The Float

Friday Reading

Will this morning's jobs release turn into a before-and-after moment? Looks like we'll want to stay tuned...

• If you read only one thing today, read this superb analysis of residential investment and lags in the macroeconomy at Calculated Risk.
• The August non-farm payroll release may make yesterday's semi-hawkish Fedspeak inoperative.
• The Wall Street Journal's Real Time Economics blog has several economists' responses to this morning's jobs report.
• There's an emerging reality for would-be retirees: Don't. At least not fully. But of course there are two realities for the "un-retired": (1) a voluntary, still-thriving, contributing-skills-and-knowledge un-retirement and (2) an involuntary, struggling, not-enough-saved un-retirement. Those versions could hardly be more different in what they mean for individual workers, the economy, and our society.
• Remember the claims of private equity and hedge fund masters of the universe that taxing their income as income would hurt the little people (i.e., the teacher/firefighter/student beneficiaries of pension and endowment funds)? Don't believe the hype.
• Speaking of: this news item can't be helping the PE/hedgie cause.
• When Michael Lewis strikes, his rhetorical prey is in deep trouble.

Jobs and the Fed

Last Tuesday, we suggested that Wall Street's burning desire for a Fed rate cut might reflect a misjudgment of just what would compel Bernanke & Co. to change policy. Here's what we wrote on the 28th:

Financial and economic conditions sufficiently bad to compel a cut in the fed funds rate may be bad enough to swamp the effects of such a cut.

Alas, this morning's incredibly ugly jobs report seems consistent with that view.* Here's the parade of horribles: A loss of 4,000 jobs in August, revisions that took June and July numbers down by 81,000 jobs, an average of only 44,000 jobs per month over the last three, and, perhaps most ominously, an unemployment rate that remained at 4.6% only because 340,000 people left the active workforce.**

Over the last few months, Bernanke has clearly signaled that he wasn't interested in sending monetary policy to the rescue of asset prices. We think that instinct was (and is) sound. But at this juncture--with housing trending lower, credit markets unfrozen but impaired, and core inflation readings (barely) within the Fed's comfort zone--there's clearly reason to expect a policy change on September 18th.

