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The gap is still small within the context of the $13 trillion American economy. And the trend could reverse if U.S. interest rates decline. But economists say America's emergence as a net payer illustrates an important point: In years to come, a growing share of whatever prosperity the nation achieves probably will be sent abroad in the form of debt-service payments. That means Americans will have to work harder to maintain the same living standards -- or cut back sharply to pay down the debt. If the trend persists, it could raise concerns about the nation's creditworthiness, putting pressure on the U.S. currency. "It's an additional challenge for the dollar," says Jim O'Neill, chief economist at Goldman Sachs. "Economists have been warning about this, but now we're starting to see the deterioration." Since the end of 2001, when the current economic expansion began, the nation's consumption, investment and other outlays have exceeded income by a cumulative $2.9 trillion -- the largest gap on record. That current-account deficit contributes directly to the nation's total foreign debt, the value of all the U.S. stocks, bonds, real estate, businesses and other assets owned by non-U.S. residents. As of the end of 2005, total U.S. foreign debt stood at $13.6 trillion -- or about $119,000 per household. Net foreign debt, which excluded the $11.1 trillion value of U.S.-owned foreign assets, was $2.5 trillion. In a recent paper, Harvard economists Ricardo Hausmann and Federico Sturzenegger went so far as to suggest that the U.S. might not be a net debtor at all. Instead, the U.S. might actually have income-producing assets abroad, such as know-how transferred to foreign subsidiaries, that have evaded measurement -- assets they call "dark matter," after a similarly elusive quarry in physics. Most economists, however, see a more prosaic explanation: Foreigners have been willing to accept a much lower return on relatively safe U.S. investments than U.S. investors have earned on their assets abroad. Take, for example, China, which since 2001 has invested some $250 billion in U.S. Treasury bonds yielding around 5% or less - part of a strategy to boost its exports by keeping its currency cheap in relation to the dollar. By contrast, U.S. direct investments abroad -- which would include things like glass maker Corning's liquid-crystal display plants in Taiwan or Intel's chip-making subsidiary in Ireland -- have returned an average 8% since 2001, according to U.S. Commerce Department data. Meanwhile, U.S. investors in emerging-market stock funds earned an average annual return on their investments of 22.3%, according to Morningstar. (The Commerce Department counts only part of that as income). Because the U.S. has tended to borrow in bonds while investing in stocks and longer-term foreign projects, it has benefited vastly from the low interest rates of recent years. Now, the interest-rate picture is changing. The Federal Reserve has raised short-term rates. As a result, payments on U.S. government debt, much of which is short-term, have risen. In Q2, the government's debt payments to foreigners rose 10% to $36 billion, accounting for most of the change in the balance of income. The nation's growing debts have made its finances more vulnerable to interest-rate changes. Cedric Tille, an economist at the Federal Reserve Bank in New York, estimates that a mere one-percentage-point rise in the relative return on U.S. foreign debt would increase the country's net debt payments by 1.1% of GDP. Back in 1995, when the U.S.'s foreign liabilities were smaller, the effect would have been only half a percentage point. Even without any major changes in rates, economists expect the burden of foreign-debt payments to rise. Estimates of that burden 10 years from now range anywhere from 0.5% to 2% of GDP, depending largely on whether the U.S. manages to curb its current-account deficit. If the deficit expands significantly and the U.S. stops earning a premium on its investments abroad, the burden could reach 5% of GDP, according to calculations made by John Kitchen, an economist in the White House's Office of Management and Budget. The size of the nation's debt payments matters because it represents a share of income that American consumers, companies and government won't be able to spend or save. The higher the debt payments, the harder it will be for the U.S. to prosper. "Your standard of living is going to be reduced unless you work much harder," says Nouriel Roubini, chairman of Roubini Global Economics. "The longer we wait to adjust our consumption and reduce our debt, the bigger will be the impact on our consumption in the future." To be sure, by some measures the U.S. foreign debt is still relatively manageable. As a share of GDP, for example, the nation's net debt stood at about 20% at the end of 2005, compared with the 15% average of the 12-nation euro zone. The United Kingdom's net debt is 17% of GDP. Mexico's is 44%. Among economists' biggest concerns, though, is the fast pace at which the U.S. is accumulating new debt. As that leads to larger interest payments, it will make the current-account deficit harder to control -- a vicious cycle that could accelerate if worried foreign investors demand higher interest rates to compensate for the added risk. "You end up having to pay more and borrow more," says the University of California's Prof. Gourinchas. "Things could get out of hand very quickly."
