The Float

More Caution on (Some) New ETFs

Today's Wall Street Journal features an interesting piece on the relationship between fast-disappearing trading-floor "specialists" and fast-appearing new exchange-traded funds. Here are the opening paragraphs from today's story:

The rapid disappearance of stock-exchange trading floor "specialists" is starting to hurt the booming exchange-traded-fund business.

Specialists are the elite traders who, for many years, have helped maintain orderly trading amid the chaos of the floor. Now they are a vanishing breed as electronic trading gains acceptance -- the New York Stock Exchange has seen its specialists decline more than 30% since last year.

That is bad news for ETFs, which resemble mutual funds but trade on an exchange like a stock. Specialists have a unique role in bringing ETFs to market: Unlike regular stocks, which raise money through initial public offerings, ETFs historically have relied on specialists to provide "seed capital" to launch.

Within the ETF industry, the lack of specialist seed funding is becoming one of the most talked-about problems.

"It used to be if you have a good idea for an ETF, you'd have specialists competing for your products," says Morgan Stanley ETF analyst Paul Mazzilli. "Now you're begging for them" to help with seeding, he says.

Let's emphasize something important: The problem here is not with ETFs in general, and in particular not with larger, more established ETFs, which continue to enjoy the excellent liquidity, low expenses, tax efficiency, and trading flexibility that make them such attractive investment vehicles. The problem is with the rush of new entrants into the ETF space over the last year or so. And with a few hundred more ETFs on the drawing board...well, this could be a problem for funds that might have a tough time launching...and staying aloft.

We've written before (here, here, and here) on the potential problems created by the flood of new ETFs, some of which reflect the (understandable/inevitable) money-making impulse more than than sound investment logic. Today's Journal story gives us another reason to be wary of gratuitous new ETFs even as we continue to enjoy the benefits of their established predecessors.

Source

Author, "ETFs Suffer as 'Specialists' Wither Away: Elite Traders Provide Seed Money for Funds; Seeking Alternatives," Wall Street Journal, June 1, 2007 (subscription required)

"The Butler Boom"

This isn't exactly stop-the-presses material, but wealthy Americans are wealthier and more numerous than ever. With entrepreneurial and IPO-/stock-driven success creating tremendous amounts of "new money," the adjustment to wealth and everything that comes with it has created a range of telling sociological developments.

Enter Robert Frank, the author of The Wall Street Journal's regular "Wealth Report" column (and blog), and now author of Richistan: A Journey Through the American Wealth Boom and the Lives of the New Rich. Today's Journal excerpts a chapter on a revealing growth industry: butlering. Here's a key section:

Most of the students live in the Starkey mansion during Boot Camp, following Starkey's strict rules. Everyone has to wear the uniform of khakis, crisp white shirts, blue blazers and brown shoes. First names are banned; everyone is "Mr." or "Ms." to stress the importance of boundaries with their future employers. The students are required to rise from their seats every time a visitor enters the room. If there's a coffee cup that needs filling, a spoon that needs polishing or a visitor who needs welcoming, the Starkey students must spring into action. The Starkey students are so wired for service that when a class break is announced, they all pounce from their seats to fill each other's water glasses and coffee cups.

Most importantly, they learn never to judge their rich future employers, whom they call "principals." If a principal wants to feed her shih tzu braised beef tenderloin every night, the butler should serve it up with a smile. If a principal in Palm Beach, Fla., wants to send his jet to New York to pick up a Chateau LaTour from his Southampton cellar, the butler makes it happen, no questions asked.

Starkey students pay more than $12,000 for Boot Camp. While that may sound steep, a good Starkey graduate can start at $70,000 to $120,000 a year, not to mention free room and board. And butlering has become one of the fastest-growing occupations in the United States after more than a half-century of decline, driven by the greatest surge in American wealth in nearly a century. Over the past 10 years, the number of multimillionaire households has more than doubled. As of 2004, there were more than 1.4 million U.S. households worth at least $5 million and more than 530,000 worth more than $10 million, according to the Federal Reserve.

