The Float

Headline PPI Up, Core Flat

This morning the U.S. Labor Department released its Producer Price Index numbers for March. Overall, the PPI rose one percent over February levels, while the "core" number, which excludes food and energy prices, was flat.

In year-over-year terms (comparing March 2007 to March 2006), the headline PPI jumped 3.2 percent and the core PPI rose 1.7 percent.

Why the big gap between the headline and the core? Energy prices were up 3.6 percent, with food rising 1.4 percent. A flat core number is the natural result of excluding the categories in which prices rose, but it's good to see the core elements behaving themselves.

How this affects Fed policymaking is the big question, of course, and there's plenty of speculation to be had from the usual suspects.

For our purposes, we think inflation tends to be a lagging indicator. If the recent spike in energy prices doesn't recede, however, higher fuel costs will either shrink corporate profit margins or pass through to consumers. Here's economist Brian Bethune of Global Insight, quoted in this morning's Bloomberg story: "Industries continue to suffer from significant cost pressures, but emerging slackness in many markets for final products will limit their ability to pass on effective price increases."

Sources

"Producer prices up 1 percent in March," Reuters, April 13, 2007

"INSTANT VIEW 3-U.S. March PPI, Feb trade deficit," Reuters, April 13, 2007

Shobhana Chandra and Joe Richter, "U.S. Economy: Producer Prices Rise; Trade Gap Shrinks," Bloomberg, April 13, 2007

Subprime: Contained? Or Contagious?

It's the big question these days on Wall Street and Main Street alike: Will problems in the subprime mortgage market drag the U.S. economy down? If so, when? And how severely?

Yesterday, Jim Christie of Reuters suggested that the subprime meltdown shouldn't have much impact on the broader housing market or the national economy. "Subprime mortgages to less creditworthy borrowers comprised only 13.7 percent of outstanding U.S. mortgage debt in the fourth quarter of 2006," Christie writes, "and their delinquency rate was 13.3 percent, according to the Mortgage Bankers Association."

That's fine, as far as it goes, but we think we have yet to see the full effects of the general downturn in housing, let alone the continuing problems in the subprime market as millions of adjustable-rate mortgages reset to significantly higher levels over the next several months. With subprime borrowers taking out roughly 40% of all mortgages over the last year, as Christie notes, we think this problem has legs, even if, narrowly defined, it's a relatively small part of the overall U.S. credit market.

Let's put all this back in perspective. Here's what we wrote about the housing market on March 26:

In supply-demand terms, we have excess supply (in the form of significant inventories, though as always with housing the details vary from region to region) and shrinking demand (wary and increasingly patient buyers, tightened lending standards removing would-be buyers from the demand side, and the disappearance of speculative buying). That's a pretty straightforward formula for falling prices, especially in areas where prices have risen the most over the last several years.

Yesterday, even the National Association of Realtors conceded this reality. The Bloomberg story on the NAR's (reluctant) announcement opened like this:

The subprime loan "debacle" will make it more difficult for borrowers to get mortgages and will cause U.S. home prices to fall this year for the first time on record, the National Association of Realtors said.

The key element in all this is lending standards. It was ever-loosening standards that got us here in the first place, and it may be tightening standards that carry us out. But just as a higher minimum wage tends to ripple up through the wage scale, tighter lending standards in the subprime market could tighten things across the board as less demand for credit pushes interest rates higher.

The point here is not that subprime contagion will wreck the entire economy. We just think it's inaccurate--or at the very least too soon--to say the problem is small and therefore inconsequential.

Sources

Jim Christie, "Subprime mortgage market woes seem well contained," Reuters, April 11, 2007

Kathleen M. Howley and Sharon L. Crenson, "Subprime 'Debacle' Will Delay U.S. Housing Recovery," Bloomberg, April 11, 2007

Cutting Through the Confusion

Following up on yesterday's post, we recommend "Cutting Through the Confusion," a short report published by the Coalition on Investor Education* and available at the North American Securities Administrators Association website.

