The Float

Fed Out of the Box

As we expected, Bernanke & Co. created a little more wiggle room for themselves in this afternoon's statement. Note the key sources of wiggle room in bold...

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 4-1/2 percent.

Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance.  However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction.  Today's action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.

Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation.  In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth.  The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

Voting for the FOMC monetary policy action were:  Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Donald L. Kohn; Randall S. Kroszner;
Frederic S. Mishkin; William Poole; Eric S. Rosengren; and Kevin M. Warsh.  Voting against was Thomas M. Hoenig, who preferred no change in the federal funds rate at this meeting.

In a related action, the Board of Governors unanimously approved a 25-basis-point decrease in the discount rate to 5 percent.  In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Richmond, Atlanta, Chicago, St. Louis, and San Francisco.

A Little Perspective on Fed Day

As the Fed's zero hour approaches, we thought we'd try to summarize the state of the financial-economic world with a few simple observations...

• However severe financial markets stresses were in early August, things have since come unstuck and markets are once again functioning reasonably well.
• Functioning markets sometimes send asset prices lower, as is the case with various securities related to the mortgage markets (emphasis on subprime, option ARMs, &c.).
• For all the breathless talk about central banks' "injections of liquidity," it's worth remembering that liquidity is basically a state of mind.
• Housing stinks something fierce. There's no getting around that, and it ain't turning around any time soon.
• The global economy remains very dynamic--and increasingly interdependent.
• Inflation is real--not spiraling out of control, but real. The key question, which has implications for Fed policy-making, is where its effects manifest themselves. In consumer prices? Or in margin compression at the corporate level?
• The American consumer is one of our planet's most astonishing species: resilient, adaptable, downright indefatigable. So far, anyway.
• Bernanke & Co. have surprised market participants before, but, as Alan Blinder said on CNBC this afternoon, the Fed appears boxed in by market expectations. 25 basis points could be nearly automatic this time, but the Board of Governors' statement may well reflect their effort to unbox themselves for future meetings.

Golf as a Contrary Indicator

Just spoke with a friend and former colleague at Merrill Lynch, who filed this pithy report on the firm's departed boss:

"I just returned from a two-month leave of absence. During those two months, I played 12 rounds of golf. Stan O'Neal played 20."

Nero fiddled while Rome burned; O'Neal teed it up.

Wednesday Reading

As the world waits for Bernanke & Co....

• Bloomberg's Vivien Lou Chen sees a "nimble" Fed navigating (certain) robust economic data and continuing concerns about housing and financial-market conditions.
• Robust economic data? Try these Q3 GDP numbers.
• MasterCard blows it out this morning. That's great for its shareholders, but this strikes us as another indication of consumers' ongoing rotation from mortgage equity withdrawal to revolving credit.
• For more on the role of revolving credit, see this bracing report from Fortune's Peter Gumbel.
• And for more on the imperative of credit expansion, see today's missive (and item #4 in particular)from Minyanvile's Kevin DePew.
• At the risk of raining on today's GDP/Fed parade, here's a reminder from Northern Trust's Paul Kasriel and Asha Bangalore that it's not all sweetness and light out there.
• The Case-Shiller Home Price Index shows no signs of turning higher any time soon, but as Calculated Risk points out, home price changes tend to be relatively sticky.
• In the November issue of Wealth Manager, James Picerno riffs on the resurgence/durability of beta in the theory and practice of portfolio management.

401(k) Workshop

We're brutally late posting this afternoon because we spent the day preparing for and conducting a 401(k) workshop for a fascinating group of professionals here in Madison. The point of the event was to help plan sponsors and various trusted advisors better understand (1) the true costs of the typical defined contribution plan, (2) the current legal and regulatory environment, and (3) the core characteristics of a genuinely fiduciary plan.

Based on the questions and comments we received today, it's clear that plan sponsors very much want to do the right thing for their employees...not to mention for their own very legitimate risk management purposes. Sponsors are interested in fiduciary concepts, recent legislative and regulatory changes, and developments in the financial services industry that are opening up impressive new options for defined-constribution plans. The point: The retirement plan marketplace is poised for significant change, and we don't think that change can come fast enough.

As we've written repeatedly in this space, the typical 401(k) plan, in which participants are presented with a menu of mutual funds and encouraged to do their best, is a badly broken model that screams out for fundamental reform.

That reform incorporates lots of details, but the central objective is incredibly simple: Deliver plans that give participants the highest possible likelihood of capturing long-term returns that are as close to the efficient frontier as possible (see adjacent chart from Investopedia, with apologies for the inappropriate apostrophe in "portfolios"; see also this July comment from Mercer Bullard to the DOL for a similar argument). What sort of plan would actually locate participants' long-term outcomes near the line indicating optimal returns for given levels of risk?

We think fiduciary plans--plans that live up to the principle and promise of ERISA itself--will feature relatively few investment choices, all of which are fully diversified, pension-caliber portfolios incorporating multiple asset classes through the use of inexpensive index-based vehicles.

ERISA, the Pension Protection Act of 2006, and Department of Labor rulemaking provide both general encouragement and specific safe harbor provisions designed to push plan sponsors into a more paternalistic stance relative to their employee-participants.

