Dollar roars back as global debts are called in
For six years the world has been borrowing dollars to bet on property, oil, metals, emerging markets, and every bubble in every corner of the globe.
By Ambrose Evans-Pritchard Last Updated: 3:48PM BST 23 Oct 2008
The strong rebound in the dollar has surprised some analysts
This has been the dollar "carry trade", conducted on a huge scale with high leverage. Now the process has reversed abruptly as debt deflation - or "deleveraging" - engulfs world markets. The dollars must be repaid.
Hence a wild scramble for Greenbacks which has shaken the global currency system and shattered assumptions about the way the world works. The unwinding drama reached a crescendo yesterday as the euro fell to $1.28, down from $1.61 in July. The slide in the Brazilian real, the South African rand, the Indian rupee, and the Korean won, among others, has been stunning.
Stephen Jen, currency chief at Morgan Stanley, said US mutual funds, pension funds, and life insurers invested a big chunk of their $22 trillion (£13.5 trillion) of assets overseas to earn a higher yield during the boom. They are now in hot retreat as the emerging market story unravels. "There is a complete rethink going on. People are bringing their money back home," he said.
Hedge funds are 75pc dollar-based, regardless of where they come from. Many are now having to repatriate their dollars as margin calls, client withdrawls, and the need to slash risk forces them to cut leverage. The hedge fund industry had assets of $1.9 trillion at the peak of the bubble.
Data collected by the Bank for International Settlements shows that European and UK banks have five times as much exposure to emerging markets as US and Japans banks, with surprisingly big bets in Latin America and emerging Asia - where they rely on dollar funding rather than euros.
The fear is that deflating booms in these frontier economies will have an 'asymettric' effect on the currency markets, setting off another round of frantic dollar buying. "It is not impossible that the euro could collapse completely against the dollar, going back to 2001 levels," said Mr Jen.
He said the "composite" dollar-zone including China, the Gulf oil states, and other countries locked into the US currency system, will together have a current account surplus next year. The de-facto euro bloc of the core euro-zone and Eastern Europe is moving into substantial deficit. This creates a subtle bias in support of the dollar.
Of course, much of the currency shift this year is a natural swing as the crisis rotates from the US to Europe and beyond. The dollar was pummelled in the early phase of the crunch when economists still thought Europe, Japan, China and the rest of the world would decouple, powering ahead under their own steam. The Federal Reserve's dramatic rate cuts were seen then as a reason to dump the dollar.
The decoupling myth has now died. The euro-zone and Japan appear to have fallen into recession before the US itself, led by a precipitous fall in German manufacturing.
The ultra-hawkish stance of the European Central Bank - which raised rates in July - is now viewed as a weakness. Foreign exchange markets are no longer chasing the highest interest yield: they are instead punishing those where the authorities are slowest to respond to the downturn.
A hard-hitting report by Citigroup this week said the ECB had unwisely ignored screaming signals from the bond markets earlier this year for a rate cut. "The ECB did not listen. Not only did they no reduce rates as they should have but they increased them in one of the biggest policy mistakes of 2008," it said.
The spectacular dollar rebound has geostrategic implications. Heady talk earlier this year that dollar hegemeny was coming to an end - or indeed that the US was losing its status as a financial superpower - now seems very wide of the mark.
http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/3242927/Dollar-roars-back-as-global-debts-are-called-in.html
Saturday 20 December 2008
ZIRP: Welcome to the world of sub-zero returns
ZIRP: Welcome to the world of sub-zero returns
Zero is a hard number to understand. In multiplication, it turns other values to nought. In division, it turns them to infinity. In finance, it turns the world upside down. No wonder investors are dizzy.
By Edward Hadas, breakingviews.comLast Updated: 12:50PM GMT 18 Dec 2008
The US is repeating a Japanese experiment with a zero in one of the most important variables in financial markets: the official overnight interest rate. This "Zirp" (zero interest rate policy) is combined with a nearly infinite quantity of government borrowing. The US government is expected to stimulate the economy - well into what looks like a bad recession - with as much as $850bn of new debt.
Meanwhile, the recession is inspiring a flight to safety. That means buying government bonds. The 2.2pc yield on the 10-year US Treasury could approach zero if the Federal Reserve follows up on hints that it will start buying Treasuries itself. So bond prices could move higher. But in the currency market, mega-debts and mini-yields are harmful, which is why the dollar has fallen back from Y98 to Y88 in a month.
The combination of falling yields and falling currency is illogical for a country that depends heavily on foreign capital. But in the Zirp world, many things don't quite stack up. The US isn't the only country that offers this investment conundrum. Take the UK, which is similarly indebted, and similarly borrowing more. The country is heading quickly towards Zirp, with the overnight rate of 2pc likely to be cut in half in January. The 10-year gilt yields a low 3.2pc. And the pound has tumbled as fast as the dollar, from E1.18 to E1.08 in a month.
The move towards Zirp is widespread. Japan never really left, and the eurozone is gradually getting there. The thinking is that free money will keep the credit system from freezing up, while higher government deficits should keep demand from collapsing.
But the policies aren't obviously working. The best that can be said so far is that the world could be in even worse shape without them. As no plausible alternatives are on offer, investors should expect more Zirp.
And that points to many sub-zero returns.
http://www.telegraph.co.uk/finance/breakingviewscom/3832292/ZIRP-Welcome-to-the-world-of-sub-zero-returns.html
Comment: ZIRP = Zero reward to creditors
Zero is a hard number to understand. In multiplication, it turns other values to nought. In division, it turns them to infinity. In finance, it turns the world upside down. No wonder investors are dizzy.
By Edward Hadas, breakingviews.comLast Updated: 12:50PM GMT 18 Dec 2008
The US is repeating a Japanese experiment with a zero in one of the most important variables in financial markets: the official overnight interest rate. This "Zirp" (zero interest rate policy) is combined with a nearly infinite quantity of government borrowing. The US government is expected to stimulate the economy - well into what looks like a bad recession - with as much as $850bn of new debt.
Meanwhile, the recession is inspiring a flight to safety. That means buying government bonds. The 2.2pc yield on the 10-year US Treasury could approach zero if the Federal Reserve follows up on hints that it will start buying Treasuries itself. So bond prices could move higher. But in the currency market, mega-debts and mini-yields are harmful, which is why the dollar has fallen back from Y98 to Y88 in a month.
The combination of falling yields and falling currency is illogical for a country that depends heavily on foreign capital. But in the Zirp world, many things don't quite stack up. The US isn't the only country that offers this investment conundrum. Take the UK, which is similarly indebted, and similarly borrowing more. The country is heading quickly towards Zirp, with the overnight rate of 2pc likely to be cut in half in January. The 10-year gilt yields a low 3.2pc. And the pound has tumbled as fast as the dollar, from E1.18 to E1.08 in a month.
The move towards Zirp is widespread. Japan never really left, and the eurozone is gradually getting there. The thinking is that free money will keep the credit system from freezing up, while higher government deficits should keep demand from collapsing.
But the policies aren't obviously working. The best that can be said so far is that the world could be in even worse shape without them. As no plausible alternatives are on offer, investors should expect more Zirp.
And that points to many sub-zero returns.
http://www.telegraph.co.uk/finance/breakingviewscom/3832292/ZIRP-Welcome-to-the-world-of-sub-zero-returns.html
Comment: ZIRP = Zero reward to creditors
**Debt deflation is tightening its grip over the entire global system.
Deflation virus is moving the policy test beyond the 1930s extremes
Debt deflation is tightening its grip over the entire global system. Interest rates are creeping towards zero in Japan, America, and now across most of Europe.
By Ambrose Evans-Pritchard, International Business EditorLast Updated: 5:50AM GMT 09 Dec 2008
Comments 187 Comment on this article
China will not lift us out - they are the most vulnerable of all Photo: AP
We are beyond the extremes of the 1930s. The frontiers of monetary policy are being pushed to limits that may now test viability of paper currencies and modern central banking.
You cannot drop below zero. So what next if the credit markets refuse to thaw? Yes, Japan visited and survived this policy Hell during its lost decade, but that was a local affair in an otherwise booming global economy. It tells us nothing.
This time we are all going down together. There is no deus ex machina to lift us out. Certainly not China, which is the most vulnerable of all.
As the risk grows, officials at the highest level of the British Government have begun to circulate a six-year-old speech by Ben Bernanke – at the time of its writing, a garrulous kid governor at the US Federal Reserve. Entitled Deflation: Making Sure It Doesn’t Happen Here, it is the manual of guerrilla tactics for defeating slumps by monetary means.
“The US government has a technology, called a printing press, that allows it to produce as many US dollars as it wishes at essentially no cost,” he said.
Critics had great fun with this when Bernanke later became Fed chief. But the speech is best seen as a thought experiment by a Princeton professor thinking aloud during the deflation mini-scare of 2002.
His point was that central banks never run out of ammunition. They have an inexhaustible arsenal. The world’s fate now hangs on whether he was right (which is probable), or wrong (which is possible).
As a scholar of the Great Depression, Bernanke does not think that sliding prices can safely be allowed to run their course. “Sustained deflation can be highly destructive to a modern economy,” he said.
Once the killer virus becomes lodged in the system, it leads to a self-reinforcing debt trap – the real burden of mortgages rises, year after year, house prices falling, year after year. The noose tightens until you choke. Subtly, it shifts wealth from workers to bondholders. It is reactionary poison. Ultimately, it leads to civic revolt. Democracies do not tolerate such social upheaval for long. They change the rules.
Bernanke’s central claim is that the big guns of monetary policy were never properly deployed during the Depression, or during the early years of Japan’s bust, so no wonder the slumps dragged on.
The Fed can create money out of thin air and mop up assets on the open market, like a sovereign sugar daddy. “Sufficient injections of money will ultimately always reverse a deflation.”
Bernanke said the Fed can “expand the menu of assets that it buys”. US Treasury bonds top the list, but it can equally purchase mortgage securities from US agencies such as Fannie, Freddie and Ginnie, or company bonds, or commercial paper. Any asset will do.
The Fed can acquire houses, stocks, or a herd of Texas Longhorn cattle if it wants. It can even scatter $100 bills from helicopters. (Actually, Japan is about to do this with shopping coupons).
All the Fed needs is emergency powers under Article 13 (3) of its code. This “unusual and exigent circumstances” clause was indeed invoked – very quietly – in March to save the US investment bank Bear Stearns.
There has been no looking back since. Last week the Fed began printing money to buy mortgage debt directly. The aim is to drive down the long-term interest rates used for most US home loans. The Bernanke speech is being put into practice, almost to the letter.
No doubt, such reflation a l’outrance can “work”, but what is the exit strategy? The policy leaves behind a liquidity lake. The risk is that this will flood the system once the credit pipes are unblocked. The economy could flip abruptly from deflation to hyper-inflation.
Nobel Laureate Robert Mundell warned last week that America faces disaster unless the Bernanke policy is reversed immediately. This is a minority view, but one held by a disturbingly large number of theorists. History will judge.
Most central bankers suffer from a déformation professionnelle. Those shaped by the 1970s are haunted by ghosts of libertine excess. Those like Bernanke who were shaped by the 1930s live with their Depression poltergeists.
His original claim to fame was work on the “credit channel” causes of slumps. Bank failures can snowball out of control as the “financial accelerator” kicks in. The cardinal error of the 1930s was to let lending contract.
This is why he went nuclear in January, ramming through the most dramatic rates cuts in Fed history. Events have borne him out.
A case can be made that Bernanke’s pre-emptive blitz has greatly reduced the likelihood of a catastrophe. It was no mean feat given that he had to face down a simmering revolt earlier this year from the Fed’s regional banks.
The sooner the Bank of England tears up its rule books and prepares to follow the script in Bernanke’s manual, the more chance we too have of avoiding a crash landing.
Monetary stimulus is a better option than fiscal sprees that leave us saddled with public debt – the path that nearly wrecked Japan.
Yes, I backed the Brown stimulus package – with a clothes-peg over my nose – but only as a one-off emergency. Public spending should be a last resort, as Keynes always argued.
Of course, Bernanke should not be let off the hook too lightly. Let us not forget that he was deeply complicit in creating the disaster we now face. He was cheerleader of Alan Greenspan’s easy-money stupidities from 2003-2006. He egged on debt debauchery.
It was he who provided the theoretical underpinnings of the Greenspan doctrine that one could safely ignore housing and stock bubbles because the Fed could simply “clean up afterwards”. Not so simply, it turns out.
As Bernanke said in his 2002 speech: “the best way to get out of trouble is not to get into it in the first place”. Too late now.
http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/3629806/Deflation-virus-is-moving-the-policy-test-beyond-the-1930s-extremes.html
Debt deflation is tightening its grip over the entire global system. Interest rates are creeping towards zero in Japan, America, and now across most of Europe.
By Ambrose Evans-Pritchard, International Business EditorLast Updated: 5:50AM GMT 09 Dec 2008
Comments 187 Comment on this article
China will not lift us out - they are the most vulnerable of all Photo: AP
We are beyond the extremes of the 1930s. The frontiers of monetary policy are being pushed to limits that may now test viability of paper currencies and modern central banking.
You cannot drop below zero. So what next if the credit markets refuse to thaw? Yes, Japan visited and survived this policy Hell during its lost decade, but that was a local affair in an otherwise booming global economy. It tells us nothing.
This time we are all going down together. There is no deus ex machina to lift us out. Certainly not China, which is the most vulnerable of all.
As the risk grows, officials at the highest level of the British Government have begun to circulate a six-year-old speech by Ben Bernanke – at the time of its writing, a garrulous kid governor at the US Federal Reserve. Entitled Deflation: Making Sure It Doesn’t Happen Here, it is the manual of guerrilla tactics for defeating slumps by monetary means.
“The US government has a technology, called a printing press, that allows it to produce as many US dollars as it wishes at essentially no cost,” he said.
Critics had great fun with this when Bernanke later became Fed chief. But the speech is best seen as a thought experiment by a Princeton professor thinking aloud during the deflation mini-scare of 2002.
His point was that central banks never run out of ammunition. They have an inexhaustible arsenal. The world’s fate now hangs on whether he was right (which is probable), or wrong (which is possible).
As a scholar of the Great Depression, Bernanke does not think that sliding prices can safely be allowed to run their course. “Sustained deflation can be highly destructive to a modern economy,” he said.
Once the killer virus becomes lodged in the system, it leads to a self-reinforcing debt trap – the real burden of mortgages rises, year after year, house prices falling, year after year. The noose tightens until you choke. Subtly, it shifts wealth from workers to bondholders. It is reactionary poison. Ultimately, it leads to civic revolt. Democracies do not tolerate such social upheaval for long. They change the rules.
Bernanke’s central claim is that the big guns of monetary policy were never properly deployed during the Depression, or during the early years of Japan’s bust, so no wonder the slumps dragged on.
The Fed can create money out of thin air and mop up assets on the open market, like a sovereign sugar daddy. “Sufficient injections of money will ultimately always reverse a deflation.”
Bernanke said the Fed can “expand the menu of assets that it buys”. US Treasury bonds top the list, but it can equally purchase mortgage securities from US agencies such as Fannie, Freddie and Ginnie, or company bonds, or commercial paper. Any asset will do.
The Fed can acquire houses, stocks, or a herd of Texas Longhorn cattle if it wants. It can even scatter $100 bills from helicopters. (Actually, Japan is about to do this with shopping coupons).
All the Fed needs is emergency powers under Article 13 (3) of its code. This “unusual and exigent circumstances” clause was indeed invoked – very quietly – in March to save the US investment bank Bear Stearns.
There has been no looking back since. Last week the Fed began printing money to buy mortgage debt directly. The aim is to drive down the long-term interest rates used for most US home loans. The Bernanke speech is being put into practice, almost to the letter.
No doubt, such reflation a l’outrance can “work”, but what is the exit strategy? The policy leaves behind a liquidity lake. The risk is that this will flood the system once the credit pipes are unblocked. The economy could flip abruptly from deflation to hyper-inflation.
