We are
THE BLUE MONEY REPORT.

Providing Crisp Commentary about the World of Money and Investing.
If you are interested in providing your readers with our syndicated column, you can request it here

The Blue Money Report
"...contributors will only give money to challengers when they have a realistic chance of winning, and incumbents only spend a lot when they have a chance of losing"
~ Steven Levitt

Welcome to the Blue Money Report

Today's Commentary: 09.26.03
Our Global Money Policy: Reach with no Grasp

Thomas Freidman of the New York Times said of the Bush administration that "the President has the reach but doesn't have the grasp". He made that reference about the handling of the Iraq situation, which, because I write about money, I will avoid. But like so many Presidential policies, they all tend to run in along the same theme.

Take for example the message released by John Snow, Secretary of the Treasury and Alan Greenspan, chairman of the Federal Reserve Board. These two money chiefs were in attendance at the G7 meeting over this past weekend and from that convergence of major industrial countries came what might have been called an accord. An accord is usually some sort of agreement, both behind closed doors and afterwards that suggest a concern for some sort of currency valuation that would have a global economy.

To bring you up to speed as to why this has any effect on the bond market, it is important to have a basic understanding of what is at play. The G7 or G8 a number wholly dependent on whim I suppose have been meeting since 1975. The major players in these meetings are concerned with the economic health of the world. What they attempt to do is fix policies that are good for the global village as a whole keeping everything on an even keel. When they release an accord, it is usually an attempt, according to the University of Toronto website, to continue to deal "with macroeconomic management, international trade, and relations with developing countries." This intervention can have some serious consequences for us here at home.

So the G7 members come out of their meeting and suggest that China and Japan stop trying to devalue their currencies. When a country does this, it makes their goods cheaper to purchase. Although Japan was quick to call the unified message meaningless, it is also important that we realize the vulnerable we are to both of these nations. China and Japan love our debt. Every time you hear the President tell Congress that he needs more money, he could cut out the middleman and go directly to the Far East.

Also important to note is that US is saying strong dollar policy, a throw back to the Robert Rubin days when he held the helm of the Treasury in a different economic time, while hoping that the dollar eases just enough to keep our debt attractive to these foreign investors. All this while not driving the economy into a tailspin. But too many folks are actually wondering if we have a significant grasp of the situation. What the US will end up with as a result of a tip of the scales in any direction is a weak dollar, falling bond prices, and the possibility that our standing as an economic force will be tripped up in the near term.

The effect of all of this on bonds has been expected. With prices falling in tandem with the dollar, the expectations that China will do nothing to change they way they do business. Foreign investors buy our debt because they assume, based on the past, that we will repay it, in full. Bond investors know though, that as Treasury prices fall, yields increase making the serviceability of our ever increasing federal budget cost more and the profit of currently held debt disappear.

There is some margin for error built into this confusion. Bond prices could recover if signs from the economy begin to look cohesively poor. Retail sales numbers posted on Tuesday gave some relief to beaten down bond prices. Federal Reserve governors are running about the country expressing concern over the so-called jobless recovery. These are not what the kind of signals that the stock market needs even as equities seem to be steadily gaining ground

To recap all of these events you have a ton of debt being sold by the US. You have a couple of buyers who have been purchasing the lion's share of these issues. You have the chance of a weakening dollar which makes previous currency purchases turn into losses. Jobs continue to be shed by the American business place in a continuous effort to show profit with less bodies, less pension obligations, and more productivity.

Fortunately, the markets aren't reacting to all of this. If they did, it would be disaterous. Fortunately, those of us who are really looking are seeing one thing: our money policy is reaching for straws and grasping nothing but air.

Today's Commentary: 09.24.03
Default Risk and Equity Returns

Note from the Editor: Larry Swedroe was kind enough to send this article along for your enjoyment. As always, Larry's opinion is not to be considered mine, although in many cases we agree. You will find his disclaimer at the bottom of the page.

The historical evidence is that while value (high book-to-market, BtM) and small-cap companies underperform (have lower levels of earnings relative to assets) growth and large-cap companies, value and small-cap stocks outperform growth and large-cap stocks. For the period 1964-2000, the return on assets (ROA) for growth stocks was 9.2 percent, while the ROA for value stocks was just 4.2 percent. Similarly, the ROA for large companies was 5.9 percent vs. 3.6 percent for small companies. However, for the period 1964- 2001, the annual average return to investors in growth stocks was 11.6 percent vs. a 16.6 percent annual average return to investors in value stocks. For large-cap and small-cap stocks the figures are 12.3 percent vs. 16.1 percent, respectively.

The conclusion of the study by Eugene F. Fama and Kenneth R. French, "The Cross-section of Expected Stock Returns," published in the Journal of Finance in June 1992, was that the outperformance of value and small-cap stocks was compensation for risk. Thus they called the outperformance risk premiums. However, Fama-French did not identify the sources of the risk premiums, leaving that to further research. Ever since then financial economists have been trying to discover the source of the size and value premium.

A study, "Default Risk in Equity Returns," assessed the effect that default risk has on equity returns.1 The authors concluded that both the size and value risk factors exhibit a strong link to default risk (a measure of financial distress). This is consistent with Fama-French belief that the value and size premiums are compensation for risk.

The authors examined data covering the period 1971-99. They first sorted stocks by default risk into quintiles. They then sorted each quintile into quintiles by both size and BtM. The following is a summary of their findings: