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At Arm's Length: 10.09.05
Left with little savings to fall back on, the average consumer/homeowner/taxpayer will need to reassess not only their worth but also their future earning power.
For most investors, the run-up and subsequent fall of stock prices in early 2000 still stings. Remember the irrationally exuberant reasons that caused the markets to catch fire and move up, and then, as if the markets collectively caught a whiff of sensibility they retreated. This still remains in the back of many investor's minds.
But few are able to point the finger at any one particular group as blameworthy for the rise and fall. A recent study by Harvard Business School professors Erik Stafford and Joshua D. Covel has found that mutual funds may be the culprit and the forces they exerted on the markets leading up to the bubble burst are still at play.
The two suggested in their report called Asset Fire Sales (and Purchases) in the Equity Markets" takes a detailed look at how mutual fund managers react to certain market events based on cash inflows and outflows. The belief that mutual fund managers were "forced" to cover themselves in the event of poor performance and spend money on stocks when they did exceptionally well was often thought of as fund specific. It turns out that their moves had a wider effect on how the markets move than previously thought.
Mutual funds that are expecting a poor performance for the quarter will often anticipate that the shareholders in the fund will flee for some other better performing fund or sector. This "voting with their feet" effect can be felt when the fund is forced, in a fire sale, to sell large quantities of stocks to cover the redemption of the funds shares.
Because investors in poor performing funds see no reason to hold on for better days, they want their money and they want it now. Most equity mutual funds, often by their own charters, keep very little cash on hand in favor of full investment of available funds. So to raise money to pay the exiting shareholders, the fund must sell some of their holdings. Until this report, it was unclear just how much of an effect this was having on a specific sector or, in some cases, the overall market.
On the flip side, funds that have had stellar quarters, have found themselves flooded with inflows of money as investors seek to hitch themselves to the rising star. This sudden spike in cash reserves must be spent - once again because of the relatively small percentage of cash fund's are permitted to keep on hand per charter rules - forcing the fund manager must buy additional stocks. While some funds, overwhelmed with money and relatively few good buying opportunities will close their doors, it often takes up to a full quarter to do so and by then, it may be too late.
The professors called these fund events as forced purchase. The result of this type of buying in the open market, often targeted at a specific sector, push the prices higher until someone sounds the warning and the whole sector crashes. In some cases, the overpricing effects the whole market place and the professors point out, this may have been the reason for the crash in 2000.
While one large fund may not have the power to bring down a whole sector, the movement is seldom isolated as the underlying stocks sudden change in value alert other holders of the equity which, by coincidence, happen to be other large funds to buy or sell as well. Anticipation of missing a run-up in price or failing to recognize a potential fall forces other funds to begin to react. I mentioned several columns ago that there are forces at work in the marketplace that are governed by program trades. These computer driven buy/sell programs allow fund managers to put some stocks in their portfolio on autopilot. These programs react to one fund's fire sale or forced purchase by jumping in automatically and buying the same or similar stocks.
Individual investors will seek to profit from this movement at their own risk. The holdings of a mutual fund are often several months old by the time they are made public. Buying the holdings of a top performing fund in the hopes that the stocks in the portfolio will rise based on the manager's forced purchases runs the risk that the stocks will become, in the market's mind, overpriced. Chasing the fire sale that happens at poor performing funds, the individual investor will try to short the beaten down shares of the fund. The market might also work against this thinking as the shares of the stocks the fund has sold begin to reach a bottom and become a sudden value.
The best way to benefit from this kind of fluctuation is to pick top performing funds whose managers have proven their expertise over a long period of time (five years) and are actively managed. For those who prefer indexing, the diversity does provide a good deal of safety from these fluctuations. For instance, the Dow jones Wilshire 5000 index has returned an average of 12.4% over the last twenty five years.
