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"Nothing can take the place of persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination are omnipotent. The slogan 'press on' has solved and always will solve the problems of the human race." - Calvin Coolidge
Robert Arnott, a money manager who heads a firm called Research Affiliates, thinks the modern investment business can learn something from Copernicus' heresy: The industry, he says, should be less afraid to question conventional wisdom particularly when it's deeply entrenched. Since 2002 Arnott has served as editor of the Financial Analysts Journal, a forum for Wall Street pros, academics and others with a serious interest in finance. A statistics whiz, he has used his journal editorials to poke at many classic investment dogmas, question their application in the real world and effectively challenge his peers to wonder whether there are better ways to construct clients' portfolios. Lately, he has been focused on a portfolio of immense proportions: the estimated $1.7 trillion that U.S. investors have in index stock funds, most of which seek to replicate the performance of the S&P500. The vast majority of market indexes, and the funds that track them, are capitalization-weighted. Arnott contends that is fundamentally flawed. Why? Think about the technology companies that were paramount in the market in March 2000, at the peak of the dot-com mania. In a cap-weighted index, "You automatically overweight all the overvalued stocks," Arnott says. A better way to construct an index, would be to weight stocks based on measures of what firms actually have accomplished, rather than solely on the often fleeting beauty contest of stock capitalization. He calls his concept "Main Street indexing," as opposed to the "Wall Street indexing" of cap weighting. Arnott and his peers at Research Affiliates have spent the last few years developing an indexing system using such measures of business success as five-year average sales and operating earnings, employment and net asset value. His system is designed to avoid holding too much of the index in stocks that already are highly valued allowing more to be invested in shares that, in theory at least, are undervalued and thus have greater future return potential. His index still will hold 80% of the stocks found in the Russell 1,000 index. But because the percentage weighting in each stock will differ from a cap-based formula, the index's performance also will differ. Back-testing from 1962 through 2003, a 1,000-stock portfolio that followed his indexing model generated an average annual return of 12.4%, beating standard indexes of major U.S. stocks by as much as 2% a year. Now, Arnott's taking his Main Street index to Main Street: Pimco this week will launch the Fundamental Index Plus portfolios, two mutual funds based on Arnott's system. Not surprisingly, the central pitch is that investors should earn more over time with Arnott's index than in standard cap-weighted indexes. Arnott faces plenty of skeptics who say he short-changes the appeal and logic of capitalization-weighted indexing. They also say his indexing technique is too unwieldy or is unlikely to produce above-average long-term returns in practice. Or both. Gus Sauter, chief investment officer at Vanguard Group, which has built its mutual fund business on cap-weighted index portfolios, says he has known Arnott for nearly two decades, and considers him "a very smart guy." But Sauter sees Arnott's Main Street stock-weighting idea as just another variation on an increasingly common theme: attempts by money managers to tweak traditional index investing in search of the best of both worlds a "passive," buy-and-hold portfolio that largely tracks the market, but with some added oomph that produces a net return better than the market. Such variations inevitably mean tilting an index portfolio toward particular market sectors, such as smaller stocks. As long as those sectors are booming, the portfolio will beat the market return but only for that long, Sauter said. "I think he really hasn't created anything new," Sauter said of Arnott's concept. Pimco's Brent Harris is a believer. The chairman of the Pimco funds said Arnott's work has helped convince him that "the study of indexes themselves is a wildly underlooked-at topic." Harris also likes the Main Street indexing method on principle, because it is based on fundamental factors that investors naturally consider in picking stocks. Arnott's reputation at Pimco already has been burnished by the success of the Pimco All Asset Fund, which he has been managing since its inception three years ago. In 2002, Harris had the idea for a "fund of funds" that could invest across all major asset classes, picking and choosing among Pimco's portfolios. He found a kindred spirit in Arnott, who also has been forecasting weak returns from traditional markets; Pimco hired Research Affiliates to manage the All Asset fund. Arnott and his staff decide each day how to allocate the All Asset fund's money among Pimco funds based on mathematical models that seek to predict the long-term return potential of each asset sector. Since its launch, the fund has generated a 14.3% average annual return, and cash has poured in, lifting assets to nearly $7 billion. The fund trailed the S&P 500 in the stock market's big comeback year of 2003 but beat it in 2004, and its Class A shares are up 3.5% year to date while the equity market has slumped. Some of Arnott's Financial Analyst Journal editorials have taken the money management industry to task, warning about the dangers of "intellectual laziness." He wonders, for example, why Wall Street thinks it is OK for many companies to continue to assume they'll earn 8.5% a year or more on their employee pension assets when returns on stocks and bonds have dwindled in this decade. If companies and their investment managers were realistic about potential returns, they would have to lower them. Arnott also has attacked those who oppose the expensing of employee stock options on corporate income statements. "We're the only country in the world where stock options aren't treated as an expense," Arnott says. In general, he believes that many long-held financial theories could use a thorough airing-out not unlike what Copernicus' ideas did for man's view of the universe. Related: Pimco Funds to Overcome The Nightmare of Inflation - Karen Damato, WSJ Index's Vulnerable to High Financial Sector Exposure - G Morgenson, NY Times A Small Flaw in Index Funds - Mark Hulbert, NY Times Do Cap-Weighted Indexes Under-Perform? Mark Hulbert, NY Times
Conventional wisdom says basic equity portfolios don't offer investors much of a real estate stake - commercial or residential. After all, the 7 REITs in the S&P 500 less than make up less than 1% of its market capitalization. But Andrew Clark, senior research analyst at Lipper, points out that "there are other industries and sectors which play a role in real estate" and therefore offer some indirect exposure. Among them are homebuilders, engineering businesses, building-products makers and home-improvement retailers - even regional banks and other lenders that do a decent amount of work in mortgage lending. When you throw in indirect real estate plays like these, Lipper found that more than 4% of the holdings of the average large-cap core stock fund were at least indirectly tied to real estate. Among midcap value-oriented funds, the figure is greater than 13%. And among small-cap value funds, it is nearly 17%. Some diversified stock funds have at least 20% exposure, direct or indirect, to real estate, according to Lipper. Nearly a third of the assets of the Alpine Dynamic Balance fund, for example, are tied in some way to the real estate market, according to Lipper. For the Hotchkis and Wiley All Cap Value fund, the recent number was 36%, Lipper said. In both cases, that's more exposure than the average stock fund has to technology or energy stocks. Mike Scarborough, president of the Scarborough Group, argues that while some fund managers are in real estate for diversification purposes, some are "also seeing a need to juice their returns." In the 90's, some funds did that with tech stocks. Today, it may be real estate. Over the last five years, shares of homebuilding companies are up more than 50%, annualized, while REIT's have delivered average total returns of more than 20% a year. By comparison, the S&P500 is down 2%, annualized, during this stretch. Sam Lieber, a co-manager of the Alpine Dynamic Balance fund, said that "everybody looks in the rear-view mirror to some degree, so we've seen folks get much more exposure to real estate than they used to." But Mr. Lieber, who is also chief executive of Alpine Management & Research, argues that even if the housing market slows, there is a reason to be invested in some of these stocks. The homebuilding industry, for example, is going through a fundamental shift from a patchwork of mom-and-pop regional businesses to large national players, he said. Even if home prices start to flatten, as Mr. Lieber expects over the next several years, he says he thinks that larger homebuilders like Toll Brothers and KB Home will continue to grow by picking up market share. The Muhlenkamp fund recently held more than 18% of its stake in homebuilder shares, according to Lipper. But its manager, Ron Muhlenkamp, says that "we're not invested in real estate; we are invested in home-building stocks." This is an important distinction, he said, because he doesn't base his assessment of these investments on the future direction of home prices but rather on the stocks' fundamentals. The earnings of many of these companies have tripled in recent years, Mr. Muhlenkamp said, so they still trade at around eight times estimated 2005 earnings, despite a run-up in share price. "Frankly, when we see companies with returns on equity of 20% or more selling at eight times earnings, we'd be very, very interested," he said. Related: The Truth About Real Estate - Jonathan Clements, WSJ
Indeed, a look at the seasonal performance table below shows that the market tends to slip into neutral, if not reverse, during June through August. (For our purposes, autumn is defined as September to November, winter as December to February, and spring as March to May.) They're not called the summer doldrums for nothing. As the table shows, the S&P500 posted an average decline of 1.2% (excluding dividends) during the summer from 1990 to 2004. What's more, all 10 sectors in the S&P 500 -- as well as the growth and value components of the index -- posted average declines, ranging from a 0.2% dip for the S&P Information Technology sector to a 3.7% slump for the Consumer Discretionary stocks. To gauge each sector's performance in context, the table also includes a column labeled F.O., which stands for "frequency of market outperformance." That serves as an indication of how consistently the sector beat the S&P 500. At first glance, no one should be surprised to see the S&P 500 and its components post their poorest performances during the summer, when it seems investors worry more about their tans than their portfolios. Plus, it marks a period of little capital inflow, as additions to IRAs and reinvested tax refunds tend to occur in the first few months of the new year. These seasonal tendencies have become common knowledge to experienced investors, in S&P's opinion. Is There a Summer Growth Effect? Yet several contradictory signals did jump out from the results, in S&P's view. First, the S&P Growth index did much better than the Value index during the summer, when one might have expected a rotation toward safe havens during typical periods of market weakness. Indeed, the growth component bested the value grouping in three of four seasons. Carrying the defensive mind-set one step further, in our view it's also interesting that the sectors with the best relative performance and F.O. were Information Technology and Financials, respectively, rather than any of the traditionally "defensive" sectors of Consumer Staples, Health Care, and Utilities. A possible answer is that the go-go growth years of the late 1990s -- when tech stocks did well regardless of the calendar -- heavily influenced the 1990-2004 period. Prepare A Strategy So, how should the average investor employ this information? First of all, we believe history should serve as a guide and not gospel, because it doesn't always repeat itself. The only significant conclusion one should draw from this analysis is that the summer months are consistently challenging for equity investors. But as the old saying goes, forewarned is forearmed. A historical perspective may prove useful in understanding market patterns. And that may ultimately help investors ride out short-term gyrations, thus allowing them to stay the course and achieve their longer-term goals.