His research, published 12 years ago in the Journal of Financial Planning, warned about the dangers of taking much more than 4% a year from a retirement portfolio. His more recent research, published five years ago in the same journal, told us we could safely withdraw 5% a year by establishing a "floor and ceiling" rule for distributions in bull and bear markets. In the August issue of the Journal of Financial Planning, Bengen advances the subject again, outlining a conceptual "layer cake" for retirement-income planning. With it, a series of decisions may increase or decrease your initial withdrawal rate. While most will remain in the 4% to 5% range, he shows that a retiree willing to assume significant risk might have a starting withdrawal rate of a whopping 7.62%. We're talking, in other words, of nearly doubling retiree spending. Since you can get 5% yields on long-term bonds, why should anyone even worry about this? Because a 5% constant yield is a commitment to declining purchasing power. A couple in their 60s can expect that one will live about 25 years. If inflation averages 3%, a $500,000 nest egg invested in 5% Treasurys will see its original $25,000 of annual purchasing power reduced to $18,600 in 10 years and to only $11,940 in 25 years. To have risk-free retirement purchasing power of $25,000 for the remainder of your life, you would need to invest your nest egg in Treasury Inflation-Protected Securities, currently earning about 2.3% over the rate of inflation. That would require a nest egg of $1,087,000. That's a lot more than the $625,000 to $500,000 you'd need for a portfolio that allowed a 4% to 5% withdrawal rate with limited risk. But only $328,000 would be needed for Bengen's higher-risk approach with the 7.62% withdrawal rate. Bengen's layer cake is based on decisions about your retirement. Here are some: Your "withdrawal scheme." This is how you plan to withdraw money. These plans range from a "lifestyle scheme" that assumes you want to sustain a given spending level for the rest of your life, to a "life-phase" scheme that recognizes that future needs may be smaller than current needs, to an "annuitylike scheme" that simply delivers an income that is never adjusted for inflation. Your asset allocation. How your portfolio is invested will have an impact on your long-term returns. Your time horizon. If you come from a long-lived family, you might want to consider a 35-year horizon. A person who already had a number of ailments, however, might feel safe planning on a 20-year horizon. Your success rate. Each portfolio and withdrawal scheme has a success rate that depends on your time horizon. Your desire to leave a legacy. Your desire to leave a certain amount to children or charities also will have an impact on your possible withdrawal rate. How often the portfolio is rebalanced and whether you assume above-average or below-average investment performance also affect your withdrawal rate. For more information see: FPAnet article by William Bengen When Volatility is Your Friend, And When It's Not - Chet Currier, Bloomberg Retirees Can Spend More at First, Cut Back Later - Ilana Polyak, NY Times Retirees Could Withdraw Up to 6% a Year - Jonathan Clements, WSJ
The tax reconciliation act included a provision that makes it possible for many more people to invest in Roth’s. On the face of it, the legislation does away with the income limitations for individuals seeking to convert a traditional IRA into a Roth starting in 2010. While that’s more than three years away, this provision actually gives workers and their spouses a back-door entry into investing in Roth IRA’s — no matter how much they earn. To be sure, the new tax law did not do away with the income restrictions that prevent highly paid workers from opening a Roth account directly. This year, single workers who earn $110,000 or more and married workers earning $160,000 or more cannot make any contributions to a Roth. And single filers earning $95,000 to $110,000 a year and joint filers earning $150,000 to $160,000 can make only partial contributions. This might explain why Roth accounts accounted for just 4% of all IRA holdings last year. But in 2010, the new law will lift the income restriction that prevents households from converting traditional IRA’s into Roth accounts. By lifting the income cap, the federal government has in effect lifted all the income barriers for gaining access to Roth accounts — without explicitly saying so. If you participate in an employer-sponsored plan, your income will determine whether you qualify for a deduction on your contribution. A single person earning $60,000 or more a year won’t qualify, for example. But you can still contribute nondeductible money into a traditional IRA. Then, in 2010, you can convert your traditional IRA. into a Roth. Since you’ve already paid taxes on those nondeductible contributions, you probably won’t face a huge tax bill at conversion four years from now; you would just be liable for taxes on the investment gains within the IRA. Even better, if you convert in 2010, the I.R.S. will let you spread out your tax bill on the converted IRA. assets over two years. By comparison, if you qualified for upfront deductions in a traditional IRA and converted it to a Roth, you would have to pay taxes on both the original contributions and the gains. Roth IRA’s should become even more popular in 2008, when some 401(k) participants will be allowed to roll over their employer-sponsored plans directly into a Roth at retirement or when they leave their companies. Under current rules, workers eligible to roll over their 401(k)’s must first move the money into a traditional account — and then convert that account if they want to be in a Roth. But a provision in the Pension Protection Act allows for direct Roth rollovers starting in 2008. The Pension Protection Act also changed the rules on inheritance of 401(k) assets. Under current rules, beneficiaries other than one’s spouse typically must withdraw all the money from the 401(k) account shortly after the owner’s death. This means heirs lose the tax shelter and have to pay income taxes promptly. But starting in 2007, nonspouse beneficiaries can roll over the 401(k) into an IRA opened expressly for that purpose. They can withdraw the money gradually, over the course of their lives. Finally, retirees who own IRA’s and are charitably minded should take note of a temporary rule change. In 2006 and 2007 only, traditional IRA owners who are 70.5 and older can make direct tax-free distributions from their IRA’s to a public charity, up to $100,000 a year. The payments must go directly from the IRA to the charity. Donations to private foundations and donor-advised funds don’t qualify. Those withdrawals won’t be counted as part of your adjusted gross income.
