The Float

Friday Reading

In NYC. So here's another quick reading hit, then back with more on Monday...

• We're sorry, but we just can't muster a whole lot of enthusiasm for Bank of America's Countrywide acquisition.
• More on the BAC/CFC story from Herb Greenberg.
• More still: MarketBeat's David Gaffen liveblogs the BAC/CFC conference call.
• Via Calculated Risk, here's the NYT's Floyd Norris on just how ridiculously sloppy things got in the mortgage origination business.
• The fiscal stimulus train looks like it's just about ready to leave the station. Here's a report on the discussion at a roundtable of prominent economists from the WSJ's Real Time Economics.

Thursday Miscellany

A travel day makes this a short one. Back tomorrow...

• Bloomberg's Rich Miller: "The next bubble to deflate may be Alan Greenspan's reputation."
• Capital One: Not pretty--and not getting prettier any time soon.
• Via the FT's Alphaville: The WSJ reports Merrill and Citi scrounging around for substantial new commitments of capital from foreign investors.
• Interesting work on "the 1/n heuristic" in 401(k) plans (which we mentioned in November).
• After yesterday's late spike, Todd Harrison's short piece on the "Plunge Protection Team" seems apt.

Wednesday Reading

Here's our only prognostication for 2008: Markets and voters have a few more surprises in store for us...

• After New Hampshire, let's not get carried away with the sort of mindless "analysis" Stephen Moore offered up on CNBC a few moments ago...that the (very) mini-rally of today's early trading reflects a "Hillary/McCain" bounce--because they're the candidates Wall Street knows best. Good grief! On this topic, we enthusiastically second Barry's thoughts. (For the love of all that's good and noble in this world, CNBC's Trish Regan, who's pretty much on our permanent list of non-favorites, just re-introduced Moore's utterly absurd notion. But wait! The S&P is now lower on the day. Investors have obviously reconsidered their enthusiasm for Clinton and McCain!)
• We've long agreed with a sentiment Matt Hougan expressed this morning at IndexUniverse: Morningstar doesn't understand ETFs. (Or doesn't explain them well, anyway.) Our semi-cynical explanation: Mutual funds are Morningstar's cash cow. ETFs? Not so lucrative for MORN. Not yet, anyway.
• Bespoke has some pretty charts on asset class performance thus far in 2008. Pretty in aesthetic terms, anyway.
• Here's one reason we're uneasy about the rush to provide short-term "stimulus" to the U.S. economy: The national debt clock spins faster every day.
• Finally, James Picerno has a nice post on the big, ongoing shifts in global equity allocations over the last decade-plus.

Stephen Roach on U.S. Asset Prices

In late October, we directed your attention to a bracing (and prophetic) commentary from Morgan Stanley's Stephen Roach. In yesterday's Financial Times, Roach published a worthy successor to that October piece. The topic: Falling asset prices in the United States.

In this important column, Roach offers a useful antidote to the primal scream for government to do something--anything!--to prop this thing up. The point of which is not that government should be indifferent to economic conditions, but that successive asset bubbles have created dysfunctional incentive structures in the American economy, and that the only way to push back toward a healthier equilibrium is to strengthen the income-based savings rate in the U.S.

Here's Roach (emphasis added):

At the core of the problem is one of the most insidious characteristics of an asset-dependent economy--a chronic shortfall in domestic saving. With America's net national saving averaging a mere 1.4 per cent of national income over the past five years, the US has had to import surplus saving from abroad to keep growing. That means it must run massive current account and trade deficits to attract the foreign capital.

America's aversion toward saving did not appear out of thin air. Waves of asset appreciation--first equities and, more recently, residential property--convinced citizens that a new era was at hand. Reinforced by a monstrous bubble of cheap credit, there was little perceived need to save the old-fashioned way--out of income. Assets became the preferred vehicle of choice.

With one bubble begetting another, America's imbalances rose to epic proportions. Despite generally subpar income generation, private consumption soared to a record 72 percent of real gross domestic product in 2007. Household debt hit a record 133 percent of disposable personal income. And income-based measures of personal saving moved back into negative territory in late 2007.