Mutual funds receive constant inflows. They are always putting their money to work. The purchasing process by large funds occurs over a much longer period. Some positions can take months if not years to build -- or unwind. The technical terms for the process of institutional buying is called "accumulation"; institutional selling is called "distribution." And institutions account for 90% of the NYSE stock market volume -- and half of that is done by the world's 50-largest investment firms. These funds are like elephants -- huge, and secretive in nature. They don't want the world to know what they are buying, because they fear traders will front-run them. But elephants leave tracks in the jungle. Their enormous girth means that they can be tracked. The same is true for institutions. Don't you think that knowing what these behemoths are up to can help you in the markets? If we know that once they buy a stock, they will keep buying it, isn't it a valuable piece of information? Knowing what they are selling -- and will continue to sell over many months -- is even more important. And that's the key to looking at charts: They are the footprints of elephants. Fundamentals are very good at telling you "what" to buy, but they are less proficient at telling you when to buy. A good example would be Microsoft. In 2002, you could have paid as much as $35 or as little as $20 per share. Same company, different entry prices. Timing is the key to profitability. Think of technicals as the "when" part of your strategy. If you learn only a few basic things about charts, you will enhance your returns significantly. I want to share with you the most important rule in all of TA: Do not buy a stock in a downtrend. You probably have heard this edict phrased differently: "Don't catch a falling knife." "Don't fight the tape." "Losers average down." Regardless of the phrasing, it is the most basic tenet of TA. As mentioned before, institutional-size positions can take months or even years to unwind. A downtrend is nothing more than the footprints of that distribution in chart form.
1. 'I love this company.' This is the statement that gets investors into more trouble than any other, and here's why: You are not buying a company -- you're buying stock in a company. Consider this: The employees of Lucent and Enron who had loaded up with their respective companies' stock thought they worked for great companies. 2. 'I am a long-term investor.' And John Maynard Keynes would reply: "In the long run, we are all dead." Being long term does not mean abandoning the responsibility to set reasonable sell triggers on both the upside and the downside. Long-term investors should still review their holdings monthly. It's important to listen to what a stock is telling you. The long run is not an excuse for riding profitable positions all the way back down to break-even or worse. The employees of Lucent and Enron who had loaded up with their respective companies' stock thought of themselves as good long-term investors. 3. 'I just heard on CNBC that...' This is the kiss of death. The lower-risk/easy trade is over by the time an item hits the airwaves. My head trader is fond of an expression: "Last man in pays for beer." Chasing the latest hyped stock is a sure way to foot the bill for everyone else's drinks. 4. 'I don't want to pay capital gains taxes.' I cringe each and every time I hear this shockingly ignorant statement. There is simply no worse reason to continue holding a position than to avoid taxes. 5. 'I'm waiting for the stock to come back to break-even.' If you bought a stock which is now underwater, there are likely legions of people waiting for the same break-even point to get out. That's what the technicians mean by "overhead resistance." In fact, much of technical analysis is based upon the psychology of people waiting to get out of -- or into -- a stock at a previously missed price. When a stock dips and then rallies, those who missed the previous low price wait for another opportunity to buy it there. That why it's called "support," and it's why buyers seem to appear at the same price on a chart in a given stock. The reverse is true of sellers.
The shift toward growth -- in particular, defensive growth stocks that can weather an economic slowdown -- is increasingly evident not only among big investment banks and boutique money managers but also among some mutual funds that pitch themselves as value funds. Morgan Stanley is telling clients to sell stocks in such classic value sectors as basic materials, financials and real estate, and move instead into names like Pfizer and GE. Investment-services firm Russell Investment Group says the managers it surveys and works with are finding it so hard to locate traditional value stocks that they are instead migrating into quality growth stocks like Johnson & Johnson, PepsiCo, GE and Microsoft, which they say now offer value. Atlanta money-management firm Montag & Caldwell says growth stocks are so underappreciated today that investors don't need to pay a premium to own high-quality companies like Estιe Lauder, Procter & Gamble, J&J and Medtronic, all of which the firm has been buying of late. Growth stocks traditionally have come from three broad sectors: health care, consumer staples and technology. The first two are considered defensive plays, because they are largely insulated from the economy's swings. Technology stocks -- ranging from large, stable companies to the smaller, more volatile stocks -- are also growth-oriented though much less defensive. Value stocks have historically come out of sectors that are susceptible to the economy's swings, such as industrials, commodities, financials, basic materials and consumer discretionary companies, including auto and appliance makers. Despite the shift by market professionals, many smaller investors continue to put their faith in value. In April alone, investors put nearly $5 billion into value funds, according to researcher Lipper. In that same month, they took more than $4 billion out of growth funds, continuing a trend that's been going on for years. Growth-oriented investors say that's a sign individuals are looking in the rearview mirror and chasing value's superior returns of the past few years. Since the S&P500 index peaked in March 2000, the Russell 1000 Value index is up about 15% cumulatively. The growth index, meanwhile, has fallen by nearly half. Yet value's returns have cooled in recent months. The Russell 1000 Growth Index is up more than 3% since April 1, more than doubling its value-index counterpart. Meanwhile, many growth stocks have posted double-digit gains. In trying to get the message out to individuals, Liz Ann Sonders, chief investment strategist at Charles Schwab, recently wrote that "the time is right to bias equity portfolios toward large-cap growth." She says the current situation "is classically reflective of a herd mentality," meaning investors continue to rush into value stocks just as they once flooded into technology. The move into growth comes at a time when investors as a whole are trying to divine Wall Street's direction. For months, the major market averages have rallied, then sunk, only to rally again. So far this year, the Dow has lost nearly 3%. Bob Turner, chief investment officer of Turner Investment Partners, a money-management firm, says many large-company growth stocks are cheap relative to their value peers, and in particular says that technology stocks that crumbled during the bear market are now "more attractively priced than I have seen them in the last 15 years or so." His firm now has a larger than normal stake in former growth favorites including Microsoft and Intel, among other tech companies. Intel, a once-battered growth stock, is up more than 16% this year. Value managers at mutual-fund company Evergreen Investments have recently increased stakes in Wal-Mart Stores and GE, and own positions in Microsoft and tech giant Cisco. It has trimmed stakes in companies in the basic-material and industrial sectors. Mutual-fund managers have been lured back into the growth stocks by their rising profits, improving balance sheets and relatively moderate price tags. Oakmark Fund manager Bill Nygren, for example, recently told an investment conference that Wall Street is now "an upside-down world" and that "buying above-average businesses at average prices is just as much value investing as is buying average business at below-average prices." The fund's new holdings include such companies as Wal-Mart and Limited Brands. Of course, the appetite for various types of stocks -- growth, value, small-cap, large-cap -- routinely cycles through phases. If the trend is now returning to growth, then value stocks that have outperformed in recent years could become a drag on a portfolio. Even some value shops are seeing promise in growth these days. NFJ Investment Group, a Dallas subsidiary of asset-management company Pimco, has grabbed stakes in disk-drive maker Seagate and computer maker Hewlett-Packard. -- stocks that back in the '90s would have been too richly priced for its taste, says managing director Ben Fischer. The firm has also built positions in pharmaceutical companies Pfizer, Merck & Co. and GlaxoSmithKline PLC, all beaten-down drug stocks traditionally favored by growth investors. Historically, growth shares carry a higher price/earnings ratio than do value stocks for a very simple reason: earnings that are growing faster than the overall market typically command a premium. Yet that premium has narrowed significantly in recent years: The spread between the P/E ratio of the Russell growth index and the P/E ratio of the Russell value index is at its lowest level in more than a quarter century, according to Ned Davis Research. Investment managers at Montag & Caldwell are betting that the market will soon accord growth stocks a much higher valuation. As overall corporate profit growth moderates, says Ron Canakaris, the firm's chief investment officer, growth stocks are likely to post earnings that will stand out. At GMO, a Boston money-management firm, financial, consumer durable and real-estate stocks are on the way out. Instead, the firm has bought names such as Home Depot, UnitedHealth Group and Dell. Such growth stocks, says Ben Inker, GMO's director of asset allocation, "are trading cheaper then they normally do vs. the market," while traditional value stocks "are more expensive relative to the market then we have just about ever seen."