Corporate profits - There's only one way for them to go from here. The S&P500 companies have had 17 consecutive quarters of double-digit operating profit growth. That's a record since S&P started tracking operating earnings in 1988, according to Howard Silverblatt, S&P's keeper of the numbers. Yet investors are paying less and less per dollar of earnings. The projected price-to-earnings ratio of the S&P is merely 15. That's inexpensive relative to recent history -- with good reason. Investors are right. Earnings have little room to rise and much to fall. And companies aren't investing as much as they should to create future earnings streams, preferring to pay dividends and buy back shares. Investors don't trust the quality of the profits, thinking companies are earning more than they should normally because of the persistence of low interest rates around the world. "I don't think we have ever seen an expansion of corporate profits in a business cycle where such a large share can be attributed to economic policy makers' behavior, rather than corporate behavior," says Doug Cliggott, chief investment officer of Race Point Asset Management. "Maybe more than one CEO suspects the same and doesn't see [the profit momentum] sustained." Cash was cheap. Now it's not. Corporate return on investment, and thus profit, has been high. But returns for investors have been lackluster in the past five years. This is an obvious result of flooding the global markets with cheap money. Supply drives prices up. Some look over the post-9/11 investing world and think investors want to take fewer risks: The price of oil has a "terrorism" premium. Gold prices have risen. American stocks seem to be inexpensive. The rise in popularity of certain risk-mitigating derivatives suggests investors are seeking more insurance than before. But this is a misreading. Speculation has been the order of the day. The housing market has exploded, as one bubble has been replaced with a larger bubble. Since stocks have been relatively boring, investors have reached for risk. Emerging markets and commodities have been hot. According to Merrill Lynch strategist Rich Bernstein's measure, commodity speculation hit an all-time high this summer. Given that corporations have gotten stronger over the past five years, this is clearly not a sign that cautious investors are judiciously signing new insurance policies. Instead, it shows that hedge funds have found an inexpensive way of making big bets out of range of the watchful eyes of fellow investors and regulators. Debt is king. It's no secret that consumers have loaded up the debt. Northern Trust's head economist, Paul Kasriel, likes to look at Federal Reserve data to get a sweeping view of the economy. He points out that total liabilities of U.S. households was at 18.5% of total assets last year, a record. "What's remarkable is that the ratio is still going up, even though asset prices of real estate have been going up at a rapid rate. That means people are borrowing more and more," he says. Households long had been providers of funds to businesses and countries. Now they are borrowers. It's a radical change, one that markets have yet to fully absorb. Many of those asset gains will prove fleeting, of course; the debt won't go away. Look at housing. The mantra from real-estate agents has been that home prices have never fallen nationally. (It's not true; but they haven't since the 1960s, which is when the good data started being kept.) That mantra will no longer be operative next year if Goldman Sachs is right. The firm's economists now predict that home prices nationwide will fall next year on average. Debt isn't bad. It's good if an entity with excess funds lends to someone who can put the dough to productive uses. But that's not what the country has been doing. We've been making money by buying and selling real estate to each other. The cheap credit did its job of pulling us out of the recession of 2001. But the juice was more like a shot of adrenaline than a free-weight workout that made us genuinely stronger. "What we are investing in is 5,000-square-foot homes. It's more of a consumption good than an investment that leads to higher productivity and output," says Mr. Kasriel. The worrisome thing is that the Fed has rendered itself much less powerful. It has already boosted the interest-rate-sensitive sectors of the economy. So what happens now that the economy is slowing? "We just may be in for a lengthy period of weakness in consumer spending where lengthy is measured in years, rather than quarters," says Goldman Sachs economist Jan Hatzius. The banking sector looks like a weak link. The reach for risk hasn't resulted in significant problems yet. Can it last? Optimists say that the risks are being spread throughout the economy and reside in entities that can handle it, such as hedge funds and private-equity firms, which in turn provide capital to businesses. Surely this is one of the most important developments of the last couple of decades: The banking sector is no longer the world's chief banker. It's clear that derivatives -- the lifeblood of the fast-money crowd -- are spreading risk, allowing the markets to weather storms. A crisis at Fannie Mae or GM or AIG could have, in another era, caused a panic. How have the bankers responded to this changed landscape? They've gorged on real estate - loans to folks who might not be able to afford their homes, financing for commercial real-estate developments and investments in mortgage-backed securities. According to Federal Reserve data, more than 62% of U.S. banks' earning assets - that is, their loans and investments - are real-estate related. So while banks might appear to be less vulnerable to a widespread corporate downturn, they're more exposed to the now-obvious housing bubble. The banks and the rest of the finance industry should heed the rule of holes: When in one, stop digging.
