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Clean out your wallet before you leave. Carry only the credit cards and identification you need for your trip, says Kim Forde, spokeswoman for American Express. Remove cards that show your Social Security number, she advises. Use stored value cards instead of cash or debit cards. If you carry a "signature" debit card, a thief can make purchases simply by forging your signature. MasterCard and Visa have "zero liability" policies for debit cards processed through their networks, but replacing the money can take up to 10 days, says Linda Foley, executive director of the Identity Theft Resource Center. If it's the end of the month, you won't be able to pay your bills on time. And checks you've already written could bounce. Stored value cards are a good alternative. MasterCard, Visa and American Express all offer versions of these cards, which are similar to gift cards. You can load them up with a specific amount of money and use them like debit cards. If the card is stolen, the issuer will replace the money. More important, the thief won't have access to your bank account. Leave your checkbook at home. Stolen checks and deposit slips are popular with thieves, Foley says. With a high-quality printer and blank checks from an office supply store, they can use your account information to create fraudulent checks. And check fraud is one of the hardest financial crimes to clear up, she says. Pack a backup credit card in case one of your cards is stolen or an account is closed. Running up big charges on your credit card may trigger your card issuer's fraud-detection alert system, says Tom Lekan, chief security officer for KeyBank. Out-of-state or overseas transactions may also trigger a fraud alert. The bank may temporarily close your account until someone contacts you and verifies that you made the charges, Lekan says. "If that's the only card you have, you're in trouble," he says. You can avoid an unexpected shutdown by alerting your credit card issuer before you leave, says Jessica Antle, a spokeswoman for MasterCard. Tell your financial institution the dates you'll be traveling and where you're going. Be aware of your surroundings. Pickpockets gravitate to such high-traffic areas as airports, vacation resorts and county fairs, Foley says. Many are more interested in stealing information than cash. Carry cash and credit cards in a travel pouch or money belt worn inside your clothes. Lock up your laptop. Even on vacation, some people lug along their laptops so they can squeeze in some work or stay in touch with the folks back at the office. But your diligence may make you a target. Laptops are coveted by criminals, particularly overseas, Lekan says. Many people store personal financial information in their computers. Hackers can bypass passwords and other security measures, Lekan says. Many travelers leave their laptops connected to the hotel network when they're not in their rooms, Lekan says. That enables a dishonest hotel employee to search your computer for information that can be sold to identity thieves. If you must take your laptop on vacation, store it in the hotel safe when you're not around, Lekan says. Don't leave your rental agreement in the car. Many rental car agreements contain personal information that could be used by identity thieves, Lekan says. When you check out, take your key card. Many travelers leave these cards in their rooms when they head home. Bad idea, Lekan says. Some hotels embed customers' credit card numbers or other personal information in the magnetic strip on the back of these cards, he says. Criminals can remove the strip and extract the information.
Brian Wansink, who studies such behavior, says shoppers invariably report -- and believe -- that they buy more than they need because "it is such a bargain." But Wansink, professor of marketing at Cornell University, says we are fooling ourselves. Psychologists, market researchers and advertisers know that there are deeper psychological reasons for this. BOGOs [buy-one-get-one-free deals] have existed in the grocery industry for many years and are a favorite because they drive up volume and can make a customer loyal to a product or store. The word "free" is key here. "Free" reverberates through the human mind like some sort of endorphin. We are drawn to any product associated with it and feel blessed to have something for nothing. We get a warm and cuddly feeling for the store that allowed us to feel this way. Then there are the bulk deals, the ones that typically offer multiple units for one price. Often the savings is minimal, but Wansink points out that signage of any type generally raises awareness and sales. (Unless there is too much signage. Signage clutter can actually cancel out the effectiveness of all signs, he says.) Many people mistakenly think that if you don't buy the suggested number in a package offer, you won't get the discount. This misconception works in the retailer's favor. Wansink explains that the number offered for one price is actually a suggestion to shoppers. He says that marketers don't necessarily expect people to buy that many. The number acts as a motivator. It encourages people to raise their "anchors." Anchors are the number of units of any product that a customer goes into a store thinking he or she will purchase. Research shows that when shoppers see a sign that offers, say, 10 for $4, they may not buy 10, but they will revise their anchors upward. Even if the store loses money giving one item away in a BOGO or has drastically cut the price in a multiple-item deal, the retailer benefits. Your purchase means that you will be stocked up and won't be shopping for that item at a competitor's store anytime soon. "The typical person shops at 2.3 grocery stores in a week, and that includes the 7-Eleven. Typically, 37 items are bought in a major shopping trip," Wansink says. Offering you two units for the price of one or offering you 10 for $3 "locks you out of shopping for that category at another store," he says. "The store may lose money, but that's a lot better for them than you going to another store." Like "free," "limit" makes us humans crazy. Any parent of a teenager or toddler knows that if we are told we can't have it, we want it. Robert B. Cialdini, Regents professor of psychology at Arizona State University and the author of several books on persuasion and influence, says the perception that, say, there is a scarcity of ketchup makes us want desperately to have it. Thus, signs that say, for example, "Limit 10" are meant to trigger the feeling that 11 or more are unobtainable and, thus, more valuable and desirable. (Does anyone know what happens if you try to check out with 12? Does the clerk refuse to sell them to you? I'm too frightened of authority to try.) Cialdini says that in an experiment, testers rated chocolate chip cookies. One jar contained two cookies. Another contained lots more. The subjects routinely rated cookies from the jar containing two as tastier and more desirable than the ones in the jar containing many. When the people were told they could have only two of a batch of cookies because they were scarce, they consistently rated them higher than those that were presented with no limits. The "limit" and "bulk buy" strategies link to another human characteristic that can get ugly. During a recent visit to my local supermarket, shoppers competed for bottles of ketchup, each the size of a pork butt, that were marked with a small sign: "2 for $4.99." One gentleman loaded six 50.5-ounce bottles into his cart. He had a smile on his face that read: It's not every day that a man heroically captures 19 pounds of any condiment, much less America's favorite. When I saw that man loading his basket with ketchup, with other customers milling around, my pulse quickened. Would there be enough left for me? You could call this greed, but Cialdini more kindly dubs it "social proof." He says I wanted to be a part of the group. Cialdini says humans determine what is correct by finding out what other people think is correct. This is also linked to the survival instincts of all animals, including us. Competition for resources exists throughout the animal kingdom. He cites "chumming" as an example. Chumming is when fishermen throw out bait and schools of fish flock to it. They snap at it with furious competitiveness. They do so even with hooks containing no bait. "The joy is not in experiencing a scarce commodity but in possessing it," even if it is only a pound of ground round, according to Cialdini. Wansink and his researchers have done many experiments plumbing the depths of our willingness to buy lots of anything that seems to be on sale. There's only one category in which limits, BOGOs and multiple-unit offers didn't work: 30-pound bags of dog food. Really? I'd buy them. And I don't even own a dog.
Some people still believe that the future can be known. They imagine two groups of people that may know the future, and therefore should be listened to. The first is pundits. Since they expound on the future all the time, they must know what they are talking about. Do they? The now-defunct magazine Brill's Content used to track the pundit's guesses, and while one or another had the occasional winning streak, over the long haul they did no better than chance. This is what you would expect. Because nobody knows the future. The second group that some people imagine may know the future are specialists of various kinds. They don't either. As a limiting case, I remind you there is a new kind of specialist occupation--I refuse to call it a discipline, or a field of study--called futurism. The notion here is that there is a way to study trends and know what the future holds. That would indeed be valuable, if it were possible. But it isn't possible. Futurists don't know any more about the future than you or I. Read their magazines from a couple of years ago and you'll see an endless parade of error. Guess what? Securities analysts don't do any better than pundits or specialists do! And yet people on Wall Street speculate about the future for a living. (A stock's price is supposed to be the net present value of its future earnings per share, remember?) Their work is often worse than useless. The problem, Crichton points out, is that, is that by it's nature speculation tends to favor superficial thinking over deep analysis and causes people to take extreme positions and inflate small problems into crises. Frequent result: people make calls that turn out to be utterly idiotic in the end. Remember, for instance, the prediction a few years ago that J.P. Morgan Chase just had to cut its dividend? It ended up being 200-proof nonsense. Those sorts of unfounded forecasts happen all the time. The opportunity for investors is for see such hooey for what it is, and act. . . . More from the Crichton Speech: There are some well-studied media effects which suggest that a simple appearance in media provides credibility. There was a well-known series of excellent studies by Stanford researchers that have shown, for example, that children take media literally. If you show them a bag of popcorn on a television set and ask them what will happen if you turn the TV upside down, the children say the popcorn will fall out of the bag. This effect would be amusing if it were confined to children. The studies show that no one is exempt. All human beings are subject to this media effect, including those of us who think we are self-aware and hip and knowledgeable.
