strategist at Ned Davis Research in Venice, Fla. "The breadth of the market has been very good," he said. "I think that's really the way you need to look at it." A continuing surprise to many Wall Street pros has been the stellar performance of smaller stocks. The Russell 2,000 index of small-company shares rose 17% in 2004. That marked the fifth consecutive year that the index performed better than the blue-chip Standard & Poor's 500. John Bollinger, head of Bollinger Capital Management in Manhattan Beach, expects smaller stocks to continue to beat blue chips because, he said, smaller companies in general have better growth opportunities than many bigger companies. "I think the bet remains with small- and mid-cap stocks," he said. Investors' sustained interest in smaller companies reminds Doug Sandler, equity strategist at Wachovia Securities, of the 1970s stock market. The latter part of that decade was a miserable one for many bigger companies, as inflation and interest rates rose. "But a lot of good things happened below the surface in that market" with smaller stocks, he noted. In the same vein, Sandler believes that investors would be wise to bet on decent gains in many foreign markets in 2005, even without a further kick from a falling dollar. But some market pros are holding out hope that big-name U.S. stocks will take back the lead in market performance this year. A shift to those stocks "did not pay off in 2004; we think it will in 2005," said Tobias Levkovich, equity strategist at Citigroup Global Markets. If investors get pickier after a two-year market rebound, they ought to be looking for relatively low stock price-to-earnings ratios, good dividend yields and strong balance sheets, Levkovich said. Many big-name stocks have all of those qualities, he said.
"Yes, asset allocation is important, but it's not nearly as important as getting money into the market," said Patti Brennan, president of Key Financial, a financial planning firm in West Chester, Pa. "Good savers will be good investors every single time." A study by T. Rowe Price, the mutual fund company, seems to confirm this. Using what are known as Monte Carlo simulations - computer models that help to predict the probability of achieving a goal - the company set out to answer a rather complex question: What percentage of preretirement income will our nest eggs be able to produce, safely, based on various rates of savings and different assumptions about asset allocation? Here's what the research found: Say you're in your 30's with 30 years to go before retiring. Assume that you've already saved a year's worth of your current pretax salary. (In other words, if you make $100,000 a year, you've banked that amount.) Say you plan to invest conservatively during your working years, with 40 percent of your holdings in stocks and 60 percent in bonds. Then assume that you will downshift even more during retirement, to 20 percent stocks and 80 percent bonds. According to the simulation, there is a very good probability - 80 percent, to be exact - that you would be able to replace 41 percent of your preretirement income once you left the work force. That assumes you're able to save and invest 15 percent of your salary annually during your working years. This figure includes all sources of savings, including your 401(k) money, 401(k) matches from your employer and profit sharing. Now say you decided to become more aggressive, putting 60 percent of your money in stocks and 40 percent in bonds during your career and then moving to 40 percent stocks, 60 percent bonds in retirement. Although you are now taking on considerably more risk, the study by T. Rowe Price says this strategy is highly likely to let you replace 43 percent of your income in retirement - a difference of just two percentage points. On the other hand, if you increased your annual savings rate modestly, to 20 percent from 15 percent, you'd be able to replace 52 percent of your income - and that's under the original, conservative asset allocation strategy that emphasized bonds. The results tell us a couple of things. First, investing more money will give you more bang for your buck than investing a smaller pot of money more aggressively. It's just the nature of investing. Moreover, you will have to save a large percentage of your salary - probably far more than most households assume - if you hope to replace most of your income in retirement. Even if you saved 25 percent of pretax income a year starting in your 30's, there's a very good chance you would be able to replace only 65 percent of income. And that's if you had already banked a year's worth of salary and invested 60 percent of the money in stocks and 40 percent in bonds during your working years. If you've managed to bank three times your annual salary by your 30's, you could replace 87% of income, based on the same assumptions. "The reason for that is compound interest," said Rande Spiegelman, vice president for financial planning at the Schwab Center for Investment Research. "Every dollar you've already saved will have a big impact on your future returns." The Schwab research center did its own