As part of the $1.4 billion "global settlement" with the SEC and a variety of state regulators, 10 major brokerage firms began offering at least one independent research "buy," "sell" or "hold" rating alongside their own analysts' ratings last July. Two other firms later joined the settlement. If a Merrill Lynch analyst issues a buy recommendation on a particular stock, for example, the firm also has to offer an independent evaluation of that stock. The settlement came in response to allegations that the firms' own research was biased because it promoted corporate clients' stock to win investment-banking business. Since independent analysts don't have business relationships with the firms they cover, they're generally considered to be more objective. Clients can request the research through their brokerage firm's Web site or toll-free number. If you own a stock that is covered by the firm's own analysts, in most cases the independent firm's ratings are also included on your trade confirmations and account statements. And if a broker calls you with a stock tip, he or she must tell you that independent research is available. So how is the independent research stacking up to brokerage offerings? Past analyses by academics and tracking services such as Investars.com showed that many of the independent firms did much better in rating stocks than analysts at investment banks, particularly when the market was performing poorly after the 2000 downturn. Their recent track records, however, are closer to Wall Street's. Over the past year, some of the brokerage firms that were part of the settlement deal have climbed higher in the rankings of the best-performing research shops. In the latest one-year period through May 1, Piper Jaffray climbed into the ranks of the 10 best-performing research firms that cover more than 500 stocks, up from a ranking of 21 based on four years of data, according to Investars.com, which evaluates performance by measuring how each firm's buy and sell picks perform against benchmarks like the S&P500 index. The research divisions of Merrill Lynch, J.P. Morgan Chase, Deutsche Bank AG and Credit Suisse Group also improved in the latest one-year rankings. Just a few years ago, the bulk of Investar's top spots were filled by independents. One reason behind the brokerages' better performance: More are now tying analysts' compensation to the performance of their recommendations. StarMine, another firm that measures research performance, says that brokerage analysts improved in 2003 and 2004, outperforming industry benchmarks by about 2.2% and 1.3%, respectively. In 2002, by contrast, investors who had followed Wall Street's buy and sell recommendations would have underperformed their benchmarks, according to the firm. In addition, a study released last fall and updated to include more data last month by Washington University's Olin School of Business and Penn's Wharton School found that since the global-settlement deal was put in place, analysts have been significantly less likely to weight their reports in favor of companies that do business with their firms. Still, many of the top-rated stock analysts in last month's WSJ Best on the Street survey -- which ranked 213 analysts at 73 firms based solely on their stock-picking ability -- came from independent firms such as Standard & Poor's and Sanford C. Bernstein. Not all of these independents are offering research through the settlement; the biggest that do include Standard & Poor's, Morningstar and Argus Research Co. Many experts say it's difficult to gauge the overall performance of independent firms. Many firms don't make their ratings public or provide their research to some of the third parties that track performance. There are also numerous ways to measure performance, so one firm's track record might look stellar under one performance system, but fall to the bottom of a list according to another system. Just how many independent research reports investors can obtain depends on their brokerage firm. In part, that's because certain firms are required to spend more than others, based largely on the size of the firm and the number of customers it has, according to an SEC spokeswoman. Lehman Brothers, which is required to spend $25 million over five years, will provide investors with just one outside report per stock, while investors at firms such as Morgan Stanley, which must spend $75 million, also over five years, will receive at least three independent research reports on most companies. A number of the brokerage firms are using some of the same sources for their independent research. So far, individual investors don't appear to be using the independent research in significant numbers, and some of the independent firms are complaining that the brokerage firms aren't doing enough to promote their research. Partly because regulators haven't asked the settlement firms to track usage, there is little information available on how many people actually request it. A study released last month by Standard & Poor's found that about 40% of investors aren't aware of the global settlement and that there is only a limited level of awareness of the availability of independent stock research. Some firms are reporting increased investor interest. "Usage has picked up constantly every single month," says Bridget Macaskill, the independent consultant for Merrill Lynch, which offers research from Morningstar and BNY Jaywalk, a unit of Bank of New York that aggregates and distributes research from more than 150 independent firms. At Bear Stearns, investors are viewing the independent research reports online at about 25% of the rate at which they are looking at the company's own research. The firm has launched an Internet tool that, among other things, notifies clients and its sales force anytime there is a ratings change and enables investors to compare the independent firms' ratings against the ratings of other independent firms as well as the firms' own ratings. The research settlement doesn't appear to have resulted in a financial windfall for independent firms, which are typically paid a flat rate based on how many stocks they cover, not on how many of their reports are requested by investors. Still, the size of the industry has grown. Today, there are about 350 to 400 independent equity-research firms in North America, generating about $1.4 billion in annual sales, up from fewer than 50 firms five years ago, says Michael Mayhew, chief executive of consulting firm Integrity Research Associates LLC. Some discount brokerage firms not involved in the settlement are using their independent research offerings as a selling point to attract customers. In February, Fidelity Investments revamped its offerings by adding two more independent research firms and performance data from Investars.com and StarMine showing how each firm's recommendations compare to others'. Fidelity customers now have access to free research reports from 12 independent research firms and one investment bank. In some cases, investors may be able to buy reports through other third parties, such as Investars.com, which charges investors $20 a month for access to its site where they can buy research, and Reuters.com, which also sells independent and brokerage research for $10 to $2,000 per report. A few independent research firms, such as ValuEngine, also sell their research reports directly to the public.
Francis Claro, senior portfolio manager at Evergreen Investments, said that in the United States "there's a 6.5% current account deficit, an environment of rising rates, some inflation, oil is very high and you have a fiscal deficit." "It's not hard to see why investors may be reluctant to buy U.S. assets," he added. Any outperformance by European markets would continue a multiyear trend. While American stocks have recovered recently, they are still down sharply over the longer term. The Morgan Stanley Capital International USA index was down 14.6% over the five years through Friday, even after factoring in dividend payments. The MSCI index of European shares shows a gain of 0.7% in dollars over the same period. In 2005, the trend has held until very recently. American stocks now have a slight advantage for the year, thanks to the fall of the euro, which reduces the value of European assets for American investors. The MSCI Europe index was down 0.8% in dollars through Friday, compared to a 0.2% loss for the MSCI USA index. The fact that the edge is so small, despite the euro's 10% decline this year and the recent "no" votes on the constitution, shows the resiliency of European markets. Dutch and French stocks rose modestly in the days after the referendums, although some analysts said the results could delay European economic changes. In a note to clients after the French vote, Philippe Tibi, research director in Paris for UBS, warned that "structural reform and perhaps privatizations may also be sidelined again." One reason the market impact was negligible may be that stocks are much cheaper in Europe than in the United States. "We've been able to find more value in Europe," said Ray Vars, a manager of global stock portfolios at North Road Capital Management. "We can buy more return on equity for a cheaper price." Paul R. Niven, head of strategy at F&C Asset Management in London, concurred. "Europe looks undervalued compared to the United States," he said. "Some markets have very attractive yields, and companies have been giving cash back to shareholders" through buybacks and special dividends. Tim Harris, European equity strategist at J. P. Morgan Private Bank in London, is less optimistic. He recently lightened the European stock component of his model portfolio. About two months ago, "we took some of our European bets off the table because we saw no reason for Europe to outperform," he said. The sales amounted to 2 percent of the portfolio, he said, and the proceeds were placed in European commercial real estate. Mr. Harris suggested that investors in the United States keep the bulk of their portfolios at home. "We tend to keep a home bias to protect against currency risk," he said. Generally over the last five years, that risk would have been worth taking. The dollar fell substantially against the euro and other European currencies over most of that time, which accounts for much of the