In 2004, the Wasatch-Hoisington Treasury fund (WHOSX) returned a startling 10.22%. As of mid-May, the same fund had returned an additional 8.61% – propelled by a mix of long-term Treasurys and zero-coupon bonds. Long-term rates continue to decline even as the Fed continues to raise short-term rates. As the pair expected, the yield gap between the longest Treasury maturity and the 10-year Treasury is down to 35 basis points. They believe it is on its way to the long-term average, 10 basis points. How can this be? Hunt and Hoisington share what might be called "data tenacity" because their decisions are carefully grounded in stacks of graphs and the interpretations that connect them. And that may be where the difference from the consensus is: their interpretation. "The 'conundrum' thing of Greenspan," Mr. Hunt said, referencing an odd word in the Fed chairman's recent testimony, "is that long rates are a function of short rates. But the alternative theory is rational expectations – that long rates respond to what is expected." "The yield curve is very robust - powerful and reliable. It's a leading indicator and a coincident indicator. It's telling us to expect slower growth and less inflation. Our basic theory is that the economy is in an interlude in which the coincident indicators tell us the economy is strong, but the leading indicators are turning down." How far? I asked. "We don't need to know. It just tells us that growth will be materially slower later this year." One bit of evidence that Mr. Hunt mentioned is the decline in mortgage refinancing applications. They have now been below the previous-year level for 20 consecutive months. Mr. Hoisington lays a single page on the table, the "Cash-out Refi Report" from Freddie Mac. It shows home equity cash-out financing of $139.5 billion for 2004. No one knows how much money is really involved, he points out, because different sources come up with different figures. Whatever the actual figure, home refinancing is a big stimulus to consumer spending. And it's going away. "We've got a synchronized decline in leading indicators," Mr. Hunt said. "We had that going into the [first] war with Iraq. Worldwide weakening is evident in coincident indicators. England, for instance, is growing only about a third as fast as we are." I asked whether they thought the euro would come apart. "We don't think so. But the dollar is strong relative to budget deficits, trade, work and monetary conditions. If you look at those factors, all are in favor of the dollar." Although Mr. Hunt and Mr. Hoisington watch different economic measures month to month, the real difference is that they view the measures in a much broader historical context than most economists, market analysts or media people. Mr. Hunt pointed out, for instance, that virtually no one has paid attention to the velocity of money for years, but it is becoming important once again. "If velocity is stable, money growth becomes important. If velocity is in a downturn, money growth is even more important," he said. As they see it, we're at the end of one of the three investment-led economic expansions of the last 150 years – the railroads, the assembly line and electricity, and computerization. Investment creates productivity gain. The same productivity gain is why employment is still below pre-recession levels – corporations haven't needed to hire as many workers. As a consequence, they point out, the employment cost index is registering the lowest growth since the index was started, and the inflation trend is still downward. They also believe that the fall of communism reopened a vast global labor market that will put (downward) pressure on wages for years to come. Finally, there is the problem of debt. "We've looked at this repeatedly, and we've concluded that when interest rates go up, they can't stay up," Mr. Hunt said. There's just too much debt out there, most of it at variable interest rates. Couple this with relatively high price/earnings multiples and low dividend yields for common stocks and they see an uncomfortable future: modest equity returns and still more decline for interest rates. Neither Mr. Hunt nor Mr. Hoisington will guess how low those rates can go. History, however, tells us that 20-year Treasurys have yielded less than 4.02% in 10 percent of the quarters since 1957, well below their recent yield of 4.5%.
The current positive spread is not contractionary; it's less stimulative than it was a year ago. With every indication that the Fed plans to proceed with its agenda of rate increases and every sign that long rates aren't going to budge in response, it's possible the curve could invert before too long. An inverted yield curve, with short rates higher than long rates, is typically a harbinger of recession. Historically, the central bank raises short-term rates aggressively to constrain inflation, crimping growth in the process. The yield curve is a simple construct that's widely misunderstood. Economists invoke it when it supports their forecast and dismiss it when it doesn't. In the past few weeks, I've read or heard the following comments about the flattening yield curve: [1] A flatter yield curve means the Fed will have to raise short-term rates more; [2] A flat yield curve usually occurs when short and long rates are higher. Rates are low now, so the flatter curve doesn't matter; [3] A flat/inverted yield curve doesn't mean what it used to mean. Such statements inspired me to craft a primer on the yield curve. For the purposes of this discussion, the yield curve will connote the spread between the overnight federal funds rate and 10-year Treasury note yield. 1. What's so special about two yields among thousands? What imbues them with such power and omniscience? What's special is the information provided by the interaction between the two rates: one set by the central bank, the other by the market. While long rates are influenced by short rates -- the current short rate and its expected trajectory -- they're also affected by real activity and inflation expectations, not to mention political and psychological considerations. The long rate is a window into the stance of policy. 2. What do you mean by the interaction between long and short rates? Consider a world where there is no central bank. When the demand for credit increases, the price of credit, or interest rate, will rise. We have a central bank, as do most countries. Most of them use an overnight or other short-term rate as a policy tool. The monetary authority provides whatever reserves the banking system demands to achieve its target rate. If the central bank is holding the short rate steady, and market rates are rising, it's a pretty good indication that the overnight rate is too low. Why? Because that rate would be rising too were it not for the Fed's injection of reserves. In other words, the demand for credit is rising faster than the Fed can supply it. 3. Who figured this stuff out? The theory behind the yield curve's role in anticipating economic growth and inflation can be traced back to Swedish economist Knut Wicksell (1851-1926). Wicksell argued that when the rate at which banks lend is below the rate of return on capital, which he called the natural rate of interest, prices would rise. When the bank rate exceeds the natural rate, prices would fall. 4. How do I know what the natural rate of interest is? You don't. It's unobservable. Which is why the interaction between the two rates provides more information than the absolute level of both rates. Think of the long rate as a check on the central bank. If policy is too easy or too tight, it will send up a flare. 5. How can falling long rates be a negative? Isn't there more incentive to borrow at 5 percent than 6 percent? Yes. And that's one part of the story. If you only looked at the level of long-term rates, the Great Depression should have been the Great Boom, and Japan's lost decade should have been Paradise Regained. In both cases, low long-term rates were a symptom of weak economic growth, not a cause of stronger growth in the future. During the Great Depression, the Fed let the money supply contract by one-third. There was no demand for credit even at a rock-bottom price. 6. Low mortgage rates have created a boom in housing. How can you say a flatter yield curve is less stimulative? Yes, I read them. Ceteris paribus, declining mortgage rates make home ownership more affordable. In the micro world of housing, credit demand is strong. For the U.S. economy overall, there are more lenders (savers) at any given rate than there were before. Whether it's Asian central banks or private investors wanting a risk-free investment, more people are choosing to save in dollars, which is pushing down long-term rates. 7. So how can that be bad? It's bad -- or at this point, less good -- because there's less incentive for commercial banks to increase the money supply. The steeper the yield curve, the more incentive there is to borrow from the Fed at the overnight rate and lend money to the private sector or Uncle Sam (buy Treasuries) at a higher rate. It's no surprise that money supply growth has slowed in response to a flatter yield curve. The money supply has gone out of fashion, but I'm an old codger.
Mutual funds and exchange-traded funds that invest in commodities and real estate investment trusts have made it possible to use these alternative investments even in very small portfolios. For commodities in particular, there's a wide array of products, from funds that invest only in gold or natural resources to all-inclusive indexes that hold everything from crude to cotton. For small investors looking for an edge but not a roller coaster ride, a broadly diversified commodities index is probably best. There's a growing number of broad commodity funds to choose from. PIMCO Commodity RealReturn Strategy uses derivatives that mimic the Dow Jones-AIG Commodity Index, and invests the remainder of the portfolio in bonds, such as Treasury Inflation Protected Securities. The Oppenheimer Real Asset fund tracks the Goldman Sachs Commodities Index, as does the Merrill Lynch Real Investment fund, and the just-launched Rydex Commodities Fund. The most important difference between these funds is how their underlying indexes are structured. The DJ-AIG Commodity Index limits exposure to the various asset classes; for example, energy exposure is capped at 33%. The GSCI's weightings are changeable, with energy currently accounting for more than 73%; for this reason, it carries substantially more risk. Funds pegged to both indexes have outperformed stocks and bonds since the first of the year. The energy-concentrated Oppenheimer fund is up 7.05%, while the more conservative PIMCO fund has gained 2.77%. By comparison, the Lehman Brothers Aggregate Bond Index has added just 1.64%, while the Standard & Poor's 500-stock index slid 1.82%. As always with specialty funds, fees for these offerings tend to be high. Most commodity funds carry substantial front loads and hefty annual expenses. For the average investor, committing 5 to 10 percent of an overall portfolio to commodities would be enough to attain substantial diversification benefits without too much risk. For more conservative investors looking to add diversity to an all-stocks-and-bonds portfolio, REIT funds have a fairly low correlation and offer good returns at about half the volatility of equities, Clark said.
While hedge funds remain the most popular alternative investment, only about 28% of those surveyed this year said that they were planning to increase their holdings in such vehicles. That compares with 42% of respondents who said last year that they planned to raise their stakes. "The simple answer is that investors are beginning to see outsized returns that they had enjoyed start to diminish," leading them to look at vehicles other than hedge funds, said Jeffrey Evans, a consultant at the Institute for Private Investors. Indeed, over the last five years, global hedge funds returned an average of 8.2%, according to Van Hedge Fund Advisors International LLC, a research firm, compared with an average of 20% in the five-year period ended in 1999. About 49% of those surveyed by the institute this year plan to increase their holdings in private equity, while only 4% expect to decrease them. Currently, private equity accounts for about 5% of these investors' portfolios.
While the top 25 S&P 500 companies spent $60 billion on share repurchases in 2004, the number of their outstanding shares only declined 0.27%. That's because stock grants to employees and stock issuance for mergers & acquisitions mostly offset the shares taken out of circulation. Data culled by S&P's quantitative strategist Howard Silverblatt show that 39% of the S&P 500 companies that engaged in buybacks during Q1-05 reduced share count-- which means 61% did not. McVey notes that Dell Computer has spent $18.3 billion on buybacks since 1993 but has more shares outstanding today. "The way we see it, a lot of money is just being transferred to employees or acquired companies, not back to shareholders," he said in a recent report to clients. McVey worries that companies far too often buy stock that has already run up in value, with the timing often a "buy high, sell low phenomenon." He also points out that many companies announce, yet never complete, major repurchase plans. McVey worries that when executives choose to do buybacks rather than investing in a company's future growth by putting money into its core businesses, they are "at least minimizing the upside return on their investment" or destroying value by "redeploying their excess cash flow to buy back expensive stock, especially when the bulk of it is linked to options issuance." That issue could get even more pronounced this year as companies scramble to accelerate the vesting of their stock options ahead of possible changes in accounting regulation that would require them to deduct option costs from earnings, Silverblatt said. The downside to buybacks also shows up in stock returns. The quantitative strategy team at Morgan Stanley looked at the effects of share buybacks on stock performance at large- and mid-cap companies over the last year, and the news isn't particularly good. Large-cap portfolios built exclusively on a share-buyback theme would have lost 4% in the 12 months ending in April. A similar portfolio of mid-cap stocks would have generated returns of 4%, but that is lower than the 8% annualized returns since August 1992. Don't count on any of this to stop corporate leaders from pushing the benefits of buybacks. It's just up to investors to understand how to cut through the hype. More Buy-Back Stats David Fried, The Buyback Letter via Forbes, 5-23 Corporations in America are buying back their own shares at lightning speed, as fast as they can amass the money in their corporate coffers. In 2003, S&P 500 companies bought back $131 billion; last year buybacks increased by 50% to a record $197 billion, and this year's pace should set another record. The sum for buybacks even exceeds the $181 billion spent on dividends in 2004. But in Barron's on May 16, there was a report from the institutional brokerage firm Rochdale Research, which aims a fire hose at our buyback investing strategy. Rochdale says many shareholders who hold on to a stock during a buyback don't realize much benefit from holding, because, contrary to expectations, many buybacks don't reduce the number of shares in a company. In fact, companies often issue additional shares for options and acquisitions at the same time they buy back shares, so the net effect is either a wash or sometimes even an increase in shares outstanding. Companies that announce buybacks usually get an immediate shot in the arm from the announcement. Investors take note and think, "Where there is smoke, there must be fire, so let's jump in." For example, Citigroup shares rose 35 cents to $45.75 on the day of the $15 billion buyback announcement, Merrill Lynch rose 2% on the April afternoon it announced an additional $4 billion buyback. But those instant bumps are not sustainable if the buyback doesn't occur. The market will take note and share price will decline, naturally.
Stock-pickers typically charge higher fees than passive index funds. They ought to shine when the principal market benchmark return is at or near zero. Gosh, the horses are standing at the gate. There are many ways to slice and dice data, but just one conclusion: There is little evidence that professional stock-pickers outperform market benchmarks in periods of flat or declining markets. So be careful how much you spend for stock-picking advice. I asked Adam Cohen, head of quantitative consulting at Zacks Investment Research, to look at the quarterly performance of major brokerage firm stock-pickers back to the first quarter of 1999. He found that the brokers' stock-pickers outperformed the S&P 500 return by nearly 8 percentage points in up markets but did slightly worse than the index in down markets. This finding should not be a surprise. An up market creates more chances to pick winners. For another look, I mined the Morningstar mutual fund database to find year-by-year results for so-called focus funds, funds that hold 40 or fewer stocks, as a proxy for stock-pickers. In only three of the last 10 years did more than half of focus funds beat the S&P 500 returns. Two of the three years--1999 and 2003--saw major market rallies. The third, 2000, was a down year. So far this year, only 11% of funds holding 40 or fewer stocks are in the black. John Rekenthaler, head of research at Morningstar, found that focus-fund managers had their best year, compared to the universe of domestic equity managers, in 1998, when the S&P 500 index jumped 28.5%. "The worst year they ever had was 1991, when the S&P was up 30%. I don't see a pattern here," Rekenthaler said. A more hopeful set of statistics for the stock-picker's market theory can be found at Investars.com, which tracks buy and sell recommendations of brokers and independent analysts. Fifty-one of 88 firms in the Investars database that make recommendations on S&P 500 stocks made buy or sell recommendations whose results beat the S&P 500 index return in the last 12 months, a period of middling stock returns. Counting "sell" as well as "buy" recommendations, "the returns for each firm relative to the S&P are higher for a flat period than for a rising market," said Kei Kianpoor, chief executive of Investars. Sixty-four of 104 firms picking among the Russell 2000 index of small-company stocks beat the Russell index return, according to Investars. Here's the point: The phrase "it's a stock-picker's market" is always true. Don't pay extra for a "stock-picker" just because you expect a dull market.
The Fed influences interest rates which affect the financial markets and the economy. Knowledge of the Fed's likely moves may help you to decide whether to use an adjustable-rate mortgage or a conventional one, whether to shift money into stocks or bonds, and even which kinds of stocks or bonds to buy. The course of Fed policy is foreshadowed by various market indicators, the most revealing being the price of futures contracts on federal funds - overnight loans among financial institutions whose rate the Fed itself closely controls. The futures contracts send clues about what is usually the most important single issue facing the markets: What will the Fed do next? And the specific question on everyone's mind these days is this: Is the Fed, which has been raising rates for nearly a year and has five more policy meetings scheduled for 2005, about finished? The answer, judging from the consensus reflected in the futures contract for December, is: We're getting close. "The funds market is telling us they're going to pause at at least two of these meetings," said John Augustine, chief investment strategist at Fifth Third Asset Management. Mr. Augustine points to the current federal funds rate of 3% and notes that a quarter-point increase at each meeting would put it at 4.25% by year-end. The December contract, however, is now trading at 3.72%. He said he believes that the Fed is likely to stop its credit-tightening in meetings toward the end of the year. These contracts, settled on the basis of the average rate for federal funds during the month, are traded on the Chicago Board of Trade. The August contract ended one recent session at 96.60, meaning that the market believed the funds rate for that month would be near the difference between that figure and 100, or 3.40 percent. You can follow the action online at www.cbot.com by clicking on "30-day fed funds." Sometimes, analysts portray their readings of funds futures prices as odds or probabilities. For example, if you assume that the Fed will raise rates by a quarter point at both the June and August meetings, bringing the level to 3.50, then a reading of 3.72 would imply there was about an 80% chance of an increase at the next meeting, in September - 3.72 being about 80% of the distance from 3.50 to 3.75. Not surprisingly, the shorter the time period, the more accurate these forecasts have turned out to be. "So far as predicting the funds rate over the next several months, the federal funds futures dominate other instruments," said Brian P. Sack, senior economist for Macroeconomic Advisers in Washington. Investors can use such readings of market expectations as a benchmark for evaluating the general investment climate as well as predicting movements in the relationship between short- and long-term interest rates. If, for example, you think the consensus is correct for modestly higher interest rates this autumn, and you have not already made an adjustment, you may want to cut back on your fixed-income investments. If you're in real estate, a conventional mortgage may seem a better bet than an adjustable one. If you are convinced that the Fed will stop raising interest rates by early fall, you may be more comfortable buying longer-term bonds. The stock market implications are tricky. Rising rates are generally not good for stocks, but if investors become confident that the Fed has inflation under control, they could start pouring money into stocks, setting off a rally. An optimist may want to buy metals or other industrial stocks, while a pessimist may want to consider food or tobacco or other so-called defensive stocks. Of course, the futures contracts merely reflect current market sentiment, and if you're a contrarian who thinks that the Fed may have already made its last move, you may want to lock in today's rates and load up on bonds or certificates of deposit. In any event, knowing the consensus is a good starting point. "The federal funds rate serves as an anchor for the financial system and other interest rates key off its current level and expected changes in it," said a 2001 study by Raymond E. Owens and Roy H. Webb of the Federal Reserve Bank of Richmond. "Accurate predictions of changes in the federal funds rate are, therefore, of great value to persons engaged in a wide variety of business activities." Since 1994, the fed has increasingly managed to guide the markets along an intended path without surprises. But the funds market can move sharply on unexpected news about the economy. For example, after the government announced on May 6 a surprisingly big increase in payroll jobs for April, the October funds futures contract jumped to 3.59 percent from 3.49 percent in just a half-hour. While the funds rate is the best predictor in the short run, researchers have found that for periods longer than six months, other market instruments, including Treasury bills, display comparable predictive power. For this, Macroeconomic Advisers favors eurodollar futures, which trade very actively on the Chicago Mercantile Exchange and pay out at quarterly maturities based on the three-month London interbank offered rate, or Libor. Movements in Treasury bills can be misleading because yields can be depressed by a panic-driven flight to quality, analysts said. For the past year, there have usually been just two realistic choices for the policy makers - raising the funds rate by either one-quarter of a point or one-half a point. Sometimes there is a third choice, and when the situation seems complex, analysts at times seek supplementary information from other markets, such as options on funds futures, a relatively new and underdeveloped contract with rich potential as a provider of information. These options are also traded on the Chicago Board of Trade. The main complication in deriving the expected policy path from the funds futures rates is adjusting for the premiums that investors require for bearing the risks of going long or short the contract. The size of this premium, which needs to be subtracted from the futures rate, can be big enough to lure speculators with no firm view on the direction of Fed policy.