study of how much investors should be saving, based on traditional assumptions like an 8% annual rate of return and 2.5% annual inflation. Its conclusion was that people in their 20's should be saving 10 to 15% of their salary each year, while people in their 30's who have nothing in the bank should start saving 15 to 25%. And those in their early 40's who previously neglected to save would need to set aside 25 to 35%. Some investors may look at these numbers and throw up their hands. "It can make people feel like it's a hopeless proposition," said Lori Lucas, director of 401(k) participant research at Hewitt Associates. But Ms. Lucas said Hewitt's own research concluded that "if you save a couple percent more a year and are willing to retire a couple years later, that can have a major positive impact on your results." All of these studies seem to point to another truth: investors should look everywhere for that incremental 2 percent. If you're not maximizing 401(k) contributions, you should. And if your company offers matching 401(k) money, you may be able to raise your contribution by less than 2 percent to achieve the additional savings. Failing to take these steps, particularly at an early age, may mean the difference between living comfortably in retirement and having to work a few more years, said Christine Fahlund, a senior financial planner at T. Rowe Price, who ran the probability studies. That is why it's important to "moderate your lifestyle as early in life as you can," she said. Monthly Employment Stats
Looking ahead, the Bush administration predicts the economy will create an additional 2.1 million jobs in 2005 a figure that private economists say is respectable and beatable. It's also a much lower estimate than a previous Bush administration forecast of 3.6 million new jobs this year. "Job growth remains positive, but still stubbornly sluggish," said Bill Cheney, chief economist at John Hancock Financial Services, calling the jobs market "decent, but uninspiring." In the report, last month's 157,000 net increase in jobs in December was close to the 175,000 that economists were predicting, but barely enough to keep up with population growth. It came on top of the 137,000 net jobs added the previous month, revised 25,000 higher than the government initially reported. The service sector added jobs in December, without help from retailers. Job growth was concentrated in health care, which added a net 36,000 positions, and business and professional services, which added a net 41,000 workers. As the holiday shopping season got into full swing, retailers ended up shedding almost 20,000 jobs overall. Analysts note that the figures are seasonally adjusted and subject to big fluctuations during that time of the year. "Because of retailers' trepidations about this holiday selling season, they didn't do the usual amount of seasonal hiring," Mayland said. The good news is the seasonal layoffs that occur in January and February should be moderate this time, he said. The housing market continued to trigger job growth. The financial service industry added a net 14,000 jobs last month and 140,000 net jobs for the year as mortgage interest rates remained at low levels. Real estate employment was flat in December, but up 42,000 over the year. Construction companies continued to hire new workers for the 10th straight month, increasing their payrolls by 13,000. But the hiring has slowed dramatically recently. Government employment rose 29,000 in December, and 172,000 for the year. Most of the growth occurred at the state and local levels, especially in education. At the federal level, the U.S. Postal Service continued to shed jobs, while employment in the rest of the government didn't change much. The number of people working more than one job in 2004 increased by 574,000 to 7.8 million.
Orders accelerated and more companies said they were adding to inventories, according to the survey of purchasing executives. A post-Christmas surge in sales suggests that consumers have the incomes and confidence to keep driving economic growth. Services account for more than two-thirds of the $11.8-trillion U.S. economy, and manufacturing accounts for less than 13%. The institute's factory index, released two days ago, found stronger growth last month. The group is based in Tempe, Ariz. "Like their manufacturing counterparts, non-manufacturers ended 2004 on a strong note and are optimistic heading into 2005, though cost pressures continue to be the dominant concern," said Stephen Stanley, chief economist at RBS Greenwich Capital. The gauge of prices that companies paid for materials and services rose to 71.4 from 71. Federal Reserve policymakers said interest rates were still too low "to keep inflation stable" and rising prices might become a risk to growth, according to minutes of their Dec. 14 meeting. The measure of new orders increased to 60.3 from 59.9. The employment index slipped to 54.9 from 55. The index of order backlogs increased to 56.5 from 54. The inventory index rose to 56 from 52.5. The general index and indexes for orders, prices and employment are adjusted for seasonal variations.