superior performance of European stocks. The dollar is still down by more than 30% against the euro over that stretch. A weaker dollar has hurt American shares in two ways: the dollar values of assets denominated in other currencies have risen, and the shrinking of the dollar has caused some European investors to avoid American stocks. Gil Knight, senior fund manager at Gartmore Global Investments, warned that the same effect might occur in reverse if the dollar's recovery continued and Europeans began buying American stocks again. But he considers such events unlikely. "Right now I would consider the U.K., Germany and Italy" as good markets to invest in, Mr. Knight said, declining to be more specific. Mr. Niven, at F&C, also recommends being heavily invested in Europe and lightly in the United States, although he suggested that European stocks were the lesser of several evils. "Equity valuations look good, compared to bonds, but over all the outlook is uninspiring," he said. Pressed to offer some investment ideas, he said that European financial stocks look appealing. Evergreen's Claro said his preference for Europe was based on more than ephemera like valuation discrepancies, foreign-exchange movements and the latest economic reports. The referendums last week may raise doubts about state-led economic changes, but he says he believes that reform is still bound to occur, even if it is one company at a time. "Long term, opportunities in Europe are being driven by a financial discipline that is being instilled," he said. Noting that restructurings intended to make businesses run more efficiently have long been promised but seldom delivered, he added, "I think it's actually happening, and over the next 15 years we're going to see a true shift." Related: Foreign Stocks Can Still Reduce a Portfolio's Risk - Mark Hulbert, NY Times Investors Look Abroad, but Not for the Usual Reason - Jonathan Fuerbringer, NY Times
Angry demonstrations by farmers are a long-standing tradition in France, but the straits that Europe's winemakers are in and their response to it exposes the serious deterioration of a once-proud, signature industry. The problem in a nutshell is that wine drinking is declining in Europe and cheaper foreign-made wine is stealing market share, but winemakers in France and Spain in particular are producing too much, creating a glut. Wouldn't this be a chance to cut prices, move excess product off the shelves and win back some market share? Mais non. The European solution is to take perfectly decent wine, even some pretty good stuff, and essentially destroy it. Surplus wine is turned over to an European Commission program that distills it into industrial alcohol as a way to keep wine prices high. In Europe, wine prices are regulated and vintners are subsidized by the Common Agricultural Policy, a founding principle of the Common Market that was formed in 1957. The aim of the policy was to allow small farmers, including vintners, to stay in business. The practice of destroying surplus wine rather than putting it on the market at discount prices has been followed for years, explains Christian Berger, agricultural attache at France's embassy in Washington. But apparently it is not enough to make winemakers happy this year: Winemakers are complaining that Brussels is paying them too little for destroying it. Thus the near-riot in late May. Instead of subsidies, waste and demonstrations, Europe's wine industry could use somebody like Fred Franzia. Franzia's Bronco Wine Co. of Ceres, Calif., stepped into the California wine grape surplus of three years ago, and the now-famous "Two-Buck Chuck" was born. Franzia bought some of his neighbors' wine at low prices, combined it with his own production, and launched the Charles Shaw label at $1.99 a bottle through the Trader Joe's chain of specialty food markets. There appears to be no thought in Europe of bottling the surplus wine rather than destroying it and exporting it at a discount price to the U.S. and other non-EU markets. "I don't think that could be done economically, what with costs of transportation," says Berger. But Australia, South Africa and Chile, with greater distances to ship, are sending wines to the U.S. market and doing a fine business at $6 to $10 a bottle. Surely a wine from France could be successful with a good marketing campaign. A Five-Buck Jacques wouldn't have to compete directly with Two-Buck Chuck, but it might be appealing to American wine drinkers. The EU, however, won't allow a Five-Buck Jacques, and so far no entrepreneurial-minded vintner appears to have broken ranks and discounted wine for fast sale. This illustrates the contrast between the U.S. preference for market solutions to commodity surpluses and Europe's preference for solving problems through government regulations. And that brings us to why citizens of France last Sunday and the Netherlands on Wednesday soundly rejected the proposed EU constitution. The new law for all 25 EU member states would have given more power to a central governing body in Brussels and pushed economic restructuring in all countries. But many of Europe's people are afraid of such changes. Most of the Continent's economies are stalled and changes in labor laws, which brought some flexibility to employers on matters of hiring and firing and costs of labor, have failed to produce benefits. The economies of France, Germany, the Netherlands and Italy, the big four of the original six founders of the Common Market, are growing at less than 1% this year, if they are growing at all, with unemployment rates as high as 12%. Once vigorous Europe is not adapting to the changed circumstances of the global economy. Now in the wake of the voters' verdicts, new economic policies won't be tried for some time, says economist Adam Posen, an expert on the EU at Washington's Institute for International Economics. Changes are needed, Posen says, "to end restrictions on retail hours and protections for special interests [winemakers, for example] and to ease the multitude of regulations that discourage new business." Another of Europe's big problems is high taxes. For most EU countries, the government's tax take amounts to 45% to 50% of the national gross domestic product, compared with 32% for the U.S. Europe is unlikely to become economically lively without tax cuts, but that is unlikely to happen because it would mean cutting government programs in the face of fierce public resistance. Given the mood in Europe toward change, it's easy to see how we came to the unexpected day when Australian and American wines are selling around the world and Europe's vintages are being turned into rubbing alcohol.
If you know that the right time to save is always now. Not tomorrow, not when you get a raise, not when you finally pay off your credit cards, but today. You no longer think that once you reach a certain magic salary number, you'll suddenly be able to afford to invest. And you understand that the sooner you start saving, however little, the less painful the process of saving will be. Consider: If you save just $40 a week, you'll have nearly $13,000 in five years, assuming average gains of 8% a year. If from ages 22 to 32 you save about the same amount in a retirement account and you earn the same 8% a year, you'll have nearly $500,000 by age 65 -- even if you never save another dime. Your goal should always be to live on 90% or less of your income and save the rest, says St. Paul financial counselor Ruth Hayden. "If you view that as a set boundary, your life will be forever different, for the better," she says. If you know that the only one you can count on is you. Your parents may still lend you a financial hand from time to time. But you're not relying on Mom or Dad to pay for your new car, subsidize the down payment on a house or even let you move back home if you fall on hard times. This kind of self-reliance means that you need an emergency fund -- a stash of cash you can use if your car needs major repairs, you're downsized or you are otherwise hit by financial misfortune. Aim to keep enough money in a money-market fund or another safe, liquid account to cover your living expenses for at least three months. If you know that YOU are your own best financial adviser. You listen to advice from accountants, planners and brokers. But you don't blindly follow their recommendations, because you recognize that their agenda may be different from yours. Before you act on any financial advice, always follow up with your own research, whether that means seeking a second opinion or just reading up on the issue. Then do a gut check to make sure you're comfortable with the move. After all, it's you who's on the hook, not the adviser. If you know that you will screw up sometimes -- and that's okay. There is no such thing as a perfect investor. You can, however, be a smart one and learn from your occasional but inevitable mistakes. When it comes to investing, after all, you have to risk some loss to garner gains over the long term. "If you never make a mistake, you're not doing enough with your money," says Ginita Wall, a certified financial planner. "The secret is to win big and lose small." One way to limit your losses and protect your gains: Take some of the emotion out of your investment decisions by setting target prices for particular holdings -- deciding in advance that you'll sell if the price drops or rises by a certain amount. If you know what is 'enough'. You have material desires like everyone else. But you recognize that those desires are fueled by an advertising-driven culture that encourages you to feel like you never have enough. The true signs of a financial grown-up: Instead of ratcheting up your lifestyle every time you get a raise, you consciously live below your means, value the nonmaterial wealth in your life, and resist the urge to buy the next big thing. In the end, says James Gottfurcht, president of Psychology of Money Consultants in Los Angeles, you know that you've reached money maturity when you realize that "financial freedom and success go not to those who have the most, but to those who need the least." Postings from Charles Munger's [of Berkshire Hathaway] Speech to the USC Business School in 1994 Thanks to The Kirk Report for giving a link to this old speeck in its 6-14-06 edition of Random Thoughts.
