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The theory is based on the historical tendency of investors to be wrong about the stock market’s direction, especially at major turning points. Investors tend to assume that what has happened will keep happening: they become progressively more bullish as the stock market rises, and increasingly bearish as it declines. Market tops are reached when there are very few bearish holdouts; most everyone who could be tempted to invest in the stock market has already done so — leaving little cash on the sidelines to propel equities higher. Similarly, market bottoms occur when almost everyone who could be persuaded to sell stocks has already thrown in the towel. At such a moment, the market is not vulnerable to much additional selling pressure. Contrarians, as followers of this market-timing approach are known, often focus on sentiment among investment newsletter editors, who are a good proxy for the mood among individual investors. The Hulbert Financial Digest, which has been tracking the investment newsletter industry since 1980, has found that the stock market performs far better, on average, after periods when newsletters are very bearish than when they are quite bullish. That’s good news today, because the average newsletter editor who focuses on short-term stock market timing is recommending that his clients allocate just 30.2% of their equity portfolios to stocks, keeping the remainder in cash. By contrast, at the end of November last year, when the Dow industrials were about 8% lower, such editors as a group were advocating an equity exposure of 70.8%. That was more than double the current level, and close to the highest allocation that The Hulbert Financial Digest has ever recorded: 79.7%. Such a reduction in bullish sentiment is unusual in the face of such a strong market. And it’s not typically seen at major market tops, which usually are characterized by extreme levels of optimism. Consider the record high sentiment reading of 79.7 percent: it came in early February 2001, not quite a year into the bear market of 2000 to 2002. On the basis of that bullishness, contrarians predicted that the bear market still had much further to go. Sure enough, by the time the bear market ended, in October 2002, the Dow industrials were 33% lower. Of course, contrarian analysis is not always reliable. In fact, it made an incorrect forecast last November and December. As noted in this column on Dec. 3, contrarians were arguing that the rising levels of bullish sentiment at the time did not bode well for the stock market. Nevertheless, the market since then has risen strongly. For contrarians, the misstep last year contains several lessons. One is that no market timing system is perfect. Another is that investor sentiment can be fickle, and should be monitored periodically to determine whether an extreme reading has persisted. Extreme bullishness that endures several months is a much more bearish sign than optimism that lasts just a week or two, according to research conducted by The Hulbert Financial Digest. As ominous as the high levels of bullishness were late last year, they did not last more than a few weeks — which may explain the bull market’s renewed lease on life. The negative sentiment that now prevails has lasted much longer. Over the last three months, for example, the average recommended equity exposure among short-term market-timing newsletters was 41.5%. Over the three previous months, the average was 49%. Clearly, the newsletters have been recommending that investors build up cash in the face of a rising market. Contrarians are fond of saying that bull markets like to climb a wall of worry. Because that wall seems firmly in place, contrarian analysis concludes that the bull market has yet more room to run.
According to experts, we should settle on a retirement date, save diligently so we retire with 80% or 90% of our preretirement income, and cut back on stocks as we age. The reality is a whole lot messier. Studies have found that older investors don't cut back their stock exposure, that only a minority of households bother calculating how much they need to save for a comfortable retirement, and that many seniors quit the work force before their target retirement date, perhaps as much as three years earlier. Even more alarming, just 66% of workers report that they or their spouse have any retirement savings at all, according to a recent study by the Employee Benefit Research Institute and Mathew Greenwald & Associates. The result? Fidelity Investments' Fidelity Research Institute calculates that the typical household is on track to retire with only 58% of its preretirement income. This figure includes Social Security and pension income. To make matters worse, many of those 'on track' will get 'derailed' by health issues or early layoffs. Retiring earlier than expected can create a slew of financial pressures. "Now you've got a longer retirement, you have a larger reduction in your Social Security benefit, and you tap your 401(k) earlier," notes Alicia Munnell, director of Boston College's Center for Retirement Research. "It sets you back on every front." Retirees are often counseled to lock up a healthy stream of guaranteed lifetime income by purchasing immediate annuities and by delaying Social Security to get a larger benefit. But in reality, more than half of seniors choose to take Social Security at age 62, the earliest possible age. Meanwhile, according to insurance researchers Limra International, last year's immediate-fixed annuity sales amounted to $6 billion -- a pittance compared with the $474 billion that poured into mutual funds. People value the bird in the hand, and that stream of income in the future just doesn't seem that significant," Prof. Munnell says. "There's a huge preference for piles over flows." After years of debate, there's an emerging consensus among financial advisers that retirees ought to use a 4% or 4.5% portfolio withdrawal rate. This is the percentage of a nest egg's value withdrawn in the first year of retirement. In subsequent years, retirees are assumed to step up the dollar amount withdrawn at the inflation rate. With this approach, you can be reasonably confident that your money will last through a 30-year retirement, even if you find yourself drawing down your portfolio's principal. Sound like a sensible strategy? It's also widely ignored. Instead, most seniors seem to follow the old rule that says you can spend your income, but you should never touch your capital, except maybe for hefty expenses like big medical bills and costly home repairs. "People aren't interested in spending down their assets," says Vanguard Group economist John Ameriks. "They're interested in spending from their portfolios. They spend their dividends and interest. They don't regularly spend down their principal." Is there anything wrong with any of this? You will likely have a more comfortable retirement if you delay Social Security, buy income annuities and follow a well-considered portfolio-withdrawal strategy. But in the end, it's probably safe to ignore the experts - provided you don't ignore their most important recommendation, which is to save diligently during your working years.
How curious that so many in the financial community should remain blissfully oblivious to live grenades scattered around the high-yield playing field. Amid all the asset bubbles that we've seen in recent years -- emerging markets in 1997, Internet and telecoms stocks in 2000, perhaps emerging markets or commercial real estate again today -- the current inflated pricing of high-yield loans will eventually earn quite an imposing tombstone in the graveyard of other great past manias. In recent months, lower credit bonds -- conventionally defined as BB+ and below -- have traded at a smaller risk premium (as compared to U.S. Treasuries) than ever before in history. Over the past 20 years, this margin averaged 5.42 percentage points. Shortly before the Asian crisis in 1998, the spread was hovering just above 3 percentage points. Earlier this month, it touched down at a record 2.63 percentage points. That's less than 8% money for high-risk borrowers. So robust has the mood become that providers of loans now rush to offer "repricing" at ever lower rates, terrified that borrowers will turn to others to refinance their loans, leaving the original lenders with cash on which they will earn even less interest. Between Jan. 1 and April 19, $115 billion of debt was repriced, representing 29% of all bank loans in the U.S. The low spreads have been accompanied by less tangible indicia of imprudent lending practices: the easing of loan conditions (or "covenants"), options for borrowers to pay interest in more paper instead of cash, financings to deliver large dividends to shareholders (generally private equity firms) and perhaps most importantly, a general deterioration in the credit quality of borrowers. In 2006, a record 20.9% of new high-yield lending was to particularly credit-challenged borrowers, those with at least one rating starting with a "C." So far this year, that figure is at 33%. No exaggeration is required to pronounce unequivocally that money is available today in quantities, at prices and on terms never before seen in the 100-plus years since U.S. financial markets reached full flower. Led by private equity, borrowers have rushed to avail themselves of seemingly unlimited cheap credit. From a then-record $300 billion in 2005, new leveraged loans reached $500 billion last year and are pacing toward another quantum leap in 2007. Even leading buyers of loans, such as Larry Fink, chief executive of BlackRock, say "we're seeing the same thing in the credit markets" that set the stage for the fall of the subprime loan market. Why should so many theoretically sophisticated lenders be willing to bet so heavily in a casino with particularly poor odds? Strong economies around the world have pushed default rates to an all-time low, which has in turn lulled lenders into believing these loans are safer than they really are. Just 0.8% of high-yield bonds defaulted last year, the lowest in modern times. And with only three defaults so far this year, we've luxuriated in the first default-free months since 1997. By comparison, high-yield default rates have averaged 3.4% since 1970; higher still for paper further down the totem pole. Like past bubbles, seers and prognosticators proclaim yet another new paradigm, one in which (to their