Start with the wealth effect. If people tend to spend more when their net worth increases, they'll spend less when it decreases. Economists use this rule of thumb: a $1 change in household wealth leads to a roughly 5-cent change in consumer spending. By that measure, a 10% decline in real estate prices would knock about half a percent off the gross domestic product. Even more significant for the economy, though, would be a collapse in home equity lending. The industry has been booming as housing prices have soared. But if prices stop rising, new borrowing against home equity will drop, and may disappear. That is important, because home equity lending amounted to more than $200 billion last year - or nearly 2 percent of the economy, according to Economy.com, a research group based outside Philadelphia. If all that borrowing - which freed up cash that was spent on new furniture, appliances, vacations, cars and the like - simply vanished, the effect could be large enough all by itself to send the economy into recession. But that's not all. The housing sector has even broader effects on the economy, by some estimates accounting for 25% of all activity. A decline in property values would most likely lead to declines in other industries, like construction, brokerage, banking and insurance. And these are important for future growth. Construction, for example, amounts to 4 percent to 5 percent of the economy, according to the Bureau of Economic Analysis. Then there's banking. Because of the leverage associated with real estate, a fall in values would affect banks and other lenders. It would probably lead to tightened credit standards, less lending and higher interest rates. If lenders begin to suffer steep losses, there is always the danger of financial contagion, in which problems at one institution ripple out to others it does business with. And there's a new wild card for the economy. In 2004, adjustable-rate mortgages made up a third of new mortgage originations. No one knows what the effect of the widespread use of A.R.M.'s would be in a down market. A climb in interest rates, of course, would put downward pressure on real estate prices, but A.R.M. borrowers would feel the pinch rapidly. If those borrowers started to default, lenders would be hurt. Adding it all up, it's easy to see how a drop in real estate prices would spell trouble for the economy. To put that in perspective, the IMF conducted a detailed study in 2003 that assessed the potential economic impact of a property slump. Reviewing the experience in the United States and 13 other industrialized countries, the I.M.F. found that a real estate bust is far more dangerous to the economy than a stock market bust. The I.M.F. calculated that a housing-price decline less than half as large as a decline in stock prices typically causes twice as big a drag on the economy and that its effects last twice as long as those of a stock market crash. Just how big a decline was the I.M.F. looking at? The I.M.F. compared a 14% decline in real housing prices with a 37% decline in stock market prices - roughly the same size as the post-2000 stock market fall in the United States. The study's findings suggest that a housing crash could cause twice the damage, and for twice as long, as the last recession in the United States. While such a large decline in housing prices might come as a shock to Americans, the I.M.F. found that similar busts happen every 20 years, on average, in the countries studied. So what can be done to prevent a housing bubble from bursting? The most attractive way for policy makers to cool the housing market would be to put pressure on lenders to tighten their credit standards. Some small steps in this direction have already been taken: Regulators have issued new guidelines on home equity lending, and new rules on first-mortgage loans are expected to follow soon. Recently, the Fed has been talking up long-term interest rates. By drawing attention to the disparity of rising short rates and stable long rates and indicating that extremely low long-term rates aren't sustainable, the Fed has been trying to nudge the long end of the market toward higher rates.
1. A house is an undiversified bet on a single piece of property. Even in today's booming real-estate market, making big money isn't guaranteed. Sure, we have all heard about the hefty gains in places like California, Rhode Island and Washington, D.C., where home prices have more than doubled over the past five years, according to home-finance corporation Freddie Mac. But not every market is like these three. Indeed, homeowners in Alabama, Iowa, Indiana, Mississippi, North Carolina, Nebraska, Ohio, Tennessee and Utah have eked out cumulative gains of less than 25% over the past five years. 2. Real estate doesn't always go up. When the current real-estate frenzy dies, the downturn probably won't look like the 2000-2002 stock-market rout, with its terrifying plunge in share prices. Instead, the housing market will likely see moderate price declines accompanied by a sharp slowdown in sales, as homeowners balk at selling their properties for less than what they deem fair. To get a sense of how much prices might drop, check out the early 1990s performance of two of today's hotter markets, Boston and Los Angeles. According to Freddie Mac, prices in the greater Boston area sank 10% during the 30 months through mid-1992, while Los Angeles was hit with a grueling six-year 21% decline. 3. Leverage bites when you get it wrong. Homeowners often quip that the bank owns most of their house. This, of course, is nonsense. The bank has merely lent these folks money. Whether their property is 60%, 80% or even 95% mortgaged, they are still the owner and thus benefit from every $1 of price appreciation and suffer every $1 of loss. Usually, that's reason to cheer. Suppose you buy a $300,000 house, putting down $60,000 and borrowing the other $240,000. If your home's value climbs 20% to $360,000, your home equity would double, from $60,000 to $120,000. This leverage, however, can also work against you. Let's say you bought that $300,000 house in Los Angeles in the early 1990s, just before prices dropped 21%. Suddenly, your house is worth just $237,000 -- and your down payment has been wiped out. What if you need to sell? With any luck, you will have whittled down a decent chunk of your loan balance with your regular monthly mortgage payments. Still, once you figure in the brokerage commission you will pay to sell, there is a chance you could leave the closing empty-handed. 4. A house is a long-term investment. Because it costs so much to sell real estate and because the combination of leverage and a home-price decline can be so devastating, you shouldn't purchase a house unless you plan to stay put for at least five years and even longer if you are buying in one of this year's frothier markets. Yet, today, stories abound of people buying properties with a view to unloading them in a matter of months. What can I say? A few years from now, we will look back and marvel at such foolishness. 5. The big money is in the rent. Unlike today's housing "day traders," most successful long-term real-estate investors don't buy properties solely for price appreciation. Instead, these investors are focused on the rental income they can collect and how that rent compares with each property's monthly mortgage payment, property taxes and other costs. There's a lesson here for home buyers. The biggest reason to purchase a house is so you can, in effect, rent it to yourself. Indeed, the value of this "imputed rent" will likely be far greater than any gain you score from price appreciation. The bottom line: When you buy a house, focus on finding a place that you will enjoy living in and where you can envisage staying put for a good long time -- and view any price appreciation as a bonus. 6. Home improvements aren't an investment. Many homeowners think that remodeling the kitchen, adding a deck or replacing the roof somehow constitutes an investment. It just isn't so. In 2004, Remodeling magazine analyzed 18 home-improvement projects. In all 18 cases, the magazine found that homeowners were unlikely to recoup the full cost when they went to sell. In other words, if you fix up your home and sell it a year later, you might recover 80 or 90 cents out of every $1 spent. And the longer you wait to sell, the less you will get back, because your home improvements will look increasingly shabby. 7. Mortgage debt has to be repaid. These days, I hear stories about folks borrowing against their homes to take vacations and buy new cars. Their justification: Whatever they borrow is less than their home's price appreciation, so they are still ahead of the game. Eventually all this mortgage debt will have to be repaid. But when? 8. The trade-down myth. In many cases, homeowners plan to trade down when they reach retirement and use the proceeds to pay off their loan balance. This plan may work. But keep in mind that trading down can involve unpleasant choices. To get your mortgage paid off while buying a comparable home, you may have to move to another state. Alternatively, you could opt to purchase a smaller place in the same part of the country. Problem is, you will probably be inclined to buy in a better neighborhood or get a home with a better view. "I've had people downsize in size," says Charles Farrell, a financial consultant in Medina, Ohio. "But they don't downsize in price. The price is pretty comparable."