Ann Stevens, an associate professor of economics at the University of California, Davis, has looked through a time series — interviews with men between the ages of 58 and 62 conducted by the Bureau of Labor Statistics and other research groups at intervals from 1969 to 2002. She found that in 1969, the average tenure of the longest job a man had held in his career was 21.9 years. In 2002, the figure was only marginally smaller: 21.4 years. In both 1969 and 2002, about half of those interviewed had spent more than two decades with a single employer. “I’m not convinced there has been a dramatic change,” said Professor Stevens, who presented her findings in a National Bureau of Economic Research working paper. That conclusion may seem surprising, given the heightened media and political attention to outsourcing, corporate overhauls and layoffs — and given the peculiar dynamics of the late 1990’s, when low unemployment, significant job growth and technological advances led many people to switch jobs voluntarily. “In those years, companies couldn’t hold on to workers,” said David Neumark, a professor of economics at the University of California, Irvine. Recent evidence indicates that jobs aren’t any more or less disposable than they were in the past. According to the Bureau of Labor Statistics, the median job tenure for all workers at their current jobs rose to 4 years in January 2004 from 3.5 years in 1983. In the same period, the percentage of workers older than 25 with job tenure of more than 10 years fell only modestly, to 30.6% from 31.9%. But there are subtle shifts underneath the headline numbers, says Steven Davis, the William Abbott professor of international business and economics at the University of Chicago. As they have become more entrenched in the work force, women have seen their average job tenure rise, to 3.8 years in 2004 from 3.1 years in 1983. In the same period, the figure declined for men — particularly for those ages 45 to 54, whose average tenure in 2004 was 9.67 years, down from 12.8 years in 1983. Job tenure has declined “among both blue-collar and white-collar male workers,” Professor Davis said. “White-collar jobs, which were historically dominated by college-educated men, are no longer quite as secure as they were a generation ago.” So what accounts for the public concern over job instability? Professor Davis notes that job stability at publicly held companies — large, brand-name businesses like Intel that make news when they restructure — has decreased markedly. “But such companies only account for about one-third of all business employment,” he said. Among privately held companies — a much larger sector — job stability has actually been on the rise in recent years. What’s more, workers have plenty of reason to feel anxious about their prospects. “Job stability isn’t the same as job security,” said Jacob Hacker, a professor of political science at Yale. The consequences of losing a job are far more severe today than they were in previous generations, as laid-off employees tend to see their compensation and benefits fall sharply when they find new employment. As a result, “people are more likely today to worry about what will happen if they lose their job,” Professor Hacker said.
Investing is a tough business, and most of us don't learn it in school. I can understand why the overwhelming majority of investors farm the tasks of asset allocation and stock selection out to the pros, however highly compensated they may be, in exchange for a little piece of mind. But with a dividend-oriented strategy in mind, I can make a strong case for owning individual stocks directly - cutting out the middlemen who want a piece of your investment profits. Warren Buffett describes the principle that made him a Borsheim's [jewelry store] customer: "If you don't know jewelry, know your jeweler." That's why I recommend that investors looking for foreign stocks--especially in emerging markets - consider mutual funds instead. In my view, it's easier to evaluate the average foreign stock manager than the average foreign stock. I'd also rather buy a superbly managed real estate investment trust like Vornado or Realty Income rather than become a landlord myself. I can't compete with the specialized knowledge these managers can offer, and their records largely speak for themselves. But when it comes to buying U.S. stocks - especially well-known blue chips - I'm skeptical that investment managers as a group can offer an edge on performance commensurate with their cost. If your strategy simply seeks the best companies in America - firms like Johnson & Johnson, Wm. Wrigley, or Southern - inserting a mutual fund manager (plus an overpriced financial planner or broker) between yourself and the actual cash generated by the business will act as a big drag on your returns. Even the best mutual fund manager in the business isn't going to be able to increase J&J's 30% return on equity for you; about the best he or she can do is keep you from being involved in major mistakes. Same goes for brokers and financial planners: I strongly suspect the best of these professionals help their clients not through what they sell, but what they don't. And consider this: The average equity-income offering in Morningstar's mutual fund database has a net expense ratio of 1.40%. The average 12-month dividend yield - which is paid after management and administrative fees - is only 1.63%. As a group, these funds do have fairly high dividend yields and significant interest income, a yield equal to 3% of assets. But of the actual income being collected, nearly half is carted off in fees. These equity-income funds' turnover ratio is 51% annually. But turnover adds additional expenses to the portfolio--transaction costs and taxable gains - that push the investor's net return even lower. Investing in stocks directly, however, can be a very low-cost proposition. Of course, managing a portfolio of individual stocks does require an investment of your time. Yet even in today's incredibly competitive markets, I believe an individual stock-picker - armed with a few basic principles - can earn attractive returns over the long run. Take the long-term view. When you're being paid to own the stocks, you can afford to be patient. Most of the pros simply can't. Focus on economic moats. Competitive advantages are rarely, if ever, the center of Wall Street's focus. Why should the sell-side analyst or hedge fund manager concern himself or herself with long-run competitive dynamics when the goal is to pick the next company to beat or miss one quarters earnings per share estimate? Changes in economic moats rarely play out in short time frames. Buy only with a margin of safety. By purchasing a stock at a discount to its intrinsic value - the investor reduces risk (providing room for error in valuation) and increases his or her profit potential should that valuation estimate turn out to be correct. Let dividends be your guide. The dividend record contains more information about the true state of a company - its financial condition, capacity to grow, and willingness to share any success with owners - than any quarterly earnings figures. The theme behind each of these four principles is this: Don't invest on Wall Streets terms. Keep those transaction and management costs in your pocket and let them compound to your advantage over time.
