SOS for the Dollar

The dollar continues to sink against most major currencies.

No one in Washington seems to be all that concerned - after all, a weaker dollar presumably makes American products and workers more competitive globally, so what's the worry?

Overseas, of course, the rapidly dwindling value of the dollar is a huge story.

As background, here's columnist James Mackinosh writing in this morning's Financial Times:

Weak, weaker, weakest. The Fed's own measure of the dollar in real terms against America's main trading partners shows that it ended March at its lowest since it first traded freely in 1973. Since then it has fallen further, as Mr. Bernanke's supportive comments on Wednesday, far from shoring up the greenback, accelerated its decline. Worse-than-expected economic growth added to the dollar's woes.

Much of the recent rise in gold and other precious metals, of course, can be traced to the increasing concern that the dollar may be losing its luster as the world's reserve currency.

With no obvious replacement for the dollar, world central banks are either turning to gold or, in the case of Hong Kong and Singapore, considering using a basket of currencies rather than the dollar to peg the value of their own currencies.

For now our markets seem unconcerned - stocks continue to inch higher, and bonds are increasing in value as well. But a longer-term bout of dollar malaise may eventually come back to haunt us.

"Where Should I Invest Money Now?"

I've been getting lots of questions recently from clients and prospects who are struggling with the current investment climate.

The economic data has been soft recently, even though first quarter earnings reports are generally better than expectations.

Stocks have moved up sharply since the beginning of the Fed's QE2 program last fall, but now it appears that the Fed is moving to the sidelines, at least for the time being.

Bonds, meanwhile, continue to rally, and yields have moved down sharply since early February. At this writing, the 10-year Treasury yields 3.32%, which is almost exactly where they were at the beginning of 2011.

Municipal yields have dropped for the last 11 days in a row, and the AAA municipal now yields 2.91%. Municipal supply has been relatively light this year for a variety of reasons, and investors have become more comfortable with the idea that municipal doomsayers like Meredith Whitney were overly pessimistic.

So, with cash and bond yields so low, and the economy showing signs of weakness, what should the individual investor do?

With this as a backdrop, I thought I would share an email that I sent to a good client this AM:

Hi,

The most attractive areas for investment, in my opinion, pretty much mirror what I mentioned to you earlier this year.

Longer maturity municipals still offer reasonably attractive after-tax returns in a low yield world.

Large cap, dividend-paying stocks are trading at a lower valuation than many other sectors of the market. In some cases, the dividend yield on the stock is better than the bonds issued by the same corporation. In addition, while the general economic news seems to have turned softer, the first quarter earnings reports for most companies have been pretty good.

I still don't find any value in shorter maturity bonds. Yields are way too low (e.g., the 2-year Treasury note yields a whopping 0.65%) unless you are super bearish on the world.

Shorter municipals, by the way, also are mostly yielding less than 1%, so I wouldn't be rushing into this sector either.

Finally, we are currently favoring the U.S. stock market vs. the overseas markets. In particular, the emerging markets look very expensive vs. the U.S., particularly when you consider that the central banks in places like China and Brazil are trying to slow their economies. Only in the U.S. and Japan are governments attempting to help economic growth and, to us, you'd rather be investing in places where you have fiscal and monetary tailwinds.

Hope this is helpful,

Dave

TIPS: Great Deal for the Government, Bad for Investors

If you truly are worried about a resurgence of inflation - which Random Glenings is not, but this is a minority view - you might be considering an investment in Treasury Inflation-Protected Securities (TIPS).

Please don't.

Quick background: TIPS offer investors the theoretical ability to hedge assets against inflation. Although the nominal yield on TIPS is lower than traditional US Treasury securities, the principal balance of your investment is adjusted higher each year based on the change in the CPI.

There are numerous problems with TIPS from both a structural and liquidity standpoint, but I won't go into them here.

My most relevant point today is that with all of the current hype about inflationary pressures, investors seem to be willing to pay almost any price for protection.

Thus, at the present time, the nominal yields - that is, the cash flow you the investor will be receiving periodically over the life of your investments - are ridiculously low on TIPS.

For maturities out to six years, for example, nominal yields are negative. Put another way, you are paying the government a fee each year for the supposed inflation protection. Even 10-year TIPS are yielding 0.72%.

Ah, you say, but at least I am protected against inflation.