We all tend to fixate on the market's short-term outlook, usually to our detriment. That is where the above question comes in. "It's a thought device," says Charles Ellis, author of "Winning the Loser's Game." "It's another way of getting your mind around the notion that you should think long term. All the retirees sitting on the beaches of Florida have the same basic ideas: Don't try to outsmart the markets, save early, let compounding work for you, pay yourself first, invest in stocks." 2. What changes would you make if you knew your friends were going to look over your financial statements? We all have aspects of our financial lives that embarrass us. Maybe we spend too much. Maybe we have too much credit-card debt. Maybe we don't contribute enough to our 401(k) plan. To get a handle on these failings, financial planner Michael Jones asks new clients whether there are any issues they hope he won't broach. That way, he can quickly identify what is worrying them. "I have a lot of people come in who are already doing a lot of great things, but they're looking for confirmation," says Mr. Jones. "People have this vague anxiety about whether they're on track or not." 3. Would you buy the investments you own today? Look through many investors' portfolios and what you see is a sorry collection of yesterday's hot investments, bought at the wrong time and never sold, because that would mean selling at a loss and admitting they made a mistake. But the resulting mishmash often bears scant resemblance to a sensible portfolio. "A good investor repurchases his portfolio every day," says Deena Katz, a financial planner. "If you own something today that you wouldn't buy, you should sell it." 4. If you had no clue what the future will bring, how would you invest? Professional and amateur investors spend countless hours trying to figure out which way the markets are headed next. And most of the time, they fare no better than gamblers betting on coin flips. My advice: Instead of building your portfolio around your financial forecasts, start by assuming you really don't know what will happen next. You will likely conclude that your best bet is to diversify broadly, minimize investment costs and favor market-tracking index funds. 5. How much are you paying Wall Street each year -- in dollars and cents? Brokerage commissions, asset-management fees, trading spreads on individual stocks, mutual-fund sales commissions, account-maintenance fees, annual fund expenses, mark ups on individual bonds. If you added up all these items, you might find they are devouring 2% of your portfolio's value each year if you are a do-it-yourself investor and maybe 3% if you use an investment adviser. On a $500,000 portfolio, we are talking $10,000 to $15,000 annually. Sound like a heap of money? Maybe it's time to cut costs. 6. If the markets nosedived, how much would you have to lose before you panicked? Take your portfolio and assume all your stocks lost half their value and all your bonds were knocked down 15%. As with the investment costs you incur, think about this drubbing in dollars and cents. If the resulting hit seems unbearably large, consider trimming your portfolio's risk level. 7. What financial lessons did you learn from your parents -- and were they the right lessons? "If your parents had tremendous fear about money, then you're likely to have some fear. If your parents were reckless with money, then either you're going to compensate by being overly responsible or you're going to share some of those traits" says Minneapolis financial planner Ross Levin. 8. How would you revamp your financial affairs if you knew you were going to die tomorrow? Sure, you would want to get a will if you didn't already have one, and you might opt for some complicated trust arrangement. But when you think about your family dealing with your financial affairs after your death, I suspect you have visions of your poor spouse and children wading through the horrifying mess you have stuffed into the basement filing cabinet. Time to organize and simplify your financial affairs? Sounds like a good idea.
The index's 10 component sectors, however, are anything but static. Energy has rallied more than 12% this year, and looks poised to pull back as earnings growth slows. Telecommunications has retreated 10%, but may be ripe for a rally. In the past 15 years, the average return differential between the best-performing and worst-performing sectors has approached 50%, leaving huge opportunities to add value in an otherwise dull market. The S&P's sectors represent disparate businesses that respond differently to economic and fundamental factors. At Harris Private Bank, we use a quantitative process based on five factors -- valuation, economic conditions, liquidity, investor psychology and momentum -- to determine which sectors are likely to outperform and underperform the index over the subsequent 12 months. Since the process evaluates sectors on a relative basis, we're simply attempting to get the best deck chair on the USS S&P 500. Whether it sails or sinks is a separate decision, and doesn't alter the fact that some stock groups will outshine others. Below I have ranked all 10 S&P sectors in order of their appeal, and compared each against its passive S&P 500 weighting, which you'll find in the table nearby. Health care has outperformed the market by 7% since last September, and remains well positioned for the next year. Health care is reasonably valued at 18.8 times forward earnings -- an 18% premium to the market's price/earnings multiple. That compares with a sector P/E of 25 and a 30% premium to the S&P one year ago. Health-care stocks benefit as the Treasury yield curve, or the yield differential between short-term and long-term bonds, flattens, a sign of economic weakness ahead. Other industry sectors tend to be less defensive, or more disadvantaged as the economy slows. And, because health-care costs often are paid by third-party providers, people generally don't cut back on medical spending when times get tougher. A strong dollar also favors this group; For every 1% rise in the trade-weighted dollar, our model suggests health care will outperform the S&P by 1%. While the dollar lately has strengthened, the group's current valuation likely would trump a resumption of the buck's decline (the dollar is down 25% from its 2001 peak). Lastly, health-care stocks do well in periods of relatively greater inflation, because the industry enjoys pricing power. Telecom, which reflects a blend of regional Bell operators and wireless carriers, is another bright spot. Investors' perception of the industry is changing. In the go-go 1990s, telecom was viewed as a play on the exponential growth of the Internet, and many companies were awarded exaggerated P/Es. Now the group is taking on utility-like characteristics, and offers investors a generous 4% dividend yield as well as stable earnings growth. Interestingly, telecom performs better than the market as industrial production slows, because its earnings are more predictable than other, more cyclical sectors. Given the most recent disappointing estimate of GDP growth -- 3.1% -- a slowdown in production could be in the cards. At a P/E of 15.3, telecom's multiple relative to the market is lower than the historical norm. With respect to momentum, the sector is just beginning its growth spurt. It outpaced the S&P 500 by 2.7% in April. Utilities, which yield 3.3%, should continue to outperform. Although the sector is not cheap -- indeed, its relative forward P/E of 15.9 is at a 15-year high -- it has other things going for it. Utilities are mostly insulated from economic slowing, as the sector's inverse correlation with industrial production suggests. In addition, higher energy costs don't pose a problem, as most utilities are able to pass along fuel costs to customers. Finance currently is under pressure, with little improvement in sight. The industry's fortunes are tied to the business cycle, and are likely to be hurt as industrial production slows. Moreover, the sector is expensive relative to its peers. Its forward P/E typically trades at a 25% discount to the S&P, as is the case today. Another concern is credit. At the moment it's easy to borrow, but lenders are growing more fearful and credit spreads, or the yield gaps between "risk-free" Treasuries and other riskier debt, are rising. As a result, financial stocks could suffer. For now, finance is ranked Neutral. Materials stocks are likely to bunt in a market performance. This sector comprises commodity and chemical companies, both of which produce early-stage inputs in the manufacturing process. The good news is that materials stocks are trading in the bottom third of their valuation range, at 13.8 times forward earnings. (Industry P/Es hit a low of 8.9 in September 1995, and a high of 20.2 in January 2002.) The bad news? The market tends to overlook the sector's fundamentals, because earnings are closely tied to commodities prices and not much else. Materials thrive as the yield curve flattens, much as it seems to be doing now. But the group's biggest enemy is its past success. The materials sector returned 13% in 2004, and investors shouldn't expect its sharp rise to continue. Consumer staples stocks are mildly appealing. Historically the sector has traded at a 20% premium to the rest of the market, and that premium now is around 15%. The group is not about to take off, but staples tend to outperform the S&P as retail sales slow. Sales have grown about 8% year over year, a performance that is unlikely to be repeated in an aging economic expansion. Consumer staples represents a solid yet unexciting sector for now. Throttle back in energy, which has had a powerful move over the past 12 months. Fueled by the surge in oil prices, this group outperformed the S&P 500 by more than 30%. Investors should take their profits and lower their exposure to a market weight. If the Fed raises the funds rate to 3.5%, which would exceed the rate of inflation, commodities, including oil, likely will retreat. On a forward P/E basis, energy historically has traded at a 20% discount to the market. While today is no exception, the group's earnings have been phenomenal, advancing by more than 60% over the past 12 months. Should earnings growth slow, which also is likely, forward P/Es would become relatively expensive unless prices pulled back. Either way, the energy sector no longer will be an investment haven. Technology, an unexciting sector six months ago, remains hopelessly unattractive. Among the S&P's 10 economic sectors, it is the most disadvantaged by rising energy prices. In addition, the bear market in tech has taught investors how economically sensitive the sector is. Tech's relative performance is highly correlated to consumer confidence and industrial production, both of which appear to be on the decline. On the bright side, the sector's P/E is relatively cheap on a historical basis, even when we remove the bubble years from the comparison. Tech also is a beneficiary of a weaker trade-weighted dollar, should the secular decline in the currency resume. Until then, however, investors should steer clear. The industrial sector is likely to take a turn for the worse. Fundamentally, the sector is expensive, as the economic expansion has lifted the shares to a premium over the S&P. Additionally, industrials thrive on narrow credit spreads because they are big borrowers, but spreads, as noted, are widening. We expect industrials to trail the market over the coming 12 months. The consumer discretionary sector is likely to lag the market. While fundamentals are reasonably priced, especially for retailers, sales growth is unlikely to be sustained at last year's levels. This sector benefits as the dollar strengthens -- again, a favorable circumstance that seems to be reversing. In addition, consumer discretionary stocks are susceptible to weakening consumer confidence and a flattening yield curve. The group has had a great run and is beginning to underperform. Odds are that it only gets worse.