While investors have a sorry history of jumping on trends too late -- that doesn't appear to be the case here: Investment strategists say foreign stocks should continue to benefit from both a further decline in the dollar and robust overseas economies. Foreign Stocks May Beat U.S. Stocks Due to GDP Growth, Currency Changes & Valuations So far this year, a widely followed international-stock benchmark, the MSCI Europe, Australasia Far-East index [EAFE] is up nearly 13% in dollar terms. That tops the 7% advance of the Dow Jones Industrial Average. "Investing globally widens your opportunity set and gives you exposure to great companies outside of the U.S.," says Dan Lefkovitz, a mutual-fund analyst with researcher Morningstar. He believes most investors should have more than 25% of their portfolios invested abroad; his own retirement-plan account is 50% in foreign-stock funds. Many investment professionals favor companies that primarily serve non-U.S. markets rather than relying heavily on exports to the U.S., and also companies that are household names overseas but may not be well-known here. "I'd look to buy primarily domestic stocks, like financials, grocers and retailers" that serve their home markets, says Uri Landesman, a senior portfolio manager at ING Investment Management. Professional investors around the globe, as well as here, have been generally favoring non-U.S. stocks over U.S. shares. One reason for the managers' move is that the U.S. economy is showing signs of slowing after the Fed's string of 17 interest-rate boosts since 2004. Current estimates for U.S. GDP for Q4 hover around 2.5%, which is below previous years' trends. In contrast, J.P. Morgan Chase estimates the global economy will grow 3.4%, with emerging markets growing at a 5.2% rate. While the Fed appears to be at or near the end of its rate-boosting campaign, central banks in Britain, Europe and Japan have recently started raising their interest rates. As a result, analysts expect foreign currencies in those markets to rise further against the U.S. dollar, as money flows toward those higher rates. When other currencies rise against the dollar, investment gains earned overseas are magnified when converted back to dollars. Without that currency boost, the year-to-date advance of EAFE in local-currency terms was recently about 5.3%. Another reason to shop overseas: Some markets still look relatively cheap. U.S. stocks have been trading at an average P/E ratio of about 17 times estimated earnings, while Europe is trading at about 15 times and the emerging markets are trading closer to 12 times, according to Donald Elefson, portfolio manager at U.S. Trust's Global Investments Division. For more information see: Foreign Stocks and the Allure of Double-Digit Growth - Paul Lim, NY Times Foreign Stocks & Rising Risks - Tom Petruno, LA Times Investing in Foreign Stocks/Funds - James Glassman, Washington Post
Is it time for a turnaround, for growth to overtake value? Perhaps soon, but not quite yet. While growth shares have been in a slump for more than six years, some investors say these stocks may need several more months to regain the lead. But the fact that growth stocks have trailed value stocks for so long — through nearly an entire business cycle — leads many investors to believe that growth is long overdue for a comeback: more professional money managers are bullish on large-cap growth stocks than on any other asset class, according to a recent survey by the Russell Investment Group. Before jumping into growth stocks, investors should consider where we are in the economic cycle, said Jason Hsu, director of research and investment management at Research Affiliates, an asset management firm. Typically, growth stocks tend to outperform value in the early phases of economic expansions and bull markets, Mr. Hsu said. A recent study by Ned Davis Research showed that growth tends to perform best relative to value in the first third of a bull market. That’s certainly not where we find ourselves today. An aging bull market is near the end of its fourth year. And according to a majority of money managers surveyed in August by Merrill Lynch, we are in the late stages of an economic cycle. Moreover, a number of the market’s largest growth stocks — which were the darlings of the late 1990’s — have run into a host of difficulties maintaining their growth rates. “There have been some very notable fundamental issues in some large-cap bellwether growth companies,” said Larry Puglia, manager of the T. Rowe Price Blue Chip Growth stock fund. “Intel has had serious deterioration in its fundamentals, Dell has had serious deterioration, and Pfizer showed some pretty dramatic slowing of growth,” he said. Mr. Puglia said he still expects growth stocks to recover soon. But the fact that so many of the biggest and most influential growth stocks are struggling will make it that much harder for the category to mount a serious comeback in the coming weeks. There’s another factor: By most accounts, the economy is either in or near a so-called plateau: the time between the last in a series of interest rate increases by the Fed to cool the economy and the first in a series of Fed rate cuts to jump-start a new expansion. Plateaus are important because they are often transitions between business cycles. Historically during plateaus, traditional defensive sectors of the economy do the best said Sam Stovall, chief investment strategist at Standard & Poor’s. These include utilities, consumer staples and health care. During plateaus since 1971, consumer utilities stocks have gained 6%, on average; consumer staples, 8%; and health care stocks, 10%, according to S&P. The market as a whole gained just 3%, on average, during those periods. If these same sectors are the leaders over the next several months, the market would seem to favor defensive-minded value investors (though the health care sector is generally divided between both growth and value stocks). The question for investors is this: How confident are you that you can find companies that will continue to increase profits in a slowdown — or a recession? If you aren’t so sure, you may do better by playing the averages, sticking with defensive-minded value stocks that pay higher dividends than growth stocks, Mr. Hsu said. At the very least, investors should stick to growth stocks that aren’t so economically sensitive — health care shares, for example — while avoiding highly cyclical industries like technology, money managers said. Moreover, before betting on a big comeback for growth, investors may want to “wait for some evidence that the Fed is not only done tightening rates, but that it’s set to start easing rates,” said Jack Ablin, chief investment officer at Harris Private Bank. Historically, growth stocks have beaten value stocks shortly after the Fed starts trimming interest rates in its efforts to jump-start economic growth. Since 1974, growth stocks in the S&P500 index have gained 11%, on average, in the six months after the first in a series of Fed rate cuts, according to an analysis by Mr. Stovall. By comparison, value stocks have gained just 7.9%.
