Wednesday, June 14, 2006

Burton Malkiel on "More than you know"

Read Malkiel's interesting review of the book "More than you know" by Michael Mauboussin in today's WSJ at

I think by now, we all know how to pick stocks: just buy stocks with growth potential that is not yet reflected in the market price. But the advice to pick funds that charge lower expenses and have low stock turnover seems much clearer to me.

Uncertainty, inflation data, and financial markets

We now have new data on inflation, both PPI and CPI indexes have been released by the BLS. The PPI, producer price index, is a measure of price changes from the prospective of the seller, whereas the CPI, consumer price index, is a measure of price changes from the prospective of households. What should we gather from the large amount of information released by the BLS?

Let's start from the PPI, released yesterday. The PPI increased by 0.2% in May after a 0.9% increase in April and a 0.5% in March. What does this mean? A 0.2% is not a big increase, but it is the series of increases that may worry the Fed. From May 2005 to May 2006 the PPI increased by 4.5%. This is a value outside the confort zone of the Fed. But, does a 0.2% reading means that inflation is slowing down, possibly due to contractionary monetary policy finally kicking in? This is not so sure. If we focus on PPI of intermediate goods used in manufacturing, the index increased by 1.1% in May, after a 0.9% increase in April, and a -0.1% in March. To the extent that increased prices of intermediate goods are passed on to prices of final goods, this increase implies a future increase in inflation.

Now the CPI, released today. The CPI increased by 0.4% in May and by 4.3% from May 2005. During the first 5 months of 2005 the CPI has increased at an annualized rate of 5.2%. Contrast this number with a 3.4% increase in the CPI in all of 2005. Excluding food and energy, the index increased at an annualized rate of 3.1% in the first 5 months; this is core inflation. The main drivers seem to be transportation (caused by increasing energy prices), medical care costs, apparel, and, perhaps more importantly, housing rentals. Both rents and owner equivalent rents have increased in May, by 0.3% and 0.6% respectively.

The data on inflation confirms some of the fears Mr. Bernanke had expressed: inflation is moving within bands that we have experienced in the recent past, but it's getting outside the Fed's confort zone. At the same time, spending and economic growth seem strong, both in the US and globally. It seems almost certain, as futures on the federal funds rate show, that the Fed will increase interest rates.

How have stock market reacted? On one hand you have strong growth, on the other rising inflation. This is an environment of uncertainty. If inflation rises, it means that high levels of growth cannot be sustained any longer, the economy is near or at full capacity. The fact that markets have dropped in the last week or so means that valuations are adjusting to a new, lower, level of growth. As the same kind of data is emerging more or less globally, and most noticeably, Japan and Europe, global financial markets are reacting in a similar fashion. Emerging markets indexes have also declined, and by more than the DJIA. This fact should not surprise. Growth in these markets is clearly related to growth in major countries such as the US, Japan, and Europe. In addition, these are riskier markets, so we should not be so surprised that benchmark indexes are down 9% in Russia and Colombia, or 5% in Turkey.

The climate of uncertainty has hit commodities too, with gold futures down 7% yesterday and 22% in the last month. Incidentally, commodity prices going down should indicate that expectations of inflation are not rising.

In conclusion, it seems that financial markets are not uncertain about what the Fed will do and about the Fed's ability to control inflation. Markets are uncertain about what's happening to growth, and what growth rate can be sustained in the near future.

Thursday, June 08, 2006

What's Happening to Stocks?

The Dow Jones Industrial Average closed below the 11,000 threshold for the first time in three month yesterday, June 7, when it hit 10,930.90. According to many in the news business, the drop is due to continued adjustments to bad news about inflation and the U.S. economy after Mr. Bernanke's speech, echoed yesterday by Atlanta FRB President Jack Guynn. Fears of inflation, and forthcoming interest rates increases by the Fed, the story goes, will slow down the economy, and that is driving down stocks (see for example today's commentary of wednesday's markets in the WSJ).

There is something wrong with this analysis. First, as low inflation promotes economic stability and long run performance, investors should greet positively actions taken by the Fed to curb inflation: further rate rises, if needed, would only benefit the economy. So stocks should react positively.

Second, is it really fear of inflation that is driving markets down? How have bonds reacted? Long term bond yields have barely changed in the last two days. The 10-yr note yield closed at 5.02%, and even the three month T-bill closed at 4.81% on monday, from Friday's 4.80%, and at 4.85% yesterday.

So, if we are to find something in Mr. Bernanke's speech that has shaken the markets, what is it? I think stock markets reacted, rationally, to his clear economic analysis of the current state of aggregate supply ---read my previous blog about the analysis. Mr. Bernanke said that there is little doubt that the economy is approaching full capacity utilization, and although productivity will continue to grow, it is unlikely that it will continue to do so at the pace we have observed in the last few years.

If stock prices before the announcement were based on longer lasting sustained growth of the kind we have experienced so far, then adjustment of growth expectations can very well explain the drop in prices. Stock prices are taking Mr. Bernanke's analysis seriously. Now, Mr. Bernanke's warning that we maybe seeing a growth slowdown soon does not mean that the economy is about to experience bad times. It just means that growth may be stabilizing closer to long run levels experienced by the U.S. (think 3% rather than 4% or more). This seems hardly bad news. So it's possible that stock markets did overreact by taking the analysis more negatively than intended by the Fed Chairman. Here I am just speculating though.