Source: Standard & Poor's, Harris Private Bank, Factset
At least three mutual-fund companies -- Fidelity, Vanguard and T. Rowe Price -- have one-stop portfolios designed for people retiring this year. They are among the first of the so-called target-retirement funds, which are customized based on investors' expected retirement dates, to reach their target years. The companies also have funds for people retiring at various dates in the future as well as for buyers who are already retired. But from company to company, the funds aimed at retirees have striking variations in the portion of assets invested in stocks, a key to the portfolios' potential returns and also their volatility. The stock exposure in the T. Rowe Price funds can be twice that for the comparable Fidelity and Vanguard portfolios. When it comes to the appropriate stock exposure, there is not one percentage that fits all. Perhaps more significant, the fund companies' differing approaches highlight the sometimes-conflicting factors that investors need to weigh in deciding how to structure their investment portfolios in retirement. With people living longer, T. Rowe Price says investors seeking to maintain their standard of living through future inflation need to harness the higher average returns that stocks have delivered. In running extensive simulations of investment performance, it found that "unless we had at least 40% to 60% in equities on your retirement date, statistically there was a serious loss in purchasing power over 30 years," says Ned Notzon, chairman of the investment advisory committee for the T. Rowe Price target-retirement funds. The firm's income-oriented portfolio for retirees is 40% invested in stocks, exactly twice the level of its Fidelity and Vanguard counterparts. Fidelity and Vanguard designed their portfolios with a premise that the average retiree may not be able to tolerate, financially or emotionally, the swings in short-term performance that can occur with significant stock exposure. John Sweeney, a Fidelity VP for mutual-fund product management, says its approach is grounded in a practice that Fidelity has observed as a leading manager of corporate 401(k) plans: Many new retirees pull more cash out of their accounts than the maximum 4% a year that academic research generally says is advisable. A heavy stock allocation can lead to a sharp drop in account value -- a risk many retirees simply can't take, he says. "We are building an asset allocation that minimizes their risk, assuming that actual experience" of higher withdrawals, Mr. Sweeney says. At Vanguard, principal Catherine Gordon says it aimed to minimize the volatility of its portfolios for retirees because most investors are "loss averse". With a less volatile portfolio, investors are less likely to panic and thus bail out in a stock-market downturn. Still, "there is a tradeoff," Ms. Gordon says, since going light on stocks may lead to a smaller nest egg in one's later retirement years. "For some people, sleeping at night trumps the risk that they might run out of money or have to curtail spending" later in life, she says. Funds for retirees are one component of the increasingly popular target-retirement fund lineups. Target-retirement funds for today's younger workers, such as Fidelity Freedom 2040 Fund and Vanguard Target Retirement 2035, emphasize stocks for their higher long-term returns. Over time, as the number of years left until retirement drops, the funds will gradually shift more and more of their assets into less volatile bond and cash holdings. Once the target year is reached, the funds are generally designed to continue to exist and to become even more conservative for a number of years. At that point, some companies' target-year funds will then merge into the associated income funds for retirees. At T. Rowe Price, the target-retirement funds continue for decades past their target dates, with the stock exposure declining to 40% after 10 years and 20% after 30 years. The firm initially planned to have the funds roll into T. Rowe Price Retirement Income, with a steady 40% allocation to stocks, but it found investors had "some sensitivity" to that high a level of stock exposure in the later retirement years, Mr. Notzon says. A number of fund companies offer online tools or more extensive fee-based services that can help investors design their own retirement portfolio. Key factors to consider: total assets and sources of income, annual spending, life expectancy and risk tolerance.
But it often takes six or seven years for returns to revert to their historical norms, he said. Despite the recent bear market - from its peak in March 2000 to its trough in October 2002, the S&P500 lost nearly half its value - blue-chip stocks have still posted average annual gains of 13.2% over the last 20 years, according to Ibbotson Associates. That's well above the 10.4% average annual return that stocks have delivered since 1926. Given that equities are coming off of one of the biggest bubbles in recent history, it may take much longer this time for stocks to reset to their norms. That may mean a prolonged period of below-average returns. How much below average? Mr. Inker has very low expectations for stocks. Over the next seven years, he predicts, domestic equities will deliver average annual returns of only around 1%. Assuming inflation of around 2.5%, that means a real return of minus 1.5% a year. But haven't stocks already lost more than 2% a year, on average, over the last five years? That's true, but sometimes it takes more than a decade for stocks to get going after a big meltdown. After stocks peaked in the mid- to late 1960's, for instance, the Dow Jones industrial average was virtually flat until 1982. David Chalupnik, head of equities at the First American Funds, isn't so pessimistic. He says he thinks stocks may gain 7% a year, annualized, over the next 25 years. But that is still around three and a half percentage points below stocks' long-term average. While he acknowledges that stocks have already suffered tremendous losses, he notes that many of the underlying economic attributes that led to above-average returns in the 1980's and 90's are likely to deteriorate. "From a productivity point of view, an earnings point of view, and a growth point of view, we're starting from such a high point," he said. To be sure, a good deal of the market's excesses have been wrung out. For example, the price-to-earnings ratio for the S&P500, based on trailing four-quarter earnings, is around 19. That is down considerably from the 2001 peak of more than 46. But Clifford Asness, managing principal at AQR Capital Management, relies on a different P/E ratio, one made famous by the Yale economics professor Robert Shiller, and finds that stocks are still historically expensive. Mr. Asness has taken the current price of the S&P 500 and divided it by the 10-year average of trailing corporate earnings. By that measure, the S&P trades at a P/E of around 26. With the exception of the late 1990's, the last time the market was this expensive was in the years leading up to the Great Depression. Many investors may not want to hear that. "People have an almost moralistic view," he said, "that they've endured such heck in recent years that things must be cheap in the stock market." He said stocks were likely to gain around 7% annually - or 4% in real returns - in the coming years. In some ways, that's a relatively optimistic forecast. Mr. Asness has studied the market's performance back to 1927, based on valuations. When stocks trade at 19.9 to 31.7 times their 10-year average real earnings - as they do now - they've typically lost 0.1% a year, in real returns, in the subsequent decade. What does it all mean for investors? For starters, there's a strong chance of another major bear market, or of more frequent corrections in coming years than we're accustomed to facing. The fact is, investors who cut their teeth in the 1980's and 90's were spoiled by unusually long bull markets. But since 1900, bull markets have lasted only 718 days - or roughly two years - on average, based on the gains in the Dow Jones industrials, according to Ned Davis Research. The rally in the equity markets that started in October 2002 is already two and a half years old. If stock returns are lower in coming years, low-cost, tax-efficient investing strategies will gain popularity, says Harold Evensky, a financial planner. Mr. Evensky says he believes stocks will return around 8% a year, on average, in the coming decade, with inflation averaging around 3%. In such an environment, Mr. Evensky said, "if you can shave half a percentage point in taxes and half a percentage point in fees, you just saved 20% of your real returns." Ultimately, the best strategy for investors in a low-return environment is simply to save more money, says Rande Spiegelman, vice president for financial planning at the Schwab Center for Investment Research. "We've gotten used to the market doing our savings for us," Mr. Spiegelman said. "Hopefully those days aren't over just yet." But if they are, investors will have to pick up the slack.
Consider how fast earnings are growing: According to the latest projection from Thomson Financial, based on reports from most but not all companies, Q1 earnings for the S&P 500 will be 13.6% higher than what they were reported to be in the first quarter of 2004. As recently as a week ago, Thomson was projecting a 12.1% increase. And at the beginning of the year, the firm was expecting the growth rate to be 7.6%. This upward revision is important to keep in mind as we interpret what is projected for the current quarter. Thomson currently is projecting that Q2 earnings for S&P 500 companies will be 7.2% higher than comparable quarterly earnings from 2004. This is higher than the 7.1% that the firm was projecting a week ago, despite the above-average number of negative pre-announcements. Notice also that the current projection of 7.2% is only slightly below the projection that stood at the beginning of Q1. Given that the current regulatory environment gives incentives to companies to be conservative when projecting earnings, the final number could very well turn out to be higher. So the earnings picture is not all that bad. Why, then, is the market not performing better? Unlike Greenspan's conundrum, however, for this one researchers have an explanation: Faster earnings growth puts more pressure on the Fed to raise interest rates. And in a head-to-head contest over which factor has greater impact on the stock market, interest rates usually trump earnings growth. Consider data compiled by Ned Davis Research. Over the past 80 years, faster earnings growth has reliably been accompanied by a more sluggish market - except when earnings were falling out of bed and were more than 25% below year-earlier levels. The 13.6% earnings growth rate that Thomson Financial is now projecting for Q1 falls in the middle of a category associated with an average S&P500 gain of 5.8% annualized - about half the market's long-term historical growth rate. Because there is a wide range in the actual returns of the quarters that fall into this category, however, the S&P 500's actual return during Q1-05 - minus 2.6% -- is well within the confines of the historical record. The projected market return for the current quarter would be only slightly higher if Thomson's projection for Q2 -- 7.2% growth -- is accurate. The category into which this would fall is associated with an average annualized return since 1924 of 9.4%, which is still below the market's long-term average. Another way of understanding the finding from Ned Davis Research is to think of the roles that earnings growth and interest rates play throughout the economic cycle. When the economy is just emerging from a recession, quarterly earnings often will be well below those of a year earlier. But the stock market, as a discounting mechanism, senses that earnings are about to start growing again. Even better, there will be no pressure on the Fed to raise interest rates, since the economy is only emerging from a recession. This combination of imminent earnings growth and no interest rate pressure proves to be a powerful tonic for the market. This explains why, according to Ned Davis Research, the highest average stock market returns since 1924 were registered in quarters in which quarterly earnings were between 10% and 25% below year-earlier levels. During all such quarters over the last 80 years, the S&P 500 produced an average annualized gain of more than 28%. Unfortunately, from the point of view of where we stand in the economic cycle today, conditions currently are not conducive to producing gains anywhere near this explosive. And they won't be again until we emerge from the next economic recession. That doesn't mean that the market must go down. After all, the historical record suggests that we should see a modest gain. But this analysis does suggest that we are fooling ourselves if we expect explosive profits from stock the market this year.