By adopting plans with true fiduciary characteristics, sponsors can simplify lots of lives (their own and those of their employees), save lots of money (after all, sponsors are participants too), and, most importantly, improve participants' long-term investment outcomes--and thus not only their standards of living in retirement, but in some cases their ability to retire in the first place.

The stakes here are very high. And the path forward is plenty clear to anyone who cares to dig underneath the veneer--and false security--of the status quo.

Bull and Bear Arguments Summarized

Last Thursday, Doug Kass used his Street.com column to describe his Wednesday appearance on Kudlow & Company. As usual these days, Kass is relatively bearish, but his piece provides a tidy collection of arguments--both bullish and bearish--concerning housing, the equity markets, and the macroeconomy. It's worth a look.

Monday Reading

Stan O'Neal memorial edition...

• Merrill's board has had enough.
• Late last week, Daniel Gross asked whether O'Neal should lose his job. The only answer that matters is in, of course. But Dan's column is still worth reading for its perspective on Wall Street's risk management practices. "For Masters of the Universe," Gross writes of O'Neal and Citi's Chuck Prince, "these guys proved to be remarkably fatalistic. As long as the market was demanding it, they believed they had no other choice put to keep dancing—to keep making loan commitments and to keep buying up mortgages to package into securities."
• MarketBeat's David Gaffen asks an apt question: Will replacing O'Neal matter?
• One more Merrill item: Yves Smith ruminates on the implications of O'Neal's now-infamous outreach to Wachovia:

"[N]o one seems to be reacting to the information content of O'Neal's move. Things look so bad for Merrill that calling, of all institutions, Wachovia, a domestic bank that has about zero in common with Merrill, and suggesting a merger, seemed reasonable. That is a move of sheer desperation, and everyone assumes it was desperation for O"Neal to save his severance package.

What if everyone has this wrong? What if O'Neal thought this was a reasonable move to save Merrill? This scenario says that, having finally gotten his arms around the dimensions of the problem, O'Neal thinks Merrill should make the best deal it can before things deteriorate further.

If that's what the phone call was really about, the people who ran Merrill's stock up today have got this badly wrong.

• Archival follow-up to our Thursday post on the fundamental problems with mutual funds: A 2004 interview with former Sen. Peter Fitzgerald (R-IL).
• Barry Ritholtz passes along part of Alan Abelson's Barron's column (and an absolutely astonishing photograph of a bear), with emphasis on the relative narrowness of the rally in the broad market averages, especially the Nasdaq 100:

[Kass] cites the Nasdaq 100's spectacular performance so far this year -- last we checked, it had shot up a cool 25%, or some 448 points -- as a startling illustration of how a few exceptionally strong stocks can give the impression of a big bull move. Of that roughly 25%, or nearly 450 points, gained by the Nasdaq 100, a whopping 230 points, or over half the index's rise, has come from just three issues: Apple (135 points), Research In Motion (60 points) and Google (35 points).

Back to the Future

Yesterday, Barry Ritholtz flagged an intriguing report from Merrill's Chief North American Economist David Rosenberg. It's a comparison of present financial/economic/market conditions with those of the late 1980s. Featuring some truly excellent charts, the entire report is worth reading. Here's a representative caption, from Chart 9:

This cycle is also hauntingly similar to the 1980s because of what happened to the housing market. Years of massive credit extension, overbuilding and "new paradigm" thinking of housing as an asset class ultimately morphed into a massive excess inventory overhang, eroding credit quality and house price deflation. We are reliving that today, except the deflation is much broader and the credit issues far more complex and global in nature.

Check it out.

Source

David Rosenberg and Neil Dutta, "1980s Redux?" Economic Commentary, Merrill Lynch, October 22, 2007

Friday Reading

With California's fires beginning to settle down and MSFT's report starting a new brushfire on Wall Street, it's time to do a little reading...

• As of this writing, crude oil is trading above $91/barrel. Barry Ritholtz summarizes the multiple forces behind this incredible move.
• $90+ oil? James Hamilton notes that it all boils down to those old standbys: Supply and demand.
• And Jeff Matthews connects the dots: The Fed, OPEC, and several telling tidbits from a few earnings conference calls.
• Could Microsoft be a growth stock again?
• Speaking of those California fires, some high-end homeowners appear to enjoy a little more protection than their neighbors.
• Jim Wiandt gets it right again: "The 401(k) market is a national embarrassment."
• The fine-grained fragmentation of the investment universe continues, as Barclays introduces several new exchange-traded notes (ETNs) in the commodities space.
• Investors' risk appetites may be relatively robust, but corporates? Not so much these days.

Thursday Miscellany

Some interesting and important stuff from around the web...

• Great news for retirement plan participants everywhere: The Department of Labor has decided to exclude stable-value funds from its definition of Qualified Default Investment Alternatives under the Pension Protection Act of 2006. (For our recent comment on this issue, click here.)
• Two super posts from Barry Ritholtz: (1) Not so fast with those September new homes sales! and (2) Can (should?) housing be rescued? (For our recent comment on the latter topic, click here.)
• Calculated Risk does its usual bang-up job on today's housing data here and here.
• More on the macro fallout from residential real estate, and the absurd orgy of leverage that got us here, from Yves Smith at Naked Capitalism.
• James Picerno has some interesting updates on correlations among major asset classes.
• Veryan Allen offers another reminder that investors should diversify not just within and across asset classes, but across investment strategies as well.