thinking) the likelihood of bankruptcy has diminished so much that lenders need not demand the same added yield over the Treasury or "risk-free" rate that they did in the past. To be sure, the emergence in the past 20 years of more thoughtful policy making may well have sanded the edges off of economic performance -- what some economists call "the Great Moderation" -- thereby reducing the volatility of financial markets and consequently the amount of extra interest that investors need to justify moving away from Treasuries. But to think that corporate recessions -- and the attendant collateral damage of bankruptcies among overextended companies -- have been outlawed would be as foolhardy as believing that mortgages should be issued to home buyers with no down payments and no verification of financial status. And just as the unwinding of the subprime market occurred at a time of economic prosperity, the high-yield market could readily unravel before the next recession. With the balance sheets of many leveraged buyouts strung taut, a mild breeze could topple a few, causing the value of many leveraged loans to tumble as shaken lenders reconsider their folly. The surge in junk loans has also been fueled by a worldwide glut of liquidity that has descended more forcefully on lending than on equity investing. Curiously, investors seem quite content these days to receive de minimis compensation for financing edgy companies, while simultaneously fearing equity markets. The price-to-earnings ratio for the S&P 500 index is currently hovering right around its 20-year average of 16.4, leagues below the 29.3 times it reached at the height of the last great equity bubble in 2000. Some portion of this phenomenon seems to reflect tastes in Asia and elsewhere, where much of the excess liquidity resides: Foreign investors own only about 13% of U.S. equities but 43% of Treasury debt. In search of higher yields, these investors are moving into corporate and sovereign debt. Today, the debt of countries like Colombia trades at less than two percentage points above U.S. Treasuries, compared to 10 percentage points five years ago. Perhaps the mispricing of high-yield debt has been exacerbated by the surge in derivatives, a generally useful lubricant of the financial markets. Banks hold far fewer loans these days; mostly, they resell them, often to hedge funds, which frequently layer on still more leverage, thereby exacerbating the risks. Another popular destination is in new classes of securities where the loans have been resliced to (theoretically) tailor the risk to specific investor tastes. But in the case of subprime mortgages, this securitization process went awry, as buyers and rating agencies alike misunderstood the nature of the gamble inherent in certain instruments. Assessing the likely consequences of a correction is more daunting than merely predicting its inevitability. The array of lenders with wounds to lick is likely to be far broader than we might imagine, a result of how widely our increasingly efficient capital markets have spread these loans. No one should be surprised to find his wallet lightened, whether out of retirement savings, an investment pool or even the earnings on their insurance policy. The bigger -- and harder -- question is whether the correction will trigger the economic equivalent of a multi-car crash, in which the initial losses incur large enough damages to sufficiently slow spending enough to bring on recession, much like what happened during the telecom meltdown a half-dozen years ago. But we have little choice but to sit back and watch this car accident happen. It would have been a mistake to dispatch the Federal Reserve to deflate the dot-com mania or the housing bubble. And it would be a mistake now for the Fed to rescue imprudent high-yield lenders. They have to learn the hard way. Hopefully, not too many innocent bystanders will share their pain.
But here’s a thought: Why not ask some bond investors directly what message they see behind the recent climb in rates? After all, they’re the ones who have been selling Treasury bonds, driving up long-term yields. And let’s face it: Stock investors often take their cues from the fixed-income market anyway, because bond investors have a better reputation for accurately forecasting the economy. In fact, many bond experts say the reasons for the recent sell-off in Treasury bonds aren’t terribly complicated. To be sure, there are some technical factors to consider — for instance, mortgage investors selling some of the Treasury bonds they owned to hedge their portfolios. But for the most part, it’s been one big mea culpa. “Those of us in the bond market got it wrong,” says Marilyn Cohen, chief executive of Envision Capital Management, a fixed-income manager in Los Angeles. At the start of the year, bond investors were buying Treasuries on the theory that the slowdown in the housing market would seriously hurt the broader economy. But recent government data have shown that the economy is turning out to be far more resilient than fixed-income traders assumed. Last week, for example, the government reported the biggest jump in retail sales in nearly a year and a half. And the annual rate of growth in the gross domestic product, just 0.6 percent in the first quarter, is expected to jump to around 3 percent in the second.This would indicate that “the bond market got a little ahead of itself” in anticipating the need for a quick rate cut by the Federal Reserve, said Christopher Vincent, head of the fixed-income group at William Blair, the asset manager. And as it became clear in recent days that the Fed probably wouldn’t trim rates to bolster the economy this year, bond investors turned around and started pushing yields higher, said Carl P. Kaufman, manager of the Osterweis Strategic Income fund. A result is that long-term bonds are back to paying higher yields than short-term debt, which is the way things usually work. Of course, that wasn’t the case in recent months because of the bond market’s fear of a possible recession. So far, these higher yields reflect strong forecasts for growth in both the domestic and global economy. But bonds aren’t necessarily predicting a corresponding spike in inflation, said Jeffrey N. Kleintop, chief market strategist at LPL Financial Services in Boston. If the bond market was truly worried about inflation brewing, market strategists say, that fear would be reflected in Treasury inflation-protected securities, or TIPS. Yet the spread between yields on TIPS and traditional Treasuries isn’t all that different from what it was at the start of the year. All of this would seem to point to an economy that’s both stronger and more stable than expected. And Duncan W. Richardson, chief equity investment officer at Eaton Vance, the asset management firm in Boston, noted that “a healthy economy is not the worst prescription for equities.” To be sure, part of the reason stocks lost ground in recent days is that higher interest rates do affect the competitiveness of equities. For instance, some people fear that rising borrowing costs may slow the corporate buyout activity that has fueled higher stock prices recently. Moreover, when yields on 10-year Treasuries have risen in the past, the price-to-earnings ratio of the S&P 500 has typically fallen. But Tobias Levkovich, chief U.S. equity strategist at Citigroup Investment Research, said that as long as 10-year Treasury yields didn’t exceed 5.5%, stocks were still likely to be considered reasonably priced. And if the economy is really accelerating in the second quarter, this should provide a tailwind to strong corporate profit growth, Mr. Levkovich said. That means stock prices could rise further even if P/E ratios don’t. Indeed, Mr. Levkovich says he believes that the S&P500 will still close 2007 at around 1,600, which would mean that stocks would climb an additional 4.4% by the end of the year. Beyond that, what should equity investors expect? Here are some possibilities: More Gains for Large-Cat Stocks If market volatility is here to stay because of higher interest rates, Mr. Richardson said, investors are likely to gravitate toward stable, dependable companies. And that should benefit large-cap stocks, he said. Moreover, if the bond market is truly reflecting strong global growth, companies with a global reach stand to benefit. Larger companies tend to generate a greater percentage of their sales overseas. Finally, rising bond yields are likely to increase overall borrowing costs for companies. Small-cap companies tend to depend more on borrowing than large-cap companies do. The Comeback of GARP Investing GARP stands for “growth at a reasonable price,” an investment strategy that calls for buying shares of companies with faster-than-average earnings growth — but only if those shares are attractively priced. Although the economy is proving stronger than expected, it’s still quite mature. And in the latter stages of an economic cycle, investors tend to focus on growth-oriented stocks, market strategists say. But, at the same time, “as interest rates rise, people do become more concerned about valuations,” said David P. Nolan, portfolio manager of the BB&T Mid-Cap Growth fund. So this is not a time to seek out the most aggressive forms of growth. A New Focus on Dividend Growth As rates rise, classic bond alternatives like high-dividend utility stocks are likely to fall out of favor. After all, if investors feel that they can get higher payouts from ultra-safe Treasuries than from utility stocks, why take the risk of owning those stocks? Rising yields are also likely to renew investor focus on payouts in general, Mr. Kleintop said. And that could drive investors to sectors where dividends aren’t as generous as bond yields but are at least growing. That would include areas like health care, financial services and even technology, he said. Continued Interest in Cyclical Stocks If the bond market is correct and the economy is indeed reaccelerating, at least for now, investors shouldn’t turn their backs on economically sensitive sectors that have been the market’s darlings for several years. These would include areas like the industrials and energy, Mr. Nolan said. Though investors are now inclined to seek shelter from this market storm, they should also remember why the stock market has been so volatile lately. It’s the bond market that’s been spooking stocks — and not the other way around. So it makes sense to pay attention to what bonds are saying.