None of these trends is sustainable. It is only a question of when they give way and what it takes to spark a long overdue rebalancing. A sharp decline in asset prices is necessary to rebalance the US economy. It is the only realistic hope to shift the mix of saving away from asset appreciation back to that supported by income generation. That could entail as much as a 20-30 percent decline in overall US housing prices and a related deflating of the bubble of cheap and easy credit.

Those trends now appear to be under way. Reflecting an outsize imbalance between supply and demand for new homes, residential property prices fell 6 percent in the year ending October 2007 for 20 major metropolitan areas in the US, according to the S&P Case-Shiller Index. Most likely, this foretells a broader downturn in nationwide home prices in 2008 that could continue into 2009. Meanwhile, courtesy of the subprime crisis, the credit bubble has popped--ending the cut-rate funding that fueled the housing bubble.

As home prices move into a protracted period of decline, consumers will finally recognise the perils of bubble-distorted saving strategies. Financially battered households will respond by rebuilding income-based saving balances. That means the consumption share of gross domestic product will fall and the US economy will most likely tumble into recession.

America's shift back to income-supported saving will be a pivotal development for the rest of the world. As consumption slows and household saving rises in the US, the need to import surplus saving from abroad will diminish. Demand for foreign capital will recede--leading to a reduction of both the US current-account and trade deficits. The global economy will emerge bruised, but much better balanced.

Washington policymakers and politicians need to stand back and let this adjustment play out. Yet the US body politic is panicking in response--underwriting massive liquidity injections that produce another asset bubble and proposing fiscal pump-priming that would depress domestic saving even further. Such actions can only compound the problems that got America into this mess in the first place.

...

It is going to be a very painful process to break the addiction to asset-led behaviour. No one wants recessions, asset deflation and rising unemployment. But this has always been the potential endgame of a bubble-prone US economy. The longer America puts off this reckoning, the steeper the ultimate price of adjustment. Tough as it is, the only sensible way out is to let markets lead the way. That is what the long overdue bursting of America's asset and credit bubbles is all about.

On the panicky body politic, we recommend Bloomberg's John Berry ("U.S. Economy Needs Time, Not Fiscal Stimulus") and Amity Shlaes ("Would Someone Get Bush Off Campaign Trail, Please"). And on the general question of falling asset prices and the interventionist impulse, please see a couple of our recent posts ("Wring Out the Excess" and "Let It Happen").

Source

Stephen Roach, "America's inflated asset prices must fall," Financial Times, January 8, 2008

Not Exactly

In the first entry of David Gaffen's Four at Four this afternoon, we find the following passage (emphasis added):

"Every day the market tries to rally, and often tries to rally several times and none of it is holding," says Michael Barron, CEO of Knott Capital in Exton, Pa. "I think for the first time in a long time you have investors who are looking at larger issues and saying, 'this may be a problem.'"

For the first time in a long time? Excuse us? That's a very strange way of describing what has been a months-long accumulation of concerns that yes, indeed, this may be a problem.

And ohbytheway, wasn't it just a few days ago that we were dealing with S&P 1490 as support/resistance? Today's close: 1390.

Timeless Lessons

In yesterday's reading post, we mentioned Larry Swedroe's "Lessons of 2007," published by the excellent team at IndexUniverse.com. Upon further review, the call on the field stands: This is a great piece.

We'd like to draw your attention to three "Lessons" in particular: Two, Three, and Seven. Here are the most telling passages from each (emphasis added in bold).

Lesson Two...

The historical evidence demonstrates that individual investors are performance chasers--they watch yesterday's winners and then buy (after their great performance) and watch yesterday's losers and then sell (after the loss has already been incurred). This causes investors to buy high and sell low--not exactly a recipe for investment success. This behavior explains the findings from studies that demonstrate that investors actually underperform the very mutual funds they invest in by significant margins.

...

The lessons are that investors need to ignore the emotions that bull (greed and envy) and bear markets (fear and panic) create and that disciplined rebalancing is the winning strategy.

Lesson Three...

For believers in active management, the equivalent of finding the Holy Grail is identifying a manager who can persistently beat the market. The hero for many "believers" had been Bill Miller, legendary manager of the Legg Mason Value Trust (LMVTX).

...