Model Behavior In the 1980s and 1990s, market commentators argued that falling interest rates justified higher and higher share prices. This notion became formalized in the Fed model, so called because it is purportedly favored by Federal Reserve Chairman Alan Greenspan. For investors, there's a lot to like about the Fed model, which involves comparing the yield on the benchmark 10-year Treasury note with the earnings of the Standard & Poor's 500-stock index. Not only did the model work well in the 1980s and 1990s, but also it's so simple that almost anybody can use it. To do so, you first have to find out the S&P 500's forecasted earnings. That figure is available at www.spglobal.com, the Web site for Standard & Poor's. Click on the link for "S&P 500 Index Earnings" and then call up the spreadsheet labeled "S&P 500 Earnings and Estimate Report." According to the site, 2005's reported earnings should come in at around 67.40. This earnings estimate is calculated so that it's comparable with the index value for the S&P 500, which lately has been trading around 1150. Usually, investors would divide that 1150 by the forecasted earnings of 67.40. That would give you the market's price-to-forecasted earnings multiple, which is currently 17. But for the Fed model, you reverse the calculation, dividing the 67.40 earnings by the 1150 index value, thus getting an "earnings yield" of 5.9%. You then compare this 5.9% to the 10-year Treasury's 4.2% yield. When the earnings yield is above the Treasury yield, as it is today, that suggests stocks are cheaper than bonds. To be sure, bond investors get their interest in cash, while shareholders receive only a sliver of earnings as dividends. The rest of a company's profits are plowed back into the business, with a view to clocking additional growth. Still, presumably management could stop pursuing growth and instead pay out pretty much all of a company's earnings as dividends. Failing Grade Seem reasonable? Unfortunately, there are a bunch of problems with the Fed model. For starters, the model is often biased toward stocks. Instead of reported earnings, fans of the Fed model often use operating earnings, which are higher because they ignore one-time accounting charges. To make matters worse, analysts are typically too optimistic in their earnings forecasts, further boosting the stock market's apparent earnings yield. Until 2001, the S&P 500's earnings yield was often compared with 30-year Treasury bonds. But when the government announced in late 2001 that it would stop selling 30-year Treasurys, Fed model users gravitated to the 10-year note instead. Because the 10-year note had a lower yield, that immediately made stocks more appealing -- or so said the Fed model. But the model's biggest problem is that bond yields and earnings yields really aren't comparable. After all, Treasury-bond interest is fixed for the life of the bond and you can count on receiving it every year. Meanwhile, corporate earnings are iffier, but they should rise over time. Indeed, even if a company paid out all of its earnings as dividends, the company's profits would still tend to climb along with inflation. Measuring Up There is a way to fix these problems, contends Jeremy Siegel, a finance professor at the University of Pennsylvania's Wharton School. Instead of using conventional 10-year Treasurys in the Fed model, he suggests substituting 10-year inflation-indexed Treasury notes. With these inflation bonds, you earn the inflation rate plus a small additional yield, currently 1.6%. Because inflation bonds and the interest they pay grow along with inflation, this 1.6% is truly comparable to the S&P 500's 5.9%. Today, as you can see, the earnings yield is much higher than the inflation-bond yield. This is no great surprise. Stocks are riskier, so the expected return ought to be higher. The key question: How much extra should stocks yield? Over the past eight decades, the S&P 500 has outpaced government bonds by five percentage points a year, according to Chicago's Ibbotson Associates. But Prof. Siegel reckons the margin of victory will be somewhat smaller in the years ahead. In fact, he figures stocks would be fairly valued if the earnings yield were two to three percentage points above the yield on inflation-indexed Treasurys. The implication: With stocks today yielding four percentage points more than inflation bonds, either stocks are cheap -- or, as Prof. Siegel suspects, bonds are expensive. Cliff Asness, managing principal of hedge-fund manager AQR Capital Management, has been a vocal critic of the Fed model. He says using inflation bonds, rather than conventional Treasury notes, is a big improvement. "Jeremy's changed it from mathematical garbage to a legitimate model," Mr. Asness says. He also says that it would be reasonable for stocks to be priced to deliver two to three percentage points a year more than bonds. "There's a good argument that says people have done too well in stocks historically and they ought to accept less," he says. "The question is, will they?" As Mr. Asness sees it, investors use the Fed model to justify their bullishness on stocks. But he isn't sure they are willing to accept the implied lower returns. Suppose annual inflation comes in at 2.5%, inflation bonds give you 1.6 percentage points more than that and then stocks outpace inflation bonds by four percentage points a year. Add it up, and you are looking at an annual stock-market return of just over 8%, and possibly less if today's earnings forecasts are too optimistic. What if investors decide that sort of return is inadequate? The Fed model may say stocks are a bargain. But that doesn't mean shares won't get a lot cheaper.
No question about it, these surveys make a salient point about the sorry lack of financial education in many school systems. In a nation where practically half the households own mutual fund shares, there is no longer room in academe or anywhere else to dismiss investing as an unsavory activity of the rich. Even if the subject isn't taught much, though, the common folk have a way of applying a healthy measure of common sense to the business of money management. A closer look at the two new surveys supports my thesis that individual investors as a class are far less benighted than is widely supposed. One of the studies, from mutual fund manager American Century Investments, tells us that many people are stumped by terms such as asset allocation and portfolio rebalancing. In a quiz administered over the Internet, only 13% of the 807 respondents got the correct answer to a question about rebalancing, or the periodic shuffling of one's holdings to keep the proportions in line with the original plan. 35% gave the forthright answer ``Don't know.'' The same quiz-takers, we should note, did much better on questions about the power of compounding and the value of diversification as a risk-management tool. The other survey, from Chicago money manager Northern Trust, covers 1,235 investors, each with more than $1 million to invest. One fault it found with its subjects was excessive optimism about the likely performance of their investment portfolios. Seems they expect to do better with their money than their own projections of market returns suggest is likely. Now, I recognize the many perils inherent in this kind of error. Financial overconfidence can lead to all manner of crackups and disappointments. Even so, it may be a mistake to try to educate people out of what seems to be a natural human trait. Efficient markets, which do a great service for all of society by channeling capital to places where it can do the most good, are created by large numbers of people trying to outsmart their fellows. If they weren't at least a little over-optimistic about their chances, they would stop trying so hard, and the efficiency of markets would suffer. The very act of investing, in one sense, is an expression of overconfidence. Investors consider all the threats they hear about, from terrorism to mysterious technical forces within the markets, and then they put their money at risk anyway. They know, deep down, that they don't know so much. In the American Century survey, only 11% rated themselves ``very knowledgeable.'' They also read constantly about scandals in the financial world -- in security analysis, in mutual funds, in insurance. Yet many of them keep trusting the system to work in their favor with a degree of fairness and integrity. This not-always-reasonable optimism generates some of its own reward. We retain faith in the system precisely because we see so many other people exhibiting the same kind of cockeyed confidence.
It may not seem like a very clever way to invest, but many investors follow such strategies nonetheless. Some do so explicitly -- "the trend is your friend" and "don't fight the tape" are old sayings on Wall Street. But what's really surprising is how people invest in this manner unconsciously. The stock market's shaky footing -- the Dow Jones Industrial Average is down 5.5% so far this year despite a slight 0.3% gain last week -- is being blamed on signs that the economy has softened. Reports on consumer confidence, orders for manufactured goods and gross domestic product came in weaker than expected. But the tendency to unconsciously follow patterns may also be part of the stock market's current woes. When the stocks have been going down, it's easy for investors to read the economic numbers in the worst light, and send stocks lower still. Market Psychology An example of how stock movements can color views turned up in a survey of professional investors Merrill Lynch conducted in April, which showed that respondents, on balance, felt that stocks were somewhat overvalued. This was in contrast to the March survey, when they felt that stocks were inexpensive. Between the March and April surveys the Dow had dropped several hundred points. The investors had come to the odd-seeming conclusion that, by falling, stocks had become somehow more expensive. "People extrapolate from whatever happened recently," says Meir Statman, a finance professor at Santa Clara University who specializes in investor behavior. "Stocks have gone down, therefore they will continue to go down. Therefore they are overvalued." Much of this comes down to simple psychology. Humans have an ingrained tendency to find patterns and then assume those patterns will recur. This is generally a good thing because it allows us to figure out how to act when we're faced with new, complex situations. But it can sometimes lead us astray. Dartmouth professors George Wolford and Michael Gazzaniga and University of California, Santa Barbara professor Michael Miller have designed experiments where participants are asked to guess which of two lights will flash next. The way it's rigged, one of the lights flashes, in a random fashion, 80% of the time while the other flashes 20% of the time. But rather than figure out that it's much better to consistently pick the one light over the other, people try to find a sequence in the flashes -- and so end up guessing correctly less than 70% of the time. Rats, in similarly constructed experiments, do a better job. The difference in the stock market is that the participants are also the people who are making the lights flash. If some investors see a stock going up and then buy it, it goes up some more. And if that brings in even more buyers, up it goes again. Moreover, frequently this price momentum, as it is called, makes fundamental sense -- at least to begin with. Say that a particular company's business begins to improve. At first only a handful of investors may figure out that this is happening, or, as is often the case with a company that has recently undergone hard times, only a handful will figure out that the improvement is long lasting. As more and more investors figure out what's going on, and buy, the company's share price goes higher. But this process of discovery can devolve into something else and people begin to confuse what's going on with the company's stock with the company itself. These perceptions also infect the analyst community and the news media. A favorite example among some market observers is Time magazine making Amazon CEO Jeff Bezos its Man of the Year in December 1999. Amazon and other dot-com shares began a deep swoon shortly thereafter. The Amazon experience is representative of the allure and pitfalls of momentum investing. When it works -- and it often does -- it works very well. But when it doesn't work, the penalties are often swift and severe. Now may be a good time for investors to consider whether they have unwittingly let themselves get caught up in momentum investing, because the market may be entering a period when the strategy goes sour. ING Investment Management senior quantitative analyst Paul Bukowski has found that buying stocks based on past price gains has worked best when the overall market has been moving higher and trading volatility has been low. That's been the general tone in recent years, and one of the reasons momentum has worked. But Mr. Bukowski warns that the markets' recent struggles, plus a rise in volatility, may mean momentum's days are numbered. Choppy trading and market losses are bad for momentum stocks, perhaps, says Mr. Bukowski, because they make people less cocksure in their investing prowess. Here's one strategy that investors can use to check themselves against loving a stock they hold simply because it has been good to them in the past: Imagine if they would buy it now if they didn't already own it. In doing this they realize that the reasons they bought the stock in the first place are no longer compelling. By the same token, it's important to avoid getting sucked in by the hype surrounding a hot stock, says Michelle Clayman, chief investment officer at New York money manager New Amsterdam Partners. Behavioral Trend "There's a behavioral trend for people to jump on the stock and try to figure out what's going on later," she says. "But you should figure out what's going on first." This is because it's often easier to invent a reason for having bought a stock than to have a good reason to buy it in the first place. It's also the case that our tendency to look for trends and patterns may lead us to trade and change strategies too often when what we should really do is sit down with a good financial adviser and determine how much money we should be putting where. It's a lot like the light experiment, Mr. Statman believes. "People move from stocks to bonds trying to figure out the system," he says. "And in the end, they end up being stupider than rats."
