The Float

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.

A Radical/Sensible Solution

He gets a little breathless from time to time--sometimes more than a little--but generally we like MarketWatch columnist Paul Farrell. His heart and mind are in the right place and he clearly cares about individual investors. So we weren't surprised to see him pick up on Ric Edelman's modest proposal: Sell all your mutual funds!*

Here are a couple highlights from Edelman, via Farrell's Monday column:

There's no greater pitfall than the one created by the retail mutual fund industry. [They] are ripping you off. You are incurring greater risks, lower returns and higher fees than you realize, and as a result you are in danger of not achieving your financial goals. The situation is shocking, and no one is more astonished than me.

When I started investing in mutual funds in the 1980s, the industry's top concern was serving shareholders. Today, though, the industry is more concerned with making profits for itself than serving its shareholders. This comes at the expense of people like you and me who have invested our life savings in mutual funds. As a result, owners of retail mutual funds today earn lower returns, incur higher risks and pay more in fees and taxes than we should.

Over the last few months, we've chronicled many of the problems with typical mutual funds in this space. As we've noted repeatedly, the problem with the vast majority of actively managed funds isn't active management per se; it's active management in a structural framework that's remarkably ill-suited to delivering what it promises to investors. Too bloated, style-constrained, and diversified to deliver excess return, most mutual funds are also too expensive to deliver market returns.

Farrell and Edelman cite the mutual fund scandals of the early part of this decade as an acute source of frustration, which of course it was. But the real scandal--sales practices that have more to do with company profits than investor interests--continues unabated...and remains under-appreciated by millions of individual investors, retirement plan sponsors and participants, and policymakers.

Consider a few statistics from the Investment Company Institute, the mutual fund industry's trade association. At year-end 2006, index mutual funds and registered ETFs accounted for the following percentages of investor assets, by type of investment:

• Large Blend Domestic Equity: 39.9%
• Other Large Cap Domestic Equity: 4.8%
• Other Domestic Equity: 17.9%
• Global/International: 12.1%
• Hybrid: 1.3%
• Fixed-Income: 6.2%

Naturally, the largest percentage is in the "S&P 500" asset class of large-cap domestic equities, where investment vehicles like Vanguard 500 and SPY have accumulated tremendous assets over the last couple decades. But note how anemic the index/ETF percentages are in all the other categories.** On a dollar-weighted basis, the average across all categories is 13.7%. Let's put that another way: 86.3% of investor assets incur significant fees to chase after a mirage.

And given what we know about investor behavior, the average investor's actual returns are significantly lower than those of the mediocre products in which they invest. That just isn't a pretty picture.

We could go on, but we'll close with Farrell's invocation of former Sen. Peter Fitzgerald (R-IL), who captured the essence of the problem with this in 2004: "The mutual fund industry is now the world's largest skimming operation, a $7 trillion trough from which fund managers, brokers and other insiders are steadily siphoning off an excessive slice of the nation's household, college and retirement savings."

That isn't necessarily enough said, but it sure is well put.

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

*Edelman makes this radical/sensible suggestion in his new book, The Lies About Money.

**Note that not all index mutual funds (or ETFs for that matter) are equally efficient and inexpensive. Which, if you think about it, is pretty darn revealing: Even (more or less) pure commodities like index funds can show significant variance in their pricing.

Sources

Paul B. Farrell, "'Sell all your mutual funds!' (Yes, all!)," MarketWatch, October 22, 2007

Investment Company Institute, "2007 ICI Fact Book--Section 3"

Stephen Roach on the Global Economy

You don't need this blog to tell you there's been plenty of bullishness on Wall Street since the Fed intervened with its mid-August cut in the discount rate. From where we sit, it's clear that all that recent optimism has been rooted in investors' faith in "global growth," a catch-all shorthand for economic strength outside the U.S. There's no question that global economic expansion has been robust, but what's coming next?

With an assist from John Mauldin, we've (finally) worked our way through a recent comment on the global economy from Morgan Stanley's Stephen Roach.