This is fascinating stuff, but the really interesting material concerns the ways in which those who grew up in the broad middle class adjust to the new realities of massive wealth. Here's an example that captures it all:

Bob still has moments when he wonders how his life got so complicated, with a home that's more like a company.

"The other day we saw a mouse in the house. Before, I would have just gotten a broom and gotten rid of the thing. But now it's different. I emailed the household manager. He called the vendor, a pest-control firm, and the pest-control firm caught the mouse. Then the household manager directed two other staff members to dispose of the mouse. That's five people to catch a mouse. It all seemed normal at the time. But then I thought about it, and I wondered, how did our lives get like this?"

Source

Robert Frank, "The Butler Boom: Wealth Explosion Sparks Labor Shortage; Starting Pay, $70,000," The Wall Street Journal, June 1, 2007 (subscription required)

Friday Data Flow

The first day of June brings a torrent of economic data: Payroll numbers, personal consumption expenditures, Michigan consumer sentiment, and an Institute for Supply Management report. Let's review:

• Like monthly housing data (and many other time series, for that matter), payroll numbers are a little slippery (due to Labor Department sampling and birth/death adjustments) and are always subject to later revision. But today's 157,000 is a decent number.
• Those jobs numbers aren't stunningly great, but they seem especially positive in the context of a tame April PCE number (up just 0.1%) and a 12-month PCE increase of just 2.0%. That's the good news in today's Commerce Department report. Not as encouraging: Adjusting for taxes and inflation, real disposable income fell 0.4%, the first decline in a year.
• Again laughing in the face of higher gas prices and a weakening job market, consumers surveyed by the University of Michigan continue to be a relatively confident bunch: The Michigan consumer sentiment index rose slightly over April levels, though slightly less than the initial mid-May estimate (which may suggest some marginal effect of spiking gas prices later in the month, but the effect appears small-to-nonexistent in these data).
• May ISM numbers were up slightly from the April reading, at the highest levels since April 2006...all of which suggests reasonable strength in manufacturing. Note, however, that the strongest job-growth sectors in the payroll report were all service-oriented.

Looking past all the details, what we see here is a remarkably flexible, adaptable, resilient American economy. We're concerned about rising consumer debt, a weak--and still weakening--housing market (with all its potential spillover effects for jobs, equity withdrawal, and consumer spending), high food and energy prices, and, of course, the slow GDP growth of Q1 2007. None of that is trivial, to say the very least, but for now the macro picture continues to look relatively encouraging.

UPDATE: Let's not get carried away with today's enthusiasm. Here's Barry Ritholtz with a bracing, must-read reminder that those things we just said we're concerned about...really matter.

Sources

Greg Robb, "Payrolls rebound in May: Jobless rate holds steady at 4.5%," Marketwatch, June 1, 2007

Rex Nutting, "Core inflation falls back to Fed's comfort zone: Personal incomes fall for first time in 20 months," Marketwatch, June 1, 2007

"May consumer sentiment rises," Reuters, June 1, 2007

"Dollar hits 7-week highs vs euro after ISM data," Reuters, June 1, 2007

Learn from Harvard's Endowment Manager

Here's a brief but excellent overview of investing, global markets, and risk management from Mohamed El-Erian, who manages the $30+ billion Harvard University endowment. One highlight where El-Erian makes a point we've been wanting to make ourselves:

Q: The U.S. market has been doing well this year, the S&P is over 7 percent, the Dow has hit some new highs. Is there anything we need to be wary of?

A: Yes. There's the increasing risk of sudden, sharp pullbacks. This occurred in May-June of last year, and in late February of this year. The corrections were technical in nature. We're likely to see more of them going forward as a growing number of hedge funds and other "fast money" investors rely on what I call "just-in-time" risk management approaches.

Instead of taking chips off the table gradually as prices go up, there are now all these sophisticated derivative-based instruments that encourage investors to "wait for the market turn." That's why you get S&P falling 4 percent in one day when nothing has really happened.