The glut concept could never be proved, but it sounded more polite than another theory: that bond buyers had a case of temporary insanity. Whatever reason investors had for accepting low yields, they're no longer so accommodating. To which world stock markets appear to be saying, "Welcome back to reality." Rising bonds yields "are a shock, but in actuality we're just going back to the way things should be," said George Goncalves, a Treasury-bond strategist at Morgan Stanley in New York. But why now? It may finally be sinking in that the global economy isn't about to roll over. "I think you're seeing a move up in rates driven primarily by strong global growth," said Vadim Zlotnikov, chief equity strategist at investment research firm Sanford C. Bernstein. Bond investors are taking another look at what's a fair yield to earn on long-term securities given the world economy's strength, the upward trend in short-term rates (courtesy of central banks), inflation risks and competition from other investments including stocks. The good news for individual investors who want to lock in a fixed return is that you're being paid much more to do so than, say, a few months ago. At 5.16% on Friday, the 10-year U.S. T-note yield was up 0.67 of a point from early March, when it was 4.49%. Is that high enough to make it worthwhile?
Take a basic choice that all investors make: You can spend your days trading in and out of big investment bets or you can settle down with a diversified portfolio. "There is a trade-off between financial entertainment and financial security," argues William Bernstein, author of "The Four Pillars of Investing." "By keeping expenses down and diversifying widely, you're forgoing a lot of the fun of investing. But at the same time, you minimize the odds of an impoverished old age." The fact is, if you save regularly and own a diversified portfolio, you have an excellent shot at retiring in comfort. But if you roll the dice, retirement could be a grim affair. True, your big investment bets could pay off handsomely. That's unlikely, however, in part because of the hefty brokerage commissions and other investment costs you incur. In addition, you have to contend with a phenomenon known as "skewness." The most an investment can lose is 100%, but its potential gain is 200%, 300% or more. Indeed, most years, the market averages are driven upward by a minority of stocks that post spectacular gains. These big winners enthrall investors, who are then tempted to abandon their boring, diversified portfolios. But if they do that, they will likely be disappointed. Because the market averages are propelled higher each year by a select group of big winners, a majority of stocks suffer below-average performance -- and these are the stocks that our dice-rolling investors will probably end up owning. To a lesser degree, the same issue arises when choosing between actively managed stock funds and index funds. An index fund replicates the performance of its target index, while an actively managed fund offers the chance to earn market-beating returns. That chance, however, brings with it the risk of failure. Standard & Poor's regularly analyzes stock funds in nine "style boxes," such as large-company growth funds and midsize value funds. Result: Over the past five years, between 59% and 89% of actively managed funds underperformed their benchmark index, depending on which style box you look. To be sure, if you buy actively managed stock funds, you probably won't fail as badly as those who make big bets on a single sector or a few stocks. Still, there's a risk of lagging far behind the market averages, something index-fund owners don't have to worry about.
One of the easiest tricks is to track whether stocks with large market valuations -- over $10 billion or so -- are outpacing small stocks with less than $2 billion in shares outstanding. If large stocks are rising faster than small stocks, that might indicate "that rates have gotten up to a level where they're starting to bite," says Mr. Paulsen. If small stocks rally, "that's telling you rates aren't high enough yet" to crimp the economy. Large companies tend to be more resilient to economic downturns than their smaller brethren, since they're more diverse and often have operations overseas. They also have more funding options, such as bond or secondary share offerings, while small companies are usually more reliant on rate-sensitive bank loans. This year, large stocks have taken the lead after trailing small stocks for several years. While the Dow is up 9.4% in 2007, the small-stock Russell 2000 Index is just 7.7% higher. If that continues, it could mean growth is waning. If small stocks move ahead, that's a sign the economy is heating up. One of the most economically sensitive sectors of the market is so-called consumer-cyclical stocks, which tend to perform well when the economy is picking up, but are hit hard when the economy is contracting. The Dow Jones U.S. Consumer Goods Index, which tracks stocks such as JetBlue Airways, Papa John's International and RadioShack, is up 5.9% this year, trailing the Dow. Investors can track the index's daily performance through an exchange-traded fund, the iShares Dow Jones U.S. Consumer Goods Sector Index Fund. While the ETF took a hit earlier this month, it has stabilized since then. If it picks up speed, that could be an indication that the economy is also accelerating. On the other hand, a move higher by consumer-staples stocks such as Procter & Gamble or health-care stocks like Pfizer would signify that investors expect the economy to slow. While consumers will cut back on discretionary items like expensive gadgets or takeout pizza when times are tough, they'll keep spending on health care and diapers. "You're going to buy eggs and aspirin no matter what the economy does," said Barry Ritholtz, chief market strategist at Ritholtz Capital Partners. Transportation stocks are also highly attuned to the economy. The Dow Jones Transportation Average, which tracks railroads, truckers and airlines, dipped earlier this month amid worries about higher rates. But in the past week it's moved up again, signaling an economic rebound. If the transportation group loses momentum, that could signal slower growth down the road.
The credit-boost companies, easily found on the Web by searching for "rent a credit card," claim they violate no federal laws and are not seeking to defraud mortgage lenders. But mortgage industry groups, federal and state regulators and credit industry leaders say the programs represent significant threats to the home lending system — opening the door to fraudulent home loan applications. Using one of these services, for example, a mortgage applicant with a history of late and missed payments and a low FICO score in the 500s could puff up his or her score well above 700 and be eligible for the best interest rates and fees. How could that happen? Check out the online pitch of one promoter: "Rent your credit and earn thousands," it proclaims. The company finds credit card holders with sterling payment histories on cards with high balances "as much as $10,000 a month or more" willing to accept unseen borrowers with poor credit backgrounds as "authorized users" on their card accounts for 90 days. Although the add-on users receive no actual access to the credit card and cannot rack up charges, the current FICO model allows the cardholders' excellent payment histories to flow directly into the credit files of all authorized users on the card. The addition of the high-quality credit quickly raises the scores of any authorized users — even though the add-on user may still be a poor credit risk and is likely to default. Authorized users traditionally have been cardholders' children, close relatives or friends — people who have little experience with the world of credit and insufficient histories to generate FICO scores. Many parents allow their high school and college family members to tag on to Visa or MasterCard accounts as authorized users to help them learn about and build their credit skills. But under federal law, there are no limitations on who can become an authorized user or on the number of potential authorized users. Nor are there bars to treating payment histories as financial commodities and renting them out. One website promoter claims that some cardholder "investors" are "able to accommodate as many as 99" authorized users simultaneously and have "as many as 22 qualifying cards" for rental, creating "thousands of dollars per card" of extra income monthly. Fair Isaac, worried that its credit scoring system is being gamed to facilitate fraud, is now readying a crackdown. Starting in September, according to Craig Watts, public affairs manager, the updated version of the FICO software available to lenders no longer will consider authorized user accounts in computing credit scores. That, in effect, will block holders of good credit from renting their account histories to authorized users to boost scores artificially. Watts said that, once fully implemented, Fair Isaac's change should eliminate much of the problem. However, some credit experts say there could be a downside: Children and other legitimate authorized users no longer will get the benefits of their parents' or grandparents' high-quality credit DNA. Their FICO scores will be depressed or might even disappear in some cases. As an illustration, a college student with little credit history on file might get a 100-point increase in her FICO score by virtue of being an authorized user on her mother's Visa card with perfect payments stretching back to the 1980s. That 100 points, in turn, might lower the student's cost of auto insurance premiums, help in job applications and show her to be a credit-worthy tenant when she seeks to rent an apartment. If FICO score calculations ignored all authorized user accounts, however, the student's score could be 100 points lower. Terry Clemans, executive director of the National Credit Reporting Assn., said that although he understands "Fair Isaac's need to solve the [application fraud] problem, I would think there must be some less drastic ways to filter out" legitimate authorized user accounts from the new breed of rented credit card accounts. Credit card companies also need to get involved, Clemans said, and "should not approve authorized user accounts" where the card holder is clearly participating in some form of rental scheme for profit. Bottom line: If you depend on an authorized user account to elevate your FICO score — whether legitimately or possibly fraudulently — don't bank on it after September.
Confidence in this conclusion weakens if you take a longer perspective and examine the ratio of the S&P500’s price to average earnings over the last 10 years, rather than to earnings over the trailing 12 months. Clifford Asness, managing principal at AQR Capital Management, says that such a focus makes sense, because 12-month earnings are quite volatile. This helps explain why P/E ratios based on 12-month earnings have such a spotty record of identifying overvalued markets, he said. “P/E ratios based on 10-year average earnings, adjusted for inflation, make much more sense for this purpose,” he added. And though that 10-year average ratio for the S&P500, now at 27.4, is lower than it was in March 2000, when it stood at 46.1, it is still at one of its highest levels ever. Other than the years associated with the Internet bubble, in fact, there has been no period since 1929 when the 10-year average was higher. Another factor that provides solace to some people is investor sentiment, which is certainly less euphoric than it was at the height of the Internet bubble, when stock-picking seemed to be the national pastime. But, again, a look below the surface suggests that you shouldn’t put too much weight on the apparent contrast. Several academic studies suggest that current sentiment isn’t likely to be low enough to prevent another bubble from forming. One such study is “Overreactions, Momentum, Liquidity and Price Bubbles in Laboratory and Field Asset Markets,” by Gunduz Caginalp, a professor of mathematics at the University of Pittsburgh, and two professors affiliated with the Interdisciplinary Center for Economic Science at George Mason University, David P. Porter and Vernon L. Smith. Professor Smith was one of the 2002 Nobel laureates in economics. Professor Porter said that one conclusion of this study — as well as other such studies of which he is aware — is that investors become largely immune to bubble-causing behavior only after living through the bursting of two successive bubbles. Because of this, the typical pattern is for a burst bubble to be followed by a somewhat less extreme version of the original — a phenomenon that some call a bubble echo. This pattern has appeared so consistently and so regularly in psychological experiments, Professor Porter said, “that you can almost set your clock according to it.” Does the decline in the real estate market over the last couple of years count as the echo of the Internet bubble, meaning that we needn’t worry as much about another collapse in the overall stock market? Unfortunately not, Professor Porter said. The immunity appears to apply only when the echo occurs in the same, or in a very similar, asset class. The real estate market, he said, is too different from the stock market to qualify. Just because a bubble echo is likely at some point doesn’t mean we’re in one right now, Professor Porter added. But he also pointed out that researchers have found that a market decline after the bursting of a bubble echo tends to be larger the more years have passed since the first bubble popped. And even if a bubble has already formed, he said, his research can’t be used to predict when it might burst. Nevertheless, he said, no one should conclude that a new bubble is impossible just because the Internet bubble is still fresh in our minds. In an interview, Professor Smith said that while he didn’t think current market valuations were as extreme as those of March 2000, he still believes that stocks are vulnerable to a significant decline. That’s partly why he is holding a good amount of cash in his own portfolio.
Professor Mohanram outlined his grading system in a paper published in the September 2005 issue of the Review of Accounting Studies. Using a database of stocks similar to those in the Dow Jones Wilshire 5,000 index from 1979 to 2001, he found that his system appeared to be more effective in screening out stocks with poor performances than in predicting those that would actually beat the market. On average, the returns of the 14 percent of stocks that received the highest grades under the professor’s system outperformed the market by an average of 3.1 percentage points a year. The stocks with the lowest scores — about 13 percent of those considered — underperformed the market by an average of 17.5 percentage points a year. The paper, “Separating Winners From Losers Among Low Book-to-Market Stocks Using Financial Statement Analysis,” may be found on the Web site of the Social Sciences Research Network, at papers.ssrn.com, and through links on AlphaSeeker.com, a site developed by Richard Sloan, now the director of accounting research at Barclays Global Investors in San Francisco and formerly a professor at the University of Michigan. Professor Mohanram developed the grading system by collecting public company reports, then screening for three measures of profitability — the ratio of net income to assets, the ratio cash flow to assets, and the difference between net income and cash flow — as well as five other variables. These were the consistency of both sales and earnings growth, and spending in three categories: research and development, advertising and capital expenditures. Institutional investors began taking notice of his research several years ago. James Montier, for example, a global equity strategist at Dresdner Kleinwort Wasserstein in London, wrote favorably about it in a research paper before the final peer-reviewed version of the paper was published. While poring through hundreds of company reports and grading all of their stocks may be beyond the ability of a typical investor, a basic guideline drawn from the study may be widely useful: stocks whose book value (assets minus liabilities) is much lower than their market value are unlikely to fare well. That means it’s important to check the balance sheet of a company before making an investment in it.“Stocks with low book-to-market ratios don’t perform well as a group,” Mr. Mohanram said, adding that their average return is 8.7 percentage points a year below the market. These stocks — generally those whose prices have shot up on investor euphoria that isn’t adequately supported by the net value of the assets stated on the company’s books — will often turn out to be a disappointment, Mr. Mohanram’s paper suggested. As recent examples of such stocks, he cited Lucent and Yahoo. At the end of 2005, Lucent’s book-to-market ratio was 0.03, and it underperformed the market by 19.5 percentage points in 2006, while Yahoo, with a book-to-market ratio of 0.15, underperformed the market by 30.5 percentage points for the same period. Those interested in using his grading system to beat the market may want to combine two strategies, Mr. Mohanram says, by buying high-scoring stocks and selling low-scoring stocks short. Short-selling, of course, can be a risky strategy and is not widely recommended for individual investors. Investors who work with brokers might ask for their help in duplicating the system, suggests Robert Hagin, a former Morgan Stanley research chief who now runs Hagin Investment Research. And investors don’t have to adopt the system completely in order to make use of it, says Jayendran Rajamony, a portfolio manager at Numeric Investors who is an admirer of Mr. Mohanram’s work. They may simply look at annual reports and research papers for any growth stocks that interest them and use his criteria — even without peer comparisons — as screens in picking or avoiding stocks. “It’s about doing fundamental analysis,” Mr. Rajamony said. “This system is a way for investors to discipline themselves to pay attention to important variables because picking growth stocks is not just about buying a stock with a good story.” In short, don’t buy a stock that holds a world of promise but not much else.