Nobel Laureate Robert Mundell warned last week that America faces disaster unless the Bernanke policy is reversed immediately. This is a minority view, but one held by a disturbingly large number of theorists. History will judge.
Most central bankers suffer from a déformation professionnelle. Those shaped by the 1970s are haunted by ghosts of libertine excess. Those like Bernanke who were shaped by the 1930s live with their Depression poltergeists.
His original claim to fame was work on the “credit channel” causes of slumps. Bank failures can snowball out of control as the “financial accelerator” kicks in. The cardinal error of the 1930s was to let lending contract.
This is why he went nuclear in January, ramming through the most dramatic rates cuts in Fed history. Events have borne him out.
A case can be made that Bernanke’s pre-emptive blitz has greatly reduced the likelihood of a catastrophe. It was no mean feat given that he had to face down a simmering revolt earlier this year from the Fed’s regional banks.
The sooner the Bank of England tears up its rule books and prepares to follow the script in Bernanke’s manual, the more chance we too have of avoiding a crash landing.
Monetary stimulus is a better option than fiscal sprees that leave us saddled with public debt – the path that nearly wrecked Japan.
Yes, I backed the Brown stimulus package – with a clothes-peg over my nose – but only as a one-off emergency. Public spending should be a last resort, as Keynes always argued.
Of course, Bernanke should not be let off the hook too lightly. Let us not forget that he was deeply complicit in creating the disaster we now face. He was cheerleader of Alan Greenspan’s easy-money stupidities from 2003-2006. He egged on debt debauchery.
It was he who provided the theoretical underpinnings of the Greenspan doctrine that one could safely ignore housing and stock bubbles because the Fed could simply “clean up afterwards”. Not so simply, it turns out.
As Bernanke said in his 2002 speech: “the best way to get out of trouble is not to get into it in the first place”. Too late now.
http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/3629806/Deflation-virus-is-moving-the-policy-test-beyond-the-1930s-extremes.html
Federal Reserve battles debt and deflation
Federal Reserve is damned either way as it battles debt and deflation
We know what causes a recession to metastasize into a slump. Irving Fisher, the paramount US economist of the inter-war years, wrote the text in 1933: "Debt-Deflation Theory of Great Depressions".
By Ambrose Evans-PritchardLast Updated: 6:34PM GMT 18 Dec 2008
Comments 66 Comment on this article
"Such a disaster is somewhat like the capsizing of a ship which, under ordinary conditions is always near stable equilibrium but which, after being tipped beyond a certain angle, has no longer this tendency to return to equilibrium, but a tendency to depart further from it," he said.
Today we call this "Gladwell's tipping point". Once it goes, you can't get back up. This is why the Federal Reserve has resorted to emergency measures that seem mad at first sight.
It has not only cut rates to near zero for the first time in US history, it is also conjuring $2 trillion of stimulus out of thin air. This is Quantitative Easing, or just plain 'QE' in our brave new world.
The key is the toxic mix of high debt and deflation. An economy can handle one at a time, but not both.
The reason why it "departs further" from equilibrium is more or less understood. The burden of debt increases as prices fall, creating self-feeding spiral. This is what Fisher called the "swelling dollar" effect. Real debt costs rose by 40pc from 1929 to early 1933 by his count. Debtors suffocated to death.
Brian Reading from Lombard Street Research has revived this neglected thesis and come up with some disturbing figures. US household debt is now $13.9 trillion, down just 1pc from its peak last year. Meanwhile household wealth has fallen 14pc as property crashes, a loss of $6.67 trillion. The debt-to-wealth ratio is rocketing.
Clearly the US is already in the grip of debt-deflation. "The obvious conclusion is that the Fed should print money to purchase private sector assets so as to drive up their price," he said.
Fed chief Ben Bernanke does not need prompting. He made his name as a Princeton professor studying the "credit channel" causes of depressions. Now fate has put him in charge of the channel.
Under his guidance, the Fed has this week pledged to "employ all available tools" to stave off deflation - and damn the torpedoes. It will purchase "large quantities of agency debt and mortgage-backed securities." It will evaluate "the potential benefits of purchasing longer-term Treasury securities," i.e, printing money to pay the Pentagon.
Put bluntly, the Fed is deliberately stoking inflation. At some point it will succeed. Then the risk flips quickly to spiralling inflation as the elastic snaps back. There will be a second point of danger.
By late 2009, if not before, the bond vigilantes may start to fret about the liquidity lake. They will worry that the Fed may have to start feeding its holdings of debt back onto the market. The Fed's balance sheet has already risen from $800bn in September to $2.2 trillion this month. It will be $3 trillion by early next year.
"The bond markets could go into free fall," said Marc Ostwald from Monument Securities.
"The Fed went into this all guns blazing just as the Neo-cons went into Iraq thinking it was a great idea to get rid of Saddam, without planning an exit strategy. As soon as we get the first uptick in inflation, the markets are going to turn and say this is what we feared would happen all along. Then what?" he said.
New Star's Simon Ward said all three measures of the US broad money supply are flashing recovery. M2 has risen at annual rate of 17pc over three months.
"It has all changed since the Fed began buying commercial paper in October. If the money supply is booming at 20pc in six months, inflation will become a concern. Given that public debt ratios are already on an explosive path, we risk a debt trap," he said.
For now, the bond markets are quiet. Futures contracts are pricing five years of deflation in the US. Yields on 10-year US Treasuries have halved since early November to 2.09pc, the lowest since the Fed's data began. Three-month dollar LIBOR has plummeted to 1.53pc.
It is the same pattern across the world. 10-year yields have fallen to 1.27pc in Japan, 3pc in Germany, 3.2pc in Britain, and 3.49pc in France.
The bond markets seem to be betting that emergency action by central banks will take a very long time to work, if it works at all. By cutting to zero, the Fed has come close to shutting down the US 'repo' market that plays a crucial role in providing liquidity. It has caused havoc to the $3.5 trillion money markets - as the Bank of Japan, burned by experienced, had warned. It has become even harder for banks to raise money. Some argue that extreme monetary policy is already doing more harm than good.
Mr Bernanke is known for his "helicopter speech" in November 2002, when he nonchalantly talked of the Fed's "printing press" and said it was the easiest thing in the world to "reverse deflation."
Less known is his joint-paper in 2004 - "Monetary Policy Alternatives at the zero-bound". By then doubts were creeping in. He admitted to "considerable uncertainty" as to whether extreme tools will actually work. Liquidity could fail to gain traction.
Put another way, the Fed is flying by the seat of its pants. It should never have let debt grow to such grotesque levels in the first place.
http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/3834108/Federal-Reserve-is-damned-either-way-as-it-battles-debt-and-deflation.html
OPEC calls on UK to cut fuel duty or risk a long-term spike in oil
OPEC calls on UK to cut fuel duty or risk a long-term spike in oil
Oil cartel OPEC has called on Western governments, including Britain, to cut duty on petrol or risk fuelling a much higher oil price in the future.
By Rowena Mason Last Updated: 2:42PM GMT 19 Dec 2008
Saudi Arabia's Crown Prince Sultan at an OPEC summit in Riyadh, November 2007. Photo: REUTERS
Saudi Arabia's oil minister Ali al-Naimi and Abdalla S El-Badri, secretary-general of OPEC, said low demand was "wreaking havoc" for oil producers.
The producers claimed the collapse of prices to a four-year low of $36 a barrel is harming investment in the sector, creating supply problems for years to come. "A number of upstream projects have already been cancelled or delayed," Mr al-Naimi said at a meeting of energy ministers in London.
A cut in fuel duty, according to OPEC, would encourge cash-strapped consumers to buy more petrol, bolster demand for oil and encourage producers to develop new supplies.
Ministers from 27 countries and delegates from oil organisations convened at the London Energy Meeting, hosted by energy and climate change secretary Ed Miliband.
Prime Minister Gordon Brown gave an opening speech at the conference urging OPEC and other producers to continue to invest despite the crumbling in oil prices. Mr Brown also called for greater transparency in oil trading. Western governments have so far resisted the suggestion that speculation plays a large part in shaping oil prices, but the Prime Minister today proposed tougher regulation of the market.
He said "visionary internationalism" was needed to stamp out volatility, which he described as "one of the most pressing problems" for the world today. "Wild fluctuations in market prices harm nations all round the world," Mr Brown said. "They damage consumers and producers alike."
Oil producing members of OPEC blamed some of the severe volatility which has seen oil slump from a record $147 in July to below $40 on speculative futures trading.
The cartel operated by OPEC cut supply by a record 2.2m barrels a day this week, but failed to drive the price of oil back up to its target $75 a barrel. Mr al-Naimi for the first time pledged Saudi Arabia's support for investment in green alternative energy sources, if the "fair and reasonable" target price of $75 a barrel is reached.
The London summit follows a meeting in Jeddah, Saudi Arabia, earlier this year to tackle the huge increase in oil prices to $147 per barrel.
"If anyone had predicted then that oil prices would fall below $40 a barrel at the Jeddah meeting, they would have been transported to a mental institution," said Dr Noe van Hulst, secretary-general of the International Energy Federation.
http://www.telegraph.co.uk/finance/financetopics/oilprices/3850142/OPEC-calls-on-UK-to-cut-fuel-duty-or-risk-a-long-term-spike-in-oil.html
Oil cartel OPEC has called on Western governments, including Britain, to cut duty on petrol or risk fuelling a much higher oil price in the future.
By Rowena Mason Last Updated: 2:42PM GMT 19 Dec 2008
Saudi Arabia's Crown Prince Sultan at an OPEC summit in Riyadh, November 2007. Photo: REUTERS
Saudi Arabia's oil minister Ali al-Naimi and Abdalla S El-Badri, secretary-general of OPEC, said low demand was "wreaking havoc" for oil producers.
The producers claimed the collapse of prices to a four-year low of $36 a barrel is harming investment in the sector, creating supply problems for years to come. "A number of upstream projects have already been cancelled or delayed," Mr al-Naimi said at a meeting of energy ministers in London.
A cut in fuel duty, according to OPEC, would encourge cash-strapped consumers to buy more petrol, bolster demand for oil and encourage producers to develop new supplies.
Ministers from 27 countries and delegates from oil organisations convened at the London Energy Meeting, hosted by energy and climate change secretary Ed Miliband.
Prime Minister Gordon Brown gave an opening speech at the conference urging OPEC and other producers to continue to invest despite the crumbling in oil prices. Mr Brown also called for greater transparency in oil trading. Western governments have so far resisted the suggestion that speculation plays a large part in shaping oil prices, but the Prime Minister today proposed tougher regulation of the market.
He said "visionary internationalism" was needed to stamp out volatility, which he described as "one of the most pressing problems" for the world today. "Wild fluctuations in market prices harm nations all round the world," Mr Brown said. "They damage consumers and producers alike."
Oil producing members of OPEC blamed some of the severe volatility which has seen oil slump from a record $147 in July to below $40 on speculative futures trading.
The cartel operated by OPEC cut supply by a record 2.2m barrels a day this week, but failed to drive the price of oil back up to its target $75 a barrel. Mr al-Naimi for the first time pledged Saudi Arabia's support for investment in green alternative energy sources, if the "fair and reasonable" target price of $75 a barrel is reached.
The London summit follows a meeting in Jeddah, Saudi Arabia, earlier this year to tackle the huge increase in oil prices to $147 per barrel.
"If anyone had predicted then that oil prices would fall below $40 a barrel at the Jeddah meeting, they would have been transported to a mental institution," said Dr Noe van Hulst, secretary-general of the International Energy Federation.
http://www.telegraph.co.uk/finance/financetopics/oilprices/3850142/OPEC-calls-on-UK-to-cut-fuel-duty-or-risk-a-long-term-spike-in-oil.html
Oil at $40 a barrel will cause 'price explosion' in future
Oil at $40 a barrel will cause 'price explosion' in future
The oil cartel OPEC is right to warn that sharply falling oil prices will create a "price time-bomb for the future", experts have warned.
By Rowena MasonLast Updated: 7:16PM GMT 19 Dec 2008
The site of Saudi Aramco's (the national oil company) Al-Khurais central oil processing facility under construction in the Saudi Arabian desert. Photo: AFP
Saudi Arabia's oil minister Ali al-Naimi and Abdalla El-Badri, secretary-general of OPEC, said low demand was "wreaking havoc" by halting investment in the sector.
Oil prices in London fell near to $40 per barrel this week – down from a spike of $147 in July– prompting OPEC to cut supply by 2.2m barrels a day. Prices were closer to $35 in New York
If the low prices stop investment in exploration and production, there will be a shortage of oil in years to come, the producers said at a global summit in London.
Prime Minister Gordon Brown called for an end to oil trading volatility, acknowledging prices could jump sharply if investment faltered. However, energy minister Ed Miliband insisted that low oil prices were good for consumers and the world economy.
OPEC called on Western governments to cut fuel tax to help push prices back up to the "fair and reasonable" sum of $70 per barrel.
Inenco, the UK's largest energy analyst, agreed that slumping demand would ultimately cause prices to rocket.
Oil exploration and production projects in the Canada, USA, Mexico, Damman have recently been shelved because they have become uneconomical.
"The oil price would need to be in the range of $70-$80 a barrel to make these projects economically viable," said Inenco consultant Ian Parrett.
Sources close to BP said the oil company feared current lack of investment would create an undersupply in three to five years' time.
Barclays Capital said global spending on production will shrink 12pc to $400bn in 2009. .
http://www.telegraph.co.uk/finance/newsbysector/energy/oilandgas/3852773/Oil-at-40-a-barrel-will-cause-price-explosion-in-future.html
The oil cartel OPEC is right to warn that sharply falling oil prices will create a "price time-bomb for the future", experts have warned.
By Rowena MasonLast Updated: 7:16PM GMT 19 Dec 2008
The site of Saudi Aramco's (the national oil company) Al-Khurais central oil processing facility under construction in the Saudi Arabian desert. Photo: AFP
Saudi Arabia's oil minister Ali al-Naimi and Abdalla El-Badri, secretary-general of OPEC, said low demand was "wreaking havoc" by halting investment in the sector.
Oil prices in London fell near to $40 per barrel this week – down from a spike of $147 in July– prompting OPEC to cut supply by 2.2m barrels a day. Prices were closer to $35 in New York
If the low prices stop investment in exploration and production, there will be a shortage of oil in years to come, the producers said at a global summit in London.
Prime Minister Gordon Brown called for an end to oil trading volatility, acknowledging prices could jump sharply if investment faltered. However, energy minister Ed Miliband insisted that low oil prices were good for consumers and the world economy.
OPEC called on Western governments to cut fuel tax to help push prices back up to the "fair and reasonable" sum of $70 per barrel.
Inenco, the UK's largest energy analyst, agreed that slumping demand would ultimately cause prices to rocket.
Oil exploration and production projects in the Canada, USA, Mexico, Damman have recently been shelved because they have become uneconomical.
"The oil price would need to be in the range of $70-$80 a barrel to make these projects economically viable," said Inenco consultant Ian Parrett.
Sources close to BP said the oil company feared current lack of investment would create an undersupply in three to five years' time.
Barclays Capital said global spending on production will shrink 12pc to $400bn in 2009. .
http://www.telegraph.co.uk/finance/newsbysector/energy/oilandgas/3852773/Oil-at-40-a-barrel-will-cause-price-explosion-in-future.html
Sterling: Why it can't stop falling
Sterling: Why it can't stop falling
By Edward Hadas, breakingviews.comLast Updated: 1:43PM GMT 19 Dec 2008
Comments 4 Comment on this article
The pound just won’t stop falling. As of Friday morning, the UK currency was down 5pc against the euro over a week, and 17pc since mid-October. This decline is all too justified.
Foreign exchange traders have short attention spans and a long list of concerns. And right now the pound ticks almost every box to fail a summary health check.