The very nature of things is that if you get a whole lot of volume through your joint, you get better at processing that volume. That's an enormous advantage. And it has a lot to do with which businesses succeed and fail. Let's go through a list - albeit an incomplete one - of possible advantages of scale. Some come from simple geometry. If you're building a great spherical tank, obviously as you build it bigger, the amount of steel you use in the surface goes up with the square and the cubic volume goes up with the cube. So as you increase the dimensions, you can hold a lot more volume per unit area of steel. And there are all kinds of things like that where the simple geometry - the simple reality - gives you an advantage of scale. For example, you can get advantages of scale from TV advertising. When TV advertising first arrived - when talking color pictures first came into our living rooms - it was an unbelievably powerful thing. And in the early days, we had three networks that had whatever it was ? say 90% of the audience. Well, if you were Proctor & Gamble, you could afford to use this new method of advertising. You could afford the very expensive cost of network television because you were selling so many cans and bottles. Some little guy couldn't. And there was no way of buying it in part. Therefore, he couldn't use it. In effect, if you didn't have a big volume, you couldn't use network TV advertising which was the most effective technique. So when TV came in, the branded companies that were already big got a huge tail wind. Indeed, they prospered and prospered and prospered until some of them got fat and foolish, which happens with prosperity - at least to some people. And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz's chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don't know anything about Glotz's. So if one is 40 cents and the other is 30 cents, am I going to take something I don't know and put it in my mouth ? which is a pretty personal place, after all - for a lousy dime? So, in effect, Wrigley, simply by being so well known, has advantages of scale - what you might call an informational advantage. Another advantage of scale comes from psychology. The psychologists use the term social proof. We are all influenced - subconsciously and to some extent consciously - by what we see others do and approve. Therefore, if everybody's buying something, we think it's better. We don't like to be the one guy who's out of step. Again, some of this is at a subconscious level and some of it isn't. Sometimes, we consciously and rationally think, "Gee, I don't know much about this. They know more than I do. Therefore, why shouldn't I follow them?" The social proof phenomenon which comes right out of psychology gives huge advantages to scale - for example, with very wide distribution, which of course is hard to get. One advantage of Coca-Cola is that it's available almost everywhere in the world. Well, suppose you have a little soft drink. Exactly how do you make it available all over the Earth? The worldwide distribution setup - which is slowly won by a big enterprise - gets to be a huge advantage. And if you think about it, once you get enough advantages of that type, it can become very hard for anybody to dislodge you. There's another kind of advantage to scale. In some businesses, the very nature of things is to sort of cascade toward the overwhelming dominance of one firm. The most obvious one is daily newspapers. There's practically no city left in the U.S., aside from a few very big ones, where there's more than one daily newspaper. And again, that's a scale thing. Once I get most of the circulation, I get most of the advertising. And once I get most of the advertising and circulation, why would anyone want the thinner paper with less information in it? So it tends to cascade to a winner-take-all situation. And that's a separate form of the advantages of scale phenomenon. Similarly, all these huge advantages of scale allow greater specialization within the firm. Therefore, each person can be better at what he does. And these advantages of scale are so great, for example, that when Jack Welch came into General Electric, he just said, "To hell with it. We're either going to be # 1 or #2 in every field we're in or we're going to be out. I don't care how many people I have to fire and what I have to sell. We're going to be #I or #2 or out." That was a very tough-minded thing to do, but I think it was a very correct decision if you're thinking about maximizing shareholder wealth. And I don't think it's a bad thing to do for a civilization either, because I think that General Electric is stronger for having Jack Welch there. And there are also disadvantages of scale. For example, we - by which I mean Berkshire Hathaway - are the largest shareholder in Capital Cities /ABC. And we had trade publications there that got murdered where our competitors beat us. And the way they beat us was by going to a narrower specialization. We'd have a travel magazine for business travel. So somebody would create one which was addressed solely at corporate travel departments. Like an ecosystem, you're getting a narrower and narrower specialization. Well, they got much more efficient. They could tell more to the guys who ran corporate travel departments. Plus, they didn't have to waste the ink and paper mailing out stuff that corporate travel departments weren't interested in reading. It was a more efficient system. And they beat our brains out as we relied on our broader magazine. That's what happened to The Saturday Evening Post and all those things. They're gone. What we have now is Motorcross - which is read by a bunch of nuts who like to participate in tournaments where they turn somersaults on their motorcycles. But they care about it. For them, it's the principle purpose of life. A magazine called Motorcross is a total necessity to those people. Arid its profit margins would make you salivate. Just think of how narrowcast that kind of publishing is. So occasionally, scaling down and intensifying gives you the big advantage. Bigger is not always better.
For example, when we were in the textile business, which is a terrible commodity business, we were making low-end textiles - which are a real commodity product. And one day, the people came to Warren and said, "They've invented a new loom that we think will do twice as much work as our old ones." And Warren said, "Gee, I hope this doesn't work because if it does, I'm going to close the mill." And he meant it. What was he thinking? He was thinking, "It's a lousy business. We're earning substandard returns and keeping it open just to be nice to the elderly workers. But we're not going to put huge amounts of new capital into a lousy business." And he knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benefit of the buyers of the textiles. Nothing was going to stick to our ribs as owners. That's such an obvious concept - that there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that's still going to be lousy. The money still won't come to you. All of the advantages from great improvements are going to flow through to the customers. Conversely, if you own the only newspaper in Oshkosh and they were to invent more efficient ways of composing the whole newspaper, then when you got rid of the old technology and got new fancy computers and so forth, all of the savings would come right through to the bottom line. In all cases, the people who sell the machinery - and, by and large, even the internal bureaucrats urging you to buy the equipment - show you projections with the amount you'll save at current prices with the new technology. However, they don't do the second step of the analysis which is to determine how much is going stay home and how much is just going to flow through to the customer. I've never seen a single projection incorporating that second step in my life. And I see them all the time. Rather, they always read: "This capital outlay will save you so much money that it will pay for itself in three years." So you keep buying things that will pay for themselves in three years. And after 20 years of doing it, somehow you've earned a return of only about 4% per annum. That's the textile business. And it isn't that the machines weren't better. It's just that the savings didn't go to you. The cost reductions came through all right. But the benefit of the cost reductions didn't go to the guy who bought the equipment. It's such a simple idea. It's so basic. And yet it's so often forgotten.
It's not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it - who look and sift the world for a mispriced be - that they can occasionally find one. And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don't. It's just that simple. That is a very simple concept. And to me it's obviously right ? based on experience not only from the pari-mutuel system, but everywhere else. And yet, in investment management, practically nobody operates that way. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And that's with a very brilliant man devoting his lifetime to it. When Warren lectures at business schools, he says, "I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches - representing all the investments that you got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments at all." He says, "Under those rules, you'd really think carefully about what you did and you'd be forced to load up on what you'd really thought about. So you'd do so much better." Again, this is a concept that seems perfectly obvious to me. And to Warren it seems perfectly obvious.
On Thursday, the Fed is all but certain to raise the federal funds rate to 3.25% and signal that it will continue to raise overnight rates at a "measured" pace. But the real debate at the meeting is expected to be about the unexpected decline of long-term interest rates, which have kept mortgage rates at their lowest level in decades and fueled what many analysts fear is a bubble in housing prices. Alan Greenspan said in February that the low long-term rates might simply be a "short-term aberration." But Greenspan and others are now suggesting that the change is more enduring. The debate is over why the change has occurred, and different theories lead to sharply disparate conclusions about the best way to respond. Earlier this month Greenspan described the trend as profoundly important and "clearly international in origin." "How we integrate it into the basic underlying monetary policy structure is something we're spending a considerable amount of time on," he added. The term premium has shrunk to almost nothing. One school of thought holds that low bond yields are a harbinger of slowing economic growth, which would reduce demand for credit in the future. Another school holds that global investors have lower inflation expectations than in the past, which reduces the risk of holding long-term bonds. If either theory is correct, the Fed could stop raising short-term rates at a much lower level than in the past. But yet another theory holds that long-term interest rates may have been depressed by other factors, including a "savings glut" around the world and efforts by Asian central banks to keep the value of their currencies down by buying United States Treasury securities. If that is true, the flood of foreign money into the country could be diluting the Fed's effort to prevent inflation. That would imply that the Fed needs to raise rates more than many investors are expecting. Greenspan is skeptical about theories based on low inflation expectations or on an impending slowdown. He also expressed concern that low long-term rates had contributed to "froth" and might be feeding inflationary pressures. Other officials have been more optimistic. William Poole, president of the FRB of St. Louis, has argued several times that long-term rates are mostly driven by investors' expectations of long-term inflation. Jeffrey Lacker, president of the FR of Richmond, suggested that there may be less uncertainty about inflation than in the past. "It's important to keep in mind that the term premium shouldn't be expected to behave in the way it's behaved in postwar cycles in which inflation was unsteady," Mr. Lacker said. "The most likely explanation for the low rates," he said, is that "inflation is low and that inflation expectations are low." Wall Street economists are as divided as Fed officials about the proper interpretation. James Glassman, a senior economist at J.P. Morgan, contends that long-term interest rates reflect the deflationary effects of globalization. "If you think of this in economic terms, East Asia and Nafta have been annexed to the United States. It looks like an economy that has far more excess capacity. Overnight, decisions by the Chinese government are releasing huge numbers of Chinese laborers. That means more excess capacity and a longer time to get back to full employment." By that interpretation, the Fed could stop raising short-term rates once they reach 3.75%. But others predict that the Fed will continue to worry about inflationary pressures, the United States' soaring level of foreign indebtedness and the dangers of a housing bubble.