Central banks are increasingly worried about spare production capacity running out -- which could force them to raise rates to their highest level in years to stave off inflation. That could puncture the ebullience of stock and bond markets, which have become accustomed to a rare combination of fast growth, low inflation and low interest rates. Already long-term interest rates are on the rise, in anticipation: U.S. 10-year Treasury bonds hit a nine-month high of nearly 5% yesterday. "Markets have gotten used to the idea that the global economy will keep producing downward pressure on prices," says Ken Rogoff, a Harvard economics professor and former chief economist at the International Monetary Fund. "But that phase may be ending." In remarks to a bankers conference in South Africa yesterday, U.S. Federal Reserve Chairman Ben Bernanke said rising Chinese domestic costs could eventually feed through to U.S. imports, but likely would only have "modest" effect. Still, he reiterated that risks to moderating inflation "remain to the upside" in the U.S. because demand is high relative to capacity. European Central Bank president Jean-Claude Trichet has warned that European industries have little scope left to raise production, and has asked unions to show restraint in seeking wage increases for the overall health of the economy. The bank is expected to raise rates when it meets today. Germany's engineering sector, the mainstay of its export-led revival, is operating at 93% of capacity, leaving the lowest amount of slack since the 1960s. Amid falling unemployment, Germany's most powerful union, IG Metall, recently pushed through a pay raise of 4.1% to cover much of the manufacturing sector this year. The Bank of England raised interest rates last month in part because "there might be less disinflationary pressure in the global economy," according to the minutes of the meeting. The cost of consumer goods in the United Kingdom has stabilized after falling persistently for many years under pressure from imports, and more U.K. manufacturers plan to raise prices than at any time since the mid-1990s, according to the Confederation of British Industry. Even the price of Chinese exports such as furniture and clothing is rising, and provincial authorities there raised long-stagnant -- and still tiny -- minimum wages by an average of 21% last year. Indian outsourcing giant Infosys Technologies recently raised entry-level wages 10% and expects to do so again amid increasing competition for its workers. To be sure, globalization still is helping contain some price pressures, and growth is still strong. Inflation remains moderate, at around 2% in industrialized countries and not much above 5% in many developing countries. The lack of price pressure has allowed central banks to leave their short-term interest rates 1.25 percentage points lower, on average, than at the peak of the world's 1990s economic boom, J.P. Morgan says -- even though the world economy is growing even faster now. The flood of cheap imports into the U.S. has benefited consumers there and subtracted about one percentage point a year from U.S. inflation for the past decade, says the International Monetary Fund. Goldman Sachs economists said in a report last week, "There are pockets where inflation has risen more than expected, but the most recent evidence ... is that inflation is receding," especially in the U.S. and Japan. Still, signs are now multiplying that global growth is fueling inflation rather than restraining it, says Richard Fisher, president of the Federal Reserve Bank of Dallas and a nonvoting member of the Fed's policy committee. "More and more, I hear people complain about the rising costs of [hiring] Indian M.B.A.s or the wages paid to Chinese workers," he says. As an inflation-damper, he adds, global capacity has gone from "tailwind to a headwind." Bruce Kasman, chief economist at J.P. Morgan Chase, warns investors world-wide have been underestimating central banks' willingness to raise rates to avoid a repeat of the spiraling inflation of the 1970s, the last time the world economy grew as strongly as today. It won't require much higher rates, he says, to "cause significant damage in the markets." Global crosscurrents from China and India and other fast-growing developing nations are raising some costs in the developed world. U.S. farmers, for instance, are paying more to export grain because the large ships they use are busy serving China's booming domestic market. The price to use the ships has risen to almost $50,000 a day from $17,000 last year, says Oivind Lorentzen III, president Northern Navigation America Inc., a Stamford, Conn.-based shipping company. The collision between rising demand and tight supply is evident in Germany, which is leading the 13-nation euro currency area to its fastest growth since the tech boom. Hanover-based tire manufacturer Continental AG says it's struggling to meet extra orders of tires from makers of trucks and cargo trailers, many of whom underestimated the surging demand for commercial transport. "We're basically sold out," says managing director Hans-Joachim Nikolin. This month, Continental raised its tire prices by up to 5%, partly passing on the cost of natural rubber, which has soared amid high demand from Asia. The shortage of tires poses a problem in turn for companies like Schmitz Cargobull AG, Europe's largest maker of cargo trailers. The company had planned to make around 44,000 trailers in the year through March, up 30% from the previous year. Instead, it ended up making 52,000 as demand for transporting goods and materials around Europe soared, notably in the fast-growing economies of Europe's ex-communist east. Europe's tire makers didn't have enough tires available to cover the extra production, so Schmitz's purchasing manager Josef Buddenkotte flew to China to buy more tires there to hold down the surge in costs. Schmitz expects to make 65,000 trailers in the year ahead, and has just raised its prices by 3.5%. Schmitz added a third production shift to cover demand, but with Germany's labor market tightening, has had to pay bonuses to attract enough staff. Schmitz also will have to digest a 4.1% rise in wages this year, under German industry's deal with the IG Metall union. Demand for wood is booming too, including for the specially treated plywood that Schmitz uses in its trailers. Finnish forestry-products company UPM can't get enough birch timber from Russia at the moment: Mild weather and muddy ground impeded logging this winter, and Russian authorities are planning to raise export duties. "We can serve long-time partners, but new customers can't be served at all at the moment," says Joachim Stinsky, German sales manager at UPM. The price of some of UPM's wood products has risen 20% in the past year, he says. The rising production costs are passed on to logistics companies that buy or hire trucks and trailers. They too are struggling to meet demand. "The cargo space that's available simply isn't enough," says Heiko Gnam, head of purchasing at Stuttgart-based logistics firm Diehl Spedition. The daily price for chartering a truck has gone up by 10% to 15% in the past year, he says. In the U.S., central bankers are paying closer attention to the short supply of goods and services around the world. As trade swells, the prices of goods and services are increasingly determined in world markets rather than simply in the U.S. market. U.S. import prices excluding oil rose 2.9% in the year through April, the fastest clip in 18 months. Employers are boosting wages because despite a slowdown in economic growth, unemployment hovers near a six-year low of 4.5% overall and just 1.9% for professionals. Doug Pruitt, chief executive of Sundt Companies Inc., a Tempe, Ariz., commercial builder, says the long slump following the 2001 recession masked a shortage of skilled professionals that has turned more acute as demand rebounded. He often pays signing bonuses of $10,000 to $20,000 for engineers, project managers, superintendents and estimators. Labor shortages have constrained Sundt's ability to grow. The company, with annual sales of about $850 million, has turned down $150 million to $200 million of work in the past two years. "I ran this office for 11 years, and we never turned down anything," Mr. Pruitt says. He says he's been charging 12% more than he would have for the same project a year ago. In China, heavy investment in new factories and infrastructure means the economy is still gaining plenty of new production capacity for the future, a trend that hasn't been stopped by the central bank's modest recent interest-rate increases. Domestic consumer-price inflation there remains low. But labor costs for exporters on the booming coast, who expected to benefit indefinitely from cheap migrant labor to migrate from inland, are going up. China's export prices rose by 5.3% on average in the year to March, according to China's customs agency, a sharp pickup from a 2.9% gain in the year to last December. Gains are coming both from labor-intensive goods such as textiles and energy-intensive produce like steel. Surveys regularly show that a majority of employers can't fill all of their available jobs, from textile workers in the south to software programmers in the northeast. At the same time, several hundred million Chinese are still scraping out a living on farms. In theory, they could triple their incomes by taking a job in manufacturing or construction. But the demand for labor and its supply are often not in the same place. In practice, the rural population in the interior can't all move away at once to the coast, where industry and foreign investment are concentrated. With China's economy looking set to grow by 10% or more for a fifth straight year, employers are aiming to expand their work force by an average of 13%, according to a survey by the labor ministry. That growth is starting to empower workers. Most measures show Chinese wages have been rising by 10% or more annually for several years straight, though rapid gains in productivity have helped contain employers' total labor costs. Still, migrants from rural areas are getting more assertive: As rising crop prices have boosted farm incomes in the past couple of years, they've also lifted people's expectations of factory life. Prospective migrants are looking for 16% higher wages than a year ago, according to a survey by the Chinese Academy of Social Sciences. "Migrant workers are getting more advanced in their thinking. They are looking at the factory's environment, living conditions, and different kinds of benefits. Now, the workers are the boss," says Hong Yong, who runs a furniture factory in Shunde, Guangdong province. China's government, under political pressure to address rising inequality, also wants to see higher wages and better social protections for workers. Zhu Changlin, vice chairman of China's furniture makers association, says employers can no longer get away with not paying unemployment insurance and other benefits to staff. Many furniture manufacturers estimate their labor bill will rise 20% this year, on top of higher costs for wood and other raw materials. Building new factories also is getting more expensive: Land prices are rising as the rapid growth of industrial parks in crowded coastal provinces starts to hit limits. China also is gradually dismantling administrative practices that have kept prices for electricity, fuel and water far below market levels. In a report this month, China's central bank said the changes would lead to a "certain increase in the overall price level." More on Inflation & Interest Rates Odds Fall for Rate Cut MarketBeat, WSJ 6-05 As recently as a month ago, markets were pricing in a more than 77% chance of a Fed rate cut by December, Harris Private Bank CIO Jack Ablin tells clients in a note today. Odds of a rate increase were non-existent. Now, after a slew of positive economic reports and Ben Bernanke’s happy talk this morning, odds of a rate cut have dwindled to 41%, while odds of a rate increase have surged to nearly 40%. That is not music to most investors’ ears. But it is good news for economically sensitive sectors such as materials, industrials and technology, Mr. Ablin notes. Not so much for defensive plays such as utilities, health care and financials. Goldman Sachs Shifts Their Expectations David Gaffen, WSJ 6-06 The forecasting folks at Goldman Sachs yesterday owned up to a prediction that didn’t work out, throwing in the towel on their call for Federal Reserve rate cuts this year, in a note that chief U.S. economist Jan Hatzius opens with the phrase, “Mmhhh, crow.” Basically, Mr. Hatzius says their forecast for slower growth hasn’t panned out, saying “the industrial sector of the economy is now clearly reaccelerating.” He also says the firm has been “very surprised at the stability of the unemployment rate.” Will the change in his views be mirrored by others around Wall Street? In the WSJ.com economist survey for May, the average year-end forecast for the federal-funds targeted rate was 5.04%, and that’s barely budged since February, when the average was 5%, suggesting the bulk of the economic community was still looking for at least one rate cut by the end of the year. It’s not a position futures traders share any more — the Chicago Board of Trade fed funds futures contracts now put just 23% odds on a rate cut by December, having reduced odds in the past couple of weeks after a string of better-than-expected economic reports and more hawkish talk from the Federal Reserve. That doesn’t mean Mr. Hatzius has given up the ghost completely. “In our view, the probability of easing is higher than that of tightening for the foreseeable future,” he writes. A bit of the pressure on the dollar of late comes in part because interest rates elsewhere are looking solid, particularly as the other major world central banks (such as Australia, the eurozone and Great Britain) continue to move in the direction of tighter policy, while the U.S., for the time being, sticks with what it’s got. With 10-year British gilts trading at 5.31% and the Australian 10-year at 6.12%, the 10-year Treasury is less attractive at 4.98%. In England, Germany and Switzerland, 10-year yields have risen 0.57 percentage point, 0.52, and 0.61 percentage point, respectively, compared with just a 0.28 percentage-point increase in the U.S. 10-year note. Several Asian countries are letting their currencies rise, potentially making it easier for China to eventually appreciate the yuan. Developing economies are growing quickly and generating enough home-grown income to absorb the hit that currency appreciation might bring to exports. And since it’s several countries letting their currencies rise, the threat of losing export market share isn’t as strong. (Justin Lahart, WSJ 6-06) Writing at Minyanville.com, Bennet Sedacca has unwelcome news for anybody hoping that 10-year Treasury notes are oversold and due for a rebound (which would, of course, pull yields lower). For one thing, it really doesn’t matter if bonds are oversold. “In bear markets, markets get oversold and stay oversold,” he writes, and “support exists to be broken.” (MarketBeat, WSJ 6-05)
And what about the adoption of inflation targets by central banks around the world, more committed than ever to price stability? Central banks by and large are currently engaged in raising benchmark interest rates. Sorry, that doesn't fit today's storyline either. Wednesday's report on U.S. productivity and costs just added fuel to already glowing embers. In a quarter when real gross domestic product barely budged -- the economy grew 0.6% in Q1-07 -- output per hour worked slowed to 1%, half the previous quarter's pace. Unit labor costs rose 1.8%, a little less than the average for the last decade. Which makes you wonder what all the Sturm und Drang was about. `The rise in unit labor costs is completely meaningless in a quarter when growth is flat,' says Jim Glassman, senior U.S. economist at JPMorgan Chase. `Every move in the market doesn't have to be about the news we're seeing. There's lots of other stuff going on around us.' Glassman says the new news in the report, overshadowed by the hyperventilating over inflationary pressures, was the deceleration in hourly compensation to 3.2% on a year-over-year basis. `It was running at 5% to 6% last year,' he says. `Now it's more in line with the ECI.' The Employment Cost Index, a measure of total compensation (wages, salaries and benefits) adjusted for the change in the job mix, for private industry workers rose 3.2% in the first quarter from a year earlier. What's more, `if you try to explain inflation by unit labor costs over the last decade, you would have a difficult time connecting the dots,' says Joe Carson, director of economic research at AllianceBernstein. On a four-quarter basis, which smoothes out the noise, unit labor costs for the non-farm business sector rose 2.2% in the first quarter, the smallest increase in more than a year. For some reason, the punishment to stock and bond markets over the last couple of days doesn't seem to fit the crime. Now, it may be that the improved trend in productivity growth starting in the late 1990s has run its course, that it's a structural shift rather than a reflection of the slowdown in growth. `In the short-term, as economic growth slows, firms that aren't sure about demand conditions produce a smaller output with the same number of employees, which accounts for the slower pace of productivity,' says Paul Kasriel, chief economist at the Northern Trust. That's why productivity is said to have a strong cyclical component. When business activity picks up after a recession, for example, corporations are slow to add workers. They crack the whip and work the current staff harder until they're sure increased demand will be sustained. And while cost-cutting has become a way of life for U.S. businesses, they don't want to lay off skilled workers prematurely, only to find the slump short-lived and themselves faced with the prospect of hiring and training new employees. When I read articles about labor costs pushing up prices, it feels as if I'm living in a time warp. Labor unions have reduced bargaining power when corporations can shut a manufacturing plant and shift production overseas. Still the idea that wages drive prices and inflation is something that never dies. `This kind of thinking is deeply ingrained at the Fed,' Glassman says. `It's as if wage gains are carved in stone. That may have been true long ago. It's not true now. There are more price takers.' All the hoopla over inflation is happening at a time when various inflation measures have rolled over. The core consumer price index, which excludes food and energy, rose 2.3% in the year ended in April, down from a 2.9% peak in September. The Fed's preferred measure, the core personal consumption expenditures price index, rose 2% in the past 12 months, the smallest increase in more than a year, bringing the gauge into the top of the Fed's comfort zone. That's clearly no comfort to the folks unloading stocks and bonds. Inflation may lag the business cycle, but they see a new cycle dawning. The U.S. slowdown is over, capital goods orders and manufacturing are picking up, and exports are benefiting from strong overseas demand. Inflation is sure to follow. `It's hard to get a U-turn in the economy without a corresponding rise in consumer demand,' Carson says. `And consumer spending is showing incremental weakness.' Same-store sales slowed to a 2.2% average pace in the February through May period from 4.1% in the same period in 2006, according to the International Council of Shopping Centers. Even if a growth comeback is at hand, the storyline lacks a key ingredient. `Inflation is about what central banks do, not about globalization and development,' Glassman says. With official central-bank rates heading up, can you guess which way inflation will go?
The markets have changed dramatically since 1989, when a busted deal for United Airlines chilled the debt markets for years on end. At the core of the change is the term "liquidity," a catch-all meaning there's lots of money in the markets for anyone who needs it. Behind the liquidity is something grander: The culmination of decades of advances in the architecture of financial markets and information technology. The result is a global, instantaneous network of hyperinformed investors, moving money from Dubai, Geneva, or Greenwich into ever-more specialized investments. Need a few billion in a few days? Someone, somewhere, will fill your tank. Will this global liquidity actually minimize the impact of the inevitable credit downturn? Or is it, in fact, only feeding a bubble? We won't know until it happens. But theories have begun to form around three different scenarios. The Big One: This is the realm of the capital letter, meant to express outsize effect: The Asian Currency Crisis or The Russian Financial Crisis. As this theory goes, some big event flips investor confidence in an instant, drying up capital as investors flee to safe havens. These are by their very nature unpredictable and devastating. Right now, credit markets are at the other end of this spectrum. Bond investors demand next to nothing to own corporate debt. The difference in yield between a risky B-rated junk bond and an ultrasafe Treasury is just 2.4 percentage points, the lowest spread on record. It's a sign of investors' high tolerance for risk. The big event causes them to quickly reassess this tolerance, dumping corporate bonds and pushing out spreads in an instant. While we have become deeply attuned to the Big One, we have also become increasingly adaptable to them. Sept. 11, of course, was a widely destabilizing force. But from a business perspective, it contributed to years of low interest rates that set the tone for today's lending free-for-all. By the time terrorists targeted London in July 2005, the markets shrugged off the effects. If the subprime lending mess is a crisis, it surely has not spread to the broader stock market, which is posting record highs by the day. "For this to come down, it has to be something of major, major proportions," says Dennis Drebsky, a bankruptcy and litigation partner at Nixon Peabody in New York. Death by Drowning: In this scenario, the pullback doesn't come from one outsize event. Instead, lenders and borrowers slowly choke on their own largess. Lenders prop up many companies in a series of refinancings, heaping new debt on old. Eventually, lenders would be compelled to tighten their standards. That's what's happened in the housing market today. A recent survey of restructuring advisers by AlixPartners found "there's unlikely to be a crash, and more of a gradual increase in companies that just can't refinance the fourth time around," says Peter Fitzsimmons, co-president of AlixPartners. Right now, we're still in the period of serial refinancing, as shown by video-rental business Movie Gallery Inc. In 2005, it took on substantial new debt to fund the $850 million purchase of rival retail chain Hollywood Entertainment Inc. Within months of winning the deal, the company's business began to shrivel. Its stock, which was trading in the $30s, was worth less than $6 by year's end. By August 2006, the company had hired a restructuring firm and was facing an inevitable "workout." But that wouldn't be necessary. Not in these markets. In March, Goldman Sachs led a $900 million refinancing secured against substantially all the company's assets. Today Movie Gallery's shares trade at around $2 each. A Movie Gallery spokesman pointed to a March statement saying the deal would provide the company with lower annual interest expenses. Lenders have found ever-more lenient ways of doling out cash. A private-equity-owned firm called NXP, the former semiconductor business of Philips, is one of many firms that have secured the most popular trend in lending now, known as the "covenant-lite revolver." Revolvers are bank loans usually drawn down as a company's last resort. This is the very moment a lender might want to keep a tight hold on its money, using covenants that test the company's creditworthiness and performance. The covenant-lite variety has fewer of those tests. As one banker put it, it's like a car that's begun to swerve, and ends off the road entirely before anyone can intervene. "The problem is that you put securities like that in a capital structure and it doesn't instill the discipline to manage their business," says David Resnick, a longtime restructuring adviser at Rothschild North America. The Slow Leak: The Slow Leak theory is the most benign of the scenarios. It's based around the idea that annual private-equity returns will gradually decline, slowly ending today's ferocious buyout binge, which comprises a third of today's record mergers volume. As private equity firms adapt, they'll pull back the reins on their borrowing, ending the debt boom before it gets too messy. Investing has already gotten harder for the private-equity groups, which face hostile shareholders and boards of directors demanding more at the negotiating table. Just yesterday, private-equity firms and hedge funds had to cough up an additional $55 million to pay for the buyout of Laureate Education, Inc. Moreover, new tax rules in Washington could force them to cough up more to the Internal Revenue Service on their profits. And it will be years until these investors realize returns on the deals they're striking today. While they're scrambling to raise ever-larger funds, they're going to have to prove to investors that they can still outpace the market at large. "The issue is not a meltdown but that they may not get the returns," says Morgan Stanley vice chairman Robert Kindler. Private-equity firms are targeting "high-teens returns, versus mid-20s three to five years ago." The risk is they borrow even more as they try to make up for faltering performance ... which will bring them right back to scenarios one and two.