Does the UK need foreign cash? That’s a big tick. The country’s balance of payments deficit is running at 3pc of GDP. Are yields low, making government debt - the holding of choice for foreigners - unattractive? That’s another tick in the box. The already low 2pc policy interest rate is set to head towards zero.
Worries about the overall financial system merit a tick too. UK banks expanded their balance sheets in the boom with an abandon usually seen in developing countries like Argentina and Turkey. The subsequent mess could end in blanket nationalisation, with all the risks of the politicised, inefficient lending decisions that often come with state control.
Now for the double tick. Currency traders don’t like governments that run big deficits, which often end in inflation. The UK government is already planning to borrow an awesome 8pc of GDP - and is likely to borrow much more.
About the only bonus for sterling right now is inflation, which is falling in the UK as it is everywhere. But even that might not last, as the weak pound drives up the price of imports, equivalent to 33pc of GDP.
For more agenda-setting financial insight, visit www.breakingviews.com
After such a rush of sterling selling, a brief rebound is possible. For longer-term optimists on the pound - yes, there are a few still out there - the main hope is that a cheap currency will spur exports. But before the Germans and Chinese can be tempted by cheaper goods from the UK, the country has to produce them. That won’t be easy, no matter how low the pound falls. The UK has moved away from manufacturing more than any other rich country. Now it is too short on intellectual and physical capacity to profit from the price advantage provided by sterling’s fall.
It will take more UK pain before there is much sterling gain.
http://www.telegraph.co.uk/finance/breakingviewscom/3850857/Sterling-Why-it-cant-stop-falling.html
By Edward Hadas, breakingviews.comLast Updated: 1:43PM GMT 19 Dec 2008
Comments 4 Comment on this article
The pound just won’t stop falling. As of Friday morning, the UK currency was down 5pc against the euro over a week, and 17pc since mid-October. This decline is all too justified.
Foreign exchange traders have short attention spans and a long list of concerns. And right now the pound ticks almost every box to fail a summary health check.
Does the UK need foreign cash? That’s a big tick. The country’s balance of payments deficit is running at 3pc of GDP. Are yields low, making government debt - the holding of choice for foreigners - unattractive? That’s another tick in the box. The already low 2pc policy interest rate is set to head towards zero.
Worries about the overall financial system merit a tick too. UK banks expanded their balance sheets in the boom with an abandon usually seen in developing countries like Argentina and Turkey. The subsequent mess could end in blanket nationalisation, with all the risks of the politicised, inefficient lending decisions that often come with state control.
Now for the double tick. Currency traders don’t like governments that run big deficits, which often end in inflation. The UK government is already planning to borrow an awesome 8pc of GDP - and is likely to borrow much more.
About the only bonus for sterling right now is inflation, which is falling in the UK as it is everywhere. But even that might not last, as the weak pound drives up the price of imports, equivalent to 33pc of GDP.
For more agenda-setting financial insight, visit www.breakingviews.com
After such a rush of sterling selling, a brief rebound is possible. For longer-term optimists on the pound - yes, there are a few still out there - the main hope is that a cheap currency will spur exports. But before the Germans and Chinese can be tempted by cheaper goods from the UK, the country has to produce them. That won’t be easy, no matter how low the pound falls. The UK has moved away from manufacturing more than any other rich country. Now it is too short on intellectual and physical capacity to profit from the price advantage provided by sterling’s fall.
It will take more UK pain before there is much sterling gain.
http://www.telegraph.co.uk/finance/breakingviewscom/3850857/Sterling-Why-it-cant-stop-falling.html
Japan Offers a Possible Road Map for U.S. Economy
Japan Offers a Possible Road Map for U.S. Economy
By MARTIN FACKLER
Published: December 19, 2008
TOKYO — When the Federal Reserve cut its benchmark rate to virtually zero earlier this week, what was a historic move in Washington seemed old hat here in Tokyo.
The Bank of Japan kept rates near zero for most of the last decade in an effort to end a long economic stagnation, and raised them only two years ago. Many economists say they believe that the zero interest-rate policy finally worked in Japan after regulators took aggressive steps that succeeded in restoring faith in Japan’s financial system and Tokyo’s ability to oversee it.
Now, with the Fed and President-elect Barack Obama turning to the same sorts of unconventional policy tools to battle the worst global economic crisis since the Depression, economists and bankers say they hope that Japan’s lessons are not lost on Washington. They say the United States needs to take the same kinds of confidence-building steps, and much more quickly than Japan did.
“Japan had years of trial and error to gets its response right, but the United States doesn’t have that kind of time because markets are changing so fast,” said Akio Makabe, an economics professor at Shinshu University. “The Fed has to move, and has to move fast, to restore confidence.”
On Friday, the Bank of Japan cut its benchmark rate to 0.1 percent, from 0.3 percent, saying in a statement that it was following the Fed’s “dramatic rate cut” to lower borrowing costs and jolt global demand. On Tuesday, the Fed lowered short-term rates to a range of zero to 0.25 percent, and vowed to pump money directly into the credit markets by buying mortgage-related debt and corporate bonds.
The Bank of Japan also announced that it would try to shore up Japan’s credit markets by buying commercial paper, a type of short-term corporate debt. Central banks in Europe have also reduced rates amid concerns the global economy could contract next year for the first time in decades.
Tuesday’s rate cut by the Fed also made short-term borrowing costs lower in the United States than in Japan for the first time in 15 years. This helped drive up the yen to 13-year highs, as investors tend to favor currencies that offer higher rates of return. The Bank of Japan said its rate cut on Friday was partly aimed at capping the yen’s gains.
The Bank of Japan first lowered interest rates to zero in 1999 for a year and then again in 2001 for five years. The Japanese central bank was trying to contain a domestic financial crisis not unlike the one now crippling global markets, in which collapsing real estate and share prices caused the bankruptcy of large financial companies, like Yamaichi Securities in 1997.
The central bank’s hope was that by lowering borrowing costs to virtually nil, it could encourage commercial banks to lend more money to businesses and consumers, rekindling demand.
Economists and former Bank of Japan officials say the biggest lesson they learned was that cutting rates alone has almost no effect when the financial system has fallen into a crisis as deep as the one Japan faced in the 1990s.
Japanese banks simply refused to lend in an environment where borrowers could suddenly go bankrupt, saddling lenders with huge, unforeseen losses. The Bank of Japan tried even more extreme measures, like using its powers to create money to essentially stuff cash into the nation’s commercial banks in hopes they would start lending again.
Exasperated central bankers found that commercial banks just let the money pile up instead of lending it out.
Economists say the United States faces a similar situation, after the sudden collapse in September of Lehman Brothers created fears of additional failures. Economists also fault Washington for its inconsistency in dealing with the financial crisis, leaving the impression that it does not have a clear strategy for dealing with ailing lenders.
In Japan’s case, economists and former bankers say, credit began to flow freely again only after 2003, when regulators adopted a tough new policy of auditing banks and forcing weaker ones to raise new capital or accept a government takeover. Economists said the audits finally removed paralysis in credit markets by convincing bankers and investors that sudden failures were no longer a risk, and that the true extent of problems at banks and other companies was finally being revealed.
Economists say Washington needs to do something similar to make banks and financial companies more transparent, and reassure investors that there were no more collapses like that of Lehman Brothers on the horizon.
“The United States needs to do it like Takenaka did,” said Anil Kashyap, a professor of business at the University of Chicago, referring to Heizo Takenaka, the former banking minister who started the 2003 audits. “We need someone to come in and give a good housekeeping seal to banks.”
Economists and former central bankers said another lesson from Japan’s experience was the importance of consistency. This became apparent in 2000, they said, during one of the bank’s more embarrassing episodes, when it raised interest rates, and lowered them back to zero a year later when the economy faltered.
Former Bank of Japan officials said they learned that bankers and investors would lend in difficult times only if they believed that rates would stay low for a long period, ensuring them adequate profits. By raising the possibility of future interest rate increases, the Bank of Japan dampened enthusiasm for lending, say bankers and economists.
“We learned that zero rates work by building expectations,” said Rei Masunaga, an economist and former director general at the Bank of Japan. “Zero interest rates take time to be effective.”
http://www.nytimes.com/2008/12/20/business/worldbusiness/20yen.html?em
By MARTIN FACKLER
Published: December 19, 2008
TOKYO — When the Federal Reserve cut its benchmark rate to virtually zero earlier this week, what was a historic move in Washington seemed old hat here in Tokyo.
The Bank of Japan kept rates near zero for most of the last decade in an effort to end a long economic stagnation, and raised them only two years ago. Many economists say they believe that the zero interest-rate policy finally worked in Japan after regulators took aggressive steps that succeeded in restoring faith in Japan’s financial system and Tokyo’s ability to oversee it.
Now, with the Fed and President-elect Barack Obama turning to the same sorts of unconventional policy tools to battle the worst global economic crisis since the Depression, economists and bankers say they hope that Japan’s lessons are not lost on Washington. They say the United States needs to take the same kinds of confidence-building steps, and much more quickly than Japan did.
“Japan had years of trial and error to gets its response right, but the United States doesn’t have that kind of time because markets are changing so fast,” said Akio Makabe, an economics professor at Shinshu University. “The Fed has to move, and has to move fast, to restore confidence.”
On Friday, the Bank of Japan cut its benchmark rate to 0.1 percent, from 0.3 percent, saying in a statement that it was following the Fed’s “dramatic rate cut” to lower borrowing costs and jolt global demand. On Tuesday, the Fed lowered short-term rates to a range of zero to 0.25 percent, and vowed to pump money directly into the credit markets by buying mortgage-related debt and corporate bonds.
The Bank of Japan also announced that it would try to shore up Japan’s credit markets by buying commercial paper, a type of short-term corporate debt. Central banks in Europe have also reduced rates amid concerns the global economy could contract next year for the first time in decades.
Tuesday’s rate cut by the Fed also made short-term borrowing costs lower in the United States than in Japan for the first time in 15 years. This helped drive up the yen to 13-year highs, as investors tend to favor currencies that offer higher rates of return. The Bank of Japan said its rate cut on Friday was partly aimed at capping the yen’s gains.
The Bank of Japan first lowered interest rates to zero in 1999 for a year and then again in 2001 for five years. The Japanese central bank was trying to contain a domestic financial crisis not unlike the one now crippling global markets, in which collapsing real estate and share prices caused the bankruptcy of large financial companies, like Yamaichi Securities in 1997.
The central bank’s hope was that by lowering borrowing costs to virtually nil, it could encourage commercial banks to lend more money to businesses and consumers, rekindling demand.
Economists and former Bank of Japan officials say the biggest lesson they learned was that cutting rates alone has almost no effect when the financial system has fallen into a crisis as deep as the one Japan faced in the 1990s.
Japanese banks simply refused to lend in an environment where borrowers could suddenly go bankrupt, saddling lenders with huge, unforeseen losses. The Bank of Japan tried even more extreme measures, like using its powers to create money to essentially stuff cash into the nation’s commercial banks in hopes they would start lending again.
Exasperated central bankers found that commercial banks just let the money pile up instead of lending it out.
Economists say the United States faces a similar situation, after the sudden collapse in September of Lehman Brothers created fears of additional failures. Economists also fault Washington for its inconsistency in dealing with the financial crisis, leaving the impression that it does not have a clear strategy for dealing with ailing lenders.
In Japan’s case, economists and former bankers say, credit began to flow freely again only after 2003, when regulators adopted a tough new policy of auditing banks and forcing weaker ones to raise new capital or accept a government takeover. Economists said the audits finally removed paralysis in credit markets by convincing bankers and investors that sudden failures were no longer a risk, and that the true extent of problems at banks and other companies was finally being revealed.
Economists say Washington needs to do something similar to make banks and financial companies more transparent, and reassure investors that there were no more collapses like that of Lehman Brothers on the horizon.
“The United States needs to do it like Takenaka did,” said Anil Kashyap, a professor of business at the University of Chicago, referring to Heizo Takenaka, the former banking minister who started the 2003 audits. “We need someone to come in and give a good housekeeping seal to banks.”
Economists and former central bankers said another lesson from Japan’s experience was the importance of consistency. This became apparent in 2000, they said, during one of the bank’s more embarrassing episodes, when it raised interest rates, and lowered them back to zero a year later when the economy faltered.
Former Bank of Japan officials said they learned that bankers and investors would lend in difficult times only if they believed that rates would stay low for a long period, ensuring them adequate profits. By raising the possibility of future interest rate increases, the Bank of Japan dampened enthusiasm for lending, say bankers and economists.
“We learned that zero rates work by building expectations,” said Rei Masunaga, an economist and former director general at the Bank of Japan. “Zero interest rates take time to be effective.”
http://www.nytimes.com/2008/12/20/business/worldbusiness/20yen.html?em
Buying Stocks on the Verge of Bankruptcy
QUESTION: Why is it that investors are buying stocks in companies that are on the verge bankruptcy like AIG (AIG: 1.60, -0.07, -4.19%) and General Motors (GM: 4.49, +0.83, +22.67%)? Is there any benefit to buying at this price, and what would be the worst-case scenario of my investment?
--Mike Ghazala
ANSWER: Let's get right to the point: The worst-case scenario is you lose your entire investment. When a company files Chapter 11 the business is reorganized, but there's no guarantee shares will be worth anything once the company emerges from bankruptcy protection. Ditto for a Chapter 7 bankruptcy liquidation, in which a company's assets are sold off. Rules governing corporate bankruptcies generally dictate that secured and unsecured creditors -- banks, bondholders and the like -- get paid off first. Stockholders are last in line, and often there's nothing left by the time their turn comes around. If there are assets remaining, stockholders may receive shares in the newly reorganized company.
So why do investors buy shares of companies on the verge of bankruptcy?
Some may truly believe the company will avoid disaster and bounce back, making the shares an attractive long-term investment.
More often than not, though, investors are looking to make a quick buck on a short-term trade. In that case fundamentals are thrown out the window. Hedge funds and institutional trading desks are often involved in highly leveraged trades of these extremely volatile stocks. With such heavy hitters in the game, and so much uncertainty surrounding the companies, we recommend that individual investors keep their distance.
One other note: Even in bankruptcy a company's shares may continue to trade, often for pennies apiece. While the low price might be tempting, liquidity is spotty because the stocks are usually forced to trade over the counter rather than on a major exchange like the NYSE.
http://www.smartmoney.com/personal-finance/college-planning/financial-crisis-answer-center/?cid=1108
--Mike Ghazala
ANSWER: Let's get right to the point: The worst-case scenario is you lose your entire investment. When a company files Chapter 11 the business is reorganized, but there's no guarantee shares will be worth anything once the company emerges from bankruptcy protection. Ditto for a Chapter 7 bankruptcy liquidation, in which a company's assets are sold off. Rules governing corporate bankruptcies generally dictate that secured and unsecured creditors -- banks, bondholders and the like -- get paid off first. Stockholders are last in line, and often there's nothing left by the time their turn comes around. If there are assets remaining, stockholders may receive shares in the newly reorganized company.
So why do investors buy shares of companies on the verge of bankruptcy?
Some may truly believe the company will avoid disaster and bounce back, making the shares an attractive long-term investment.
More often than not, though, investors are looking to make a quick buck on a short-term trade. In that case fundamentals are thrown out the window. Hedge funds and institutional trading desks are often involved in highly leveraged trades of these extremely volatile stocks. With such heavy hitters in the game, and so much uncertainty surrounding the companies, we recommend that individual investors keep their distance.
One other note: Even in bankruptcy a company's shares may continue to trade, often for pennies apiece. While the low price might be tempting, liquidity is spotty because the stocks are usually forced to trade over the counter rather than on a major exchange like the NYSE.
http://www.smartmoney.com/personal-finance/college-planning/financial-crisis-answer-center/?cid=1108
The Most Dangerous Way to Invest Today
The Most Dangerous Way to Invest Today
By Todd Wenning December 19, 2008 Comments (7)
This market panic has taught or reminded investors of many important lessons, including the importance of diversification, investing only in companies whose business you can understand, and that "cash ain't trash" after all.