Barron's: Is the bad news outweighing the good news these days? Global growth is certainly slowing. But I think the slowdown in the economy is good news because there were some inflationary pressures starting to build up in the system. We saw it in the data and we were hearing it anecdotally from companies. So to use the clichι, this is the pause that refreshes and it increases the odds that we have a prolonged expansion. Barron's: What is your outlook for growth this year? Growth is definitely going to slow and will be noticeable. You had 3% in Q2, but that will decelerate in Q3 to about 2.5% and maybe even 2% by Q4 and the first half of 2006. Barron's: Will we be spared a recession? I don't think we have the ingredients for a recession. There was an inflation scare that is fading pretty quickly -- not disappearing but fading pretty quickly. The slowdown in the economy further increases the odds that inflation probably slows a little bit. Tom Gallagher, our head of policy research, has the Fed stopping at 3.75%, given its hawkish bias towards inflation and because growth has been OK. Also, the Fed is very focused lately on housing and housing prices and might tighten a touch more than they would otherwise to reduce the froth in that market. The key ingredient for why there probably won't be a recession is that wage inflation has remained tame. Prior to previous recessions, there's been a clear acceleration in inflation and wage inflation and the Fed has had to really slam on the brakes. Another characteristic of a mid-cycle slowdown is that bonds and fed funds converge. The bond market figures out before the Fed decides to change rates that the economy is slowing. Obviously, the yield curve has flattened as bond yields have come down. The same thing happened in 1985 and 1995. By the summer of 1995, bond yields and fed funds were at equilibrium and the Fed was finished tightening. We are forecasting fed funds and bond yields to converge at roughly 3.8%, similar to what occurred in 1995. Barron's: Yet a lot of people assume a flattening of the yield curve is enough to push us into recession. The flattening of the yield curve is going to increase the odds you get a slowdown. Also, there's been a very sharp slowdown in money supply, which suggests the Fed is tighter than the 3% fed funds suggest. Historically, it is the change in the fed-funds rate that drives the change in money supply and not the level. The Fed was easing very aggressively in 2001 and 2002 and the fed-funds rate plunged 500 basis points. Now it's up 200 basis points, and that has corresponded perfectly with a very sharp slowdown in money supply to basically zero. It is the combination of all these forces, from oil to money supply to the yield curve, that are indeed contributing to this slowdown. Barron's: There has been a lot of comparison to 1995 in the ISI reports. In the 1980s and 'Nineties you had very long expansions. But within both, there were roughly three cycles. The first cycle I'd call the strong advance, in which the economy finally comes out of recession and accelerates enough so there is some inflation concern and the Fed tightens. That happened in 1984, that happened 1994 and that happened in 2004. Then, in both the previous two decades and maybe again now, in part as a result of that tightening, the economy slowed. It slowed in 1985, it slowed in 1995. In both of those periods, the Fed then eased and the economy reaccelerated. Today, there is a comparison not only to the '95 period but also maybe to the '85 period, where the economy slows because of central-bank tightening and higher oil prices. We are moving into the mid-cycle slowdown. Barron's: What sets this period apart? In both '85 and '95, the stock market absolutely had a very strong run. In the 1985 period it was more of a step function, where the market rallied 40% and then went sideways. In 1995, it was just a steady climb in the stock market. I think, on a historical basis there should be a decent rally in the market. We think the market can rally roughly 15% from its spring low of April 20. Barron's: Are you still concerned about a looming financial crisis? Yes. As you go into a mid-cycle slowdown, there's always been a financial crisis. We've had a little taste of strains in the system with the GM and Ford debt downgrades. I still think we are going to end up with a very clear financial crisis. I don't know if it is going to be problems at GM and Ford resurfacing, or some other part of the economy or another country. But historically, the combination of higher interest rates and a slowdown in the economy puts a lot of pressure on the weak links. Barron's: What's your outlook on capital spending? We are going to have a full-blown economic slowdown, from consumer spending to capital spending. That's in part related to a slowdown in corporate profit growth. S&P 500 operating earnings, year-over-year, could move down toward zero by the fourth quarter. If companies start to see that kind of pressure on their profits, they'll cut back on spending or certainly slow spending growth, including capital spending. The Business Roundtable and Duke University usiness-confidence measures have started to weaken. That to me is confirmation we are probably starting to see the slowdown in profits and suggests a slowdown in employment and capex. Barron's: What about the global scene? This is a full-blown, synchronized global slowdown, and actually some parts of the world will probably be weaker than the United States. It is very true for the emerging markets. The main culprit there is energy. Historically prior to every domestic and global slowdown we've always had an increase in energy prices. The case and evidence for slower growth outside of the United States is even more powerful than it is inside. There is so much weak foreign economic news from Europe and the U.K. in particular. We've exported a lot of our manufacturing activity to these developing economies, and as we slow, they slow. Barron's: Will foreign interest in U.S. bonds continue? That's had some impact on our bond market. But bond yields around the world have declined dramatically. The real main driver for lower bond yields, globally, is that inflation is going to stay low. Even Greenspan retracted his "conundrum" remark and said the financial market's focus on low inflation is encouraging bond yields around the world to move lower. So foreign-central-bank buying of bonds could be a factor, but the driving force is a slowdown in global growth and low inflation. Barron's: Where are we headed with oil? Our integrated-oil strategist, Mike Rothman, believes that because of the global slowdown, oil prices should move lower -- toward $45 by year end. Barron's: I was surprised to read in one of your reports that productivity declined quarter-over-quarter. So was I. It does look as if Q2 productivity could actually decline slightly. It is going to put some pressure on corporate profit margins. I suspect as a result you are going to see a very clear slowdown in employment, in part because of the pressure on productivity and therefore profit margins. Barron's: But has employment really ever picked up to the extent you would have expected in a recovery? Absolutely not. There is plenty of slack in the system. This employment cycle is anemic relative to the 1994-95 employment cycle and that was a jobless recovery. That is another key reason why I think inflation stays low; there is still plenty of labor-market slack in the system. And I think it [the cause of the slack] has to do with health-care costs. There seem to be three key drivers for employment growth. Two of them are real GDP and the GDP price deflator, or a company's ability to sell a product at a certain price. But the third variable seems to be health benefits, or benefits in general. And benefit inflation has been too strong. Employment growth has been restrained given the strength in benefits. Companies are just saying no. One of the most positive things that could happen for the long-term employment cycle would be a very clear slowdown in benefit inflation. Maybe it is starting. We saw the Employment Cost Index in Q1. If that were to continue, it would be very helpful to long-term employment growth. Barron's: Where do you expect interest rates will end up? Ten-year Treasury yields move down to 3.60 and the Fed should be done at roughly 3.75. The Fed will tighten probably at the June, August and September meetings, bringing the fed-funds rate to 3.75%. But by then it should be clear we're in a mid-cycle slowdown. Barron's: So are you bullish on bonds here? I would be bullish on bonds. First, the economy slows. Second, there's lower inflation. In addition, there is still an awful lot of bears on the bond market, and from a contrarian standpoint, that makes bonds a fair bet. It is not just in the U.S., but globally there have been tremendous rallies. Long rates in China are down to about 3½%. In Germany, they are down to about 3.20. At 4% in the U.S., we're not low compared to the rest of the world, and maybe we're a little on the high side. Barron's: Thanks, Nancy.