Well, maybe, but if you just leave your money in a money market fund, or invest in short maturity CD's, you will be better-protected and have considerably more liquidity.

Why is that?

If you look back historically - say, over the last 60 to 70 years - short term interest rates and inflation rates track very closely. In the language of economists, "real" short-term interest rates are 0% over longer periods of time.

This stands to reason, even in today's environment. If the Fed were to witness a resurgence in inflationary pressures, they would most likely ratchet up short term rates fairly quickly.

In other words: Don't buy TIPS. As a fellow citizen of the United States I appreciate your efforts to reduce our government deficit, but there are better ways to contribute.

What Happens When the Fed Leaves The Party?

There was a time when the Federal Reserve, and the Fed's policy decisions, received as much media attention as my beloved New England Revolution soccer team.

Back in the Carter administration, for example, then-chairman G. William Miller joked that when he was first appointed head of the Federal Reserve, his relatives thought he was going to head up a bourbon company.

(Mr. Miller was famous for insisting that Fed meetings should be over as quickly as possible, and he often succeeded: it was not unusual for a Miller-led meeting to conclude in 10 minutes.)

No more. The Fed, and Fed actions, are scrutinized and discussed as much as any government actions.

And so last weekend, right next to the stories of the wars in Libya and elsewhere, there was a front page story in last Sunday's New York Times discussing whether the Fed's second round of quantitative easing (so-called QE2) had any positive effect on the economy other than causing stock prices to move sharply higher.

http://www.nytimes.com/2011/04/24/business/economy/24fed.html?_r=2&hp#

The consensus in the article was essentially that QE2 was a flop, a zephyr in the economic breeze.

I'm not really sure this is true, and the news magazine The Economist begs to differ as well:

So what happened after Mr Bernanke made it clear to markets that the Fed would act again? Growth accelerated, from a 1.7% annualised pace in the second quarter to 2.6% in the third quarter and 3.1% in the fourth quarter. Inflation expectations ceased falling and began rising back to normal levels. Confidence rose. And the pace of hiring improved meaningfully. In both February and March, private firms added over 200,000 jobs. Since the Fed's policy began, the unemployment rate has fallen a full percentage point.

http://www.economist.com/blogs/freeexchange/2011/04/monetary_policy_3

My point in mentioning all of this today is that there seem to be unmistakable signs that economic growth is beginning to slow again - just when the Fed is ending its QE2 program.

Some economists are pointing towards higher oil prices, which certainly is playing a large role in changing consumer behavior. Housing continues to sputter along, and unemployment rates are far higher than they typically would be in a normal economic recovery.

First quarter GDP will be reported later this week, and it will probably be around +1.5%, down considerably from the fourth quarter of 2010, when GDP came in at +3.1%.

Then there's my favorite barometer, the bond market. Bond yields have fallen 21 basis points over the last 9 trading days, and the 10-year Treasury now yields 3.36%. Apparently there are lots of investors who think locking in returns just north of 3% is better than any alternative.

I remain positive on the stock market for the time being, but diligence remains important in this environment.

Pepsi Thinks Inflation is Bubbling Up

Hugh Johnston is the chief financial officer of PepsiCo. According to an interview published in this morning's Financial Times, Mr. Johnston is not happy with the way the Fed focuses on the so-called "core" inflation rate.

Mr. Johnston believes that the government's way of reporting inflation understates the impact that rising food prices are having on consumers.

Quoting Mr. Johnston: "The reality right now is that food and fuel are quite inflationary", particularly on families earning less than $70,000 a year. While the core inflation rate is being quoted at 1.2%, food prices have climbed 2.7% over the past year, and gasoline prices prices have increased +28%.

The calculation of inflation is always controversial, but it seems to be getting more press than normal these days. The bond market doesn't seem to be worried - the 10-year Treasury is yielding around 3.4%, or about 40 basis points less than a year ago - but that hasn't stopped any number of analysts from commenting that inflation is just around the corner.

Yesterday's New York Times carried a short piece that talked about the problems of reporting inflation especially when it comes to food and energy.

At the top of the list for year-over-year changes in food and energy costs (according to the Bureau of Labor Statistics):

Gasoline +28%
Lettuce +27%
Bacon +16%

But look at the bottom of the list:

All fresh fruit -2%
Wine unchg.
Eggs +1%
Poultry +2%

Inflation rates, like so much data, can be subjective in the way they are reported.