Another lesson that must be heeded is that "bottom up" research is a downright dangerous way to invest. To review, "bottom up" research looks at businesses first and de-emphasizes macroeconomic factors. If this market has taught us anything, however, it's that ignoring the economy can have dire consequences.
No Fa-Fa-Fa-Foolin
Picking a stock without considering the economic environment is like picking out your clothes in the morning without considering the weather that day. Sure, that Def Leppard 1987 Hysteria Tour T-shirt may be comfortable and give you tons of street cred, but it's just not practical in a foot of snow.
All joking aside, no matter what sector you're looking at, there are macroeconomic factors that will make a big difference to your investing thesis -- durable-goods orders if you're looking at manufacturers, housing starts for homebuilders.
Right now, for example, companies dependent on consumer spending are facing some serious headwinds:
The American labor force is weakening.
In the last three months, the economy has shed 1.25 million jobs. Unemployment currently sits at 6.7%. Add that figure to the 12.5% underemployment rate (part-time workers who want to work full-time), and you have nearly 20% of the American workforce not contributing its full potential to the economy. These figures could get higher, since they haven't even taken into account the massive layoffs recently announced by Bank of America (NYSE: BAC), 3M (NYSE: MMM), and Dow Chemical (NYSE: DOW).
Consumer credit is drying up.
To compound the problem of unemployment, credit card companies like American Express (NYSE: AXP) and Capital One Financial (NYSE: COF) have become much more conservative with their lending standards, raising rates, reducing credit limits, or denying credit altogether. With 60-plus-day delinquencies up some 24% since August, it's hard to blame them for these moves. But the combination of less available credit and less income from employment will inevitably lead to less spending.
Baby boomers are being walloped by this economy.
This economy couldn't have come at a worse time for the 78 million or so baby boomers approaching or already in retirement. According to Fidelity, at the end of 2007, its 401(k) participants aged 60 to 64 held a median 66% of their portfolios in equities. Given that the S&P 500 is down 38% year-to-date, it's reasonable to assume that the median boomer 401(k) lost about 25%-30% of its value this year. Besides the stock market losses, an estimated $4.5 trillion of wealth has been wiped out as a result of the real estate market crash of the past two years.
This new reality is significant on many levels, but the biggest consequence of a poorer boomer generation may be found in the retail sector. The boomer demographic accounts for about 40% of total consumer spending (about $3.8 trillion annually). Since consumer spending makes up 70% of our GDP, you can see how much a suddenly stingy boomer generation can hurt our economy.
If boomers cut just 10% of their $3.8 trillion in annual spending this year, it could set GDP back some 3%. Less boomer spending would negatively affect retailers across the board, from women's clothiers like Ann Taylor (NYSE: ANN) to casual-dining restaurants like Darden Restaurants' Red Lobster and Olive Garden.
Where we're left
Despite these mounting economic woes, there are still stocks worth buying in this market. But the research process must begin with a macroeconomic analysis, followed by a thorough vetting of businesses.
Since we launched our Motley Fool Pro service in October, we've taken the plight of the U.S. consumer very seriously, focusing our research on companies that produce goods and services that people need, versus what they want. For example, we'd be much more inclined to research a stock like Johnson & Johnson (NYSE: JNJ) versus a beaten-down retailer like Abercrombie & Fitch. Consumers can do without $100 blue jeans, but they are much less likely to do without things like Band-Aids, Sudafed, and Tylenol.
Even though Abercrombie may look like a value at the moment from a bottom-up approach, it could be an even better value six months or a year from now. After all, even value is vulnerable without a catalyst to unlock it, and there appears to be no economic catalyst in sight for consumer-goods companies like Abercrombie. Ignoring that fact could cost you money and sleep while you wait -- potentially for years -- for retail to rebound.
At Pro, we're only interested in buying undervalued stocks with both strong fundamentals and positive economic support. Our top priority is accuracy, and we have a goal of generating positive returns with at least 75% of our investments. This means we must not only be selective with the investments we make, but also fully consider the economic environments in which they operate.
Pro analyst Todd Wenning pours some sugar in his afternoon coffee, in the name of love. He does not own shares of any company mentioned. Johnson & Johnson, Dow Chemical, and Bank of America are Motley Fool Income Investor recommendations. 3M and American Express are Motley Fool Inside Value picks. The Fool owns shares of American Express. The Fool is investors writing for investors.
By Todd Wenning December 19, 2008 Comments (7)
This market panic has taught or reminded investors of many important lessons, including the importance of diversification, investing only in companies whose business you can understand, and that "cash ain't trash" after all.
Another lesson that must be heeded is that "bottom up" research is a downright dangerous way to invest. To review, "bottom up" research looks at businesses first and de-emphasizes macroeconomic factors. If this market has taught us anything, however, it's that ignoring the economy can have dire consequences.
No Fa-Fa-Fa-Foolin
Picking a stock without considering the economic environment is like picking out your clothes in the morning without considering the weather that day. Sure, that Def Leppard 1987 Hysteria Tour T-shirt may be comfortable and give you tons of street cred, but it's just not practical in a foot of snow.
All joking aside, no matter what sector you're looking at, there are macroeconomic factors that will make a big difference to your investing thesis -- durable-goods orders if you're looking at manufacturers, housing starts for homebuilders.
Right now, for example, companies dependent on consumer spending are facing some serious headwinds:
The American labor force is weakening.
In the last three months, the economy has shed 1.25 million jobs. Unemployment currently sits at 6.7%. Add that figure to the 12.5% underemployment rate (part-time workers who want to work full-time), and you have nearly 20% of the American workforce not contributing its full potential to the economy. These figures could get higher, since they haven't even taken into account the massive layoffs recently announced by Bank of America (NYSE: BAC), 3M (NYSE: MMM), and Dow Chemical (NYSE: DOW).
Consumer credit is drying up.
To compound the problem of unemployment, credit card companies like American Express (NYSE: AXP) and Capital One Financial (NYSE: COF) have become much more conservative with their lending standards, raising rates, reducing credit limits, or denying credit altogether. With 60-plus-day delinquencies up some 24% since August, it's hard to blame them for these moves. But the combination of less available credit and less income from employment will inevitably lead to less spending.
Baby boomers are being walloped by this economy.
This economy couldn't have come at a worse time for the 78 million or so baby boomers approaching or already in retirement. According to Fidelity, at the end of 2007, its 401(k) participants aged 60 to 64 held a median 66% of their portfolios in equities. Given that the S&P 500 is down 38% year-to-date, it's reasonable to assume that the median boomer 401(k) lost about 25%-30% of its value this year. Besides the stock market losses, an estimated $4.5 trillion of wealth has been wiped out as a result of the real estate market crash of the past two years.
This new reality is significant on many levels, but the biggest consequence of a poorer boomer generation may be found in the retail sector. The boomer demographic accounts for about 40% of total consumer spending (about $3.8 trillion annually). Since consumer spending makes up 70% of our GDP, you can see how much a suddenly stingy boomer generation can hurt our economy.
If boomers cut just 10% of their $3.8 trillion in annual spending this year, it could set GDP back some 3%. Less boomer spending would negatively affect retailers across the board, from women's clothiers like Ann Taylor (NYSE: ANN) to casual-dining restaurants like Darden Restaurants' Red Lobster and Olive Garden.
Where we're left
Despite these mounting economic woes, there are still stocks worth buying in this market. But the research process must begin with a macroeconomic analysis, followed by a thorough vetting of businesses.
Since we launched our Motley Fool Pro service in October, we've taken the plight of the U.S. consumer very seriously, focusing our research on companies that produce goods and services that people need, versus what they want. For example, we'd be much more inclined to research a stock like Johnson & Johnson (NYSE: JNJ) versus a beaten-down retailer like Abercrombie & Fitch. Consumers can do without $100 blue jeans, but they are much less likely to do without things like Band-Aids, Sudafed, and Tylenol.
Even though Abercrombie may look like a value at the moment from a bottom-up approach, it could be an even better value six months or a year from now. After all, even value is vulnerable without a catalyst to unlock it, and there appears to be no economic catalyst in sight for consumer-goods companies like Abercrombie. Ignoring that fact could cost you money and sleep while you wait -- potentially for years -- for retail to rebound.
At Pro, we're only interested in buying undervalued stocks with both strong fundamentals and positive economic support. Our top priority is accuracy, and we have a goal of generating positive returns with at least 75% of our investments. This means we must not only be selective with the investments we make, but also fully consider the economic environments in which they operate.
Pro analyst Todd Wenning pours some sugar in his afternoon coffee, in the name of love. He does not own shares of any company mentioned. Johnson & Johnson, Dow Chemical, and Bank of America are Motley Fool Income Investor recommendations. 3M and American Express are Motley Fool Inside Value picks. The Fool owns shares of American Express. The Fool is investors writing for investors.
Friday 19 December 2008
Time In the Market and Timing the Market
Time In The Market:
I believe time in the market, with proper asset allocation, is preferable to "timing the market," which is a fool's game. In my view, time in the market refers to:
Here's a classic example: Which would you rather have -- $1million today or one penny doubled every day for one month? If you chose the penny doubled then you are the "winner" with $5,368,709.12. Time exponentially expands the compounding effect. With less time to invest, even the most skilled traders will find themselves at an enormous disadvantage to compounding interest...
Timing the Market / Investment Outcome:
Since "timing the market" is intended to control the "investment outcome," I combine them into the same points: As for timing the market, of course it is a "controllable" investing variable and it is possible to accomplish successfully but how prudent can it be to attempt when the vast majority of investors are not successful at doing it?
Where investors are commonly misled here is with their own perception of investment gains and "chasing performance."
For example, if you invest $100,000 into a stock and it returns 30% in the first year and loses 10% in the second, is your average return 20 percent? No. After the first year, you'll have $130,000 and after the second, you'll have $117,000 for a total gain of 17% (or roughly 8.5% compounded). If you just earned an "average" 10% per year, you'd have $121,000 at the end of year two.
Now consider that you were the "average" investor and your "friend" earned 30% in the first year. Are you going to hold to your allocation earning "just" 10% or will you be tempted to jump to your friend's "strategy?" Being "average" has its merits...
While anyone can throw darts at a wall and beat the markets over a short period of time, the markets are too efficient to outperform consistently over longer periods time. Investors should not use stocks as short-term investment vehicles, anyway, and any person calling themselves a "financial philosopher" would not partake in such pursuits.
In summary, investing should be a means of making money work for you not a means of making you work for it. As author, Mitch Anthony, puts it, "life is not about making money, money is about making a life."
Now get on with your life...
You may see this blog post and others like it at the Carnival of Financial Planning.
Source:
http://financialphilosopher.typepad.com/thefinancialphilosopher/2007/06/asset-allocatio.html
I believe time in the market, with proper asset allocation, is preferable to "timing the market," which is a fool's game. In my view, time in the market refers to:
- investing early,
- investing often, and
- staying in for the long-term.
Here's a classic example: Which would you rather have -- $1million today or one penny doubled every day for one month? If you chose the penny doubled then you are the "winner" with $5,368,709.12. Time exponentially expands the compounding effect. With less time to invest, even the most skilled traders will find themselves at an enormous disadvantage to compounding interest...
Timing the Market / Investment Outcome:
Since "timing the market" is intended to control the "investment outcome," I combine them into the same points: As for timing the market, of course it is a "controllable" investing variable and it is possible to accomplish successfully but how prudent can it be to attempt when the vast majority of investors are not successful at doing it?
Where investors are commonly misled here is with their own perception of investment gains and "chasing performance."
For example, if you invest $100,000 into a stock and it returns 30% in the first year and loses 10% in the second, is your average return 20 percent? No. After the first year, you'll have $130,000 and after the second, you'll have $117,000 for a total gain of 17% (or roughly 8.5% compounded). If you just earned an "average" 10% per year, you'd have $121,000 at the end of year two.
Now consider that you were the "average" investor and your "friend" earned 30% in the first year. Are you going to hold to your allocation earning "just" 10% or will you be tempted to jump to your friend's "strategy?" Being "average" has its merits...
While anyone can throw darts at a wall and beat the markets over a short period of time, the markets are too efficient to outperform consistently over longer periods time. Investors should not use stocks as short-term investment vehicles, anyway, and any person calling themselves a "financial philosopher" would not partake in such pursuits.
In summary, investing should be a means of making money work for you not a means of making you work for it. As author, Mitch Anthony, puts it, "life is not about making money, money is about making a life."
Now get on with your life...
You may see this blog post and others like it at the Carnival of Financial Planning.
Source:
http://financialphilosopher.typepad.com/thefinancialphilosopher/2007/06/asset-allocatio.html
Four investment variables that are controllable
The Wisdom of Asset Allocation
"God grant me the serenity to accept the things I cannot change, courage to change the things I can, and the wisdom to know the difference." Reinhold Niebuhr (1892-1971)
Those words underscore the foundation of prudent investing. There are things we can control and there are things we can not. Knowing the difference is imperative and "the wisdom" lies in the application of that knowledge...
Among the primary variables of investing, the investor may control:
(1) the amount to be invested;
(2) the allocation of the assets;
(3) the holding period or time in the market; and
(4) the timing of the investment.
Where investors make their biggest mistake is focusing intently on trying to control the one investment variable that is uncontrollable --
(5) the outcome of the investment (amount of gain/loss)...
Although most investors understand that the vast majority do not beat the market averages, especially over long periods of time, it is in our fallible human nature to believe that we will be among the "above average." Whether one ascribes to Jack Bogle's rantings on Lake Wobegone, where everyone is above average, or to the validity of the Efficient Market Hypothesis (EMH) or not, it is difficult to argue against the evidence that the greatest advantages to be gained by the investor is within a combination of the four investment variables that are controllable.
Read further:
http://financialphilosopher.typepad.com/thefinancialphilosopher/2007/06/asset-allocatio.html
"God grant me the serenity to accept the things I cannot change, courage to change the things I can, and the wisdom to know the difference." Reinhold Niebuhr (1892-1971)
Those words underscore the foundation of prudent investing. There are things we can control and there are things we can not. Knowing the difference is imperative and "the wisdom" lies in the application of that knowledge...
Among the primary variables of investing, the investor may control:
(1) the amount to be invested;
(2) the allocation of the assets;
(3) the holding period or time in the market; and
(4) the timing of the investment.
Where investors make their biggest mistake is focusing intently on trying to control the one investment variable that is uncontrollable --
(5) the outcome of the investment (amount of gain/loss)...
Although most investors understand that the vast majority do not beat the market averages, especially over long periods of time, it is in our fallible human nature to believe that we will be among the "above average." Whether one ascribes to Jack Bogle's rantings on Lake Wobegone, where everyone is above average, or to the validity of the Efficient Market Hypothesis (EMH) or not, it is difficult to argue against the evidence that the greatest advantages to be gained by the investor is within a combination of the four investment variables that are controllable.
Read further:
http://financialphilosopher.typepad.com/thefinancialphilosopher/2007/06/asset-allocatio.html
Those that went with Madoff chose faith over evidence
Who isn't a Madoff victim? The list is telling.
Although many smart people seem to have been taken in, one expert argues that anyone who really did their homework would have seen the warning signs.
By Nicholas Varchaver
Last Updated: December 17, 2008: 10:14 AM ET
Untangling Madoff's web
More Videos
Financial frauds ruin lives
NEW YORK (Fortune) -- As the number of victims of Bernard Madoff, the criminally charged founder of the investment firm that bears his name, seems to multiply with the speed and force of a hurricane, certain types of investors seem to be absent -- so far, anyway -- from the casualty list.
That's no accident, argues James Hedges IV of LJH Global Investments, a boutique firm that invests in hedge funds and private equity for high-net-worth families. In other words, score one for the big institutions that stick to standard rules rather than allowing their managers to invest on personal connections or hunches.
"There's no Duke Endowment [among the list of Madoff investors]," Hedges says. "There's no Harvard management, there's no Yale, there's no Penn, there's no Weyerhauser, no State of Texas or Virginia Retirement system."