"For pension funds, a tracking error of 0.1% different from the index is unacceptable, generally speaking," says Ron DeLegge, editor and publisher of ETFguide.com, a San Diego-based web site focused on ETFs. "So, a bigger difference with ETFs is a problem." The good news is the vast majority of ETFs do in fact have a very close correlation to their underlying indexes. According to a Morgan Stanley study, out of 219 U.S. ETFs, 81 posted 100% correlation to their respective indexes, and 96 recorded between 99% and 100% correlation. The bad news: 42 of the ETFs, or 19% of the total, had less than 99% correlation to their underlying index. Most of the ETFs with significant tracking errors follow international indexes, according to analyst Deborah Fuhr, author of the Morgan Stanley study. One reason for the discrepancy is that some of the stocks in foreign indexes have very small capitalizations. As such they aren't liquid enough to support the large-scale buying that an ETF would create. It can also be very expensive for U.S.-based portfolio managers to purchase foreign stocks. "A lot of ETFs have been created in the last 18 months that market themselves based on an index that they really cannot replicate," says Herb Morgan, president and chief investment officer at Efficient Market Advisors, an investment advisory firm. "Look at Brazil." The Morgan Stanley data showed that iShares MSCI Brazil (EWZ) correlates to the Bovespa, the main index for the Brazilian stock market, by only 95.03%. Meanwhile, iShares MSCI Hong Kong (EWH) is even worse, with a correlation of only 94.51% to the Hang Seng index. Another problem with foreign indexes is that sometimes a single stock can make up a huge portion of the benchmark. This can lead to difficulties for ETF managers because of regulatory requirements for diversification. The SEC mandates that no more than 25% of a fund can be held in any one security. If a particular index has a stock making up more than 25%, the fund manager must compensate by purchasing more of other stocks, says iShares spokeswoman Christine Hudacko. In addition, in the rest of the fund, all the stocks that separately comprise 5% or more of the portfolio cannot total more than 50% of the entire portfolio. The problem isn't limited to international portfolios. Even some domestic ETFs are falling far short of near-perfect correlation. The Morgan Stanley report showed that Vanguard Telecommunications Services (VOX) posted a 97.64% correlation to the MSCI US IM Telecommunications Index. Meanwhile, iShares Dow Jones U.S. Telecom Sector (IYZ) correlates to the S&P 500 Telecommunications Services Index by just 95.67%. SEC diversity rules are playing a role here, too. With only 10 stocks in the S&P 500 Telecommunications Index, Verizon Communications (VZ) comprises more that 25% of the sector benchmark. To avoid running afoul of regulators, iShares Dow Jones U.S. Telecom Sector needs to carry 22 different stocks. And in the S&P index, there are so few names that the top three securities comprise about two-thirds of total assets. "When you have an index with only ten securities, you will wind up with a fund with more than ten stocks in order to pass both of these diversification tests," says Hudacko. "This is where investors need to find out what a fund is holding." IShares' web site regularly updates ETF holdings, she says. In these situations, ETF managers are forced to find alternative stocks with similar characteristics. Poor security selection can cost shareholders precious returns. "In some cases the tracking error works out better for the fund, giving it a better return for the index," says SEC spokesman John Heine. "But that's not always the case." Gary Gastineau, managing director of ETF Consultants, a consulting firm, says there are other reasons an ETF may fail to perfectly track its index. Some ETFs aren't permitted to reinvest dividends, while others unnecessarily keep too much cash on hand. He says the tendency to hoard cash is a carryover of the need of mutual-fund managers to have plenty on hand to cover redemptions. But rules governing ETFs offer managers more noncash options to cover redemptions. The lesson here is a valuable one: Investors purchasing an ETF to capture the performance of the underlying index should do their homework before submitting a buy order. While most ETFs keep pace with their benchmarks, one in five doesn't, according to Morgan Stanley. And for the expense-conscious investors that tend to be attracted to ETFs, every fraction of a percentage point counts. Monthly Employment Stats
Health care employment rose by 35,000. Hospitals added 14,000 jobs, and employment also increased in doctors’ offices, home health care, and outpatient care centers. Employment in social assistance grew by 13,000 over the month; about half of the increase occurred in child day care services. Employment in food services and drinking places continued to trend up in August (+16,000). Over the year, food services has added 217,000 jobs. Employment in financial activities edged up in August. Job growth in the sector has slowed in recent months. Professional and business services employment continued to trend up in August (+26,000), but at a slower pace than in the prior 3 months, when job gains averaged 52,000. Employment in temporary help services has changed little thus far this year. Over the month, employment in wholesale trade was little changed. Within retail trade, job losses occurred in department stores (-9,000) and gasoline stations (-5,000). Since its most recent peak in August 2005, employment in retail trade has declined by 101,000. Department stores accounted for half of the decline. In the goods-producing sector, mining added 5,000 jobs in August, with gains in oil and gas extraction and in related support activities. Mining has expanded by 126,000 jobs, or 25 percent, since its most recent low in April 2003. Construction employment edged up in August following 5 months of little change. Within manufacturing, job losses in motor vehicles and parts (-7,000), wood products (-5,000), furniture and related products (-4,000), and paper and paper products (-3,000) more than offset small gains elsewhere. Since June 2006, manufacturing employment has declined by 34,000. The average workweek for production or nonsupervisory workers on private nonfarm payrolls decreased by 0.1 hour to 33.8 hours in August, seasonally adjusted. The manufacturing workweek also fell by 0.1 hour to 41.3 hours, while factory overtime was unchanged at 4.5 hours. Average hourly earnings of production or nonsupervisory workers on private nonfarm payrolls rose by 2 cents, or 0.1 percent, in August to $16.79, seasonally adjusted. This followed increases of 8 cents (0.5%) in July and 7 cents (0.4%) in June. Average weekly earnings decreased by 0.2% in August to $567.50. Over the year, average hourly earnings increased by 3.9% and average weekly earnings increased by 4.2%.