Beyond the temporary factors contributing to a sluggish recovery from the recession of 2001, some think that globalization, the movement of jobs offshore and the declining influence of trade unions could be putting pay envelopes on a permanent diet. Some companies have concluded that the past practice of increasing wages faster than inflation is no longer needed to keep employees from leaving. It may never, in fact, be needed again. Naturally, not many human-resource managers are trumpeting their commitment to holding the line. But in a recent issue of Workforce Management, a leading trade journal for human-resources executives, the latest advice is plenty blunt: "Annual pay increases designed for optimal hiring and retention are no longer needed," the magazine declares. "If your salary-increase budget for 2005 is much higher than 3 percent, you're probably overspending," the article advised. Even though real wages are falling for many workers, consumers continue digging deep into their pockets to keep the economy growing. Consumer spending has remained relatively high during the recovery while savings levels have declined. Meanwhile, average growth in wages and salaries fell below 3 percent for the 12 months through September for U.S. sector employees, according to the U.S. Bureau of Labor Statistics. Pay grew at 2.4 percent — the lowest increase on record, partly because soaring health-benefit expenses raised overall compensation costs for employers, some economists say. Hourly wages for production and service workers — representing four-fifths of the nation's work force — declined or remained flat year over year, when accounting for inflation, every month since May, according to the bureau's reports. "Real wages are falling for a lot of workers," said economist Jared Bernstein of the Economic Policy Institute in Washington, D.C., which conducts economic research that focuses on low- and middle-income workers. "It's surprising and disheartening, three years into the recovery with strong productivity growth, we're still looking at declining wages." Salary growth historically has averaged between 1 percent and 2 percent above inflation, and it hovered closer to 2 percent in the late 1990s, according to Mercer Human Resource Consulting's surveys of employers. "Now it's closer to 1 percent," said Steven Gross, leader of Mercer's U.S. compensation consulting practice. "Until the basic supply and demand changes, I don't see a lot of upward pressure for wages." At the same time, companies are paying more for employee health care, which boosts the costs of total compensation even while salaries lag. "Compensation has been rising at a pretty rapid clip," said Nariman Behravesh, chief economist for research firm Global Insight. "That's a trade-off a lot of companies have made." Economists predict wages will rise when hiring picks up. Despite the fact that the economy is adding jobs, 1.2 million fewer people are employed than in March 2001, when the recession started. Meanwhile, the number of available workers has increased. "Jobs growth and wage growth has been weaker than in other recoveries," said Behravesh. "It's another symptom of the unusual nature of this upturn."
Just the Facts Earnings Growth vs Stock Returns Mark Hulbert, CBS MarketWatch 1-12 Data compiled by Ned Davis Research, shows that over the last eighty years, the S&P 500 has turned in some of its most mediocre showings during periods in which quarterly earnings were growing the fastest. In fact, but for the very worst quarters - ones in which earnings fell by more than 25% -- there was a perfectly inverse relationship: On average, the faster the earnings growth, the lower the S&P 500 return. Why should this be? The key to understanding this, according to Martin Zweig, the fund manager and former newsletter editor who Ned Davis Research credits with noticing the phenomenon, is realizing that the stock market is a discounting mechanism, anticipating the future rather than merely keeping score on what's already happened. Because the stock market looks forward rather than backward, it more often than not will rise in anticipation of the economic recovery that is just around the corner. Just the converse applies when earnings are growing the fastest. Quick Facts, Stats & Opinions The average return on equity for companies in the S&P 500 is 21% , according to Bloomberg data. Rising free cash flow -- earnings, amortization and depreciation minus capital expenditures per share -- is about 8% for the S&P 500. (Laure Edwards, Bloomberg News 1-31) In a recent study of personal debt and credit scores across the nation, Experian found that consumers with debts above the national average also tend to have better credit scores — they know how to manage their debt well. U.S. consumers have an average debt of $11,224. Yet consumers with debt exceeding that amount have an average credit score of 695, compared with the national average score of 677. (Marshall Loeb, MarketWatch via Seattle Times 1-30) Standard & Poor's estimates that companies as a group will boost their annual dividend rates this year by about 12%, though that could prove conservative. The Standard & Poor's 500-stock index now yields about 1.8%. Look to solidly profitable companies with a long history of paying out ever-larger dividends each year. S&P each year publishes just such a list of so-called Dividend Aristocrats. This year's list includes 58 companies from the S&P 500, 18 from the S&P MidCap 400 and nine from the S&P SmallCap 600. (Jeff D. Opdyke, WSJ 1-23) Shares of small companies have traded at aP/E multiple that's about 20% lower than that of large-cap stocks on average since the end of 1978, when Frank Russell Co. started tracking these metrics. But now, large-caps are cheaper. (Ian McDonald, WSJ 1-14) In 2004 `rising stars,' or companies whose credit ratings were raised to investment grade, outnumbered `fallen angels' that fell to junk status for the first time in six years, according to Moody's Investors Service. (Chet Currier, Bloomberg 1-14) According to the Wall Street Winners' editors, "the spread between BB bonds [i.e. junk] and 10-year Treasurys is 1.47 percent... That's a five-year low and not far from an all-time low. In fact, the [current] spreads are narrower than during the 'New Economy' (i.e., between 1999 and early 2000)." How large can this spread become? In early 2002, for example, it grew to around 6 percentage points, or some four times as great as it is today. (Mark Hulbert, CBS.MarketWatch 1-12) Home Page Previous Factoid Top Sites
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