This excellent publication clarifies the distinction between investment advisors and brokers, describes the primary means of paying for financial services, and offers a list of questions investors should ask before hiring a financial professional. Though we encourage you to read the whole thing (again, it's short), these are a few questions you should ask before signing up with a service provider:

1. What services do you offer?
2. What qualifications do you have to offer those services?
3. How do you charge for those services? Do you receive compensation from other sources if you recommend that I buy a particular stock, mutual fund, or bond?
4. Would my account be an advisory account or a brokerage account?
5. Are you required by law to always act in my best interests? Will you put that commitment in writing?
6. What potential conflicts of interest do you have when recommending investment products to me, and will you disclose those conflicts?
7. Will you provide me with a written record of any disciplinary history for you and your firm?
8. Will you give me your Form ADV (the registration form that must be filed by investment advisers) and/or your Form U4 (the registration form used by persons who work with brokers)?

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*Member organizations in the Coalition on Investor Education are the Consumer Federation of America, the North American Securities Administrators Association, the Investment Adviser Association, the Financial Planning Association, and the CFA Institute.

The Fiduciary Difference

Lots of news and views lately on the apparent judicial demise of the SEC's so-called "Merrill Lynch Rule," which exempted brokers from the fiduciary duties and disclosure requirements of the Investment Advisers Act of 1940.

Last night at Marketwatch, Thomas Kostigen offered his perspective on this story in his Sophisticated Investor column. Here are a few key passages:

The U.S. Court of Appeals for the District of Columbia ruled March 30 that the Securities and Exchange Commission doesn't have the authority to allow some brokers to sidestep regulation as investment advisers....

Investment advisers adhere to a different set of standards than the transaction-oriented broker, or registered representatives, as they are known in the financial services industry. Investment advisers are mandated to provide advice that is in the best interest of a client. They can't recommend an investment product strictly for the purposes of a sale....

Registered representative brokers, however, could until now sell investment products that were in their best interest (say a higher-paying commission product) instead of in their client's best interest.

This is probably why more wealthy people have chosen investment advisers to manage their money. Can you trust that a broker employed by a large Wall Street brokerage firm is selling you the right type of investment product for your portfolio or is merely trying to make a buck?...

The brokerage industry says this is doing the client a disservice because brokers can offer advice on whether some products may be more appropriate or better than others and they should be allowed to speak up. However, the brokerage industry doesn't want the liability that goes along with the role of dispensing that advice....

If the brokerage industry bucks the new ruling, which is a good bet, then people should look for investment advisers who are fiduciaries.

The brokerage houses are in a tough spot here. Fee-based "advisory" accounts have become enormous revenue centers for companies like Merrill, Morgan Stanley, Smith Barney, major banks, and insurance companies. Shifting back to a transactional, commission-based business model seems very unlikely. Fuller disclosure--true disclosure--of brokers' potential conflicts of interest would problematic for the big brokers as well. But assuming fiduciary responsibility for the actions of huge sales forces--some of whom, to put it bluntly, are not especially sophisticated or well-trained*--would expose these firms to tremendous litigation risk. We'll be fascinated to see how the corporate players handle these difficult trade-offs...and the PR risk of saying "No thanks, we don't want to be forced to act in our clients' interests."

Regardless of how all this plays out, independent firms like Interlake will retain an important distinction. Rather than fight it, as the big brokers have, we welcome our fiduciary duty, because it's the right way to do business and because it assures our clients that our interests are fully aligned with their own.

We'll have more on all this in future posts, including some interesting research findings on public understanding of the broker/advisor distinction. (UPDATE: We describe those findings briefly in this post.)

For another take on this story, see William Barrett in Forbes.

*We want to be clear here: Many brokers are sophisticated, effective investment professionals. From experience, however, we can tell you that their employers are much more interested in training them to sell than they are in training them to manage money responsibly.

Sources

Thomas Kostigen, "Trust is a must: Where rich people go for advice, and why," Marketwatch, April 10, 2007

William P. Barrett, "Is Your Broker an F-Word (Fiduciary)?" Forbes, April 9, 2007

Excesses of the ETF Gold Rush

Forbes ran this piece a couple weeks ago, but we just found it today and we think it's worth a look. Behind all the snark is a very good point about excessive specialization and funkiness in the world of exchange-traded funds (ETFs). In fact, this point is so good, we've made it ourselves! Here's a passage from our website's discussion of recent developments in the ETF marketplace:

The ETF category is expanding rapidly, and, as usual when there's money to be made in a given product line, many new ETFs leave much to be desired: too specialized, too expensive, too trendy, and too late.