One final thought about inflation. With the economy stabilizing at a lower growth rate, it is natural that money supply should grow less rapidly, otherwise there would be to many dollar bills chasing to few goods to buy, which would spur inflation. Thus the need to raise rates a little. It seems investors should be confident about future Fed policy, as bond traders seem to be showing.

What's your take?

Wednesday, June 07, 2006

What's your take on interest rates?

In a public appearance on Monday, Fed chairman Ben Bernanke highlighted the state of the economy and, according to the media, sent down the DJIA by 1.77%.

What did he say about the economy? And what's the relevance of his comments for future interest rate policy? I am going to review his comments and take a stand on the next target for the federal funds rate.

Bernanke aknowledged the robust (i.e. above trend) growth of the U.S. economy during the past three years and attibuted it mostly to advances in productivity and increase in the labor force ---underlying fundamentals. But then he stated:

" While we cannot ascertain the precise rate of resource utilization that the economy can sustain, we have little doubt that after three years of above trend growth, slack has been substantially reduced."

This is a statement that the economy, given current resources and technology, is approaching full production capacity. In my macro class, I call this region of the aggregate supply function the "danger zone", an area in which the Fed start to worry about inflation. This is because further increases in production, due to increased aggregate demand, can come only at higher prices.

Bernanke says there is little doubt about it, we are in the danger zone!

Increasing prices, inflation, tend to reduce excess demand, demand that is not sustainable in the short run because the economy is near full capacity. Bernanke is not sure that this is already happening, here is why.

He says that personal consumption expenditures, which make two thirds of US output, has shown slowing growth in the past quarter. High energy prices affected income and expenditure of an increasing number of households. Fuel prices have increased more than 30% in the past year (from 2.11 to 2.86 a gallon nationwide), and households are starting to feel the effect of this increase. The housing market is cooling, which might induce household to take out less home equity loans to finance their consumption. Payroll data shows signs of employment slowdown, and the number of initial jobless claims is up.

On the other hand, unemployment rates are still low and investment is rising at a good pace. In particular, while residential housing is slowing down, non-residential construction is picking up, which might take some of the slack from residential housing. Other business investment, like IT and equipment, is also increasing. Corporate bond spreads remain low, showing little signs of increasing risk, and global growth seem high this year.

And now inflation, what's happening to inflation? Core inflation, exluding volatile energy and food prices, has been at 3.2% in the past 3 months, and at 2.8% in the past six months. This is an unwelcome development according to Mr. Bernanke. What about inflation expectations? Measures of expected inflation and inflation risk indicate that expected inflation is on the rise, and while the current level is whithin values experienced in the last year or so, it bears closed watching. Mr. Bernanke also said that anectodal reports show that firms are having difficulty attracting workers in some sectors.

To summarize, we have an economy close to full capacity, in which inflation is already at reasonably high levels, and in which it is not clear that price increases have slowed down the "robust growth" ---above trend--- we have been experiencing in the past three years.

Before jumping to conclusions about the future course of monetary policy, we should think about policy so far. The Fed has been increasing rates for a while, and given the lags with which monetary policy affects aggregate demand, it's not so obvious that further increases are needed. One has to weigh two risks: (i) slowing down the economy by increasing rates if they are not needed vs. (ii) letting inflation increase by not raising rates. Even disregarding speculations about credibility, a new chairman, and similar arguments advanced by the press, with the unemployment rate so low, the Fed can afford raising the target federal funds rate by a quarter point (to 5.25%) at the next meeting and my guess it's that this is what they will do.

Tuesday, June 06, 2006

Business Cycles and Large vs. Small Cap Performance

In the past 5 years, the Russel 2000, a yardstick for small-stock performance, is up more than 40%, while the Dow Jones, which tracks 30 of the nation's biggest public companies, has been about flat (read Diya Gullapalli's article on the June 5 WSJ Mutual Funds Report).

There appears to be cycles of performances between the two classes of stocks in the data. Large cap stocks tend to outperform small caps during periods of slow growth or recessions, and small caps outperform large caps when the economy is rebounding from a recession and its growth is greater than usual.

The argument for these cycles seems to be based on the fact that prices and revenues of small cap companies are more susceptible to business cycles than prices and revenues of large companies. A cited reason for this is that large companies enjoy economies of scale.

Another reason for this apparent performance is that small cap companies are usually companies with potentially fast growing profits and revenues. But growth prospects are uncertain and hard to estimate, and changes in growth prospects have large effects on stock prices. Thus, during economic contractions, when uncertainty about economic prospects is higher, small caps may take a bigger hit.

How can this be useful to investors? Given these cycles, the answer is obvious, one should invest in small cap funds or companies in expansions and in large cap funds or companies in contractions. Investors can take advantage of this strategy to the extent that we can predict expansions/contractions. Notice though the market would try to undo this profitable strategy with price changes: Prices of small caps would increase right at the beginning of an expansion, thus eliminating future capital gains. Under this hypothesis then, only unpredictable components of business cycles are responsible for the performance cycles. Thus, there is no way to take advantage of the performance cycles: small caps are simply a riskier investment opportunity.

According to this view, small caps should earn a greater long-run return relative to large caps, in compensation for the extra risk. This is indeed the case in the US, where in the last 80 years or so small caps have outperformed large caps.

Notice this type of "efficient market" type of analysis is based on two testable implications: that small companies profits are more strongly procyclical, and that their prices react to changes in expected growth prospects of the company. I am not sure we have direct and convincing evidence on these.