The question now is whether the Fed's blunt instrument*** will be enough to counteract the economic weakness that continues to flow from residential real estate, which, after all, is where trouble began several months ago.

~~~~~~~~~~~~~~~~~~~~

*No doubt: The initial monthly BLS numbers don't constitute the world's most reliable data series, but there's no way around the weakness of today's release.

**Note that the broader "not in labor force" category jumped by 592,000.

***By blunt we mean imprecise and heavily lagged, with full economic effects (as distinct from potentially faster-acting psychological effects) manifesting themselves several months after a given change in monetary policy.

Source

Bob Willis, "U.S. Employment Declines for First Time Since 2003," Bloomberg, September 7, 2007

A Little Afternoon Poetry

It's true. We're suckers for a well-turned phrase. So we had to smile when CNBC's Steve Liesman gave us this just after noon today:

Here's what we know now. We thought that the greatest asset of our new derivatives-driven financial system was that risk was comfortably spread widely. Now we know our greatest liability: Risk is uncomfortably widespread.

That's good stuff.

Asset Allocation and Rising Correlations

Strategic asset allocation is a large part of our business and has rightly earned a prominent place in the firmament of High Money Management. One core assumption behind diversification across asset classes is that those asset classes will demonstrated relatively low levels of correlation (or, to be more precise, covariance). When A is down, the theory goes, B will be up (or down less, or in any case somehow independent of A). Rooted in modern portfolio theory, the point here is not only to reduce portfolio volatility and risk, but to achieve the maximum possible return for a given level of volatility and risk.

But like everyone else on and around the Street, we've noticed an apparent rise is correlation among several major asset classes in recent months and years, with the financial markets' Summer squall demonstrating this development in stark terms.

In the chart at right, you can see year-to-date performance for six major asset classes: U.S. equities (blue line); international equities (red line); emerging market equities (black dashes); U.S. bonds (green dashes); U.S. REITs (gold line); and commodities (pink line). Note that you can click on the chart to see a larger image.

The obvious exceptions to the relatively tight correlations on display in this chart are domestic fixed income (which held relatively steady, with Treasuries outperforming corporates) and REITs (which underperformed other asset classes after their January spike and still took a big hit in late July along with nearly everything else).

Look at the YTD numbers for U.S. and international, stocks, commodities, and fixed income: the range runs from 2.35 to 6.51% (not including dividend and interest payments, which would tighten the range even more).

Now take a look at the mid-July to mid-August period of maximum market stress. With the clear exception of fixed income and the partial exception of commodities, asset values deteriorated in near-lockstep, falling 10 to 15% from peak to trough. 

We see three primary implications of all this.

First, it's not at all obvious that correlations will remain elevated, so the point is definitely not to abandon strategic asset allocation. And even if correlations have risen, they're still well short of one, so there's still value in diversification across asset classes.

Second, the inclusion of historically unorthodox (but increasingly widely-held) asset classes such as commodities has probably become more important for individual investors. Which isn't to say commodities will definitely outperform, just that they're marginally more likely to perform differently.

Third, we think it makes more sense than ever to seek out non-correlated strategies as a complement to increasingly correlated asset classes. Whether it's through hedge funds, non-traditional mutual funds, separate account managers, or some other mechanism, the risk-return optimization of modern portfolio theory increasingly calls for diversification across strategies as well as asset classes.

If you're interested in reading more on the dilemmas created by rising correlations, we recommend James Picerno's thoughtful piece in the latest issue of Wealth Manager. 

Source

James Picerno, "Decisions, Decisions...," Wealth Manager, September, 2007

The Blame Game

When things go haywire, fingers start pointing. And this piece from Fortune's Peter Eavis is worth reading not only on its analytical merits, but for the very excellent pointing-finger icons used to assign various levels of blame for the subprime-induced credit squeeze.

The blamed: borrowers, mortgage brokers, appraisers, mortgage lenders, Wall Street, rating agencies, and (most of all, for Eavis) the Fed.

For what it's worth, we think Eavis gets the fingers just about right. In general, our belief in fiduciary standards of care (which we think responsible financial professionals should apply even when not required by law) leaves us assigning more blame to those working in the involved industries who did know better but got carried away by greed and euphoria...and ended up buring lots of people along the way.

That's not to say borrowers are blameless. Not at all. But there, too, it's important to distinguish between (1) sophisticated speculator-flippers who should have known better and got burned and (2) naive, aspiring, first-time buyers who didn't have the wherewithal to know better...and got burned. It's that latter group where the application of fiduciary principles would have saved untold expense and grief.

UPDATE: Expense and grief? Here's what that looks like, and it's not a pretty picture.

Source

Peter Eavis, "Subprime: Let the finger-pointing begin!" Fortune, September 6, 2007

Amy Hoak, "New foreclosures set record in latest MBA survey," MarketWatch, September 6, 2007

The High-Stakes Battle Over QDIAs

Back in June, we argued that variable annuities have no legitimate place in defined contribution plans (see our take on the 401(k) market here and part 2 of W. Scott Simon's devastating 5-part indictment of variable annuity products in 403(b) plans here). Insurance products have an important role to play in many parts of our lives. But they do not belong in defined contribution plans.

Nevertheless, as we can see in the current battle over the definition of default investment options in defined contribution plans, the insurance industry has a hard time taking no for an answer.

In the current BusinessWeek, Dawn Kopecki summarizes the dispute between mutual fund outfits and insurers over what the Department of Labor (DOL) should include in its definition of Qualified Default Investment Alternatives (QDIAs).

Because last year's Pension Protection Act encourages plan sponsors to enroll employees automatically in their defined contribution plans, the DOL has to decide what sorts of investment vehicles qualify as suitable/permissible defaults for automatically enrolled participants. The debate between mutual fund managers and insurers turns on whether the insurers' "stable value funds" should be included in the list of QDIAs.

Here's are the key summary passages from Kopecki's piece:

[T]he early version of the regulation snubbed stable-value funds, insurance vehicles filled with high-quality bonds and other interest-bearing securities. It was a blow to insurers. It was a blow to insurers. Until now, stable-value funds, which guarantee principal and interest, have been the go-to choice for companies with automatic enrollment plans. The funds accounted for $413 billion in retirement savings last year—money that may shift to the mutual fund industry if stable-value funds don't make the final list or default options in existing plans don't get grandfathered in.

