Shifting into neutral

In the American financial system, the economy is governed by two separate but equally important groups: The Federal Reserve, which controls monetary policy, and Congress, which controls fiscal policy. These are their stories.

For the past seven years, the Fed has done nearly all the work of trying to raise the economy out of the worst recession since the Great Depression. The Fed has not only cut rates, but launched three massive bond-buying programs to keep long-term interest rates low. By keeping rates low, the Fed has allowed millions of homeowners to refinance their mortgages at lower rates, and allowed businesses to refinance their debt at lower rates as well.

Moody’s Baa-rated corporate bond yields

In both cases,the Fed’s actions have put money back into the pockets of consumers and businesses. Reducing your debt payments is essentially the same as increasing your revenue, all other things being equal.

At this point, the Fed has pretty much used up all its ammunition. Short-term rates are at zero, and the Fed would love to nudge rates higher, if only to give it some room to cut rates during the next recession. Higher mortgage rates would probably spur some brief buying as purchasers scramble to get into the market before rates get too high. And it wouldn’t hurt that long-suffering savers got some return on their investments.

While the Fed has been working hard, the fiscal side of the ledger has been hardly working. During a recession, business spending dries up entirely, as companies focus on survival, rather than expansion. Unfortunately, the net effect of cutting business spending in a contraction is further contraction. When you lay off workers — or even when other companies lay off workers — they cut back spending sharply.


State and local governments, which were in reasonably good shape before the recession, also cut spending. While many states had rainy-day funds, no one expected a downturn of the severity of the 2007-2009 recession.  As a result, teachers, construction workers, police, fire and medical personnel also joined the ranks of the unemployed at an unusually harsh rate. No matter what you feel about government spending, an unemployed teacher is just as unemployed as an unemployed plumber. And, if you’re traveling across country, check out the state of the highways you drive on. If you need a new front-end alignment after your trip to Lake Wippitysnappity, it’s probably because of big cutbacks on basic structures.

State spending in 2009 dollars

Federal spending, too, has been remarkably restrained for a recessionary period. The $152 billion Economic Stimulus Act of 2008, signed into law by President George W. Bush, was primarily tax rebates and tax incentives for business. The $831 billion American Recovery and Reinvestment Act of 2009, signed into law by President Barack Obama, had $288 billion in tax cuts and $105.3 billion in infrastructure spending.

As the economy has recovered, however, state and local spending has started to pick up — as have tax revenues. According to the Brookings Institution, government spending has gone from a net negative for the economy to a net neutral the past 12 months. (For those who argue that government doesn’t create jobs: Please say that to a policeman or fireman and report his response to me. I’ll wait.)


Should the Federal government actually create a long-term fix for the federal highway fund and should state and local governments resume maintaining infrastructure at previous levels, you might start looking at domestic infrastructure companies.

A few suggestions:

* A.O. Smith (ticker: AOS) is in the prosaic business of boilers and heaters, which sounds uninteresting until you remember that every building in the country — including public ones usually needs one.

* Chicago Bridge and Iron (CBI), provides conceptual design, technology, engineering, procurement, fabrication, modularization, construction, commissioning, maintenance, program management, and environmental services worldwide.

* Cummins (CMI), ubiquitous maker of engines, especially those found in heavy equipment.

None of these are guaranteed, of course. But if you think U.S. infrastructure is going to start rising again — and for the sake of my poor car’s front end, I hope so — these might be a good place to start.



Here’s what has the Fed worried

Even though the job market has been picking up, the Federal Reserve is still worried about the specter of deflation — a period of falling prices. And that’s why it declined to raise short-term interest rates at its most recent meeting.

Federal Reserve Chair Janet Yellen
Federal Reserve Chair Janet Yellen

If you know anyone who lived through the Great Depression, you’ll know that falling prices are a terrible thing. As prices fall, companies have to cut prices to produce goods. Typically, that means cutting wages. When wages fall, people can afford fewer things, and prices continue to fall. It’s a miserable cycle of poverty for working people.

But wait, you say. Rents are going up. Car prices certainly aren’t falling. And any number of things that you buy day to day — like, say, a burrito at Chipolte — are increasing. All true. In fact, if you exclude food and energy from the government’s Consumer Price Index, prices have gained 1.8% since June 2014.

As people like to point out, food and energy is a big darn exclusion. Food prices have risen 1.8% the past 12 months. But energy prices have fallen 15%. We’re in the middle of the longest gas price slide since January. And a gallon of unleaded now averages $2.69 a gallon, 83 cents less than a year ago. If you fill your 14-gallon tank once a week, that’s an annual savings of nearly $604.