The really bad news is that most of Miller's great returns came when the fund was much smaller. The great returns attracted huge cash flows, and the longer the streak went on the greater the flows. The worst performance came when the fund had the most dollars. Thus, the returns actually earned by investors in the Legg Mason Value Trust are actually well below the returns reported by the fund. Of course, this is not the fault of the fund. Instead, the fault lies with investors who chose to ignore the evidence from academic studies that there is virtually no persistence of performance beyond the randomly expected (at least among winners—losers tend to repeat because of high expenses). And, as history suggests it would, the fund experienced large outflows in 2007. Investors withdrew almost $10 billion of assets in the fourth quarter of 2007 from the Legg Mason family of funds. Thus, even if Miller manages to once again outperform, many investors won't be there to benefit.

Lesson Seven...

Morningstar dedicates a large amount of resources to identifying the great money managers. It rates about 5,000 mutual funds, giving just 500 its coveted five-star rating.   

But why settle for the top 500? Why not invest in just the very best in each asset class? In November 2001, Morningstar created its Aggressive Wealth Maker and Wealth Maker portfolios. In May 2002, it added the Wealth Keeper Portfolio. Each portfolio contains less than 10 funds. It's Morningstar's effort to identify the best of the best. This provides us a living laboratory to test the ability to identify future outperformers. How has Morningstar done? All three of the portfolios trail their benchmark portfolios that consist of simple broad market index funds. The Aggressive Wealth Maker trails its benchmark by 1.41 percent per annum, while the Wealth Maker and Wealth Keeper trail their benchmarks by 1.28 and 1.76 percent per annum, respectively. And we should note that the hurdle is actually too low, as Morningstar includes small- and value-oriented funds in its portfolios, while its benchmark contains only total market index funds. Since small and value stocks have outperformed broader market indices, Morningstar's portfolios had a tailwind at their backs aiding their performance. Unfortunately, it was not enough.

All good stuff. Per Swedroe's Lesson Three, we posted on the question of asset bloat back in July (here and here).

Bill Miller's Legg Mason Value Trust strikes us as a particularly apt example of the problems asset bloat causes for fund managers. In fact, this discussion reminds us of Miller's Fall 2004 commentary, in which he acknowledged the constraints created by big, concentrated positions in his portfolio (emphasis added):

This time last year, I believed that 2004 was likely to see some retracement from the embrace of risk, and that more conservative, dividend paying, and generally higher quality issues would probably fare well in the ensuing months. I considered cutting back on some of our best performers of '03, including Amazon, Nextel, and Interactive, but elected to stand pat.

There were two reasons for this: first, we are the largest, or among the largest shareholders of these companies, and our holdings in them represented large positions in our portfolio. Reducing our positions sufficiently to make a difference might have created substantial market impact costs, especially if other investors believed we might be seeking to exit our holdings entirely.

Fascinating stuff.

Plosser Speaks

Don't miss today's remarks from Philadelphia Fed President Charles Plosser, who does a much better job of acknowledging the Fed's limitations than many "experts" on the Street. (For more on this theme, see yesterday's post). Here are a few highlights...

The influence of changes in the FOMC's targeted funds rate on inflation and economic growth occurs with a lag, so by necessity the FOMC must be forward-looking in setting an appropriate funds rate target. It must forecast future economic growth and inflation based on available data on the economy and financial conditions, including a particular target path for the fed funds rate.

...

As I mentioned at the outset, forecasting the economy is a difficult task. But policymakers, like business leaders, really have very little alternative. Changes we make to the funds rate today will not have any appreciable effect on prices, employment, or output for at least several quarters. That means any decision we make today will depend, in part, on our forecast of the economy for the latter half of 2008 and for 2009, since that is when its effects will most likely be felt. While the forecasting task is a difficult one, we are fortunate to have an extraordinary team of economists in Washington and in the Federal Reserve Banks that help us develop our projections and assess the economic landscape.

As you are no doubt aware, the monthly statistics reported on the economy can be volatile and subject to revision. Recall that in early September we thought the economy had lost 4,000 jobs in August, only to learn in October that it actually had gained 93,000 jobs. The FOMC works hard to differentiate those factors that may have only a temporary impact on the economy or inflation from those of a more sustained nature.

...