And the declines are inevitably broad-based and seemingly indiscriminate. Individual investors need to try to remain calm in order to minimize the risk of selling at the wrong time - instead try to have the right mindset, assess the situation, and be able to weather it out as long as the underlying economics remain sound. Because going forward, these technical selloffs will likely be a more frequent fact of life in the market.

That's important stuff. We encourage you to read the whole thing.

Source

Marcia Vickers, "Global guru: The head of Harvard's $30 billion endowment talks about investing, the market, and the global economy," Fortune, May 31, 2007

The Plot Thickens

Interesting news flow over the last couple days.

Yesterday, we learned that Pulte Homes will cut roughly 16 percent of its workforce--on top of already-announced job cuts. Here's Pulte's CEO Richard Dugas, Jr.: "The homebuilding environment remains difficult and our current overhead levels are structured for a business that is larger than the market presently allows." That's pretty straightforward stuff. As we wrote on Tuesday, the unwinding of housing appears likely to continue for some time.

Then this morning the Commerce Department reports revised first quarter GDP growth of 0.6 percent, slightly below consensus expectations (which pegged the revision at 0.8 percent). Inventories fell and the trade gap widened, but the conventional wisdom is that tighter Q1 inventories will encourage a kind of catch-up production in Q2. Here's an optimistic take on the macro situation. And here are a few more reactions to this morning's economic news.

Of course yesterday's headlines were dominated by the S&P 500 finally surpassing its all-time closing high from March, 2000. Add in dividends and subtract inflation and we're pretty darn close to where we started seven years ago.

You don't need us to tell you that the last year has been an unusually robust period for the broad averages. We think the path of least resistance is still higher...especially with continuing M&A activity such as Wachovia's takeout of A.G. Edwards. We'll be watching for signs of weakening breadth as mega-cap names take the lead from the smaller end of the market, but yesterday's shake-off of the China pullback suggests that this bull still has some life left in it.

Sources

"Home builder Pulte Homes says needs to cut more jobs," Reuters, May 30, 2007

"First quarter growth weakest in over 4 years," Reuters, May 31, 2007

Joanne Morrison, "Economy may have seen worst of slowdown," Reuters, May 31, 2007

"INSTANT VIEW 3-U.S. Q1 GDP revised to +0.6 pct," Reuters, May 31, 2007

Alexandra Twin, "Record day on Wall Street," CNNMoney.com, May 30, 3007

"Wachovia to buy A.G. Edwards for $6.8 billion," Reuters, May 31, 2007

Reading the M&A Tea Leaves

Yesterday's Wall Street Journal featured two important perspectives on the ongoing boom in private equity and M&A. (See previous posts on the topic here, here, and here).

In his "Ahead of the Tape" column, Justin Lahart notes low corporate bond yields have been a driving force behind all this activity (including share buyback programs). The logic here is simple: Borrowing is cheap and easy because investors have bid up prices (and thus driven yields down) over the last few years.

Check out the significant decline in mid-quality corporate bond yields in the chart to the right. Lahart observes that even as yields have fallen, corporate earnings have risen and the broad market has returned to roughly its March 2000 levels. In those seven years, the market's price-to-earnings multiple has fallen from roughly 28 to 16.

If borrowing is easy and shares are (relatively) cheap, the logic of the recent private equity/M&A boom is straightforward. "Debt is being issued for the purpose of buying stocks," writes Lahart, "and that's driving up stock prices."

Naturally, there's always (or at least there should be) concern when conditions seem so right for so long. Here's Lahart: "If the corporate bond market is driving stock prices, what happens if the bond market gets into trouble?"

Which leads us to Henny Sender's piece, just across page C1. "It would be a fool's game to predict the end of the private-equity buying frenzy, but certainly some signals are there," writes Sender.

If major players in private equity move the smartest of the smart money, this piece is at least cautionary.

Carlyle Group co-founder David Rubenstein at the same conference also was bearishly looking ahead. "There hasn't been a failure for five years. We need to prepare people for the reality that some deals will fail," he said. He added: "Greed has taken over. Nobody fears failure."

