The Float

Friday Reading

Another long weekend? If we must.

• At Minyanville, Kevin Depew has a special guest making the bear case.
• In the Los Angeles Times, Michael Shermer notes the evolutionary roots of "irrational" economic behavior (via Jeff Saut).
• Big mutual fund companies and the Investment Company Institute go to war over the tax treatment of exchange-traded notes.
• To no one's surprise, Bernanke and Paulson choose the sunny side of the arbitrary recession line. But to their credit, they do acknowledge serious challenges.
• In The Economist's Buttonwood column, a fair-minded treatment of hedge funds.

More Toles

Tom Toles does it again.

Faster Markets

We think investors help themselves when they take an inter-disciplinary approach to the financial markets. In this sense, we recommend just about everything written by thinkers like Michael Mauboussin and Nassim Nicholas Taleb. These authors and others like them don't--and, of course, can't--hand their readers the market's playbook. But they do help us all think more broadly and deeply, in primarily probabilistic terms, about investor behavior and market dynamics.

One of the more intriguing ideas we've run across in recent years emerged from the intersection of media, technology, and politics. Mickey Kaus gave this phenomenon a name: The Feiler Faster Thesis. Here's Kaus, writing in 2000, with a concise summary of the concept (emphasis in the original):

The basic idea is this: The news cycle is much faster these days, thanks to 24-hour cable, the Web, a metastasized pundit caste constantly searching for new angles, etc. As a result, politics is able to move much faster, too, as our democracy learns to process more information in a shorter period and to process it comfortably at this faster pace. Charges and countercharges fly faster, candidates' fortunes rise and fall faster, etc.

The premise here is simple, and applies in obvious ways to the financial markets. In fact, let's make a few simple changes to the above excerpt:

The basic idea is this: The news cycle is much faster these days, thanks to 24-hour cable, the Web, a metastasized pundit caste constantly searching for new angles, etc. As a result, financial markets move much faster, as our investors learn to process more information in a shorter period and to process it comfortably at this faster pace. Bullish claims and bearish claims fly faster, assets' fortunes rise and fall faster, etc.

That rings true to us. But it's important not to get too carried away with the Feiler Faster Thesis. For months now, we've heard analysts (and hacks) claim that the subprime problem was "contained," that markets have already "priced in" recession risk, that the worst is "behind us." Now, at some point, such claims will be true. But so far, in this months-long episode, they haven't been.

The Feiler Faster Thesis provides a serviceable model of information flow and processing. But it doesn't eliminate the behavioral-psychological underpinnings of the financial markets. Consider "Second-Order Effects Coming Thick and Fast," a recent post from Michael Panzner.

Each day brings word of new chaos in the financial world. Interestingly, while many observers, including me, were focusing on what we believed would be the first-order effects of credit problems at the bond insurers (e.g., forced selling of securities by institutions who could only hold instruments with a certain minimum credit rating), the second-order effects are already being felt, too.

The rest of the post--on reduced spending by municipal borrowers, among other things--is well worth reading. But the key point is this: The Feiler Faster Thesis doesn't stipulate accelerated events or processes so much as faster responses by market participants. Have equity investors already taken asset values to their recession-expectant lows? We don't know. It's conceivable. But faster markets don't necessarily imply a faster economy.

Appropriate adjustments to asset values will always be functions of price and time. Recent bouts of volatility--not at all historically unprecedented, but clearly more pronounced than we've seen for several years--suggest that market participants may be operating in a faster world. But wringing longstanding excesses out of the financial markets will take a while, Feiler Faster Thesis or no.

A Hussman Highlight

From John Hussman's most recent market comment (emphasis added in bold).

The S&P 500 is now behind Treasury bills for the period since November 2005, which underscores the difficulty in retaining market returns that are achieved in periods of rich valuation. It's certainly possible that we will recruit enough improvement in market internals to infer that investors are once again willing to load up on market risk, but at present, we don't have that evidence.

Again, my guess, and it's just a guess, is that a sustained rally--if only a sustained bear market rally--will be more likely a) at the point that investors fully accept recession as common knowledge, so they can start putting "recession" behind them without fear that it's still ahead, or b) at the point the S&P 500 declines a full 20% from its high (anywhere below 1250)--again, so they can start putting "bear market" behind them without fear that it's still ahead. Strangely, the market often responds well when investors recognize that their fears have become reality, because at that point investors can at least begin to believe that the worst is behind them.