Quick Facts, Stats & Opinions You Can't Roll Without a Well Rounded Life Jonathan Clements, WSJ 9-13 Having difficulty figuring out what you want from life? Consider an exercise, suggested by Carol Anderson, president of Money Quotient in Poulsbo, Wash., which provides life-planning training to advisers. Start by drawing a wheel hub with nine spokes, which represent work, close relationships, finances, leisure activities, intellectual life, community involvement, physical health, emotional health and your home. Next, on a scale of one to 10, rate your level of satisfaction with each of these areas, with a score of 10 marked at the rim of the wheel and a zero placed at the hub. Finally, to gauge how well-rounded your life is, connect the dots. "That gives you a graphical representation of how you feel about your life," Ms. Anderson says. "If you have a low number in a particular area, it's a sign that something is missing." Folks who try the exercise often indicate they're dissatisfied with the amount of leisure time they have and with their health, both physical and emotional. Most Flippers Still Making Money Tom Petruno, LA Times 9-24 HomeSmartReports.com, a San Juan Capistrano company that tracks housing data, last week published a report on second-quarter home flipping activity in 147 metropolitan areas. The firm considers a house flipped if it is sold within nine months of being purchased. Tracking those transactions, HomeSmartReports.com found that 17.1% of all homes flipped in the second quarter were money losers for the sellers, up from 15.4% in the first quarter and 12.2% in the fourth quarter of last year. Flippers who lost money in the quarter lost a median of $38,975, said Michael Ela, head of HomeSmartReports.com. Even so, if 17.1% of flippers lost money, 82.9% either made money or broke even — far better odds than Vegas. For those flippers who made a profit in the second quarter, the median gain was $42,500, Ela said. With growth rates estimated at about 14%, the third quarter looks likely to continue the string of double-digit earnings growth for the S&P 500, which would tie a record of 13 consecutive quarters of such growth. Analysts have fretted, however, that earnings growth will eventually start to slow, and Zacks Investment Research points out this morning that analyst revisions are beginning to show a negative trend. "The total number of downward revisions over the last month now exceeds the total number of upward revisions," said Dirk Van Dijk, head of research at Zacks, saying that this is the first time this has happened for 2006 and 2007 estimates this year. The ratio of positive-to-negative estimates for 2006 is now 0.8, and it's 0.91 for 2007. What that suggests is that earnings growth is beginning to slow, and analysts are adjusting by knocking down their figures. However -- and this is a big caveat -- Mr. Van Dijk warns the ratio has fallen at a time when there are fewer revisions coming out. "I think it's potentially very significant," he said. "It would be much more significant if it were happening a month ago or a month from now, when you [will] have a higher total number [of revisions]." (David Gaffen, WSJ 9-19) Buybacks are still going nuts, according to analysts at Standard & Poor's, who said in a commentary today that the record level of buybacks has reduced the overall outstanding shares in eight of the 10 S&P sectors. "The record $116 billion in S&P 500 buybacks during the second quarter resulted in a reduced share count in all but two S&P 500 sectors," said Howard Silverblatt, senior index analyst at Standard & Poor's, in a statement. Birinyi Associates estimates that buyback announcements for S&P 500 issues year-to-date at $506.89 billion, an 83% increase from the pace set in 2005. The spate of buybacks played into S&P's latest rebalancing of the S&P 500, boosting the representation of the financials, telecom and utilities sector. The sector that was whittled down the most was health care, which is now 12.83% of the S&P 500, compared with 12.95% before this rebalancing. (David Gaffen, WSJ 9-18) If someone says “oil producer,” what country pops to mind? Chances are, the answer will be Saudi Arabia. And Saudi Arabia has for years topped the list of the world’s oil producers. But over the summer, Russia sneaked past the Saudis to top the list, with a six-month average of 9.37 million barrels a day, compared with 9.32 million for the ex-champ. (Hubert Herring, NY Times 9-17) Nasdaq stocks have four-letter ticker symbols. If there's a fifth letter, it's there to signify something. Here are the fifth letters you're most likely to see: F designates a foreign company. Y is for foreign stocks trading as American Depositary Receipts (ADRs). E is for companies delinquent in filing reports with the Securities and Exchange Commission. A and B refer to class A or B of the company's stock. Q indicates that the firm is in bankruptcy proceedings. {Motley Fool 9-15) Imagine for a moment that there were enough immigrants and young people to offset the number of boomers who will be retiring. If that were the case, would they have the financial wherewithal to fill boomers' shoes? "To think that all the boomers have to do is sell their homes to pay for retirement and health care begets the legitimate question of 'to whom and at