By slashing short-term interest rates to 45-year lows, the Fed encouraged Americans to borrow more, gave them little reward for saving and helped ignite a surge in housing prices. President Bush and Congress joined in with steep tax cuts that boosted household purchasing power. All that spending contributed to a growing U.S. economy, a steady increase in imports and -- given that Americans are so eager to borrow and foreigners so eager to lend -- a mountain of foreign debt. This is pleasant for Americans as long as it lasts. But Fed officials, international financial watchdogs and private economists say it can't. At some point, American consumers must spend less, save more and rely less on foreigners' savings. How that will happen puts the nation in uncharted territory: After treating a bubble, how does the Fed manage the side effects of its medicine? "We have done what no other economy has done before, faced with an asset bubble," Lawrence Lindsey, a former Fed governor and Bush adviser, said at a recent panel discussion. Praising both the Fed's rate cuts and Mr. Bush's tax cuts, he said, "This is the first time in history the textbook economic policy... was used, and worked. The problem is, once you finish that chapter of the economic texts, you turn the page and the page is blank -- because no one has gone through the process before." The Fed is confident these imbalances will be resolved with little pain. As it raises interest rates, consumers will slow their spending and save more. Foreigners' appetite for U.S. goods will rise. The engine of U.S. growth will shift smoothly from consumers and government to business investment and exports. A Minority Sees Big Trouble Ahead But a minority of economists warn of a more damaging scenario. Some say the Fed has simply replaced the stock-market bubble with one in housing, which could burst. That would sap the consumer spending that mortgage refinancing and home-equity loans have fueled. Or foreign investors could stop buying U.S. stocks and bonds, sending the dollar down and inflation up, prompting both the Fed and bond market to jack up interest rates sharply. In either case, the U.S. economy could slow sharply or fall into recession. Faced with an asset bubble, a central bank has two choices: Prick it early or wait for it to burst and try to contain the damage. The Fed in 1929 and the Bank of Japan in 1989 tried the first route, raising interest rates in response to rapidly rising asset prices. The result in the U.S. in the 1930s was depression and deflation. In Japan it was stagnation and deflation that continues today. In the 1990s, Mr. Greenspan chose the second route. As long as the prices of goods and services were stable, he would leave the stock market alone. When the stock bubble finally burst, the Fed cut short-term rates aggressively beginning in 2001 and then held them at a 45-year low of 1% through early 2004 until the Fed was sure the threat of deflation had receded. Mr. Greenspan knew his strategy carried risks. But he saw far greater ones in responding timidly as the collapse of the biggest asset bubble in history wiped out more than $5 trillion in shareholder value, and terrorist attacks, war and corporate scandal rattled confidence. The economic expansion to date suggests he was right, and the odds are that he will retire as scheduled next January with his reputation for economic stewardship intact. But if a collapse in housing prices or a run on the dollar triggers a new recession, Mr. Greenspan's legacy may be different. The Fed is conducting a "crucial experiment" in post-bubble monetary policy, says Edward Chancellor, a financial historian. "We don't know what the outcome is yet." Lower interest rates normally operate through several channels. They encourage consumers to buy things on credit today instead of saving to buy the items later. They boost stock and home prices, which makes the owners of those assets wealthier and more willing to spend. They encourage businesses to borrow and invest. And they depress the dollar, boosting exports. But after 2001, some of these channels were blocked. Businesses, burdened with a glut of unused equipment from the bubble years and cowed by geopolitical and regulatory uncertainty, didn't borrow to invest. And the dollar didn't fall initially, but rose because foreign economies were in even worse shape than the U.S.'s. This meant the economy relied disproportionately on the one channel that did respond: consumers. They bought record numbers of houses and cars, mostly on credit. They also borrowed against their houses' appreciated values, allowing them to spend more still. To Mr. Greenspan, who had studied housing and mortgage markets all his life, this came as no surprise. "Households have been able with increasing ease to extract equity from their homes, and this doubtless has helped support consumer spending in recent years, complementing the traditional effects of monetary policy," he observed in August 2003. The Best of Alternatives Accused by some of fostering excess, Fed officials responded that the alternative was worse: a deeper recession and the risk of deflation -- a period of generally falling prices, which can worsen a downturn by making it harder for workers and companies to repay debts. In a February 2003 speech Fed Governor Donald Kohn, one of the central bank's principal monetary-policy strategists, agreed low interest rates had had an outsize impact on car sales, home construction and housing prices. But that "has kept more people employed and reduced the risk of deflation," he said. By January 2004, the expansion seemed entrenched enough for Mr. Greenspan to declare victory: "Our strategy of addressing the bubble's consequences rather than the bubble itself has been successful." While "large residues" of household and foreign debt remained, they would not be a barrier to growth; such imbalances, he suggested, would dissipate with time. Instead, they have grown. "The magnitude of these imbalances is increasingly moving into unfamiliar territory," Mr. Kohn said in April. Since his February 2003 speech, house values have risen 25% and total mortgage debt by 28%, while after-tax incomes have expanded just 13%. The household saving rate, a low 2% in 2000, has fallen to 0.9%. A growing share of mortgages have gone to speculators and people making little or no down payment. House "prices have gone up far enough since then -- relative to interest rates, rents and incomes -- to raise questions," Mr. Kohn said in April. Current-Account Deficit in the Danger Zone Meanwhile, the current-account deficit, the broadest measure of the shortfall on trade and investment income between the U.S. and the rest of the world, has moved into a zone that many economists consider dangerous. It stands today at 6% of GDP, up from 4% in 2000. To finance it, the U.S. now borrows about $2 billion a day from foreigners. As the foreign debt mounts, so does the risk that investors will demand a higher interest rate or lower dollar to keep on lending. To be sure, a major cause of the U.S. current account deficit is that weak European and Japanese growth reduces demand for U.S. exports. And China's fixed exchange rate keeps the prices of Chinese goods artificially low, giving its television sets, bicycles and barbecue grills an edge in the U.S. market. But the U.S. saves so little that when the U.S. cuts taxes and consumers take out mortgages, the money to finance both increasingly comes from abroad, in particular, foreign central banks. Those banks purchase U.S. dollars to keep the greenback high against their own currencies, thereby supporting their exports to the U.S. They then invest those dollars in U.S. bonds, in effect providing the financing for Americans to buy those exports. Since 2000, foreign-brand cars have surged to 43% of the U.S. market from 35%, according to Motorintelligence.com. In the meantime, foreign holdings of U.S. Treasury bonds and bonds backed by Americans' home mortgages have jumped 80%. In the first quarter of this year, General Motors made more money on mortgages than on cars or car loans. Since the beginning of 2001, the number of Americans employed in manufacturing has fallen by 2.8 million, or 16%, while the number in residential construction, real estate and banking has risen by 766,000, or 14%. "If I were a biologist I'd call this a perfect example of symbiosis," former Fed Chairman Paul Volcker mused in a February speech. "Contented American consumers matched against delighted foreign producers. Happy borrowers matched against willing lenders. The difficulty is, the seemingly comfortable pattern can't go on indefinitely." Almost every economist agrees. The debate is over how, not whether, the global economy rebalances: Will it be smooth, through some combination of declining dollar and accelerating foreign demand? Or will it be chaotic, with a dollar collapse, much higher U.S. interest rates and perhaps a global recession? Mr. Volcker thinks a crisis is likely. Investor confidence could fade "at some point," he said, with "damaging volatility in both exchange markets and interest rates." His successor is more sanguine. Capitalist economies, Mr. Greenspan believes, always have imbalances but are also continuously reallocating resources and capital to correct them. Thus, imbalances seldom become crises. "The number of forecasts of crises. . . is far in excess of the number of crises that actually occur," Mr. Greenspan told a recent audience. "There is something equivalent to an invisible hand which continuously is readdressing market imbalances to reach equilibrium." Fed staff research shows that in the past, when a big, rich country has a large current account deficit, it usually narrows without crisis. Homes may be overvalued but are much harder to trade than stocks and thus unlikely to collapse abruptly. Fed officials expect home prices to stagnate while incomes advance, bringing affordability back to historic ranges. What Should the Fed Do Next? Having helped create today's imbalances, Fed officials acknowledge some responsibility to reduce them. By raising rates, Mr. Kohn explained, the Fed will make saving more attractive, slow the rise in housing prices, and "thereby lessen one of the significant spending imbalances." And Mr. Greenspan adds, "an increase in household saving should also act to diminish borrowing from abroad," narrowing the current account deficit. That benign scenario has yet to unfold. Business investment is growing but by less than the Fed had expected. And while the trade deficit narrowed sharply in March, for the first quarter as a whole it hit a record of $694 billion on an annualized basis, or 5.7% of GDP. Meanwhile, even as the Fed raises short-term interest rates, long-term interest rates, which are set on markets, have actually declined, a development that baffles Mr. Greenspan. Since mortgage rates are tied to long-term bond yields, home prices have advanced at one of their fastest rates yet over the spring. Mr. Greenspan has acknowledged "a little froth" in the housing market. What should the Fed do? Mr. Volcker, focusing on the current account deficit, thinks the Fed ought to put added weight on keeping inflation under control. "I am worried about a tendency to relax our guard," he said. It is critical foreigners remain confident that "those trillions of dollars they are piling up are going to be protected against inflation." Some of today's Fed leadership shares this view: The Fed can minimize the odds of crisis by keeping inflation down, which means erring on the side of higher interest rates. Mr. Lindsey, on the other hand, believes the Fed should worry less about inflation and more about keeping the housing market from sinking. "You don't want to collapse asset prices," he says. "You want to give people time to adjust in a gradual way." He thinks the Fed should slowly raise its target for short-term interest rates, now at 3%, to 3.5%, and then stop. Mr. Kohn, in his April speech, made it clear the Fed would not let imbalances deter any necessary action to keep inflation down: "We should not hesitate to raise interest rates to contain inflation pressures just because it might set off a retrenchment in housing prices, just as we were willing to keep rates unusually low as house prices rose rapidly."