That doesn't mean that things won't, in fact, deteriorate beyond a 20% market decline or a shallow and well-recognized recession. But as I've frequently noted, most bear markets are not simply one-way movements. Bear markets typically comprise two, three or more separate 10-20% declines, punctuated by fast, furious rallies. It's easy to forget that the 2000-2002 bear included three bear market advances of 20% from intra-day low to intra-day high, as well as numerous smaller advances, all of which were surrendered in subsequent plunges to new lows.

This is a good time to review what bear markets look like, because even though our own focus is always on the prevailing Market Climate, an understanding of how such market periods evolve can be helpful in riding one out. As I wrote in April 2000, bear market psychology typically evolves something like this:

"This is my retirement money. I can't afford to be out of the market anymore!"

"I don't care about the price, just get me in!!"

"It's a healthy correction"

"See, it's already coming back, better buy more before the new highs"

"Alright, a retest. Add to the position--buy the dip"

"What a great move! Am I a genius or what?"

"Uh oh, another selloff. Well, we're probably close to a bottom"

"New low? What's going on?!!"

"Alright, it's too late to sell here, I'll get out on the next rally"

"Hey!! It's coming back. Glad that's over!"

"Another new low. But how much lower can it go?"

"No, really, how much lower can it go?"

"Good Grief! How much lower can it go?!?"

"There's no way I'll ever make this back!"

"This is my retirement money. I can't afford to be in the market anymore!"

"I don't care about the price, just get me out!!"

Discipline. Risk Management. Capital preservation. Words to live by in any market environment--and especially this one.

Wednesday Reading

Stimulus bill gets signed. Cue sound of crickets...

• We've noted repeatedly that the price and availability of money are different things. But that doesn't mean they're unrelated. Here are two stories, both via the tireless Yves Smith, on the tortured relationship among interest rates, lending standards, risk aversion, and capital flows: "Fed Rate Cuts Fail to Reduce Borrowing Costs"and "Muni Auction Bond Failures Lead to Turmoil, High Rates."
• Barry's right. This is a joke.
• More from Mr. Ritholtz: Those "bullish" retail sales weren't bullish on much...except inflation.
• Another take on those retail sales from the WSJ's Real Time Economics.
• Interesting stuff on sovereign wealth funds--and the brewing political backlash against them--from the FT's Alphaville.
• Oh. Right. The stimulus package.

Must-See TV

A moment ago on CNBC, from Phil Dow, Director of Equity Strategy at RBC Dain Rauscher (emphasis added in bold):

Mark Haines: What do you make of this market, Phil? Every time I think it's gonna break down, it picks up steam again.

Phil Dow: Well, we had a bad week last week. My guess is this is just, is just some buying going on.

Could be!

Systemic Credit Contraction

Not that this is an original, world-historical insight, but we've repeatedly argued that in a consumer-driven economy perched on a pyramid of credit expansion, credit contraction is a cold-blooded killer. (See this and this, for instance.)

Two new media accounts suggest that reporters and editors are (belatedly) realizing just how pervasive credit problems have become.

First, in this morning's New York Times, Vikas Bajaj and Louise Story summarize the story reasonably well (emphasis added in bold):

Like subprime mortgages, many prime loans made in recent years allowed borrowers to pay less initially and face higher adjustable payments a few years later. As long as home prices were rising, these borrowers could refinance their loans or sell their properties to pay off their mortgages. But now, with prices falling and lenders clamping down, homeowners with solid credit are starting to come under the same financial stress as those with subprime credit.

"Subprime was a symptom of the problem," said James F. Keegan, a bond portfolio manager at American Century Investments, a mutual fund company. "The problem was we had a debt or credit bubble."

...

At the end of September, nearly 4 percent of prime mortgages were past due or in foreclosure, according to the Mortgage Bankers Association.

That was the highest rate since the group started tracking prime and subprime mortgages separately in 1998. The delinquency and foreclosure rate for all mortgages, 7.3 percent, is higher than at any time since the group started tracking that data in 1979, largely as a result of the surge in subprime lending during the last few years.

And here's perfect (though anecdotal) evidence that we had too many people playing a dangerous game of musical chairs...and too few chairs.

An example of the spreading credit crisis is seen in Don Doyle, a computer engineer at Lockheed Martin who makes a six-figure income and had a stellar credit score in 2004, when he refinanced his home in Northern California to take cash out to pay for his daughter’s college tuition.

Mr. Doyle, 52, is now worried that he will have to file for bankruptcy, because he cannot afford to make the higher variable payments on his mortgage, and he cannot sell his home for more than his $740,000 mortgage.