Caution on the part of even some of the players could be bearish for stocks, coming at a time when one of the biggest supports for the stock market is the assumption that private equity will buy bad companies because they are inexpensive and good companies because they are good. Should private-equity firms pull back, that support could vanish.

Some analysts say that without a widespread belief in the appetite of LBO firms for publicly traded companies, stock prices would be far lower.

Not long ago, a buoyant stock market would hardly have paid heed to the views of private-equity firms. No longer. At $281 billion, U.S. private-equity deals have more than tripled from a year ago, accounting for 35% of all mergers and acquisitions, up from about 16% last year, and most of them involve publicly traded targets, according to data from Thomson Financial.

But it isn't necessarily time to run for the exits, as Sender notes.

The industry has seen this divide before. Some private-equity firms pulled back in the second half of 2005, only to regret the decision as the debt markets threw money at their braver counterparts.

From our perspective, the diverging views Sender describes are probably healthy. After all, a little creative tension between bulls and bears makes for functioning capital markets.

But ultimately, we come back to Lahart's point. Can the debt markets keep it up? For how long? If not forever (and we know nothing is forever), what will crash the party? When?

UPDATE: We missed this yesterday, but over at the Marketbeat, David Gaffen cites Citigroup's Tobias Levkovich on the question of shrinking equity supply:

Tobias Levkovich, head of equity strategy at Citigroup, has a nice primer on just how the private equity boom is boosting stock prices, pointing to data showing that the rate of new equity issuance is currently contracting at an annualized rate of about 6%.

This is similar to the late 1980s, when equity issuance contracted at a seasonally adjusted annual rate anywhere from 4% to 7% between 1984 and 1989 – which is part of what fueled the market’s rise at that time.

The cash given to shareholders, replaced by debt issued by private equity buyers, is then redeployed into the market. "M&A activity generally peaks one year before equity markets top out because of the cash-redeployment requirement," he writes.

Sources

Henny Sender, "Private Equity: Is Deal Frenzy Nearing End? Big Firms Split in Views Over Pace of Buying; Stock Prices May Suffer," Wall Street Journal, May 29, 2007 (subscription required)

Justin Lahart, "The Mismatch in Stock Price, Corporate Debt," Wall Street Journal, May 29, 2007 (subscription required)

Shanghai Pulls Back

With the Shanghai Stock Exchange Composite off 6.5 percent today, memories of late February come rushing back. But the reaction this time appears much more muted. Overnight, the Nikkei 225 shed only 0.5 percent and, at the moment, anyway, the U.S. market has bounced off its opening lows. What's different this time? This Reuters story offers a few clues. It's worth a look, especially if you're interested in what distinguishes the Chinese market from other world bourses--and how those differences affect our perspectives on what happens in Shanghai.

Note: We've written here and here on the amusing/unsettling characteristics of the latest run-up in Chinese shares.

Source

Jeffrey Hodgson and Ian Chua, "Latest China stock dive lacks global punch," Reuters, May 30, 2007

Milo Gets It Right

We've written several times on the broker-advisor distinction and the importance of fiduciary principles and practices in delivering top-flight financial services. (Our posts on the topic are here, here, here, and here.)

This weekend's Wall Street Journal featured a no-nonsense letter from Milo Benningfield, a San Francisco investment advisor. We think Milo's right on target, and we've reproduced his letter in its entirety:

Please don't blame the SEC for forcing consumers to abandon fee-based brokerage accounts ("SEC Decision Forces Investors to Make Choice," Personal Journal, May 17). Blame the brokerage firms themselves for their continued refusal to allow their registered representatives to assume the two fundamental responsibilities imposed by the Investment Advisors Act of 1940: the fiduciary duty to put a client's interest before one's own and the duty to disclose conflicts of interest to the client.

It would seem fairly straightforward to require anyone advising a client on, say, an investment decision affecting their life savings to have to put that client's interest first. But the some 600,000 stockbrokers in the U.S. today have no such duty. Rather, they have only to satisfy a vague, minimal standard of "suitability" when making investment recommendations. By contrast, the approximately 40,000 Registered Investment Advisors must satisfy the far more stringent--and fair--fiduciary duties imposed by the IAA.