On the one hand, you have the Federal Reserve Board, which has raised short-term interest rates eight times over the last year. Minutes from the Fed's most recent monetary policy meeting show that central bankers are confident the economy is still on track for growth. The recent soft patch is "likely to be transitory," the minutes said, and it would be a mistake to "overreact to a comparatively small number of disappointing indicators, especially when economic fundamentals appeared to remain quite supportive of continued solid expansion." On the other side of this debate is the bond market, which appears to be focusing squarely on the disappointing signs like slumping manufacturing activity and four consecutive months of decline in the leading economic indicators. A result is that the target for the federal funds rate has climbed to 3% from 1% since the Fed began tightening monetary policy last June. At the same time, yields on 10-year Treasury notes have fallen below 4% from 4.62%. In industry jargon, the yield curve has flattened considerably. For a brief time starting in February, Alan Greenspan seemed to be winning this debate with the bond market. Shortly after Mr. Greenspan described as a "conundrum" the simultaneous decline in long-term yields and climb in short-term ones, bond traders took notice, said Edward Yardeni, chief investment strategist at Oak Associates. In fact, yields on 10-year Treasuries jumped more than half a percentage point by late March, before reversing course. Today, conventional wisdom seems to be shifting slightly to the bond market's point of view. A Merrill Lynch survey in May showed that 52% of global money managers say the current economic expansion is nearing an end. By comparison, 44% say we're only midway into this economic cycle. (Since 1945, the average expansion has lasted more than five years; the current cycle is about three and a half years old.) In reality, the two camps aren't all that far apart. The Fed, for instance, is not claiming that economic growth is accelerating, or that the economy will keep growing in perpetuity. Instead, it is just making the case that the economy is in the middle innings of growth. By contrast, the bond market isn't arguing that we're headed for recession just yet. Recessions are typically preceded by an inverted yield curve, where long-term rates are lower than short-term rates. For the moment, the yield curve has simply narrowed, as it typically does in times of Fed tightening. The bond market is simply saying that we're in the late innings of growth. For most buy-and-hold investors, this distinction between the mid- and late-cycle phases of the economy isn't that huge. Whatever inning we're in, it's clear that this economic cycle is maturing. When that happens, stock market leadership typically shifts from fast-growing small stocks to shares of large, blue-chip companies that can produce consistent earnings growth without the need for a rapidly accelerating economy. To be sure, investors have been predicting a blue-chip resurgence for years, without much to show for it. But after five years of small-cap outperformance, many market strategists say change is in store. So far this year, the S&P500 blue chips has lost 1.3%, while the S&P600 index of small stocks is down 1.1%. "We think we're reaching an inflection point," said Joe Battipaglia, chief investment officer at the brokerage firm Ryan Beck & Company, who contends that the economy is in its mid-cycle phase. Even if economic growth slows considerably, Mr. Battipaglia predicts that large stocks will outperform small ones because the blue chips are less volatile and offer more downside protection in the form of dividends. Typically, in the middle to late stages of an economic cycle, value-oriented stocks - those that have been beaten down or overlooked and that trade at relatively inexpensive prices - are likely to thrive, said Sam Stovall, chief investment strategist at Standard & Poor's. But because value stocks have trounced growth-oriented shares for the last five years, many investment strategists say the trend may be about to reverse. Mr. Battipaglia contends that consumers are better off financially than some economists say, so the consumer discretionary sector, which is more growth-oriented than the broad market, should show promise. Robert Turner, chairman and chief investment officer at Turner Investment Partners, says investors should not overlook tech stocks. Even if the current economic cycle is nearing an end, the inclusion of some growth stocks in a portfolio could offer some protection. That's because two of the most popular value-oriented sectors, financial services stocks and energy, could be hit hard in a downturn. If the economy is approaching a recession, financials would be hurt by rising credit risks while energy prices are likely to slip in the face of falling demand. Your opinion about whether the economy is in its mid- or late-cycle phase could affect the type of value stocks you own. If you think the economic expansion is only half through, you may want to stick with the red-hot energy sector. David Kotok, chairman and chief investment officer at Cumberland Advisors, says there are still opportunities for investors in oil and natural gas stocks. But if you think the economy is about to roll over, more defensive value areas may be attractive - including consumer staples and utilities, which tend to do best as the economy shifts from expansion to contraction. Whichever you choose, "this is not the time to be making big sector bets," said Nicholas P. Sargen, chief investment officer at Fort Washington Investment Advisors. For one thing, some economists and market strategists say the bond market may not be sending a crystal-clear sign of an economic slowdown. They wonder if other factors, like the voracious foreign appetite for Treasuries, are contributing to low bond yields. Another possibility is that the Fed and the bond market could each be partly correct. In other words, the cycle could be between the middle and late innings. If that's the case, Mr. Sargen says, there is an argument for "parking your portfolio in the middle of the road" - just to play it safe. Monthly Employment Stats
Over the past year, the nation has added an average of 180,000 jobs a month. That pace has slowed to about 158,000 jobs a month since February, a trend that economists say is in line with other indicators of slower but continued economic growth. The extraordinary reluctance to hire in May was partly a rebound from torrid pace in April, when employers added 274,000 people to their payrolls. "The economy has slowed from its strong pace, but the data have been so strange and volatile that it is unclear what its true condition is," said Joel Naroff, president of Naroff Economic Advisers. The Labor Department said that the number of non-farm payroll jobs, based on its survey of 400,000 worksites, was essentially flat in most industries. Job growth essentially stalled in retailing, temporary-help agencies, entertainment and business and professional services - all areas that had been big sources of new employment over the past year. Manufacturing companies shed another 7,000 jobs in May, and have eliminated 67,000 jobs since last August. The results highlighted the apparently permanent decline in factory employment as a result of rising productivity and increased "outsourcing" of production to China and other low-wage countries. Only a few industries added significant numbers of workers. One was health care, which has been been expanding faster than the overall economy for years and added 26,000 jobs in May. The other big area was residential home construction, which added 20,000 jobs, and provided further evidence of the economy's dependence on the housing boom. But there were other indicators that the labor market continues to expand. The unemployment rate edged down to 5.1 percent in May, compared with 5.2 percent in April, even as greater numbers of people entered the workforce. Hourly wages for production and non-supervisory workers climbed about 3 cents an hour, to $16.03, and have climbed about 2.6 percent over the past year. Still, that was less than the rate of inflation. Richard Berner, chief United States economist at Morgan Stanley, said the American labor market still appears to be expanding at a moderate pace. "When you peer through the fog of volatility in these data, the labor markets are continuing to improve," Mr. Berner said. "The economy is fine." On Thursday, the Labor Department estimated that unit labor costs, the cost of labor to produce a dollar's worth of production, climbed by 3.3 percent in the first three months of 2005. Fed officials consider labor costs one of the most important indicators of looming inflation, and they have already made it clear in public pronouncements that they were more worried about inflation than about slower economic growth. "We do not expect Fed officials to alter their - broadly upbeat - view of the labor market on the basis of this report," wrote economists at Goldman Sachs, in a note to clients today. "The market is too optimistic in believing that the end to the rate hikes is near. More Stats Rex Nutting, MarketWatch 6-03 Payroll growth in March was revised down by 24,000 to 122,000, while April payroll gains were unrevised at 274,000. February's gain was unrevised at 300,000. So far in 2005, payroll growth has averaged about 180,000, nearly identical to last year's payroll growth. Average hourly earnings increased 3 cents, or 0.2%, to $16.03 in May. Wage earnings are up 2.6% in the past year. The average workweek was steady at a revised 33.8 hours. Total hours worked in the economy increased 0.1%. Hiring weakened across most sectors in May, but most industries were still adding jobs. Private sector hiring slowed to 73,000 in May from 261,000 in April. Factory employment fell by 7,000, the 10th decline in the past 12 months. Construction jobs increased by 20,000. Service-sector employment rose by 64,000 after 232,000 in April. Most of the gains were in health services, which rose by 33,000. Retail employment increased by 11,000. Temporary help jobs fell by 4,000. Nearly half of the employment gains - 36,000 -- were related to the housing market, including residential construction, real estate and related retail jobs. Among 278 industries, 55.8% were hiring in May, down from 63.7% in April. Among 84 manufacturing industries, 46.4% were hiring in May, down from 49.4% in April. The picture painted by the separate household survey was brighter, with employment rising by 376,000. Unemployment fell by 16,000 to 7.65 million. The labor-participation rate rose to 66.1% from 66%. In the past three months, the household survey shows employment has risen by 1.3 million.
Just the Facts The New Home Improvement (Margaret Webb Pressler, Washington Post 6-26 People are pouring into their back yards. The Propane Education and Research Council claims that the number of homeowners with an outdoor living space will double in the next two years. Outdoor spaces, meanwhile, are second only to kitchens as the top renovation projects in people's homes. The Hearth, Patio & Barbecue Association (HPBA) says 31% of households are considering improving their outdoor grill area, with the most popular steps being a new or better patio or deck, new outdoor furniture and upgraded landscaping. Eight percent of those owners say they plan to add a built-in island for grilling, much like those designed for indoor kitchens with cooktops and counters. Outdoor furniture maker Laneventure reports that 60% of "industry professionals," such as designers, architects and real estate agents, say an outdoor living space adds 10% to 30% to the value of a home. Though the HPBA says it's possible to start an outdoor room with a relatively modest investment of about $2,000 for a grill, patio furniture and an outdoor heater, the typical expenditure is a lot higher. "The dealers that we are talking to tell us that is usual for people spend anywhere from $15,000 to $100,000 on the outdoor room," said Donna Myers, a spokeswoman for the trade group. HPBA's fact sheet on outdoor rooms suggests it's at least a $10 billion business, with Americans spending well over $3 billion on grills and accessories last year, another $3 billion or more on hot tubs and spas and yet another $3 billion on all-season furnishings. Those involved in marketing these backyard products say there's a spiral effect going on: As more products are improved and marketed, more people want them and more companies push to create new products to satisfy that growing demand. Weber is looking to expand into outdoor heaters, lighting and possibly regular cooktops. Furniture manufacturer Laneventure has expanded into outdoor draperies for pergolas and rugs for patios. Flat Yield Curve Bad Omen for Junk Bonds Jonathan Fuerbringer, NY Times 6-12 The total return from the junk-bond market drops sharply when the spread between the 10-year Treasury note and the 3-month Treasury bill falls below 1.55 percentage points according to research by Martin S. Fridson, the publisher of Leverage World, an independent research service for the high-yield market. That's the midpoint of the quarterly spreads since Q4-88. When the quarterly spread has been below that level, the average quarterly return has been 1.20 percent, versus 3.28 percent when the spread has been more than 1.55 points. As of Friday, the spread between the yields on the 10-year note and the 3-month bill, had narrowed to 1.04 percentage points. Before the 10-year yield popped above 4 percent Friday, the spread was less than 1 percentage point. Fridson cites three reasons for this pattern of decline. First, a flattening of the yield curve, is often a signal of an economic slowdown. Second, rising | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||