The reason is simple, in Hedges' view. Letting Madoff manage your money "wouldn't pass an institutional-quality due diligence process," he says. "Because when you get to page two of your 30-page due diligence questionnaire, you've already tripped eight alarms and said 'I'm out of here.' "
In short, in Hedges' opinion, any sophisticated entity that actually did its homework would have seen the warning signs.
Hedges got the chance to see those signs up close: In 1997, when he was advising the Bessemer Trust, the giant wealth manager, he visited Bernard Madoff to discuss investing with Madoff's firm.
"I found him stylistically like a lot of traders: fast-talking, distractable, not remarkable," Hedges says of Madoff. But during their two-hour meeting, Hedges says, "there was one red flag after another."
For starters, he couldn't grasp Madoff's investing strategy. "I kept saying, 'you've got to explain it to me like I'm in first grade,' " he says. To no avail.
Then there was the fact that Madoff was charging no fees other than trading commissions: "The notion that something is fee-less -- which is what they largely proferred -- is too good to be true."
The fact that Madoff's operation was audited by a microscopic accounting firm also worried him. "He was also so secretive about his asset base -- that was another red flag."
In the end, Hedges was uncomfortable and Bessemer decided not to let Madoff manage any of its money.
In Hedges' view, those that went with Madoff chose faith over evidence. "You've got people who
Certainly many of the institutions that turned to Madoff will challenge Hedges' views, as many will face litigation from their own clients. So far, two of the large fund-of-funds with the largest sums under Madoff's control, Tremont and Fairfield Greenwich, have already asserted that they conducted extensive due diligence before investing. Many others will take the same position.
Should Hedges' opinion be borne out and corporate and state pension funds remain absent from the roster of Madoff victims -- of course, there will be many more names added to the list -- it will only heighten the Madoff tragedy. Because, in the end, it would show that this was one investing disaster that could easily have been avoided.
First Published: December 16, 2008: 5:51 PM ET
Although many smart people seem to have been taken in, one expert argues that anyone who really did their homework would have seen the warning signs.
By Nicholas Varchaver
Last Updated: December 17, 2008: 10:14 AM ET
Untangling Madoff's web
More Videos
Financial frauds ruin lives
NEW YORK (Fortune) -- As the number of victims of Bernard Madoff, the criminally charged founder of the investment firm that bears his name, seems to multiply with the speed and force of a hurricane, certain types of investors seem to be absent -- so far, anyway -- from the casualty list.
That's no accident, argues James Hedges IV of LJH Global Investments, a boutique firm that invests in hedge funds and private equity for high-net-worth families. In other words, score one for the big institutions that stick to standard rules rather than allowing their managers to invest on personal connections or hunches.
"There's no Duke Endowment [among the list of Madoff investors]," Hedges says. "There's no Harvard management, there's no Yale, there's no Penn, there's no Weyerhauser, no State of Texas or Virginia Retirement system."
The reason is simple, in Hedges' view. Letting Madoff manage your money "wouldn't pass an institutional-quality due diligence process," he says. "Because when you get to page two of your 30-page due diligence questionnaire, you've already tripped eight alarms and said 'I'm out of here.' "
In short, in Hedges' opinion, any sophisticated entity that actually did its homework would have seen the warning signs.
Hedges got the chance to see those signs up close: In 1997, when he was advising the Bessemer Trust, the giant wealth manager, he visited Bernard Madoff to discuss investing with Madoff's firm.
"I found him stylistically like a lot of traders: fast-talking, distractable, not remarkable," Hedges says of Madoff. But during their two-hour meeting, Hedges says, "there was one red flag after another."
For starters, he couldn't grasp Madoff's investing strategy. "I kept saying, 'you've got to explain it to me like I'm in first grade,' " he says. To no avail.
Then there was the fact that Madoff was charging no fees other than trading commissions: "The notion that something is fee-less -- which is what they largely proferred -- is too good to be true."
The fact that Madoff's operation was audited by a microscopic accounting firm also worried him. "He was also so secretive about his asset base -- that was another red flag."
In the end, Hedges was uncomfortable and Bessemer decided not to let Madoff manage any of its money.
In Hedges' view, those that went with Madoff chose faith over evidence. "You've got people who
- were disintermediated [i.e., didn't have a professional representative], or
- unsophisticated, or
- went in through a personal relationship.
Certainly many of the institutions that turned to Madoff will challenge Hedges' views, as many will face litigation from their own clients. So far, two of the large fund-of-funds with the largest sums under Madoff's control, Tremont and Fairfield Greenwich, have already asserted that they conducted extensive due diligence before investing. Many others will take the same position.
Should Hedges' opinion be borne out and corporate and state pension funds remain absent from the roster of Madoff victims -- of course, there will be many more names added to the list -- it will only heighten the Madoff tragedy. Because, in the end, it would show that this was one investing disaster that could easily have been avoided.
First Published: December 16, 2008: 5:51 PM ET
What makes deflation such a dreaded condition
Deflation is an empty threat (so far)
In such a deep recession, the word is bound to come up. But a close look at the numbers shows that it's a long shot at this point.
Anthony Karydakis, Contributor
December 18, 2008: 9:37 AM ET
AMERICA'S MONEY CRISIS
Hedge fund graveyard: 693 and counting
Fed OKs credit card crackdown
Good news when this bubble pops
Fuel prices drop, but airfares don't
Cheap money: The Fed rate cut and you
More from Fortune
5 funds for 2009
WiMax: Not dead yet
Chrysler's management merry-go-round
FORTUNE 500
Current Issue
Subscribe to Fortune
This recession has been so unusual that it has brought back economic phenomena that haven't been seen in generations, at least not in the U.S. Chief among them is deflation. It's a scary prospect that has been on people's minds since evidence of a deepening recession started proliferating quickly earlier in the fall.
What makes deflation such a dreaded condition is that, once it takes hold, it motivates consumers to hold back on spending in the expectation that they will be able to buy things at a cheaper price later. This causes further drop in demand today, leading to more cutbacks in production and even slower economic activity, which feeds into more price declines -- a highly destabilizing dynamic.
Against that backdrop, the report earlier this week on November's Consumer Price Index (CPI) was eagerly anticipated, as it was likely to shed some light on whether such deflation fears are realistic in this environment. The anxiety over such a prospect had already been heightened by a sizeable decline (-1.0%) in the index in October and a highly unusual drop (-0.1%) in the so-called "core" CPI that month. (Core CPI is the overall index minus the notoriously volatile components of food and energy, which together account for about one-fourth of the total.)
So, with the stakes so high for the November report, what was the verdict?
On the face of it, the sharp 1.7% decline in the CPI last month (its biggest monthly drop ever and its fourth consecutive one since August) added fuel to the concerns that the economy may be about to get hit by powerful deflationary forces. Adding to that impression, the CPI is now up only 1.1% in the last 12-month period, while it was up by 3.7% in the 12-month period to October and 5.6% in the corresponding period to July.
So, there is no doubt that a major downtrend in the rate of inflation is already manifesting itself in strong terms. It is important, though, to draw a sharp distinction between the terms "disinflation" and "deflation," which are sometimes inadvertently lumped together. The first means a slower pace of inflation (that is, prices are still rising), while the second means an outright decline in the price level.
However, before jumping to the conclusion that deflation is around the corner, it's important to consider several factors that present a significantly less bleak picture.
Let's begin with some basic facts:
November's decline in the overall index was largely due to a 17% decline in energy prices and, specifically, a nearly 30% collapse in gasoline prices. However, excluding the food and energy components, the core index was flat for the month, despite a 0.6% decline in new vehicle prices, in line with dismal auto sales numbers reported in the last couple of months by all automakers. Several key categories (apparel, entertainment, medical care, shelter costs) all showed moderate increases, suggesting the absence of any broad-based downward pressure on prices.
So the inflation downtrend since July is largely the result of a dramatic decline in commodity prices (and particularly energy prices) and to a lesser degree the rebound of the dollar and the pullback in consumer demand. Looking ahead, it appears that the pace of erosion in commodity prices is slowing and the dollar's rebound is stalling, as the perceived depth of the U.S recession is raising some anxiety around the globe.
As a result, any further declines in the overall CPI are likely to moderate in the coming months. Still, there's a realistic probability that at some point in the next few months, the CPI will dip into negative territory on a 12-month basis and the word "deflation" will start appearing in headlines again.
The question that arises then is: Does this mean that the dreaded deflationary forces, which in the postwar era had visited only Japan among the major industrialized countries (for a protracted period starting in the '90s), have now reached the U.S. shore?
The answer is: not necessarily so, for two reasons:
1. A simple dip in the overall CPI for a few months into negative territory on a year-over-year basis is not tantamount to a full-fledged deflationary trend. For such a dynamic to emerge, it will take a more prolonged period of declining prices, which can only be achieved in the context of a lengthy and steadily deepening recession. This is not a totally unrealistic scenario, but it disregards the Fed's series of extraordinary measures (including Tuesday's decision to bring the overnight interbank rate down essentially to zero) and the massive domestic fiscal-stimulus program waiting in the wings. The combined effect of such unprecedented actions should help cushion any further downside risks beyond the first quarter of 2009.
2. A generally more reliable measure of inflation (although less popular in terms of broader public perceptions) is the core CPI, which, by excluding the two most volatile components (food and fuel) of the index, also tends to be dramatically more stable over time. True, the core index has also drifted lower since July but at a much more measured pace, 2% last month, down from 2.5%. Changes in the core index are very incremental on a month-to-month basis, so it is unlikely that it will slip into negative territory any time soon. In all likelihood, the economy will have already started showing signs of life by the time such a slow-moving downtrend brings the core CPI close to the feared zero mark.
It is exactly because of the less noisy nature of the core CPI that Fed officials tend to pay considerably more attention to that price measure--rather than the overall CPI--in addition to their favorite inflation indicator, the core PCE (Personal Consumption Expenditures) price index. Both of these measures are currently in the vicinity of 2% and unlikely to emanate any deflationary signals in the foreseeable future.
Naturally, the longer the recession drags on, the higher the risk that the current disinflationary trend will convert itself into a deflationary one. But the distance between the two is real and, at this point, the risk of the latter outcome -- beyond the phase of a simple arithmetic quirk for a short period--is indeed low.
Anthony Karydakis is a former chief U.S. economist with JP Morgan Asset Management and currently an Adjunct professor at New York University's Stern School of Business.
http://money.cnn.com/2008/12/18/news/economy/deflation_recession.fortune/
In such a deep recession, the word is bound to come up. But a close look at the numbers shows that it's a long shot at this point.
Anthony Karydakis, Contributor
December 18, 2008: 9:37 AM ET
AMERICA'S MONEY CRISIS
Hedge fund graveyard: 693 and counting
Fed OKs credit card crackdown
Good news when this bubble pops
Fuel prices drop, but airfares don't
Cheap money: The Fed rate cut and you
More from Fortune
5 funds for 2009
WiMax: Not dead yet
Chrysler's management merry-go-round
FORTUNE 500
Current Issue
Subscribe to Fortune
This recession has been so unusual that it has brought back economic phenomena that haven't been seen in generations, at least not in the U.S. Chief among them is deflation. It's a scary prospect that has been on people's minds since evidence of a deepening recession started proliferating quickly earlier in the fall.
What makes deflation such a dreaded condition is that, once it takes hold, it motivates consumers to hold back on spending in the expectation that they will be able to buy things at a cheaper price later. This causes further drop in demand today, leading to more cutbacks in production and even slower economic activity, which feeds into more price declines -- a highly destabilizing dynamic.
Against that backdrop, the report earlier this week on November's Consumer Price Index (CPI) was eagerly anticipated, as it was likely to shed some light on whether such deflation fears are realistic in this environment. The anxiety over such a prospect had already been heightened by a sizeable decline (-1.0%) in the index in October and a highly unusual drop (-0.1%) in the so-called "core" CPI that month. (Core CPI is the overall index minus the notoriously volatile components of food and energy, which together account for about one-fourth of the total.)
So, with the stakes so high for the November report, what was the verdict?
On the face of it, the sharp 1.7% decline in the CPI last month (its biggest monthly drop ever and its fourth consecutive one since August) added fuel to the concerns that the economy may be about to get hit by powerful deflationary forces. Adding to that impression, the CPI is now up only 1.1% in the last 12-month period, while it was up by 3.7% in the 12-month period to October and 5.6% in the corresponding period to July.
So, there is no doubt that a major downtrend in the rate of inflation is already manifesting itself in strong terms. It is important, though, to draw a sharp distinction between the terms "disinflation" and "deflation," which are sometimes inadvertently lumped together. The first means a slower pace of inflation (that is, prices are still rising), while the second means an outright decline in the price level.
However, before jumping to the conclusion that deflation is around the corner, it's important to consider several factors that present a significantly less bleak picture.
Let's begin with some basic facts:
November's decline in the overall index was largely due to a 17% decline in energy prices and, specifically, a nearly 30% collapse in gasoline prices. However, excluding the food and energy components, the core index was flat for the month, despite a 0.6% decline in new vehicle prices, in line with dismal auto sales numbers reported in the last couple of months by all automakers. Several key categories (apparel, entertainment, medical care, shelter costs) all showed moderate increases, suggesting the absence of any broad-based downward pressure on prices.
So the inflation downtrend since July is largely the result of a dramatic decline in commodity prices (and particularly energy prices) and to a lesser degree the rebound of the dollar and the pullback in consumer demand. Looking ahead, it appears that the pace of erosion in commodity prices is slowing and the dollar's rebound is stalling, as the perceived depth of the U.S recession is raising some anxiety around the globe.
As a result, any further declines in the overall CPI are likely to moderate in the coming months. Still, there's a realistic probability that at some point in the next few months, the CPI will dip into negative territory on a 12-month basis and the word "deflation" will start appearing in headlines again.
The question that arises then is: Does this mean that the dreaded deflationary forces, which in the postwar era had visited only Japan among the major industrialized countries (for a protracted period starting in the '90s), have now reached the U.S. shore?
The answer is: not necessarily so, for two reasons:
1. A simple dip in the overall CPI for a few months into negative territory on a year-over-year basis is not tantamount to a full-fledged deflationary trend. For such a dynamic to emerge, it will take a more prolonged period of declining prices, which can only be achieved in the context of a lengthy and steadily deepening recession. This is not a totally unrealistic scenario, but it disregards the Fed's series of extraordinary measures (including Tuesday's decision to bring the overnight interbank rate down essentially to zero) and the massive domestic fiscal-stimulus program waiting in the wings. The combined effect of such unprecedented actions should help cushion any further downside risks beyond the first quarter of 2009.
2. A generally more reliable measure of inflation (although less popular in terms of broader public perceptions) is the core CPI, which, by excluding the two most volatile components (food and fuel) of the index, also tends to be dramatically more stable over time. True, the core index has also drifted lower since July but at a much more measured pace, 2% last month, down from 2.5%. Changes in the core index are very incremental on a month-to-month basis, so it is unlikely that it will slip into negative territory any time soon. In all likelihood, the economy will have already started showing signs of life by the time such a slow-moving downtrend brings the core CPI close to the feared zero mark.
It is exactly because of the less noisy nature of the core CPI that Fed officials tend to pay considerably more attention to that price measure--rather than the overall CPI--in addition to their favorite inflation indicator, the core PCE (Personal Consumption Expenditures) price index. Both of these measures are currently in the vicinity of 2% and unlikely to emanate any deflationary signals in the foreseeable future.
Naturally, the longer the recession drags on, the higher the risk that the current disinflationary trend will convert itself into a deflationary one. But the distance between the two is real and, at this point, the risk of the latter outcome -- beyond the phase of a simple arithmetic quirk for a short period--is indeed low.