...

But the Labor Dept., which has been developing the final rules, thought investors needed a little extra juice in their retirement portfolios. "It is unlikely that the returns of [stable-value] funds will be sufficient to generate adequate retirement savings for most participants or beneficiaries," the Labor Dept. wrote in its initial proposal, asserting that stable-value funds were little better than holding cash.

We don't use mutual funds in our private client work or our 401(k) plans, but we think the DOL got it right the first time. So what do the insurers say?

"[Stable value funds] may not be right for all employees, but they should have the choice," says Stable Value Investment Assn. President Gina Mitchell.

That's a lovely sentiment, but it's not what this debate is about. It's not about employee "choice." It's about plan sponsors' paternalistic assignment of newly enrolled participants to appropriate default options. And stable value funds don't pass the only test that matters: Would a newly enrolled particpant be well-served if he or she stuck with this default for the next 20 years? Clearly, plans should make low-risk, low-volatility options available to participants. But given the force of inertia--which often keeps participants tied to their initial defaults--the DOL should stick to its initial instinct: No stable value funds in the menu of QDIAs.

Naturally, the Investment Company Institute--the public face of the mutual fund industry--has taken a firm stand against the insurers in this debate. We aren't the world's biggest fans of the ICI (see here, here, and here, for example), but they're absolutely right in this instance. The ICI's Paul Schott Stevens summarized the case perfectly in early July:

Sources

Dawn Kopekci, "Wrestling For The 401(k) Purse," BusinessWeek, September 10, 2007

Paul Schott Stevens, "Keep Stable Value Funds Out Of Auto Enroll," Forbes.com, July 2, 2007

Let me be clear:The mutual fund industry has much to gain under this proposal. But more importantly, America's workers have much to lose if their retirement savings are placed in investments that emphasize safety over long-term growth.

Wednesday Reading

Apparently it's Wednesday already...

• Writing at Market Movers, Yves Smith offers up a clever typology of subprime borrowers and, more importantly, a note on the role of cash-out refinancings in the "subprime drama"
• If subprime mortgagors decide to rebuild their balance sheets (and no, we aren't holding our breath), they'll have to ignore their friends in the credit card business.
• We think the still-cresting foreclosure wave is serious stuff, but does that mean we can't step back and laugh every now and then?
• In collaboration with several state and federal agencies, the Fed has published a set of recommendations encouraging lenders to modify at-risk mortgages. Greg Ip's Wall Street Journal account is here (subscription required).
• And another important Journal item: "Housing Slump Strains Budgets Of States, Cities" (subscription required)
• Writing in Fortune, Jeremy Grantham reads the fundamentals and restates his bearishness.
• And because it takes two to make a market: Over at MarketWatch, Mark Hulbert reads the technicals and sees key bullish signs.

The Plural of Anecdotes? Data

Jeff Saut's weekly missives are almost always must-reads, and today's entry is no exception. His point that we've witnessed "more of a 'collateral crunch' than a real credit crunch" resonates especially well around here, where we've noted that the unwinding of excessive leverage is an unhelpful complement to deteriorating collateral.

But we're not quite as convinced by his suggestion that "so far, people with good credit can still get a conventional mortgage or loan just as easily as they could two years ago." Is that right? Clearly borrowers with good credit  can still get loans. We aren't seeing anything like a total lenders' strike. But anecdotes like the following from Newsweek's Dan Gross are beginning to add up:

Meanwhile, new mortgages are getting harder to come by, and not just for borrowers with subprime credit. Freaked-out lenders are ratcheting up requirements for minimum-credit scores and down payments. Kim Dicce, a Realtor in Tampa, where housing inventory is piling up, notes that lenders now seem to be requiring buyers in her area to put 15 to 20 percent down and have a credit score above 700. "Now we only have one third of the eligible buyers that we had before, and five times as many houses."

Even allowing for the hyperbole in that last line, this is not a pretty picture. And it's exactly why we wrote this two weeks ago.

We haven't taken the time to dig up the data, but we'd like to see the distribution of credit scores in the U.S. What percentage are higher than 700? 650? If anyone has ready access to the answer, please let us know.

UPDATE: Cancel that! We should have taken the time to dig up the data...because it took all of 30 seconds. Here's the chart from Fair Isaac, which shows that roughly 58% of credit scores are at or above 700, 15% are below 600, and the remaining 27% fall between 600 and 700. Though lender rules (and exceptions to those rules) vary, the distinction between prime and subprime borrowers generally falls between 600 and 650.

Sources

Jeffrey Saut, "Homesick?!" Raymond James, September 4, 2007

Daniel Gross, "The New Money Pit," Newsweek, September 10, 2007

"Cheapest Stocks in 12 Years"

As Wall Street lurches back for this holiday-shortened week, we noticed a Bloomberg story celebrating "the cheapest stock market in almost 12 years." The story quotes a few money managers who sound the Street's typical bullish notes. Here, we're a little more cautious. As we noted just after the Fed broke the market's August fever, all this talk about "cheap stocks" tends to lean on the first half half of the price-earnings multiple. Fortunately, Bloomberg's reporters found a voice of reason out in the Pacific Northwest (emphasis added):

Valuations for many stocks aren't attractive enough to go "bottom-fishing,'' said Patricia Edwards, who helps manage $11.9 billion at Wentworth, Hauser & Violich in Seattle. The slump caused by defaults on mortgages to people with poor or limited credit has hurt the profit outlook for companies such as homebuilders and financial firms.

"Catching falling knives is a dangerous art and not one I have perfected,'' said Edwards, the firm's managing director. "They're only cheap if the earnings hold up, and there's not a lot of confidence with the E portion of their P/E ratios.''

Edwards is right: The big question these days concerns the quality and sustainability of earnings. The corporate sector has been operating at peak profit margins for some time, and while it may not be accurate to say the only way from here is down, the medium-term probabilities aren't exceptionally bullish. Some economic weakness has been priced into the market over the last several weeks, but whether these recent moves are enough to provide a base for meaningful, sustainable gains remains to be seen. And as always the Fed remains a wild card.

One more thing about the title of this Bloomberg piece: Summer swoon? Look, on the morning of August 16th we were clearly in swoon territory, and maybe heading lower. But when this story went up, the broad market averages were roughly 5% off their recent highs. That's not trivial, but it's not exactly world-ending either. So we're not sure "swoon" is the right term at the moment.

Source

Eric Martin and Daniel Hauck, "Cheapest Stocks in 12 Years Greet Investors After Summer Swoon," Bloomberg, September 4, 2007