Today's Commentary: 10.10.05
Help Wanted
Federal Reserve Chairman Alan Greenspan and his fellow bankers were out in force over the last several weeks talking about inflation. In fact, Federal Reserve Governor Donald Kohn will be speaking to that very subject this Tuesday. This is worth noting because John Snow has repeatedly told us that inflation is in fact, tame. (The only comfort I get from listening to Mr. Snow, the Secratary of the Treasury speak is the fact that he is not a candidate for Mr. Greenspan's soon-to-vacated post at the end of January.) So who is right and what effect will inflation have on the choice for Greenspan's replacement?
I'm not so sure that the Chairman's job should be filled by any of the nominees on the President's current list. If Mr. Bush's choice needs to be, as he has suggested, of unimpeachable independence, then we could be in for an interesting economic shift of policy not to mention a departure from White House policy. But more on who is on that list later.
The markets did not take the word inflation in stride. Along with a slew of other hard to digest news from a mixed bag of job's revisions and reports, to predictions of a weaker than expected earnings season, to the fact that if energy begins to give back any of its recent gains the whole thing would fall like a house of cards. The S&P 500, which if you exclude energy would be showing a scant 10% return for the year. Sorting through the unnecessary and yet important news that continues to arrive about the economy is akin to shoveling frogs into a wheelbarrow.
Let's say we start with a little inflation lesson first. We will be hearing a great deal about it leading up to the release of the CPI this Friday. What the Fed sees, how Wall Street reacts, and more importantly, how the consumer adapts can be quite different, which can lead to additional confusion about what the number really means.
The markets understand the trouble with inflation. Although consumers deal with it on a daily basis with every gas guzzling trip to the pumps and the grocery stores, Wall Street takes a different look at what we all consider a simple battle between higher prices versus wages.
Any significant increase in inflation, Wall Street knows, has the effect of lowering earnings. This, they fear will begin to show up in lower P/E ratios. While in most scenarios, this would create a buying opportunity, during inflationary times, it could signal a retreat from the markets.
Inflation can have an effect on the cost of goods and this can directly effect the earnings of a company. Although many reports of late point to the ability of companies to absorb higher fuel and production costs, it is becoming a safer bet that this will not last much longer. It may become increasingly fashionable to be bearish on the economy as inflation settles in over the landscape.
This worry has further increased each time one of the Fed governors address the issue. It is the role of the central bank to control the supply of money and set interest rates to control the rate of economic expansion. Under the Greenspan regime, they have controlled money supply by using analysis of how much money there is currently in circulation. His successor might use another school of thought, one that seeks to control the quality of the money circulating as opposed to the quantity.
Measuring how much money is out there and whether businesses will borrow it and consumer will spend it is becoming more difficult to determine. The Consumer Price Index is widely predicted to jump 1% higher than than the previous month's reading. Greenspan and company usually remove the volatile portions of the index (fuel and food) and concentrate on the core index, which is expected to rise 0.3%.
If the root cause of inflation is money supply over demand, expect yet another increase in the short term interest rate. Milton Friedman suggested that "inflation is always and everywhere a monetary phenomenon" that he saw as enough of a reason to institute fiscal restraints. The administration has only given lip service to fiscal restraint, in effect, undermining the efforts of the Fed to slow the economy enough to make the next bursting bubble less painful.
Mr. Snow suggests that, in order for the economy to continue to grow at the current rate of 3%, excessive borrowing by the federal government is not only necessary but is still good policy. Unfortunately, spending our way out of this may not be an option.
Let's try to determine what kind of inflation Mr. Greenspan is so concerned about. The current type of inflation is not Demand Pull Inflation, an effect of "too much money chasing too few goods". There are plenty of goods in the marketplace albeit foreign goods and they are cheap enough for most consumers to buy. That supply of goods seems endless and the ability to borrow to buy them is still historically affordable.
The consumer however has gotten too comfortable with cheap money and low payments on the money they borrow to make those purchases. But times they are a changin'. Credit card companies have begun to raise their minimum payments and mortgage lenders may follow suit becoming more focused on quality loans as opposed to riskier ones. Mr. Greenspan has found fault with mortgage lenders who continue to creatively finance a cooling housing market. No one has been able to accurately predict how the consumer will react.