According to Bloomberg data, the average U.S. high-yield bond fund returned 11.9% in the past year through the middle of this week; 9.3% a year in the past three years, and 9.3% for the past five years. On closer inspection, however, private-equity firms make dubious friends for old-line fund managers. Over time they pose a serious competitive threat. The current wave of buyouts is a natural free-market response to one of the defining financial features of the times -- cheap, abundant credit. If you look at stocks in isolation, they might not strike you as unusually attractive bargains. At between 17 and 18, the price-earnings ratio of the Standard & Poor's 500 Index is middling by historical standards. The picture changes when stocks are set against the background of unusually low interest rates. At an average yield of 4.5 percent over the past three years, the 10-year U.S. Treasury note has traded at 22.2 times its annual interest payments. Is there an arbitrage that can be done here? Why yes, if I simply buy a stock and sell a bond I gain a relatively low- priced asset in exchange for a high-priced one. So that's what I do, I buy the outstanding stock of Such-and-Such Enterprises, then turn around and sell bonds of Such-and-Such in a roughly equivalent amount. As a bonus, there may be some things I can do with Such- and-Such as its private owner to increase its market value. In a year or two or three, perhaps I can translate those changes into a profit when I sell Such-and-Such back to public ownership again. Along the way, I create value that might not otherwise ever have existed. Where's the harm to mutual funds or any of my other fellow investors? Well, of course, if my strategy works I got the better of them, earning far more for myself than they got from the sale of their stock or their investment in the bonds I issued. That's only part of the story. My leveraged buyout amounted to a trade across asset classes (stocks and bonds), something the typical mutual fund isn't set up to do. A stock fund pretty much sticks to stocks, a bond fund to bonds. Even a fund that is free to range from one type of asset to another is likely to be limited in its maneuverability, given such strictures on funds as the need to price all their holdings daily. With my buyout I have, in effect, transferred a chunk of investment return to a realm where mutual funds can't get at it. Oh well, you may say, they can simply look to other stocks to make up for it. It's a big world out there and getting bigger all the time, what with globalization and all. Maybe so, but today's sophisticated client doesn't want just any old return from an active money manager. He wants market-beating returns, known in the trade as alpha. He can get a market return from a low-cost index fund. Presumably, there is a less-than-infinite supply of alpha to go around. To whatever extent private-equity firms, hedge funds, and the like can grab some of that alpha away from traditional buy-and-hold investors such as mutual funds, the old-style investors are put at a disadvantage. So far, this threat is more theoretical than actual. Plain old mutual funds are thriving, with $11.1 trillion-plus of U.S. assets, and still growing. Could a recession or some other misadventure come along and blow up a couple of private-equity deals, deflating the whole buyout balloon? Private equity has always been a highly cyclical world. Even in that event, though, surely the techniques introduced by modern financial engineers aren't going to disappear. They have permanently changed the game. With all their great attributes, mutual funds aren't exempt from the danger of falling behind the times. Monthly Employment Stats
Employment in the health care industry continued to grow in May (+25,000), with gains in ambulatory health care services and hospitals. Over the year, health care added 363,000 jobs. Employment in social assistance continued to trend up in May; the industry added 11,000 jobs over the month and 72,000 over the year. In the leisure and hospitality sector, employment in food services and drinking places rose by 35,000 in May. This industry has added 361,000 jobs over the year. Elsewhere in the service-providing sector, employment in private education, information, and wholesale trade continued to trend up over the month. Retail trade employment changed little in May and has shown no net increase since March 2006. Within professional and business services, job gains continued over the month in computer systems design (+8,000) and in architectural and engineering services (+7,000). Employment in temporary help services was little changed over the month and has shown little movement since its recent peak in December 2005. In financial activities, employment rose in securities, commodity contracts, and investments (+6,000) and in commercial banking (+4,000) in May. These gains were largely offset by small declines in other components of the sector. Employment in construction was unchanged in May, with no significant movements among the component industries. Since its recent peak in September, construction employment has decreased by 54,000. Manufacturing employment continued to decline in May (-19,000). About half of the decline occurred in motor vehicles and parts manufacturing, which lost 10,000 jobs over the month. Over the year, factory employment decreased by 164,000, with motor vehicles and parts accounting for nearly half of the loss. In May, the average workweek for production and nonsupervisory workers on private nonfarm payrolls increased by 0.1 hour to 33.9 hours, seasonally ad- justed. The manufacturing workweek and factory overtime each fell by 0.1 hour to 41.0 and 4.1 hours, respectively. The index of aggregate weekly hours of production and nonsupervisory workers on private nonfarm payrolls rose by 0.5 percent in May to 107.5 (2002=100). The manufacturing index fell by 0.3% over the month to 94.9. Average hourly earnings of production and nonsupervisory workers on private nonfarm payrolls increased by 6 cents, or 0.3%, in May to $17.30, seasonally adjusted. Average weekly earnings grew by 0.6% over the month to $586.47. Over the year, average hourly and weekly earnings rose by 3.8% and 4.1%, respectively. In May, total employment was about unchanged at 145.9 million, and the em- ployment-population ratio held at 63.0%. The civilian labor force also was about unchanged at 152.8 million, and the labor force participation rate remained at 66.0%. The jobless rates for the major worker groups--adult men (4%), adult women (3.8%), teen-agers (15.7%), whites (3.9%), blacks (8.5%), and Hispanics (5.8%) - showed little or no change. The number of persons who worked part time for economic reasons, at 4.5 million, was little changed in May but was up by 332,000 over the year. Challenger, Gray & Christmas said employers announced plans in May to cut 71,115 jobs, up 32% from the year-ago period, but the pace of job-cutting still remains below last year’s level. A total of 337,773 job cuts have been announced by employers so far this year, according to the outplacement consultancy, down 8.5% from last year. (David Gaffen, WSJ 6-06)
Quick Facts, Stats & Opinions Google Search Tips Sellsius Real Estate Blog. 6-23 [1] Use the pipe (|) for an either/or search (or use the word “or”): fsbo|by owner. [2] Use two periods (..) to find information within a number range, including years: worst housing markets 1980..2006. [3] Exclude search terms with a minus sign (-): worst housing markets 1980..2006 -best. (since the prior search usually includes best and worst, use the minus sign if you only want the bad news) [4] Find similar terms with the tilde (~): ~cheap homes. You get auctions, foreclosures, etc. [5] Use the wildcard star (*) if you don’t know the missing word: a man’s home is his *. Get a list of definitions with “define:” define:foreclosure. [5] To search a particular site use “site:”. Fluorescent Bulbs Save Cash & Energy Diana Ransom, WSJ 6-24 The price may now be right to cast out those old incandescent bulbs and light your home with energy-efficient compact fluorescents. A number of retailers are offering "compact fluorescent lamps" or CFLs in multiple-unit packs for a fraction of their former price. At Home Depot, for example, a pack of four 13-watt CFLs -- providing the same illumination as a standard 60-watt bulb -- currently costs $7.97 or less than $2 each. Five years ago, a single bulb cost $7.97. The Energy Federation, a not-for-profit company that distributes energy-efficient products, says the average price of a CFL is around $3, down from $9 in 2000 and $20 in 1990. CFLs can be cheaper