For some, it's been an uncomfortably bumpy ride. Fully 55 stocks in the S&P500 moved 1% or more - up or down - on at least 50 of the 80 trading days this year through Wednesday. Some swung that much on at least 60 days, and one did so on 68 days. That stock-by-stock volatility may help explain why investor-sentiment readings are bearish and why money has been flowing out of many stock mutual funds. As of Wednesday, the net outflow from domestic stock mutual funds for April was $745 million. While data from big mutual funds reporting at the end of the month should turn the April inflows positive, AMG Data Services said the monthly gain was likely to be the smallest of the year. Some investors may be unnerved by a recent climb in the Chicago Board Options Exchange Volatility Index for the S&P500, a broad measure of stock market volatility. It was at 14.87 on Wednesday, up from a nine-year low of 11.10 in February. But it is still well below its record of 45.74 in October 1998, after the Fed arranged the private bailout of Long-Term Capital, and below the 45.08 reached in August 2002, two months before the stock market hit its bear-market lows. Other investors may be afraid of recent bounces in the S&P500 index, which had five daily moves of 1 percent or more in the 11 trading days from April 13 to last Wednesday. But it had only 11 days that volatile all year through Wednesday. That is below the 17 volatile days in the comparable period last year, and well below the 40 during the periods in 2001 and 2003. But people who are heavily invested in certain stocks have still been whipsawed. The 55 most volatile stocks include some that have been battered for years, like Calpine, the power producer whose stock price has collapsed since 2000, and Delta Air Lines, one of the many beleaguered air carriers. Some, like JDS Uniphase and Ciena, trade at very low prices, where a percentage-point move is just pennies. Others are quite popular, including Yahoo, eBay and Apple Computer. Many days this year have been dizzying. Some 60 stocks in the S&P500 moved 3% or more on at least 11 days. They include Advanced Micro Devices, Monsanto, Phelps Dodge, Lucent Technologies and Pulte Homes. The biggest daily climb in the index itself was 2 percent, and the biggest decline was 1.7%. Another picture of volatility is seen in the 19 stocks of the S&P500 that are held by the largest number of accounts at Merrill Lynch. On the whole, these stocks, which include Intel, I.B.M., Citigroup, Johnson & Johnson, General Electric, Microsoft, Wal-Mart Stores, Exxon Mobil, Pfizer and ChevronTexaco, have been a little less volatile. For this group, the average number of daily moves of at least 1% was 28. That compares with an average of 35 for the overall S&P500. But in both cases, most of those moves have been down. At the other end of the spectrum, Guidant, a pacemaker manufacturer, fittingly had the lowest volatility. It did not move at much as 1 percent on any day this year through Wednesday. Following it on the least-volatile list were Kellogg, with eight volatile days, and Anheuser-Busch, with 11. Lower volatility has generally meant better performance, but many companies in the quieter group have not been spared from the overall stock market slump this year, which left the S&P500 down 4.6% for the year through Wednesday. Anheuser-Busch, for example, was down 7.4%. The worst-performing low-volatility stock, I.B.M., was down 21.8%. It had 15 days of gains or declines of 1 percent or more. Over all, the 29 stocks that had 20 or fewer volatile days declined 1.9%, on average, through Wednesday, while the 22 stocks with at least 55 such moves tumbled by an average of 17.1 percent. Even if broad market volatility has been historically modest, big day-to-day moves in the stocks in the S.& P. 500 have made equities less appealing and a broad market rebound even more difficult. Monthly Employment Stats
The unemployment rate held steady at 5.2%. After a report Thursday on worker productivity showed that labor cost pressures rose in the first quarter, inflation pressures in the jobs report were mild: average hourly earnings rose five cents, or 0.3%. to $16.00. "Clearly, this report is something of an antidote to the gloomy tone of most recent data," Ian Shepherdson of High Frequency Economics wrote in a research note. Stephen Gallagher, an economist at Societe Generale, told clients in a note that "Just as the March report had widespread softness, the gains in April are also widespread, suggesting that the April data is a correction." The report showed job growth in most major categories of employment except manufacturing, which cut 6,000 jobs. The service-producing industry added 229,000, nearly twice as many as in March. Within that category, the leisure and hospitality industry added 58,000 jobs -- the biggest increase in more than a year. Retailers, construction companies and financial services also reported more hiring. The report also eased some fears that economic growth is slowing down, and is likely to keep the Federal Reserve on track to increase interest rates in the months ahead. The U.S. central bank on Tuesday raised its key interest rate, the federal-funds rate, for the eighth time in 10 months and indicated it aims to keep raising the rate in quarter-percentage-point increments. The fed-funds rate now stands at 3%. "The solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices," Fed policy makers said in a statement. Still, they said, "labor market conditions ... apparently continue to improve gradually," and "pressures on inflation have picked up." The average work week grew for the first time in seven months, climbing 12 minutes to 33.9 hours. In year-on-year terms, average hourly earnings were up 2.7% in April. The labor-force participation rate, seen as an indicator of labor-market slack, rose to 66%, the highest level of the year, while the employment-to-population ratio rose to 62.6.% Separately, U.S. consumer credit outstanding rose by $5.5 billion in March to $2.127 trillion, the Fed said. That follows a revised $5.8 billion rise in February to $2.121 trillion, originally reported up $5.6 billion. Non-revolving credit rose by $5.1 billion in March after rising a revised $2.6 billion in February, first reported up $1.5 billion. Revolving credit, such as credit cards, rose by $386 million in March after rising by a revised $3.2 billion in February, first reported up $4.1 billion. In annual terms, consumer credit rose at a 3.1% rate in March after growing at a 3.3% annual growth rate in February. Revolving credit rose at a 0.6% annual rate in March after rising at a 4.8% annual rate in February. Non-revolving credit rose at a 4.7% annual rate in March after growing at a 2.3% rate in February. For Q1-05, consumer credit grew at a 4.3% annual pace, up from the 3.7% pace in Q4. In Q1, revolving credit grew at a 3.9% pace, after rising at a 3.7% rate in Q4. Non-revolving credit grew at a 4.6% rate in the first quarter, up from 3.8% in Q4.
Despite the quarter-to-quarter increase, productivity has risen 2.5% in the last year, less than half of its annual increase at the beginning of the year in 2004, Steven A. Wood of research service Insight Economics wrote in a note to clients. "The steadily rising trend in productivity growth that started in 1995 has been arrested," he wrote. Joshua Shapiro, chief U.S. economist at Maria Fiorini Ramirez said that "the boost to corporate profits from margin expansion on the back of rapid productivity growth and lower unit labor costs has likely run its course." He said that "the big question now is how much companies will be able to raise prices" to offset higher compensation costs. The Labor Department's report Thursday showed that the increase in unit-labor costs reflected a sharp acceleration in the growth of workers' compensation per hour. Adjusted for inflation, compensation per hour increased 2.4%, up from a 0.2% rate in Q4. Output growth slowed to a 3.6% rate from 3.7% in Q4. Workers' hours rose 1%, down from a 1.6% rate in Q4.
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