Yes indeed. Now the key passages from Megan Johnston and Michael Maiello in Forbes:

It's hard to keep track of all the new exchange-traded funds being sold today, and by all indications a lot of people aren't. At last count there were 407 ETFs, roughly double the number from a year earlier. Many new ETFs are languishing on the exchanges because nobody really wants to trade them....

That means the marketing gurus behind these tenuously assembled baskets of securities are going to have to get creative. That’s too bad, because they've already delved into the realm of the absurd....

In the rapid flow of new offerings, ETF sponsors often sell the flavor of last month.

We think that's all exactly right. We believe strongly in the benefits of ETFs, especially relative to conventional mutual funds. But it's important to remember why these vehicles attracted so many professional and individual investors in the first place.

In some ways, ETFs represent the cutting edge of the investment world. (At Interlake, we think they're better mousetraps in pretty much every way that matters.) But that cutting edge may cut in the wrong direction if it strays too far from the tried-and-true principles of low expenses, tax efficiency, and broad diversification.

Source

Megan Johnston and Michael Maiello, "Beware: Exchange-Traded Freaks," Forbes, March 27, 2007

A New Interlake White Paper

From time to time, Interlake Capital Management will publish White Papers on various topics in money management and personal finance. Longer and more in-depth than our typical blog posts, these White Papers will be available here at The Float (over in the right-hand column) and on the Suggested Reading page at the Interlake website.

Today, we're pleased to offer our first White Paper: "The Logic of Paying for Good Professional Help," which explains the nature and impact of fees and expenses in the financial services industry. We think high-caliber investment guidance is itself a good investment, and we hope the framework presented in this White Paper helps our readers invest in the right kind of professional help.

As always, we welcome your feedback.

Expectations of Profit Growth Falling

In the Sunday New York Times, Paul Lim writes about the significant decline in expectations for year-over-year profit growth at S&P 500 companies. Over the last few years we've seen consistent, record-setting, double-digit profit growth for U.S. corporations. Since the 2001 recession, economic growth and increasing corporate efficiency have kept profit levels soaring.

Now, however, with the "first derivative" of profit growth (i.e., the rate of change in the rate of change) falling, we'll be watching for indications of material disappointment in the upcoming earnings season. On the other hand, given the diminished expectations shown in the figure to the right, we may actually get a few positive surprises relative to those expectations. On balance, we're cautious because the overall trajectory in profit growth will almost surely be down.

Another less-widely-appreciated factor in recent market strength has been the shrinking supply of stock itself. As Justin Lahart writes in today's Wall Street Journal, massive share buybacks and a seemingly relentless pace of buyouts (by other corporations and by private equity) have reduced the total supply of equities. As in any other market, stock prices are driven largely by supply and demand. Without a reduction in demand, a reduction in supply should drive prices higher. We think this reduction in supply has been a major factor supporting higher stock prices over the last couple years. (Note the net negative issuance of U.S. equities in the figure to the right.)

One problem with these buyback- and buyout-driven reductions in supply is that they reflect a kind of financial engineering, making earnings per share rise faster than operating earnings themselves. Three more problems noted by Paul Lim in the Times:

1. With so many shares in the corporate treasury, companies can inject new supply into the market just as easily as they bought their shares back in the first place.
2. Share buybacks necessarily come at the expense of investment in business expansion. This trend may feel good in the short run, but if it comes at the expense of future growth, the longer-term effects will be much less positive.
3. The buyout boom will saddle most targets with significant new debt, much of which will remain with these companies when their private equity buyers take them public again.

We'll have more on these topics in the days and weeks to come.

Sources

Paul J. Lim, "A Caution Signal on Profits. A Red Light for Stocks?" The New York Times, April 8, 2007

Justin Lahart, "Shares Head To the Sidelines: At What Cost?" The Wall Street Journal, April 9, 2007 (subscription required)