The fourth quarter of 2007 and the first quarter of 2008 are going to be quite weak; that has been clear for a number of months. My forecast already incorporates the prospect that we will get some bad economic numbers from various sectors of the economy in the coming months. Since monetary policy's effects on the economy occur with a lag, there is little monetary policy can do today to change economic activity in the first half of 2008.

...

I am still optimistic that the economy will improve appreciably by the third and fourth quarters of 2008, and that is when any monetary policy action today will begin to have noticeable effects. Overall real GDP growth will be faster in the second half of 2008 as the economy begins to return to its longer-run trend growth of about 2-3/4 percent. On a fourth-quarter to fourth-quarter basis, I expect that the economy will grow about 2.5 percent in 2008, close to its pace in 2007, and that it will be growing more consistently near its longer-term trend in 2009.

I am concerned that developments on the inflation front will make the Fed's policy decisions more difficult in 2008. Recent data suggest that inflation is becoming more broad-based. Recent increases do not appear to be solely related to the rise in energy prices. Consequently I see more worrisome signs of underlying price pressures. Although I am expecting slow economic growth for several quarters, we should not rely on slow growth to reduce inflation. Indeed, the 1970s should be a sufficient reminder that slow growth and falling inflation do not necessarily go hand in hand. Moreover, the 1990s should remind us that we can have sustained economic growth without generating inflation.

Although inflationary expectations have crept up only slightly since early September based on inflation-indexed Treasury securities, my sense is that these inflation expectations are more fragile now than they were six months ago. If inflation expectations continue to rise, it will be difficult and costly to the economy to deliver on our goal of price stability and puts at risk the Fed's credibility for maintaining low and stable inflation.

The entire speech is worth reading. We recommend it.

Hubris

This morning on CNBC, some talking head (a guest, not a host) made a set of deeply strange noises about the economy and the market remaining unsettled "until the Fed figures out what's going on." And then, one presumes, once the Fed figures it out, all will be right with the world. A moment later, this guest described the Fed as "the smartest people in the world." Good grief! Truly, it's amazing these Olympian gods deign to deal with something as mundane as the Fed funds rate in the first place.

Back in mid-September, we mentioned Wall Streeters' "remarkable belief in the capacity of the guardians at the Fed to pretty much vanquish the business cycle." For a bunch of people supposedly schooled in the workings--and benefits--of free markets, this strikes us as downright bizarre.

Let's be clear: The Fed--the FOMC, its staff, its regional banks, the whole organization--is stocked with terrifically smart, well-intentioned people. They're good public servants and they deserve our respect. But let's not get carried away with these notions of precision-guided bureaucratic power. We've posted repeatedly on the limitations of Fed authority (here, here and here, for example). Our basic premise--that the Fed has more power than authority*--seems especially apt now as more and more market observers begin to suspect that the good ol' business cycle is still with us.

In addition to the Fed and its monetary policy toolbox, we're now hearing rumblings out of Washington about some sort of fiscal stimulus package. We take no position on the relative merits of the various notions circulating these days (corporate tax cuts, targeted income tax cuts, one-time tax credits, &c.). Here we'll simply note that investors shouldn't expect too much in terms of actual economic impact from any such proposals. Not in terms of timing, precision, or adequacy--to say nothing of unintended consequences.

It's one thing for a CNBC guest to say all we need is the Fed to figure it out. It's another for CNBC's hosts to let that sort of nonsense go unchallenged. Intelligent investors--intelligent citizens--know not to expect so much from our important but decidedly imperfect public institutions.

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* A couple quick working definitions: Power is the capacity to act (i.e., lower the fed funds rate). Authority is the capacity to define the nature and consequences of one's actions (i.e., as desirable, rational, logical, helpful, productive, &c.).

Source

"Paulson: Don't want to rush economic stimulus," Reuters, January 7, 2008

Monday Reading

Snow. Ice. Fog. Rain. Thunder. The upper Midwest is in fine form these days...

• Speaking of five stages of things that aren't much fun, here's Barry Ritholtz with a great post: "5 Stages of Market Grief."
• John Hussman's latest market comment is big and burly. Check it out.
• Commercial real estate continues to weaken.
• Treasuries may seem like a safe haven, but there may not be much there there.
• Another breezy-but-smart entry from Jeff Saut.
• At IndexUniverse, Larry Swedroe has a useful retrospective on 2007.