As previous posts on Random Glenings have indicated, food and fuel prices are notoriously volatile, which is why they are excluded from core inflation calculations. In 2008, for example, oil prices peaked in the spring, but then proceeded to fall by more than -53% for the next 12 months.

Stocks Ignore S&P, Roar Ahead

After a rocky start to the week, the stock market roared ahead yesterday.

S&P warnings about the future credit ratings of trillions of dollars of US debt may prove prescient in the future, but for now the market wants to move higher.

The Financial Times this morning had an article titled "Investors Seek Clues in a Cloudy Earnings Picture". Written by Michael Mackenzie and Michael Stothard, the piece had a number of interesting statistics on the market.

Company earnings reports have been reasonably good for the first quarter of 2011. While we are still early in earning season, of the 60 companies in the S&P 500 that have reported 78% have beaten expectations.

The blended earnings growth for the S&P 500 in the first quarter is running at +12%, roughly equal to expectations at the beginning of the year.

Not surprisingly, the sectors with the highest earnings growth rates include materials (+39%); energy (+31%); and industrials (+23%). Not coincidentally, these three sectors have been the best performers in the S&P year-to-date.

And, according to the Financial Times, the forward 12-month P/E ratio for the S&P is 13x, which is below the average of the last 10 years.

Interesting, Merrill Lynch research indicates that their retail investor is selling, not buying this market. Here's an excerpt from Merrill's David Bianco earlier this week:

Overall flows: Largest net sales since May 2010
The first week of reporting season was met with widespread selling of US stocks by BofAML clients. Net sales of $1.6bn last week (4/11-4/15) were the largest level of net sales since May 2010. This compares to net buys of $0.28bn the prior week. All three client types (hedge funds, institutional clients, and private clients) were net sellers last week. Hedge funds returned to net selling of US stocks last week after net buying for the prior three weeks. Over the past year, hedge funds have not been net buyers for more than three consecutive weeks. All three size segments (small, mid and large) also saw net sales last week.

In my opinion, in addition to reasonably good fundamentals, the huge reservoir of liquidity that the Fed and Bank of Japan are providing the markets are also aiding the stock market.

There will be a time to sell stocks, but I don't think we're there yet. I think the party ends when the Fed starts raising interest rates, but this doesn't seem to be in the cards for a few months at least.

Housing Continues to Suffer

Housing is a mess.

While most of the attention of financial analysts and media is focused on the rapid rise in the prices of commodities like oil and gold, housing prices in many parts of the country continue to tick lower.

The problem is largely psychological. Even if they can afford it, no one wants to buy a house if they think prices will be lower 6 months ago.

I had a long conversation last week with someone who is very involved in the home mortgage market in the Boston area.

After her children graduated college, she and her husband decided to "downsize" and sell their house.

After sitting on the market for several months, they finally sold their home, but at a price well below assessed value ("my neighbors are not happy with us", she said with a rueful smile).

So what now?

Well, this well-connected, savvy mortgage lender has decided to rent. She, like many Americans, believe that housing is trapped in a downward price spiral. While renting a home lacks that psychic appeal of owning real estate, at least you don't feel like your retirement assets are locked up in a depreciating asset.

Here's the change of housing prices since their peak in 2006, courtesy of the blogger West Wing:

Home prices (median) since '06 peak: Miami -32%, Tampa -33%, L.A. -35%, San Diego -37%; Phoenix -50%; Ft. Myers -54%; Vegas -55%

Little wonder that most Americans are avoiding buying homes.

Bloomberg carried an article about this trend yesterday. Here's an excerpt, with the full link below:

The most affordable real estate in a generation is failing to lure buyers as Americans like Pauli sour on the idea of home ownership. At the end of 2010, the fourth year of the housing collapse, the share of people who said a home was a safe investment dropped to 64 percent from 70 percent in the first quarter. The December figure was the lowest in a survey that goes back to 2003, when it was 83 percent.

“The magnitude of the housing crash caused permanent changes in the way some people view home ownership,” said Michael Lea, a finance professor at San Diego State University. “Even as the economy improves, there are some who will never buy a home because their confidence in real estate is gone.”

Americans Shun Most Affordable Homes in Generation as Owning Loses Appeal - Bloomberg