Anthony Karydakis is a former chief U.S. economist with JP Morgan Asset Management and currently an Adjunct professor at New York University's Stern School of Business.
http://money.cnn.com/2008/12/18/news/economy/deflation_recession.fortune/
**The growing threat of deflation from a globally synchronised recession
I have been trying to understand deflation. Have I experienced this before in Malaysia? A friend explained this as an environment of falling prices in assets and almost everything, and yet no one is buying. General unemployment is high during the same time and there is falling wages too. He lamented that in this situation one should be brave to snap up cheap and good assets at the opportune time. The immediate income may not be good at the time of buying during the deflationary environment but future potential gains or returns will more than compensate.
-----
The growing threat of deflation
A widespread drop in prices might seem like a good thing to most consumers, but the Fed and economists see it as another reason to worry.
By Chris Isidore, CNNMoney.com senior writer
Last Updated: December 18, 2008: 10:03 AM ET
AMERICA'S MONEY CRISIS
Hedge fund graveyard: 693 and counting
Fed OKs credit card crackdown
Good news when this bubble pops
Fuel prices drop, but airfares don't
Cheap money: The Fed rate cut and you
When cheap isn't good
NEW YORK (CNNMoney.com) -- Lower prices are probably at the bottom of the list of most Americans' current economic worries. But for a growing number of economists, it's their biggest fear.
A widespread drop in prices is known as deflation. And typically, it's not just the price of consumer goods that fall. Home prices, stock prices and even people's salaries often head lower as well.
The biggest problem with deflation is that when businesses need to continually cut prices to spur sales, they eventually respond by cutting production. That results in growing job losses, and could, in the worst case scenario, even cause a depression.
And several economists say they are far more worried about the threat of deflation now than they have been in the past. The Federal Reserve may also be more concerned about deflation as well.
The central bank cut its key interest rates to near 0% Tuesday. In its statement, the Fed said it expects inflation to "moderate further" but it stopped short of suggesting that inflation would drop "to levels consistent with price stability" as it has in prior statements.
"I think the Fed's statement clearly reflected some alarm that there is a greater risk of not just deflation, but of depression," said Bernard Baumohl, executive director of The Economic Outlook Group, a Princeton, N.J., research firm.
Just a month ago Baumohl put the chance of a deflation at between 10% to 20% sometime in 2009. Now he believes there's a 30% chance of deflation.
Drops in consumer prices
Economists have reason to fear that a deflationary spiral is looming.
On Tuesday, the government reported that its Consumer Price Index -- a key gauge of inflation -- fell a record 1.7% in November. Over the past three months, retail prices have plunged at a 10% annual rate.
While much of that drop was caused by falling gasoline prices, the so-called core CPI, which strips out volatile food and energy prices, declined by 0.1% in November, the first decline in that reading since the severe recession of 1982.
Core consumer prices are now up only 0.4% on an annual basis over the past three months. That is below the 1% to 2% annual range that is generally believed to be the Fed's comfort zone for inflation.
It doesn't take much of a price decline to cause economic pain. During Japan's so-called "lost decade" that started in the 1990s, prices only fell by 1% annually. But those deflationary pressures resulted in a prolonged recession.
So far, few economists believe that a couple of months of price declines is enough evidence to suggest that the U.S. is now going through a period of deflation.
But economists think the Fed should try and nip deflation in the bud and that was probably the reason why the central bank cut interest rates by more than expected.
"They're not dismissing [deflation] the way they did in the past," said David Wyss, chief economist for Standard & Poor's.
Economists debate threat
Wyss said he doesn't believe that deflation is likely to take hold in the next year. But he cautions that if the current recession continues into 2010, "the risk is significant."
Of course, not all economists are voicing increased fears about deflation.
A senior Fed official told reporters on a conference call Tuesday that deflation is not now a major worry, but conceded that the central bank would continue to closely monitor prices to make sure it doesn't become a problem.
Rich Yamarone, director of economic research at Argus Research, said his firm's deflation index is showing less of a deflation threat today than it did in 1998 or 2002-2003, the last time many economists were fearing deflation.
Yamarone said the deflation fears proved overblown in those periods, and he's confident the threat of falling prices won't play out again this time.
"We believe that the market, the Fed and the business press are all going to get it wrong this time around as well," he said. He said the drop in commodity prices, particularly oil, has caused what will prove to be a temporary fall in other prices.
Bernanke's deflation views
Whether or not Yamarone is right may depend on how the Fed continues to respond to this economic crisis.
Fed Chairman Ben Bernanke has spoken frequently in the past about deflation and how he thinks it was a significant factor in the Great Depression, his area of expertise when he was an economics professor at Princeton University.
In November 2002, Bernanke, then a Fed governor, gave a speech about how to combat inflation. That speech may offer some hints as to how the Fed may fight deflation if it becomes more of a threat.
Bernanke became known in some circles as "Helicopter Ben" for his facetious suggestion in that speech that even if the Fed cut interest rates to zero, it could continue to battle deflation by other measures, including dropping large wads of cash from helicopters.
The speech clearly signaled that Bernanke was less scared of cutting rates to zero than he was by the threat of deflation, which he described in terms that appear prescient today.
"Deflation is in almost all cases a side effect of a collapse of aggregate demand -- a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers," he said at that time.
He said deflation would then lead to recession, rising unemployment and financial stress. And he added that while "deflation in the United States is highly unlikely, I would be imprudent to rule out the possibility altogether."
He argued that the Fed and Congress could take steps beyond cutting rates to ward off serious deflation. And he expressed confidence such measures would work, as long as they were taken before deflation took hold.
"Prevention of deflation remains preferable to having to cure it," he said in the speech.
And in his concluding remarks, he added that "the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit...zero."
First Published: December 17, 2008: 2:50 PM ET
http://money.cnn.com/2008/12/17/news/economy/deflation/?postversion=2008121714
-----
The growing threat of deflation
A widespread drop in prices might seem like a good thing to most consumers, but the Fed and economists see it as another reason to worry.
By Chris Isidore, CNNMoney.com senior writer
Last Updated: December 18, 2008: 10:03 AM ET
AMERICA'S MONEY CRISIS
Hedge fund graveyard: 693 and counting
Fed OKs credit card crackdown
Good news when this bubble pops
Fuel prices drop, but airfares don't
Cheap money: The Fed rate cut and you
When cheap isn't good
NEW YORK (CNNMoney.com) -- Lower prices are probably at the bottom of the list of most Americans' current economic worries. But for a growing number of economists, it's their biggest fear.
A widespread drop in prices is known as deflation. And typically, it's not just the price of consumer goods that fall. Home prices, stock prices and even people's salaries often head lower as well.
The biggest problem with deflation is that when businesses need to continually cut prices to spur sales, they eventually respond by cutting production. That results in growing job losses, and could, in the worst case scenario, even cause a depression.
And several economists say they are far more worried about the threat of deflation now than they have been in the past. The Federal Reserve may also be more concerned about deflation as well.
The central bank cut its key interest rates to near 0% Tuesday. In its statement, the Fed said it expects inflation to "moderate further" but it stopped short of suggesting that inflation would drop "to levels consistent with price stability" as it has in prior statements.
"I think the Fed's statement clearly reflected some alarm that there is a greater risk of not just deflation, but of depression," said Bernard Baumohl, executive director of The Economic Outlook Group, a Princeton, N.J., research firm.
Just a month ago Baumohl put the chance of a deflation at between 10% to 20% sometime in 2009. Now he believes there's a 30% chance of deflation.
Drops in consumer prices
Economists have reason to fear that a deflationary spiral is looming.
On Tuesday, the government reported that its Consumer Price Index -- a key gauge of inflation -- fell a record 1.7% in November. Over the past three months, retail prices have plunged at a 10% annual rate.
While much of that drop was caused by falling gasoline prices, the so-called core CPI, which strips out volatile food and energy prices, declined by 0.1% in November, the first decline in that reading since the severe recession of 1982.
Core consumer prices are now up only 0.4% on an annual basis over the past three months. That is below the 1% to 2% annual range that is generally believed to be the Fed's comfort zone for inflation.
It doesn't take much of a price decline to cause economic pain. During Japan's so-called "lost decade" that started in the 1990s, prices only fell by 1% annually. But those deflationary pressures resulted in a prolonged recession.
So far, few economists believe that a couple of months of price declines is enough evidence to suggest that the U.S. is now going through a period of deflation.
But economists think the Fed should try and nip deflation in the bud and that was probably the reason why the central bank cut interest rates by more than expected.
"They're not dismissing [deflation] the way they did in the past," said David Wyss, chief economist for Standard & Poor's.
Economists debate threat
Wyss said he doesn't believe that deflation is likely to take hold in the next year. But he cautions that if the current recession continues into 2010, "the risk is significant."
Of course, not all economists are voicing increased fears about deflation.
A senior Fed official told reporters on a conference call Tuesday that deflation is not now a major worry, but conceded that the central bank would continue to closely monitor prices to make sure it doesn't become a problem.
Rich Yamarone, director of economic research at Argus Research, said his firm's deflation index is showing less of a deflation threat today than it did in 1998 or 2002-2003, the last time many economists were fearing deflation.
Yamarone said the deflation fears proved overblown in those periods, and he's confident the threat of falling prices won't play out again this time.
"We believe that the market, the Fed and the business press are all going to get it wrong this time around as well," he said. He said the drop in commodity prices, particularly oil, has caused what will prove to be a temporary fall in other prices.
Bernanke's deflation views
Whether or not Yamarone is right may depend on how the Fed continues to respond to this economic crisis.
Fed Chairman Ben Bernanke has spoken frequently in the past about deflation and how he thinks it was a significant factor in the Great Depression, his area of expertise when he was an economics professor at Princeton University.
In November 2002, Bernanke, then a Fed governor, gave a speech about how to combat inflation. That speech may offer some hints as to how the Fed may fight deflation if it becomes more of a threat.
Bernanke became known in some circles as "Helicopter Ben" for his facetious suggestion in that speech that even if the Fed cut interest rates to zero, it could continue to battle deflation by other measures, including dropping large wads of cash from helicopters.
The speech clearly signaled that Bernanke was less scared of cutting rates to zero than he was by the threat of deflation, which he described in terms that appear prescient today.
"Deflation is in almost all cases a side effect of a collapse of aggregate demand -- a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers," he said at that time.
He said deflation would then lead to recession, rising unemployment and financial stress. And he added that while "deflation in the United States is highly unlikely, I would be imprudent to rule out the possibility altogether."
He argued that the Fed and Congress could take steps beyond cutting rates to ward off serious deflation. And he expressed confidence such measures would work, as long as they were taken before deflation took hold.
"Prevention of deflation remains preferable to having to cure it," he said in the speech.
And in his concluding remarks, he added that "the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit...zero."
First Published: December 17, 2008: 2:50 PM ET
http://money.cnn.com/2008/12/17/news/economy/deflation/?postversion=2008121714
Wednesday 17 December 2008
Wade into the market? Or plunge?
Mutual Funds10/21/2008 12:01 AM ET
Wade into the market? Or plunge?
Evidence suggests that jumping right in with your money may generate better results than investing gradually over time. Here's why.
By Tim Middleton
With the stock market wackier than Daffy Duck, risk has risen to unprecedented levels. On Thursday, the CBOE Volatility Index ($VIX.X), which measures volatility of the prices of stock-futures contracts, soared to 80 -- the highest in its history. It's often called the fear index, and any reading over 30 is considered ominous.
That's a reason one of investing's most treasured precepts -- dollar-cost averaging, or DCA -- is finding wider and wider acceptance. You do this automatically in your 401(k), contributing a fixed amount each month, whether stocks are up or down. Thus, in a period of volatility, you spread your risk. This year, prices were down in seven of the first nine months, with extreme losses in January, June and September, not to mention the first couple of weeks of October.
But dollar-cost averaging is mind balm only. It doesn't actually reduce risk, and it doesn't increase returns.
In fact, there's evidence that investors should approach the market more aggressively. Over short periods as well as long, investing lump sums is the equal of dollar-cost averaging, except in those rare times when the market is going straight up, when lump-sum investing does better.
"At our firm, we tell clients that there is no difference," says Paul A. LaViola, the vice president of RTD Financial Advisors in Philadelphia. "However, emotionally, it can make someone feel better if they DCA when the market is going down or they are unsure about the market."
My household invests both ways, twice monthly in my wife's 403(b) and our brokerage and mutual fund accounts, and lump sums into my SEP-IRA (simplified employee pension individual retirement account) two or three times a year. My wife recently changed jobs, and we'll be rolling her old 403(b) into an IRA. It's a considerable amount, and we'll reinvest all of it. DCA is pointless, except as a crutch.
Surprising results Don't believe me? You're not alone. "I am a huge proponent of dollar-cost averaging, especially in volatile times like we are currently experiencing," says Jane M. Young of Pinnacle Financial Concepts in Colorado Springs, Colo. "I have not conducted any studies, so my opinion is based on 12 years' experience working with clients." I can understand that financial novices -- the clients of financial advisers -- are soothed by DCA. But I have done some research, and here's what I've found:
Vanguard 500 Index Fund (VFINX) over 10 years
Investments of $100 per month
Lump-sum investments of $1,200 per year
Lump-sum performance (compared with monthly investments)
Date
Price
Total portfolio value
Total portfolio value
Total portfolio +/-
Annual dollar +/-
Annual percentage +/-
Market performance
Nov. 2, 1998
$108.49
$100
$1,200
Oct. 1, 1999
$126.05
$1,267
$1,394
$128
$128
10.1%
16.2%
Oct. 2, 2000
$132.02
$2,521
$2,692
$171
$44
1.7%
2.7%
Oct. 1, 2001
$97.86
$2,922
$2,961
$39
-$132
-4.5%
-19.5%
Oct. 1, 2002
$81.87
$3,493
$3,410
-$83
-$122
-3.5%
-22.3%
Oct. 1, 2003
$97.19
$5,498
$5,390
-$108
-$25
-0.5%
11.8%
Oct. 1, 2004
$104.55
$7,130
$7,078
-$52
$56
0.8%
6.7%
Oct. 3, 2005
$111.30
$8,798
$8,763
-$36
$16
0.2%
2.3%
Oct. 2, 2006
$127.04
$11,324
$11,322
-$2
$34
0.3%
10.0%
Oct. 1, 2007
$142.83
$13,999
$14,053
$54
$56
0.4%
10.4%
Oct. 1, 2008
$82.87
$8,962
$8,880
-$82
-$136
-1.5%
-39.4%
Note: Figures may not add up because of rounding.
This shows the relative performance of two portfolios established 10 years ago in the Vanguard 500 Index Fund (VFINX), the investable form of the standard stock benchmark. One investor put in $100 on the first day of every month. The other put in $1,200 on Nov. 1 of each year.
Ten years later, we can see there is no significant difference in their returns, either in their total over the period or their annual performance. Even in this disastrous year, when the fund itself has gone down 39.4% in the past 12 months, the lump-sum investor did only 1.5% worse than the DCA investor. The greatest disparities in the overall portfolio were a lump-sum advantage of $171 in 2000 and a DCA advantage of $108 in 2003.
I shared my study with several financial advisers, and one raised two pertinent questions about my method: Why did I choose to begin in November, as opposed to some other month? And why did I choose Vanguard 500 rather than a surrogate for some other benchmark, such as small caps or foreign stocks?
To answer the first, I wanted 10 full years of data, as of the most recent possible date. Beginning in November 1998 allows both investors to make identical annual contributions. Further, I chose Vanguard 500 because this is the market. Most investors have the bulk of their equity assets in domestic big caps.
The adviser didn't ask why I chose 10 years as my study period, but I'll tell you anyway: It reflects roughly five years each of bull and bear markets. In fact, the current bear market and that of 2000-02 are both monsters, marked by declines of more than 40% -- the only time besides 1973-74 this has happened since the 1930s.
If anything, such extreme downward volatility should have favored the DCA investor. But it didn't.
Continued: What advisers say
What advisers say One adviser with whom I shared my study said it was unconvincing because the lump-sum contributions each November themselves represent DCA, only annually instead of monthly. More realistic, he said, is the lump sum that arrives possibly only once in a lifetime, such as an inheritance or 401(k) rollover.