Here's Roach's bracing introduction:

At work is yet another post-bubble adjustment in the world's largest economy--this time, the bursting of America's massive property bubble. The subprime fiasco is the tip of a much larger iceberg--an asset-dependent American consumer who has gone on the biggest spending binge in the modern history of the global economy. Seven years ago, the bursting of the dot-com bubble triggered a collapse in business capital spending that took the US and global economy into a mild recession. This time, post-bubble adjustments seem likely to hit US consumption, which at 72% of GDP, is more than five times the share the capital spending sector was seven years ago. This is a much bigger problem--one that could have grave consequences for the US and the rest of the world.

On the American consumer, Roach notes that income and wealth effects--the only sustainble sources of consumption growth--seem to be weakening at the same time:

Growth in US consumer demand is typically powered by two forces--income and wealth (see Figure 1). Since the mid-1990s, income support has lagged while wealth effects have emerged as increasingly powerful drivers of US consumption. That has been especially the case in the current economic expansion, which has faced the combined headwinds of subpar employment growth and relatively stagnant real wages. As a result, over the past 69 months, private sector compensation--the broadest measure of earned labor income in the US economy--has increased only 17% in real, or inflation adjusted, terms. That falls nearly $480 billion short of the 28% increase that had occurred, on average, over comparable periods of the past four US business cycle expansions.

Lacking in support from labor income, US consumers turned to wealth effects from rapidly appreciating assets--principally residential property--to fuel booming consumption. By Federal Reserve estimates, net equity extraction from residential property surged from 3% of disposable personal income in 2001 to nearly 9% by 2005--more than sufficient to offset the shortfall in labor income generation and keep consumption on a rapid growth path. There was no stopping the asset-dependent American consumer.

That was then. Both income and wealth effects are now coming under increasingly intense pressure--leaving consumers with little choice other than to rein in excessive demand. The persistently subpar trend in labor income growth is about to be squeezed further by the pressures of a cyclical adjustment in production and employment. In August and September 2007, private sector nonfarm payrolls expanded, on average, by only 52,000 per month--literally one-third the average pace of 157,000 of the preceding 24 months. Moreover, this dramatic slowdown in the organic job creating capacity of the US economy is likely to be exacerbated by a sharp fall off in residential construction sector employment in the months ahead. Jobs in the homebuilding sector are currently down only about 5% from peak levels despite a 40% fall-off in housing starts; it is only a matter of time before jobs and activity move into closer alignment in this highly cyclical--and now very depressed--sector.

Moreover, the bursting of the property bubble has left the consumer wealth effect in tatters. After peaking at 13.6% in mid-2005, nation-wide house price appreciation slowed precipitously to 3.2% in mid-2007. Given the outsize overhang of excess supply of unsold homes, I suspect that overall US home prices could actually decline in both 2008 and 2009--an unprecedented development in the modern-day experience of the US economy. Mirroring this trend, net equity extraction has already tumbled--falling to less than 5.5% of disposable personal income in 2Q07 and retracing more than half the run-up that began in 2001. Subprime contagion can only reinforce this trend--putting pressure on home mortgage refinancing and thereby further inhibiting equity extraction by US homeowners.

Roach goes on to question the logic of "global decoupling" (i.e., the assumption/expectation that the world economy is increasingly immune to U.S. weakness), arguing that the fact of deepening cross-border linkages and the concept of global decoupling--especially in export-dependent Asia--are fundamentally incompatible. As if that weren'et enough, he then takes up the weak and weakening dollar, the inadequacy of established central bank policymaking, and the political economy of asset bubbles.

We're serious: Spend a few minutes reading this important piece.

Source

Stephen Roach, "A Subprime Outlook for the Global Economy," Reprinted in John Mauldin's "Outside the Box," October 22, 2007

Wednesday Reading

Another day, another reminder (this one from Merrill Lynch) of just how badly some debt securities had been mispriced...