The brokerage firms need only accept these fiduciary duties themselves in order to allow customers to keep their fee-based accounts. Unfortunately, the firms continue to cling to their minimal "suitability" standards while doing as much as possible to look like true Registered Investment Advisors. (Have you met anyone recently who actually called themselves a stockbroker, rather than a financial advisor, financial consultant or the title of the day, wealth manager?) The result is an uneven playing field and a very unfortunate one for the investing public, who, of course, are the ones most likely to trip on it.

Milo Benningfield

That's important stuff. We encourage our readers to think seriously about what it means for the industry and, more importantly, for their own financial affairs.

Sources

Milo Benningfield, "Blame the Brokers, Not the SEC," Letter to the Editor, Wall Street Journal, May 26-27, 2007 (subscription required)

Jane J. Kim and Eleanor Laise, "SEC Decision Forces Investors To Make Choice," Wall Street Journal, May 17, 2007 (subscription required)

Real Estate Continues to Unwind

Back on Thursday, we noted that new home sales picked up in April in response to dramatically lower prices (the April median price fell 10.9 percent from a year earlier). Then on Friday, the National Association of Realtors reported that sales of existing homes fell to the slowest pace since 2003.

Here are three key paragraphs from Sudeep Reddy's summary piece in the weekend Journal:

The 2.6% decline from March, to a seasonally adjusted annual rate of 5.99 million homes, followed a revised 7.9% drop in March. April's sales rate was down 10.7% from a year earlier, figured from the National Association of Realtors showed.

The number of existing homes for sale jumped 10.4% at the end of April to 4.2 million, equal to 8.4 months' worth of sales at the current selling rate, up from 7.4 months in March. The unsold properties relative to sales hit a 15-year high.

The median home price in April of $220,900 was just 0.8% below the year-earlier level. The media price can be misleading because the mix of sales between higher- and lower-priced homes changes. Lately, there may have been fewer sales of cheaper homes because of the huge drop in subprime lending. That would tend to skew the media higher, suggesting home prices may actually be declining more than the reported median suggests.

The most telling fact: bloated inventories, which go straight to the heart of supply and demand in the real estate market. Sellers will have to adjust to this environment by waiting patiently, reducing prices, or taking their properties off the market.

Monthly real estate data (especially on new home activity) are notoriously volatile and thus subject to significant amendment. But the overall picture in real estate is clear. There's a big overhang in excess inventory, and the unwinding of the housing market isn't anywhere near finished.

All of which--especially in the face of spiking gas prices--makes today's consumer confidence number all the more remarkable. It seems the American consumer is as close to an unstoppable force as we can find in the economic realm.

UPDATE: Barry Ritholtz draws our attention to a Bloomberg story on just how deep and lasting the pullback in residential construction might turn out to be. Here are the key passages:

New home construction in the U.S. may take until 2011 to return to last year's level, said David Seiders, chief economist for the National Association of Home Builders in Washington.

Monthly construction starts would need to jump by 21 percent to reach Seiders's benchmark for full recovery, which is 1.85 million. There were 1.53 million in April, the Commerce Department said. At the height of the five-year housing boom in January 2006, construction began on 2.29 million homes.

"We've fallen way below trend because we soared way above trend during boom times,'' Seiders said in an interview. "The upswing will be relatively slow, unlike earlier cycles.''

The inventory of unsold homes is the largest since the Chicago-based National Association of Realtors started counting them in 1999 and house prices have suffered the steepest drop since the Great Depression, according to the realtors' group. Defaults and foreclosures also may rise as about $650 billion of loans to subprime borrowers, those with poor or limited credit histories, reset at higher interest rates by 2009.

Sources

Sudeep Reddy, "Home Prices Could Soften as Sales Decline," Wall Street Journal, May 26-27, 2007 (subscription required)

"Consumer mood rises, as does inflation fear," Reuters, May 29, 2007

Bob Ivry and Brian Louis, "U.S. Home Construction Bust May Last Until 2011," Bloomberg, May 29, 2007