"The whole plan was to get out" before his rate reset, he said. "Now I am caught. I can't sell my house. I'm having a hard time refinancing. I've avoided bankruptcy for months trying to pull this out of my savings."

And as the housing ATM seizes up, consumers turn to the power of plastic. Unfortunately, the picture there isn't much brighter. From Mara Der Hovanesian (and three colleagues) in the latest BusinessWeek:

The credit crisis that began rumbling through the mortgage market last summer is now spilling over to the nation's other great expanse of borrowing: credit cards. Banks have extended $740 billion to Americans like the Fitzgeralds, a 15% jump over the past five years. With the economy weakening, delinquencies are rising, particularly in states battered by the housing bust.

The casualties are piling up. Profits at Citigroup's (C) U.S. card division dropped 53% in the fourth quarter from the third. JPMorgan Chase (JPM) reported in the latest period a 40% year-over-year jump in credit-card costs, to $1.8 billion. At American Express (AXP) provisions for loan losses rose 70%, to $1.5 billion, a sign that even the well-heeled may be feeling the pinch. "Every day we obsess [over] how bad could it get," Richard D. Fairbank, CEO of one of the largest card issuers, Capital One (COF), told analysts on Jan. 23. He also conceded that the nearly $2 billion it has set aside for loan losses may not be enough. "The real answer is: Nobody knows."

Banks and other card issuers are lowering credit limits, hiking interest rates, and refusing to approve applications as part of a broad clampdown to prevent more losses. That leaves strapped consumers with few options. Homeowners can no longer turn their equity into cash to pay their bills. Tough bankruptcy laws passed in 2005 narrowed another avenue of escape. So some desperate borrowers are resorting to more perilous measures: raiding their retirement accounts and insurance plans and seeking loans from alternative credit sources such as payday lenders and pawnshops that extract a high price for the cash.

We'd like to see some hard data before we leap to conclusions about whether people are tapping into their retirement accounts to finance current consumption (or service current debt), but that would be a deeply dysfunctional, for many people downright disastrous, consequence of the ongoing credit contraction. Stay tuned.

Sources

Vikas Bajaj and Louise Story, "Mortgage Crisis Spreads Past Subprime Loans," New York Times, February 12, 2008

Mara Der Hovanesian, Christopher Palmeri, Nanette Byrnes and Jessica Silver-Greenberg, "Over the Limit," BusinessWeek, February 7, 2008

Monday Reading

Our Monday/Wednesday/Friday tradition continues, if a little late in the day...

• Barry Ritholtz finds the bass line of a tune called "Systemic Crisis." In Norway, circa 1987.
• News from the Dow Jones Industrial Average: BAC and CVX are in, MO and HON are out. Not that it matters all that much.
• As ever, markets turn on supply and demand. And housing inventories remain something other than bullish.
• Real estate is local. And so are recessions.
• Good stuff from James Picerno on changing asset class correlations.

ETFs and Index Funds: Still Modest in Most Categories

Last Tuesday we posted three charts showing that even after expanding at a much faster clip than open-end mutual fund assets for more than a decade, exchange-traded funds remain a modest part of the asset management business.

We closed that item by noting that the big question in the industry isn't so much the rise of ETFs per se (as interesting, important, and useful as they might be), but about the future prospects of long-only money management delivered through big, diversified, expensive mutual funds.

Today we have three more charts, each telling the same story in its own way.

First, a side-by-side comparison of open-end index fund and ETF assets (in blue) and non-indexed open-end fund assets (in red). All data are courtesy of the Investment Company Institute.

Next, the same data stacked to clarify the relative percentages of index-based (blue) and actively-managed (red) assets.

Finally, a year-end 2006 snapshot of indexed and non-indexed assets in six categories.

    

We first wrote about these data back in October. We still like what we wrote then:

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.

The introduction of actively-managed ETFs will require another level of subtlety in this kind of analysis.

As we see it, actively-managed ETFs should have some of the strengths that make index-based ETFs so attractive: trading flexibility, modest explicit expenses, and relative tax-efficiency. Rapid portfolio turnover could diminish this last advantage, depending on the effectiveness of specific ETFs' creation/redemption processes. On the other hand, actively-managed ETFs could suffer from some of the weaknesses that afflict open-end mutual funds: consequential implicit costs, non-trivial market impact, excessive diversification, benchmark-hugging, and, of course, the risk of sustained underperformance.