• Nicholas Taleb, author of The Black Swan, isn't happy with the Nobel Committee's favorite capital markets theories (via Naked Capitalism).
• Tim Price wants the presses stopped: An investment bank has issued pertinent research! The topic in play in that research (from Citigroup) is the "maturity" of the current bull market, the key question being where we find ourselves on the adjacent figure (from the FT's Alphaville). Six o'clock? Or pushing toward nine?
• From Barry Ritholtz, a superb analysis of the credit/interest rate bubble that drove the housing market over the last several years.
• In other Merrill Lynch news, a less-noticed but plenty revealing story: When bad brokers do even worse things--and their bosses circle the wagons. (Note additional commentary from Felix Salmon.)
• More moral hazard talk, this time on the question of mortgage modifications (courtesy Reuters' Al Yoon and Walden Siew).

The Fox Business Top Tick?

Slate's Daniel Gross proposes the mother of all contrary indicators: The launch of the Fox Business Channel. Here's Gross:

The on-air talent at Fox Business Channel, which debuted last Monday, is uniformly peppy. But since their smiling pusses flooded the airwaves, talking up the jargon-free virtues of capitalism and the sheer fun of business, the market has been grumpy. Have you noticed that the Dow Jones Industrial Average fell every single day last week?

It could be a simple case of bad luck. The stock market, after all, is famously unpredictable and moves in inexplicable, highly random fashion. On the other hand, maybe we shouldn't be surprised. Big old-media companies, with their long corporate-planning processes and general lack of urgency, are frequently slow to learn about new trends--and even slower to capitalize on them. As a result, by the time their new products launch, the trends they're designed to monetize have frequently ended.

We've mentioned the "cover story contrarians" phenomenon a few times over the last several months (here, for instance). Gross's latest entry in that particular sweepstakes is worth a look.

Will Apple's Strength Translate?

One of the curious characteristics of last week's market action was that one technology name after another--Google, eBay, Yahoo!, &c.--reported very strong third quarter results...and the broad market slumped all week in spite of so much tech strength.

The reasons were as clear as they get on a short-term basis (which is to say only partially clear): a resurgence of credit market concerns, continuing deterioration in housing, and weak forecasts and commentary from some major industrial concerns, most notably Caterpillar.

With Apple reporting super Q3 numbers after the bell yesterday, the early tone of the equity markets is clearly bullish. Against the backdrop of last week's sour action, the key test won't be today's trading so much as the next few days, with the Street's gaze firmly fixed on Merrill Lynch tomorrow and ExxonMobil next Thursday, among others.

The fact that investors had taken a few percent off the top of the market last week created a little room for Apple's numbers to set the bulls running again. Also: numbers from American Express, UPS, and DuPont were relatively strong, despite a few references to weakness in the U.S. Weakness in Texas Instruments and Coach, along with a minor downward adjustment in Target's same-store sales projections for October, can't compete with the enthusiasm unleashed by Apple's ongoing success story.

Mortgage Resets

This picture speaks for itself...

 

(From the IMF, via Credit Suisse and Calculated Risk)

Sam Zell on Risk Management

Saturday's Wall Street Journal featured Collin Levy's interview with famed real estate investor Sam Zell, who demonstrated a world-class mix of skill, luck, and judgment when he sold his Equity Office Properties to Blackstone for $39 billion in February. (Zell knows his timing was impeccable: "Obviously the deal that was done Feb. 7 could not be done Sept. 7," he says.)

With its unifying focus on risk assessment and management, the entire discussion is intriguing and well worth reading. Here we'll reflect on three of Zell's most interesting observations.

First, on the question of the timing of the EOP sale to Blackstone [emphasis added]: "Any day you don't sell, you buy, and I wasn't willing to buy at the price they were willing to pay, so I sold it." That's a formulation worth remembering: If you don't sell, it's like buying all over again (but without the transaction costs, of course).

Second, Zell echoes our argument that liquidity is a state of mind: "What has changed now is not the existence of liquidity -- there's plenty -- but the will to use it. The problem isn't a sudden lack of money, but a lack of confidence from the people who control it. Resurrecting that confidence will be the key, and it's unlikely to happen in the near-term."

Third, Zell makes another familiar argument (which we've made here and here): "While credit panics may not be anyone's idea of fun, their benefit is that they begin to restore some sanity and caution, keeping the animal spirits in balance." Exactly right.

Source

Collin Levy, "Professor Risk," Wall Street Journal, October 20, 2007 (subscription required)