Could we be experiencing Cost Push Inflation instead? As much as the current inflation environment resembles that of the oil crisis of the seventies - higher fuel prices with limited availability, it is different in a number of ways. With supply shock, as this kind of inflation is often known, the argument goes like this: if the money supply is constant any increases in the cost of a good or service will decrease the money available for other goods and services. When that happens, the price of some those goods will fall and that will offset the rise in price of those goods whose prices have increased.
Evidence of this comes on reports of lowered prices in the retail sector heading in the holiday season. Trying to entice customers into their cars with the hope of cheaper goods in the marketplace is a knee jerk reaction to higher prices at the pumps. One set of prices rise while another sector drops their prices.
Built-in Inflation might suit our descriptive needs but falls short when it describes the vicious circle often created when this type of inflation takes hold. This type of inflation involves two separate things: wages and price. Workers want to keep pace with inflation while employers want to keep wages in control. If prices rise significantly, workers want higher wages. Given the right opportunity, once built-in Inflation is allowed to rise, no amount of fiscal or monetary policy can control it without a great deal of expense. So far wages have not kept pace with our current inflation rate and workers, thankful for employment have not pushed for more money.
This developing inflation situation will influence who the President picks to fill Mr. Greenspan's spot at the Central Bank. The new Fed chief, despite what the President says, cannot have a policy that differs from the White House. Fighting inflation, an index that rises far more often than it falls will not be welcomed by a banker who believes in any type of Keynesian approach. Keynes would see any inflationary pressures easily resolved through increases in taxation and reduction in government spending. A monetarist Fed chief, one who believes that money supply control is the best method would not find themselves on Mr. Bush's list either. Using monetary policy, this kind of head banker would focus on goals such as constraining inflation, full employment, setting interest rates to discourage or encourage borrowing which would, encourage or discourage expansion.
Expect Mr. Bush's choice will most likely be a member of the school supporting supply side economics. These macroeconomic thinkers see tax cuts and business incentives as the only way to encourage economic growth. These folks focus on production without regard to demand, a belief that if you give the wealthy the incentives, they will reinvest it in the economy and as a result, make it grow. Paul Krugman of the New York Times has referred to this as "a trojan horse for upper bracket tax cuts without economic justification".
Greenspan's replacement will be, as I mentioned earlier, someone who shares Mr. Bush's economic outlook and with whom he can buddy up with should he need to just talk economic turkey. He doesn't need, as evidenced in his pick for Supreme Court Justice, someone of great intellect or renown. The candidates seem to be narrowed down to Glenn Hubbard, the President's former chairman of the Council for Economic Advisors and currently the dean of Columbia University Business School. He is the hand's down favorite if he is willing to leave his academic post for the spotlight once again.
Martin Feldstein has an impressive list of independent credentials and has worked with the President on his attempts at Social Security reform. He was, it should be noted, critical of President Ronald Reagan's deficits when he was employed by him. This independent thinking does not settle well with Republicans so you can assume that his name is on the list as window dressing.
Ben Bernanke, a former Fed governor who was brought into the folds as the President's replacement for Hubbard was an early contender for Greenspan's job and is still a front runner because of his deeply conservative bent. Mr. Bush is not a big fan of free thinkers and because of this, Mr. Bernanke might be overlooked. Unimpeachable independence is not necessarily a White House policy even if Mr. Bernanke fits the description.
Lawrence Lindsey is on the short list of candidates for the job as well. His former post as director of White House National Economic Council does put him in alignment with Mr. Bush's thinking. He is also a former Fed governor tapped to serve the White House's needs.
Other candidates now on the list include Fed Governor Donald Kohn, Fed Vice Chairman Roger Ferguson, and ex-Dallas Fed President Robert McTeer.
Remember, Mr. Bush is open to suggestions but is expected to make a decision as early as November. Until then, we can expect continued short term rate hikes and even more outward concern about inflation.
We're going to ignore the description of inflation as it applies to currency, although the current state of affairs with our dollar warrants a discussion, we'll let it pass. Instead, we want to consider inflation as a broad look at a basket of goods. Folks who measure these kinds of things, including
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