"Accordingly, for most of my clients I say, 'Why not just invest the lump sum and be done with it?' Most people will take this approach," says Warren J. McIntyre of VisionQuest Financial Planning in Troy, Mich. "However, for someone skittish about the market by nature, especially during a volatile time like now -- I think DCA is a great strategy from a psychological standpoint."
Fair enough. Every investor needs to remain in his own comfort zone. But research from DCA critics has demonstrated that lump sums aren't just the equal of DCA but are instead superior to it.
Dimensional Fund Advisors, a firm that runs sophisticated index funds that are sold only through financial advisers it trains in-house, did a study in 2004 called "To Wade or Plunge." In it, the firm studied four types of portfolios -- domestic equity, domestic balanced, global equity and global balanced -- over periods dating to 1970 for foreign securities and to 1927 for domestic stocks and bonds. In the trials, one portfolio invested on the first day of each year, while the other invested quarterly.
"For the domestic portfolios during the 1927-2003 period, plunging beat wading in about two-thirds of the trials. The average one-year excess return of plunging over wading was nearly 6% for the domestic equity portfolio and about 4% for the domestic balanced portfolio," the study says.
"For global and domestic portfolios during the 1970-2003 period, plunging again beat wading in about two-thirds of the trials. The average excess returns for plunging over wading were about 4.5% for global equity, 3% for global balanced, 5% for domestic equity and 3.4% for domestic balanced."
Despite such evidence, most of the two dozen or so financial advisers I polled last week are strong supporters of DCA. I don't blame them. What if they had recommended that a new client take the plunge on Oct. 1? By Oct. 10, the Vanguard 500 fund was down 22.5%. The client would have been gone, and everyone he met for the rest of his life would hear what a lousy adviser that poor sap turned out to be.
But if I had invested a bundle on Oct. 1, I would have gritted my teeth and held on. By Oct. 13, my loss was only 13.5%. Ten years from now I'll be lucky if I can remember what happened in those 10 days. And I would be sitting on a nice wad of money.
So take your choice. You'll probably make more money investing lump sums, but there's a chance you won't. You make choices like this all the time; you can break your neck riding a bike. TV's Monk -- whose theme song is "It's a Jungle Out There" -- doesn't strike me as the lump-sum type, but I suspect most of us are.
Meet Tim Middleton at The Money Show MSN Money's Tim Middleton will be among more than 50 investing experts gathered in the nation's capital Nov. 6-8 for the fourth annual Money Show Washington, D.C. Just days after the election, this elite group will present more than 170 free workshops to help you prepare for changes in the political landscape. Admission is free for MSN Money users.
To register, call 1-800-970-4355 and mention priority code 009554, or visit the Money Show Washington, D.C., Web site.
At the time of publication, Tim Middleton didn't own any securities mentioned in this article.
http://articles.moneycentral.msn.com/Investing/MutualFunds/wade-into-the-market-or-plunge.aspx?page=all
Wade into the market? Or plunge?
Evidence suggests that jumping right in with your money may generate better results than investing gradually over time. Here's why.
By Tim Middleton
With the stock market wackier than Daffy Duck, risk has risen to unprecedented levels. On Thursday, the CBOE Volatility Index ($VIX.X), which measures volatility of the prices of stock-futures contracts, soared to 80 -- the highest in its history. It's often called the fear index, and any reading over 30 is considered ominous.
That's a reason one of investing's most treasured precepts -- dollar-cost averaging, or DCA -- is finding wider and wider acceptance. You do this automatically in your 401(k), contributing a fixed amount each month, whether stocks are up or down. Thus, in a period of volatility, you spread your risk. This year, prices were down in seven of the first nine months, with extreme losses in January, June and September, not to mention the first couple of weeks of October.
But dollar-cost averaging is mind balm only. It doesn't actually reduce risk, and it doesn't increase returns.
In fact, there's evidence that investors should approach the market more aggressively. Over short periods as well as long, investing lump sums is the equal of dollar-cost averaging, except in those rare times when the market is going straight up, when lump-sum investing does better.
"At our firm, we tell clients that there is no difference," says Paul A. LaViola, the vice president of RTD Financial Advisors in Philadelphia. "However, emotionally, it can make someone feel better if they DCA when the market is going down or they are unsure about the market."
My household invests both ways, twice monthly in my wife's 403(b) and our brokerage and mutual fund accounts, and lump sums into my SEP-IRA (simplified employee pension individual retirement account) two or three times a year. My wife recently changed jobs, and we'll be rolling her old 403(b) into an IRA. It's a considerable amount, and we'll reinvest all of it. DCA is pointless, except as a crutch.
Surprising results Don't believe me? You're not alone. "I am a huge proponent of dollar-cost averaging, especially in volatile times like we are currently experiencing," says Jane M. Young of Pinnacle Financial Concepts in Colorado Springs, Colo. "I have not conducted any studies, so my opinion is based on 12 years' experience working with clients." I can understand that financial novices -- the clients of financial advisers -- are soothed by DCA. But I have done some research, and here's what I've found:
Vanguard 500 Index Fund (VFINX) over 10 years
Investments of $100 per month
Lump-sum investments of $1,200 per year
Lump-sum performance (compared with monthly investments)
Date
Price
Total portfolio value
Total portfolio value
Total portfolio +/-
Annual dollar +/-
Annual percentage +/-
Market performance
Nov. 2, 1998
$108.49
$100
$1,200
Oct. 1, 1999
$126.05
$1,267
$1,394
$128
$128
10.1%
16.2%
Oct. 2, 2000
$132.02
$2,521
$2,692
$171
$44
1.7%
2.7%
Oct. 1, 2001
$97.86
$2,922
$2,961
$39
-$132
-4.5%
-19.5%
Oct. 1, 2002
$81.87
$3,493
$3,410
-$83
-$122
-3.5%
-22.3%
Oct. 1, 2003
$97.19
$5,498
$5,390
-$108
-$25
-0.5%
11.8%
Oct. 1, 2004
$104.55
$7,130
$7,078
-$52
$56
0.8%
6.7%
Oct. 3, 2005
$111.30
$8,798
$8,763
-$36
$16
0.2%
2.3%
Oct. 2, 2006
$127.04
$11,324
$11,322
-$2
$34
0.3%
10.0%
Oct. 1, 2007
$142.83
$13,999
$14,053
$54
$56
0.4%
10.4%
Oct. 1, 2008
$82.87
$8,962
$8,880
-$82
-$136
-1.5%
-39.4%
Note: Figures may not add up because of rounding.
This shows the relative performance of two portfolios established 10 years ago in the Vanguard 500 Index Fund (VFINX), the investable form of the standard stock benchmark. One investor put in $100 on the first day of every month. The other put in $1,200 on Nov. 1 of each year.
Ten years later, we can see there is no significant difference in their returns, either in their total over the period or their annual performance. Even in this disastrous year, when the fund itself has gone down 39.4% in the past 12 months, the lump-sum investor did only 1.5% worse than the DCA investor. The greatest disparities in the overall portfolio were a lump-sum advantage of $171 in 2000 and a DCA advantage of $108 in 2003.
I shared my study with several financial advisers, and one raised two pertinent questions about my method: Why did I choose to begin in November, as opposed to some other month? And why did I choose Vanguard 500 rather than a surrogate for some other benchmark, such as small caps or foreign stocks?
To answer the first, I wanted 10 full years of data, as of the most recent possible date. Beginning in November 1998 allows both investors to make identical annual contributions. Further, I chose Vanguard 500 because this is the market. Most investors have the bulk of their equity assets in domestic big caps.
The adviser didn't ask why I chose 10 years as my study period, but I'll tell you anyway: It reflects roughly five years each of bull and bear markets. In fact, the current bear market and that of 2000-02 are both monsters, marked by declines of more than 40% -- the only time besides 1973-74 this has happened since the 1930s.
If anything, such extreme downward volatility should have favored the DCA investor. But it didn't.
Continued: What advisers say
What advisers say One adviser with whom I shared my study said it was unconvincing because the lump-sum contributions each November themselves represent DCA, only annually instead of monthly. More realistic, he said, is the lump sum that arrives possibly only once in a lifetime, such as an inheritance or 401(k) rollover.
"Accordingly, for most of my clients I say, 'Why not just invest the lump sum and be done with it?' Most people will take this approach," says Warren J. McIntyre of VisionQuest Financial Planning in Troy, Mich. "However, for someone skittish about the market by nature, especially during a volatile time like now -- I think DCA is a great strategy from a psychological standpoint."
Fair enough. Every investor needs to remain in his own comfort zone. But research from DCA critics has demonstrated that lump sums aren't just the equal of DCA but are instead superior to it.
Dimensional Fund Advisors, a firm that runs sophisticated index funds that are sold only through financial advisers it trains in-house, did a study in 2004 called "To Wade or Plunge." In it, the firm studied four types of portfolios -- domestic equity, domestic balanced, global equity and global balanced -- over periods dating to 1970 for foreign securities and to 1927 for domestic stocks and bonds. In the trials, one portfolio invested on the first day of each year, while the other invested quarterly.
"For the domestic portfolios during the 1927-2003 period, plunging beat wading in about two-thirds of the trials. The average one-year excess return of plunging over wading was nearly 6% for the domestic equity portfolio and about 4% for the domestic balanced portfolio," the study says.
"For global and domestic portfolios during the 1970-2003 period, plunging again beat wading in about two-thirds of the trials. The average excess returns for plunging over wading were about 4.5% for global equity, 3% for global balanced, 5% for domestic equity and 3.4% for domestic balanced."
Despite such evidence, most of the two dozen or so financial advisers I polled last week are strong supporters of DCA. I don't blame them. What if they had recommended that a new client take the plunge on Oct. 1? By Oct. 10, the Vanguard 500 fund was down 22.5%. The client would have been gone, and everyone he met for the rest of his life would hear what a lousy adviser that poor sap turned out to be.
But if I had invested a bundle on Oct. 1, I would have gritted my teeth and held on. By Oct. 13, my loss was only 13.5%. Ten years from now I'll be lucky if I can remember what happened in those 10 days. And I would be sitting on a nice wad of money.
So take your choice. You'll probably make more money investing lump sums, but there's a chance you won't. You make choices like this all the time; you can break your neck riding a bike. TV's Monk -- whose theme song is "It's a Jungle Out There" -- doesn't strike me as the lump-sum type, but I suspect most of us are.
Meet Tim Middleton at The Money Show MSN Money's Tim Middleton will be among more than 50 investing experts gathered in the nation's capital Nov. 6-8 for the fourth annual Money Show Washington, D.C. Just days after the election, this elite group will present more than 170 free workshops to help you prepare for changes in the political landscape. Admission is free for MSN Money users.
To register, call 1-800-970-4355 and mention priority code 009554, or visit the Money Show Washington, D.C., Web site.
At the time of publication, Tim Middleton didn't own any securities mentioned in this article.
http://articles.moneycentral.msn.com/Investing/MutualFunds/wade-into-the-market-or-plunge.aspx?page=all
Now is the perfect time to invest
Mutual Funds12/16/2008 12:01 AM ET
Now is the perfect time to invest
It's tempting to stay on the sidelines of a turbulent stock market, but you should take advantage of today's rock-bottom prices. Here's why -- and how.
By Tim Middleton
The 2007-08 bear market has been the worst since the Great Depression, more savage than that of 1973-74, which most of us remember only dimly, if at all, and 2000-02, which we remember all too well.
What's more, the combination of two deep bears in less than a decade has poisoned many people against common stocks. The Standard & Poor's 500 Index ($INX) has gone down an average of 0.9% a year over the past 10 years, from November 1998 through November 2008. Given this sobering lesson, who would want to own these things?
You would.
Whether you're just getting started as an investor or rebuilding a portfolio shattered by the recent chaos, you need to remember that how well you do depends on what you pay at the outset. And prices now are at rock bottom.
"Today, in my view, the stock market is presenting you with one of the great buying opportunities of your lifetime -- perhaps the greatest," says Steve Leuthold, the manager of the Leuthold Core Investment (LCORX) fund, which ranks in the top 2% of similar funds over the past 10 years. "Buy 'em when they hate 'em."
Since this bear market began 14 months ago, virtually every asset class, from foreign and domestic stocks to commodities to real estate, has been driven down at least 50%. Even among bonds, only U.S. Treasurys have held up well. The benefits of diversification, in short, have proved to be illusory.
But that doesn't mean -- in the words every market loser has uttered -- that this time it's different.
"The importance of asset allocation, the insidious power of inflation, diversification using uncorrelated asset classes and long-term stock market performance still exist," says Michael L. Kalscheur, a financial consultant with Castle Wealth Advisors in Indianapolis. "Most people are looking at the most recent information and assume that's how it will always be. It will not always be this way."
Whether you're building a portfolio or rebuilding an old one, the tried-and-true lessons still apply: Balance risks against each other while relying on equities to build wealth. If you have become increasingly defensive over the past year -- and most people have -- now is the time to reverse the process.
How much worse could it get? I believe the bear market is over. But say I'm wrong and it's not. Having fallen more than 50% already, just how much further can stock prices fall? How much risk remains?
Junk bonds are yielding 22%, nearly twice their historical average. Since the vast majority of corporate bonds are rated junk, do you really believe more than half of the American private sector is going to go broke? That didn't happen even in the Great Depression.
Here is what you should not do in the coming year: Wade cautiously back into risky markets such as stocks, dollar-cost averaging your way back to a normal, stock-heavy portfolio.
This is the time to plunge. Dollar-cost averaging is almost never a good idea, as I explained in a recent column, but it's a really lousy idea right now.
That's because stock market recoveries tend to be front-loaded. Since 1900, according to Leuthold's research, "the median first-year price gain of 40.9% represents almost half of the median 83.6% total bull market gain for the Dow." Gains in the first three months are the sharpest of all, averaging just over 18%.
So take the money you've got to invest -- all of it -- and build (or rebuild) your portfolio today.
By the way: I'm doing this myself in my own portfolio, and subscribers to my newsletter, ETF Insider, have already done it, effective Dec. 1. Since bonds have remained positive throughout the bear market, we had profits in them, which we trimmed. We added that to the cash hoard we had built up when we cut back on our riskiest positions earlier in the year, and we swapped nearly everything into foreign and, primarily, domestic stock funds. We also bolstered our holdings of emerging market stocks and commercial real estate, which had been beaten down the most.
Continued: Building your portfolio
Building your portfolio How you allocate your assets is the most important decision you will make in terms of future returns. That, rather than individual-security selection, accounts for 90% of total portfolio returns.
The most attractive asset classes on a total return basis are:
Domestic small-capitalization stocks.
Domestic large-cap stocks.
Emerging-markets stocks.
Foreign developed-market stocks.
Since an investment portfolio is long term by its nature -- money you need in only a few years should be protected in Treasury bills and short-term bond funds -- at least 50% of it should be apportioned among these groups. And for Mr. or Ms. Typical Investor, I would make this equity allocation 75%.
Stocks provide the most reliable mixture of potential for capital growth and protection against inflation. For young investors, my allocation recommendation would be 100%, and indeed that's where two of my three children have their investments. (The third may buy a home soon and so holds a considerable portion in bonds.)
The most attractive assets for diversifying risk in a stock-heavy portfolio are:
Domestic high-quality bonds, particularly mortgage and corporate bonds.
Foreign high-quality bonds.
Domestic commercial real estate, in the form of funds that invest in real-estate investment trusts, or REITs.
Commodities, notably energy.
Cash, in the form of T-bills or money market accounts.
In taxable investment accounts, municipal bonds take the place of corporate, U.S. government and mortgage bonds. Munis are particularly cheap right now, yielding far more on an after-tax basis than taxable bonds.
During periods of high inflation, Treasury inflation-protected securities, or TIPS, can take the place of at least some of the high-quality bond allocation. That's not the case now, however.
Assuming you have 75% of your assets in equity funds, I would allocate the balance like this: 5% in a commodity/energy fund, 5% in REITs and 15% in domestic high-quality bonds such as Pimco Total Return (PTTRX), the most widely held such mutual fund.
I wouldn't own foreign bonds at the moment because the U.S. dollar is rallying, and currency translations are therefore increasingly unfavorable. For the same reason, I would be light on foreign developed-market equities -- but not emerging markets, where currencies play less of a role.
Both energy and REITs are down much, much more than stocks in the current market, so you could snap up real bargains there.
Higher returns ahead If you think this plan is too risky, think again. Just as relatively low stock returns this decade could have been predicted (and in fact were, by Warren Buffett, among others), based on extreme out-performance in the 1990s, relatively high returns going forward are almost reflexive. This cycle is known as reversion to the mean, and the mean returns of stocks over long periods are in the low double digits.
"History shows us that after a substantial bear market, we can expect the returns of equities to be higher in the near term," notes Tom Adams, a financial adviser with Mentor Capital Management in Elmhurst, Ill.
Having pointed out the negative returns of stocks over the past 10 years, Leuthold tracked the history of stock performance in every 10-year period in which the market averaged an annual gain of 1% or less. Then he looked at the succeeding 10 years. The worst performance in those periods was a gain of 101% between 1938 and 1948. The best was a surge of 325% between 1974 and 1984. The average was 183%.
Buffett, so negative on stocks as this decade began, has lately become outspokenly bullish. No investor in our lifetimes has proved more adept at understanding the market.
So whether you are new to investing or renewing your commitment to it, you have chosen a very favorable time. Don't dally. Your financial future depends on what you do now.
At the time of publication, Tim Middleton didn't own any fund mentioned in this article.
http://articles.moneycentral.msn.com/learn-how-to-invest/now-is-the-perfect-time-to-invest.aspx?page=all
Now is the perfect time to invest
It's tempting to stay on the sidelines of a turbulent stock market, but you should take advantage of today's rock-bottom prices. Here's why -- and how.
By Tim Middleton
The 2007-08 bear market has been the worst since the Great Depression, more savage than that of 1973-74, which most of us remember only dimly, if at all, and 2000-02, which we remember all too well.
What's more, the combination of two deep bears in less than a decade has poisoned many people against common stocks. The Standard & Poor's 500 Index ($INX) has gone down an average of 0.9% a year over the past 10 years, from November 1998 through November 2008. Given this sobering lesson, who would want to own these things?
You would.
Whether you're just getting started as an investor or rebuilding a portfolio shattered by the recent chaos, you need to remember that how well you do depends on what you pay at the outset. And prices now are at rock bottom.
"Today, in my view, the stock market is presenting you with one of the great buying opportunities of your lifetime -- perhaps the greatest," says Steve Leuthold, the manager of the Leuthold Core Investment (LCORX) fund, which ranks in the top 2% of similar funds over the past 10 years. "Buy 'em when they hate 'em."
Since this bear market began 14 months ago, virtually every asset class, from foreign and domestic stocks to commodities to real estate, has been driven down at least 50%. Even among bonds, only U.S. Treasurys have held up well. The benefits of diversification, in short, have proved to be illusory.
But that doesn't mean -- in the words every market loser has uttered -- that this time it's different.
"The importance of asset allocation, the insidious power of inflation, diversification using uncorrelated asset classes and long-term stock market performance still exist," says Michael L. Kalscheur, a financial consultant with Castle Wealth Advisors in Indianapolis. "Most people are looking at the most recent information and assume that's how it will always be. It will not always be this way."
Whether you're building a portfolio or rebuilding an old one, the tried-and-true lessons still apply: Balance risks against each other while relying on equities to build wealth. If you have become increasingly defensive over the past year -- and most people have -- now is the time to reverse the process.
How much worse could it get? I believe the bear market is over. But say I'm wrong and it's not. Having fallen more than 50% already, just how much further can stock prices fall? How much risk remains?
Junk bonds are yielding 22%, nearly twice their historical average. Since the vast majority of corporate bonds are rated junk, do you really believe more than half of the American private sector is going to go broke? That didn't happen even in the Great Depression.
Here is what you should not do in the coming year: Wade cautiously back into risky markets such as stocks, dollar-cost averaging your way back to a normal, stock-heavy portfolio.
This is the time to plunge. Dollar-cost averaging is almost never a good idea, as I explained in a recent column, but it's a really lousy idea right now.
That's because stock market recoveries tend to be front-loaded. Since 1900, according to Leuthold's research, "the median first-year price gain of 40.9% represents almost half of the median 83.6% total bull market gain for the Dow." Gains in the first three months are the sharpest of all, averaging just over 18%.
So take the money you've got to invest -- all of it -- and build (or rebuild) your portfolio today.
By the way: I'm doing this myself in my own portfolio, and subscribers to my newsletter, ETF Insider, have already done it, effective Dec. 1. Since bonds have remained positive throughout the bear market, we had profits in them, which we trimmed. We added that to the cash hoard we had built up when we cut back on our riskiest positions earlier in the year, and we swapped nearly everything into foreign and, primarily, domestic stock funds. We also bolstered our holdings of emerging market stocks and commercial real estate, which had been beaten down the most.
Continued: Building your portfolio
Building your portfolio How you allocate your assets is the most important decision you will make in terms of future returns. That, rather than individual-security selection, accounts for 90% of total portfolio returns.
The most attractive asset classes on a total return basis are:
Domestic small-capitalization stocks.
Domestic large-cap stocks.
Emerging-markets stocks.
Foreign developed-market stocks.
Since an investment portfolio is long term by its nature -- money you need in only a few years should be protected in Treasury bills and short-term bond funds -- at least 50% of it should be apportioned among these groups. And for Mr. or Ms. Typical Investor, I would make this equity allocation 75%.
Stocks provide the most reliable mixture of potential for capital growth and protection against inflation. For young investors, my allocation recommendation would be 100%, and indeed that's where two of my three children have their investments. (The third may buy a home soon and so holds a considerable portion in bonds.)
The most attractive assets for diversifying risk in a stock-heavy portfolio are:
Domestic high-quality bonds, particularly mortgage and corporate bonds.
Foreign high-quality bonds.
Domestic commercial real estate, in the form of funds that invest in real-estate investment trusts, or REITs.
Commodities, notably energy.
Cash, in the form of T-bills or money market accounts.
In taxable investment accounts, municipal bonds take the place of corporate, U.S. government and mortgage bonds. Munis are particularly cheap right now, yielding far more on an after-tax basis than taxable bonds.
During periods of high inflation, Treasury inflation-protected securities, or TIPS, can take the place of at least some of the high-quality bond allocation. That's not the case now, however.
Assuming you have 75% of your assets in equity funds, I would allocate the balance like this: 5% in a commodity/energy fund, 5% in REITs and 15% in domestic high-quality bonds such as Pimco Total Return (PTTRX), the most widely held such mutual fund.
I wouldn't own foreign bonds at the moment because the U.S. dollar is rallying, and currency translations are therefore increasingly unfavorable. For the same reason, I would be light on foreign developed-market equities -- but not emerging markets, where currencies play less of a role.
Both energy and REITs are down much, much more than stocks in the current market, so you could snap up real bargains there.
Higher returns ahead If you think this plan is too risky, think again. Just as relatively low stock returns this decade could have been predicted (and in fact were, by Warren Buffett, among others), based on extreme out-performance in the 1990s, relatively high returns going forward are almost reflexive. This cycle is known as reversion to the mean, and the mean returns of stocks over long periods are in the low double digits.
"History shows us that after a substantial bear market, we can expect the returns of equities to be higher in the near term," notes Tom Adams, a financial adviser with Mentor Capital Management in Elmhurst, Ill.
Having pointed out the negative returns of stocks over the past 10 years, Leuthold tracked the history of stock performance in every 10-year period in which the market averaged an annual gain of 1% or less. Then he looked at the succeeding 10 years. The worst performance in those periods was a gain of 101% between 1938 and 1948. The best was a surge of 325% between 1974 and 1984. The average was 183%.
Buffett, so negative on stocks as this decade began, has lately become outspokenly bullish. No investor in our lifetimes has proved more adept at understanding the market.
So whether you are new to investing or renewing your commitment to it, you have chosen a very favorable time. Don't dally. Your financial future depends on what you do now.
At the time of publication, Tim Middleton didn't own any fund mentioned in this article.
http://articles.moneycentral.msn.com/learn-how-to-invest/now-is-the-perfect-time-to-invest.aspx?page=all
The Scope and Limitations of Security Analysis
The Scope and Limitations of Security Analysis
Analysis connotes the careful study of available facts with the attempt to draw conclusions therefrom based on established principles and sound logic. However investment is by nature not an exact science. Therefore, both individual skill (art) and chance are important factors in determining success or failure.
Graham wrote (Security Analysis, 1951 edition):
“The market and business cycles since 1933 – like those before 1927 – have provided a suitable proving ground for security analysis.
However, in the years of 1927-1933, both the advance and the decline in stock prices were so extreme during this period that the conclusions suggested by informed and conservative security analysis were found to have little practical utility. This was the more true because the business depression of the early 1930’s was so unexpectedly severe as to vitiate many conclusions regarding safety and value that had been reasonable in the light of past experience.”
The quality and quantity of the published corporate data has added to the scope and dependability of security analysis.
Three Functions of Security Analysis
The functions of analysis may be described under three headings: descriptive, selective, and critical.
1. Descriptive Function.
Descriptive analysis limits itself to marshalling the important facts relating to an issue and presenting them in a coherent, readily intelligible manner. But there are gradations of accomplishment, and of related skill, in this descriptive function.
The least imaginative type is found in the familiar and indispensible statistical presentations of the various security manuals and similar descriptive services. (These include Fitch, Moody’s and Standard & Poor’s.) Here the material is accepted essentially in the form supplied by the company; the figures are set down for a number of successive years; then certain standard calculations are added – e.g., earnings per share, number of times fixed charges were earned.
A more penetrating descriptive analysis can often go much farther than this in presenting the published figures. In many cases the latter need various kinds of adjustment in order to bring out the true operating results in the period covered, and particularly in order to place the data of a number of companies on a fairly comparable plane. Here the analyst must consider such matters as contingency reserves, special allowances for depreciation, “LIFO” versus “FIFO” inventory accounting, non-recurring gains and losses, nonconsolidated subsidiaries, and many other possible items.
On a still higher level of analysis would rank the evaluation of favourable and unfavourable factors in the position of the issue. This might include consideration of the changes in the company’s position over a long period of years, also a detailed comparison with others in the same field, also projections of earning power on various assumptions as to future conditions. The analyst who can do these jobs well will undoubtedly be ready to go forward to the stage of decision and selection.
2. The Selective Function.
The senior analyst must be ready to pass judgment on the merits of securities. He is expected to advise others on their purchase, sale, retention, or exchange.
Many laymen believe that if a security analyst is worth his salt he should be able to give good advice of this sort about any stock or bond issue at any time.
This is far from true. There are times and security situations:
· that are propitious for a sound analytical judgment;
· others which he is poorly qualified to handle;
· many others for which his study and his conclusions may be better than nothing, but still of questionable value to the investor.
Furthermore, we should acknowledge that there are some serious differences of opinion among practicing security analysts as to the basic approach to the selective function.
3. The Critical Function of Security Analysis.
The principles of investment finance and the methods of corporation finance fall necessarily within the province of security analysis. Analytical judgments are reached by applying standards to facts.
· The analyst is concerned, therefore, with the soundness and practicability of the standards of selection.
· He is also interested to see that securities, especially bonds and preferred stocks, be issued with adequate protective provisions, and more important still – that proper methods of enforcement of these convenants be part of accepted financial practice.
· It is a matter of great moment to the analyst that the facts be fairly presented, and this means that he must be highly critical of accounting methods.
· Finally, he must concern himself with all corporate policies affecting the security owner, for the value of the issue which he analyses may be largely dependent upon the acts of the management. In this category are included questions of capitalization setup, of dividend and expansion policies, of managerial competence and compensation, and even of continuing or liquidating an unprofitable business.
On these matters of varied import, security analysis may be competent:
· to express critical judgments,
· looking to the avoidance of mistakes,
· to the correction of abuses, and
· to the better protection of those owning bonds or stocks.
Analysis connotes the careful study of available facts with the attempt to draw conclusions therefrom based on established principles and sound logic. However investment is by nature not an exact science. Therefore, both individual skill (art) and chance are important factors in determining success or failure.
Graham wrote (Security Analysis, 1951 edition):
“The market and business cycles since 1933 – like those before 1927 – have provided a suitable proving ground for security analysis.
However, in the years of 1927-1933, both the advance and the decline in stock prices were so extreme during this period that the conclusions suggested by informed and conservative security analysis were found to have little practical utility. This was the more true because the business depression of the early 1930’s was so unexpectedly severe as to vitiate many conclusions regarding safety and value that had been reasonable in the light of past experience.”
The quality and quantity of the published corporate data has added to the scope and dependability of security analysis.
Three Functions of Security Analysis
The functions of analysis may be described under three headings: descriptive, selective, and critical.
1. Descriptive Function.
Descriptive analysis limits itself to marshalling the important facts relating to an issue and presenting them in a coherent, readily intelligible manner. But there are gradations of accomplishment, and of related skill, in this descriptive function.
The least imaginative type is found in the familiar and indispensible statistical presentations of the various security manuals and similar descriptive services. (These include Fitch, Moody’s and Standard & Poor’s.) Here the material is accepted essentially in the form supplied by the company; the figures are set down for a number of successive years; then certain standard calculations are added – e.g., earnings per share, number of times fixed charges were earned.
A more penetrating descriptive analysis can often go much farther than this in presenting the published figures. In many cases the latter need various kinds of adjustment in order to bring out the true operating results in the period covered, and particularly in order to place the data of a number of companies on a fairly comparable plane. Here the analyst must consider such matters as contingency reserves, special allowances for depreciation, “LIFO” versus “FIFO” inventory accounting, non-recurring gains and losses, nonconsolidated subsidiaries, and many other possible items.
On a still higher level of analysis would rank the evaluation of favourable and unfavourable factors in the position of the issue. This might include consideration of the changes in the company’s position over a long period of years, also a detailed comparison with others in the same field, also projections of earning power on various assumptions as to future conditions. The analyst who can do these jobs well will undoubtedly be ready to go forward to the stage of decision and selection.
2. The Selective Function.
The senior analyst must be ready to pass judgment on the merits of securities. He is expected to advise others on their purchase, sale, retention, or exchange.
Many laymen believe that if a security analyst is worth his salt he should be able to give good advice of this sort about any stock or bond issue at any time.
This is far from true. There are times and security situations:
· that are propitious for a sound analytical judgment;
· others which he is poorly qualified to handle;
· many others for which his study and his conclusions may be better than nothing, but still of questionable value to the investor.
Furthermore, we should acknowledge that there are some serious differences of opinion among practicing security analysts as to the basic approach to the selective function.
3. The Critical Function of Security Analysis.
The principles of investment finance and the methods of corporation finance fall necessarily within the province of security analysis. Analytical judgments are reached by applying standards to facts.
· The analyst is concerned, therefore, with the soundness and practicability of the standards of selection.
· He is also interested to see that securities, especially bonds and preferred stocks, be issued with adequate protective provisions, and more important still – that proper methods of enforcement of these convenants be part of accepted financial practice.
· It is a matter of great moment to the analyst that the facts be fairly presented, and this means that he must be highly critical of accounting methods.
· Finally, he must concern himself with all corporate policies affecting the security owner, for the value of the issue which he analyses may be largely dependent upon the acts of the management. In this category are included questions of capitalization setup, of dividend and expansion policies, of managerial competence and compensation, and even of continuing or liquidating an unprofitable business.
On these matters of varied import, security analysis may be competent:
· to express critical judgments,
· looking to the avoidance of mistakes,
· to the correction of abuses, and
· to the better protection of those owning bonds or stocks.
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