Savvy investors will do more than just decide between "active" and "passive." They'll pay for active management only in vehicles that have a plausible chance of delivering what successful active management offers (but can't guarantee): prudent risk management and attractive absolute returns over entire market cycles.

Target-Date Funds Revisited

Back in October, we posted an item on international exposure in target-date mutual funds. Given the increasing prominence of these funds of funds in defined-contribution retirement plans, investors should to understand the characteristics, strengths, and weaknesses of these investment vehicles.

Here's how we closed that post:

At this point, retail investors' demonstrated preference for international mutual funds feels a little like good old fashioned performance-chasing, but many Americans have become more comfortable with investing outside the U.S. Investors' true test will come when the "bull market in everything" no longer holds.

We drafted that October item just hours after the S&P 500 reached its all-time (nominal) high of 1565. (Note that VEU, Vanguard's non-US ETF that combines developed and developing markets, peaked on October 31st.)

So if the bull market in everything no longer holds, Tom Lauricella's piece in the February 4th Wall Street Journal seems especially timely. The topic: Equity exposure in taret-date funds. Here's Lauricella's opening riff:

The stock market's plunge is providing the first stress test for dozens of target-date mutual funds, a type of investment that has become hugely popular in the past few years.

The concept behind a target-date fund is that the fund manager will automatically rebalance holdings to take a more conservative position as the fund approaches its "target" date.

Unfortunately, the current results aren't great for some investors who can least afford bad times: those closest to retirement. Thanks to hefty weightings in stocks, some target-date funds have posted double-digit losses over the past four months.

Fair enough. But once again we have to point out that retirement isn't the finish line. What is? An investor's life expectancy. And purchasing power risk is plenty real and plenty serious. Lauricella suggests that providers of target-date funds have increased their equity exposure of late.

During the bull market, fund companies rolled out target-date funds with higher and higher weightings in stocks. Their reasoning: People stand a good chance of living 20 or 30 years beyond retirement, so the conventional thinking on owning lots of bonds on the day you retire is outdated. "Clients that are two years away from retirement are not two years away from needing the money," says Ranji Nagaswami, chief investment officer of AllianceBernstein. An Oppenheimer representative cites similar reasoning.

Sounds sensble to us. But there could be another factor. As ever, Wall Street's sales imperatives intervene.

But could the more-aggressive stance also have something to do with the fact that until recently, in an increasingly crowded field, the bigger the stock position, the better the performance and the bigger the sales? Alliance and Oppenheimer say no.

Not all funds have gone the more-aggressive route. The 2010 target-date fund of Wells Fargo Advantage Funds has 26% of assets in stocks. It lost a slim 1.5% between Oct. 9 and Jan. 22. Wells Fargo points to data showing that most people pull money out of 401(k) plans at retirement. "We believe it's important to minimize risk as people decide what to do with their assets," a spokesman says.

From where we sit, we see three key takeaways from all this:

1. Target-date funds vary widely. In terms of asset class exposure, one shop's 2020 fund may be another's 2030. And they aren't necessarily "one-stop shops," especially in retirement plans where investors may be tempted to just go with the most appropriate year. The convenience and leave-it-alone nature of these funds are great, but they can still fall well short of the ideal investment policy for specific investors.
2. Whatever their underlying allocation objectives might be, target-date funds will reflect the strengths and weaknesses of their constituent funds, some of which are likely to be stuffed into these convenient vehicles because they can't be sold on their own merits. We've seen this in many plans--and we think it stinks.
3. The Wells Fargo spokesman quoted by Lauricella makes a good point. People should be deciding what they'll do with their accumulated assets as they approach retirement. By our lights, that recommends target-risk funds rather than target-date funds. Working with (preferably fiduciary) advisors, 401(k) participants and other investors should have meaningful control over their exposure to short-term risk. But as we've noted repeatedly, risk management is not synonomous with risk reduction.

Target-date funds are blunt instruments. Some are better than others. Some are less expensive than others. Some have a sensible, market-driven rebalancing discipline. Unfortunately, most rebalance just because the (irrelevant) calendar tells them to.

Rank-and-file investors--and retirement plan particpants in particular--need access to fully diversified, institutional-caliber portfolios. Target-date funds can play a role in that. But we think target-risk portoflios, especially those that favor inexpensive index-based vehicles, are a better solution for most investors.

Source

Tom Lauricella, "Target-Date Funds May Hit the Mark--But Whose Mark?" Wall Street Journal, February 4, 2008