than traditional bulbs when the CFLs' longer lives are factored in -- and the savings is multiplied by the CFLs' stingy energy consumption. CFLs last, on average, eight times as long as incandescent bulbs, according to a spokeswoman for the Environmental Protection Agency's Energy Star program. A package of six 60-watt incandescents sells in most Home Depot locations for $2.92, or 49 cents per bulb. You would spend almost $4 to provide the same amount of light over the lifetime of one $2 CFL from the same retailer. With CFLs, you also save big on energy costs. Replacing one 60-watt incandescent with a 13-watt CFL might save you about $30 in energy costs over the life of the CFL, according to the EPA. "With the price of CFLs going down and the cost of energy going up, it makes sense to replace more and more bulbs with the [energy-efficient] lamps," says Jennifer Thorne Amann, a senior research associate for the American Council for an Energy-Efficient Economy. US Market Correlations Paul Lim, NY Times 6-03 Currently, there is a correlation of about 85% between movements in the Standard & Poor’s 500 index of domestic stocks and the Morgan Stanley Capital International EAFE (for Europe, Australia and the Far East) index of foreign shares. But it is important to note that not all individual foreign markets are so closely aligned with Wall Street. Consider Japan. Currently, there is a correlation of only 29% between movements in Japanese stocks and United States stocks, according to S&P. And over the last 20 years, that figure has never risen higher than 59%. Several other Asian stock markets are also relatively uncorrelated with the S.& P. 500, including India, at 43%; Hong Kong, 55%; and South Korea, 67%. That means Asian stocks could help diversify your portfolio more than European or even Latin American equities. Markets in Germany, France, Spain and Britain, for example, all now have a correlation of more than 80% correlation with the S&P500. There is a 74% correlation between Mexican stocks and domestic shares. Debit Card Stats Elizabeth Olson, NY Times 6-17 About 25% of 18-25 year olds, in nationwide survey conducted for Visa in April, survey used their debit cards for a majority of micropurchases, which are those less than $5. That was twice as many as in their parents' age group, defined as those at least 45 years old. There are 350 billion annual transactions of less than $5, and last year they totaled $1.32 billion, according to MasterCard’s research. And that number is expected to rise. A survey released in March by the research firm Bankrate.com found that nearly all large banks had eliminated these small fees on debit cards. But some merchants still add their own fees. A more expensive problem can occur when a bank account is accidentally overdrawn and several small debit charges are posted to the account, each one setting off a separate overdraft charge. These charges cause 46% of overdraft fees, according to “Debit Card Danger,” a report by the Center for Responsible Lending, a nonprofit policy group, which analyzed the accounts of 2,400 customers at the nation’s 15 largest banks. Overdrafts can also be a danger with paper checks, but the study found that they are responsible for only 25% of overdraft charges. According to the debit card report, which was released in January, the consumer pays $2.17 in fees for every overdraft debit dollar. The average debit overdraft charge is $34, the report found. The Investment Company Institute, the mutual fund trade group, found that investors in stock funds paid fees, including loads and expense ratios, that averaged about 1.1 percent, a decline of 0.04 percentage points from 2005. The competition over expense ratios among mutual funds helped lower the average ratio slightly, to 88 basis points. A concentration of assets in investments such as retirement accounts meant many investors were able to skip paying retail and instead receive big discounts. The average maximum sales load on stock funds available to investors was about 5.3 percent last year, but the large sums of money 401(k) plans wield meant discounts and waived fees reduced the average load investors actually paid to 1.3 percent. (Tim Paradis, AP 6-24) More than two-thirds of adult Americans have life insurance, but people between 35 and 64 years old are six times more likely to become disabled than they are to die. So why do fewer than a third of us have disability coverage? Meet the "availability bias." Humans rely on images and emotions that come easily to mind, whether it's an extremely vivid event, like death, or a fairly recent one, like the Dow's new high. That leads to what University of Chicago researcher Cass Sunstein calls "probability neglect." "We tend to ask what's the worst -- or best -- that could happen," he says. "Instead, we should be asking, what's likely to happen?" (N Bullock & J Paskin, WSJ 6-24) A study by Birinyi Associates found that companies that don't announce stock-buyback programs on average have seen similar gains in share price to companies that do. The 385 S&P 500 index companies that announced stock-buyback plans between 2000 and 2005 saw a median gain in their share price of 40% over that period, while the remaining companies that did not announce such programs saw a median gain of 39%. (Harry Weber, AP 6-24) Among workers with 401(k) accounts who left their jobs in 2005, 27 percent took the money as a lump sum of cash, Vanguard’s most recent data showed. Forty-seven percent kept the money in the plan, and 24 percent rolled it over into another retirement account. (Shira Boss, NY Times 6-16) The Center for Retirement Research reported last year that 7 in 10 people, ages 51 to 61 in 1992, experienced a “negative shock” in the following decade, through a job loss, health problems, or losing a spouse. Those events ate away at household wealth, with divorce being the most devastating, causing an average 44% decline in assets. (Shira Boss, NY Times 6-16) Carrying a load of debt into retirement can be a dangerous thing. But a growing number of people are doing it. In 2004, 60.6 percent of families headed by someone 55 or older carried debt, up from 56 percent in 2001, according to the Employee Benefit Research Institute. Their level of debt rose, too, from an average $29,309 in 1992 to $51,791 in 2004. One in 10 workers 40 or older worries about being able to pay off non-mortgage debt before retirement, according to a survey conducted for the AARP. (Martha Hamilton, Washington Post 6-17) The S.& P. 500 now has an average P/E of around 18, compared with a record high of 46.5 at the end of 2001. In the last 20 years, the S.& P. 500 index has had an average P/E ratio of 22.7. (J. Alex Tarquinio, NY Times 6-03) Blue Marble Research President Vinny Catalano suggests P/E (price/equity) ratios should be temporarily replaced by PE (private equity) ratios — a clever way of saying a relentless buyout boom is not only keeping a floor under the market but could be making stocks artificially expensive. But he warns that the boom “may not be sustainable, resulting in PEs reverting back to P/Es.” (MarketBeat, WSJ 6-05) Hedge Fund / Private Equity News Briefs The further you look back, the better funds of hedge funds look, according to Mellon Analytical Solutions. In its latest quarterly report, MAS found that the median returns for pooled funds of hedge funds over the past three years ending March 31 was 8.3% a year – less than half the 17.2% racked up by U.K. equity funds. Yet, if you add two years to the mix, looking at a five-year period, the pooled funds actually come out considerably better – 9.1% a year vs. 8.4% for the U.K. equities. According to MAS equities looked better over the three-year period because of “a slightly higher level of risk.” It noted that the median standard deviation during that period was 6.5% for the U.K. equities while 5.3% a year for the FoHFs. That median deviation over the five-year period widened considerably, with 14.5% a year for the U.K. equity funds, compared with 4.9% a year for the FoHFs. For the 12-month period ending March 31, funds of hedge funds returned 7.4%, with a median return of 3.4% for the first quarter of 2007. Mellon noted that pension fund investment in alternatives rose from 0.2% of total assets in 2001 to 2.2% at the end of last year. Further, the average fund of hedge funds had 43.1% of its assets in directional strategies, 14.7% in event-driven strategies, 15.2% in non-directional strategies and 27% in a variety of other strategies and cash. (Hegde Fund Daily 6-05) Home Page Previous Factoid Top Sites
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