what price?' " Bond guru Bill Gross of Pacific Investment Management wrote. "If there are fewer X'ers and Y'ers to unload even their second homes to, rudimentary supply/demand curve analysis suggests prices must adjust downward to facilitate the transfer, incorporating the ability of immigrants and future first-time buyers to afford what now seem to be unaffordable starter homes." (Danielle DiMartino, Dallas Mornings News 9-07) The inversion of the yield curve is often cited as a predictor of forthcoming recessions. With the three-month Treasury bill currently yielding 4.98% and the 10-year note at 4.82%, the chances of a recession are currently pegged somewhere around 30%. But Richard Bernstein, chief quantitative strategist at Merrill Lynch, says the curve's shape also presages a profits recession, pointing out that it has correctly predicted this in 1971, 1975, 1980 and 2001. "Although the slope of the yield curve is not particularly good at forecasting the magnitude of the profits cycle, it does appear to be a reliable directional indicator," he writes. By his estimate, a profits recession will ensue by mid- to late-2007, and argues that the "high-beta" stocks -- those that correlate well with the rest of the market, which have rallied recently -- are the ones that tend to do poorly in such an environment. "We would use August's beta rally to sell higher beta stocks and rotate into more defensive, higher quality issues," he writes. (David Gaffen, WSJ 9-07) Hedge Fund / Private Equity News Briefs Fund of hedge funds is still the most popular alternative investment asset class, grabbing 44% of all new money pouring into the $1.26 trillion industry, but slightly down from the 50% level in 2004, says Watson Wyatt Worldwide. Last year, according to the research conducted in conjunction with Global Alternatives magazine, FoHFs added an estimated 85 billion to its coffers, followed in popularity by real estate ($59 billion, or 30%), private equity funds of funds ($42 billion, or 21%) and commodities ($10 million, or 5%). The survey did not list direct hedge fund investment as an asset class since, according to Paul Deane-Williams, most WWW clients go the FoHF route. Pension plans increased its investment in alternatives by 24% to $77 billion, with real estate their favorite class (35%), with funds of hedge funds close behind (34%), p.e FOF (25%) and commodities (6%). Pension plans now constitute the single largest alternatives investor, representing 37% of the total, followed by "other institutions" (23%), high net-worth individuals (16%), mutual funds (13%), insurance companies (9%) and foundations and endowments (3%). (DialyII 9-13) Hedge funds in August were firing on four of six cylinders that make up the Dow Joes Hedge Fund Strategy Benchmarks. Equity long/short was the biggest mover for the month, pumping up 2.7%, which still left it at only 2.6% year to date but taking it out of negative territory for the first eight months of the year. Convertible arbitrage zoomed 1.5% in August and is the second-best performing DJ Benchmark strategy YTD with 8.2%. Top performer so far this year is distressed securities, which inched up only +0.7% for August, but a respectable 8.6% YTD. Of the remaining benchmarks, merger arbitrage and equity market neutral were flat, 5.8% and 4.9% YTD, respectively. (Hedge Fund Daily 9-07) Investors are being warned that the information within in hedge fund databases maybe less than meets the eye. The main reason for the skepticism is that the hedge funds themselves provide data on performance, risk statistics and their portfolio managers, and the databases for the most part don't verify the accuracy of the information. (Hedge Fund Daily 9-07) Surprisingly, hardly any mid-market private equity deals ever live up to expectation, according to research by Grant Thornton. The U.K. accounting firm found that 96% of all such deals fail to fulfill early promises, as a result of before-and-after shortcomings. Said Grant Thornton partner David Axon, 'It is well recognized that poor planning pre-deal and weak execution post deal, particularly in the case of business integrations or separations is likely to lead to underperformance.' He noted, that 'it is the stand alone businesses that can cause significant financial pain post deal.' Axon, who is part of the Operations and Post Deal Services team that conducted the research, said disappointment could be avoided: 'It's not hard to see why management due diligence is growing in popularity. The problem is that it's impossible to provide guarantees that management can deliver the business plan.' According to Grant Thornton research, 41% of those polled pointed the figure to underperforming management, while 24% blamed overestimation of anticipated post-deal benefits as the main reason for disappointment, 14% fingered poorly considered integration plans, and 12% chalked it up too 'poorly considered acquisition strategy.' There was another surprising finding: While 20% of mid-market p.e. investors acquired business through the formal auction process in the past year, only 2% feel this is the best way to go about getting one; 21% said the auction process is more suited to bigger firms. (DailyII 9-05) Home Page Previous Factoid Top Sites
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