But what probably worries the Fed is not falling oil prices, which is generally regarded as a Good Thing by the average consumer. Here’s a chart of copper prices the past three months:







Here’s what silver looks like:







Here’s cattle prices:







A few charts don’t necessarily bode deflation. But they could bode slowing economic activity. If that’s the case, raising interest rates would simply slow the economy further.

By this time, even hermit Japanese soldiers from World War II have figured out that the Fed will raise interest rates sooner or later. By and large, the stock and bond markets have priced in a 0.25% interest rate hike sometime between now and the end of the year. But the odds of any sudden increase in rates seem increasingly long, at least as long as there’s the faintest whiff of deflation in the air.



Some things are more interesting than you’d think

My latest piece for Morningstar is titled “Should you worry about bond market liquidity?” And for those who nod off at the words “bond” and “liquidity,” I understand. But the bond market is a peculiar beast, starting with the fact that there is, really, no bond exchange. And if there are disturbances in the bond market, it can be very difficult indeed for your fund manager to sell certain bonds.

Anyway, check it out. Really.


Five reasons to love this lousy market

What”s the matter, Bunky? You say you decided to dip your toes in the market and had them nibbled by sharks? You say your biggest speculation today is how long you can look at the Dow Jones industrial average without weeping? You say you visited your broker’s web site, only to discover it’s now run by a bankruptcy lawyer?

Brokers with their hands on their faces.
Brokers with their hands on their faces.

Well, cheer up, Bunky! Someday, the clouds will part, the sun will shine, and you’ll be running with the bulls once again! But until then, here are five reasons to love this nasty market:

1. Tax losses. Let’s say you bought Ali Baba at $119 back in November, and now you’re wishing you’d thrown in your lot with the 40 thieves. BABA is down to about $81. What should you do? Sell it. You can use your losses to offset an unlimited amount of capital gains. If you have more gains than losses, you can deduct up to $3,000 from your 2015 income. If you really backed up the truck, you can carry additional losses over to your 2016 taxes.

2. Cheap stocks. The biggest knock against this market has been that it’s too darn expensive. Valid criticism! But now the market is 5% cheaper. And some areas, such as energy, are much, much cheaper. ExxonMobil, for example, is down nearly 24% and sports a dividend yield of 3.7%. The price of oil is a big wild card, but it’s better to buy a high-quality company like ExxonMobil when it’s cheap than when it’s dear.

3. Rising yields. A rising yield is typically a function of falling prices, not corporate largess. If you have a $50 stock that pays out $1 in dividends, its yield is 2%. If that stock falls to $40, its yield rises to 2.5%. Right now, some traditional dividend favorites are seeing some nice yields. Duke Energy, for example, yields 4.6%. AT&T yields 5.5%. While a high yield is also a yellow flag — the company might cut its dividend, and Wall Street hates that — it could also be a good deal.

4. Rebalancing. As downturns go, this one has been a piker. Normally, you need a 10% move down to be in a correction, and a 20% dive to be in a bear market. So let’s not get overly dramatic yet. But if you want your portfolio to have a set mix of stocks and bonds — 60% stocks and 40% bonds is a traditional conservative blend — you sometimes have to sell some of your winners and add to your losers to get back to where you want to be. You should wait until your portfolio is at least 10 percentage points out of whack. But if you have an aggressive portfolio, you might be approaching those levels.

5. Schadenfreude. For those of you who don’t speak German or have an English major in the family, schadenfreude is a German word meaning, roughly, “laughter at the expense of others.” Have a friend who’s been touting gold all these years? Give him a call.


Reducing risk by adding dynamite

If you’re simply trying to get the highest possible return per dollar, then your best investment is a lottery ticket. At the moment, a winning $1 PowerBall ticket will net you a sweet $90 million.

cattlepitUnfortunately, the odds of winning that $90 million is about the same as meeting a talking giraffe named Lester. And if you take no risk at all, by investing in one-month Treasury bills, you earn nothing at all – less than nothing, if you take inflation into account.

The general idea, then, is to get your maximum return for most acceptable amount of risk. Normally, that means starting with a diversified portfolio of stocks and stirring in other investments that don’t march in lockstep with the New York Stock Exchange.

The other investments are meant to make the ride to your goal less bumpy – not necessarily to make you rich, or even to beat the Standard and Poor’s 500 stock index. The idea is to get a return that won’t have you dreaming about dollar bills with wings flying off into the night.

The traditional diversifiers for a stock portfolio are bonds – which, according to a recent study, are the most hated investment in America at the moment. Another is cash.

A third is commodities – specifically, managed futures funds —  which sounds a bit like reducing fire hazards with dynamite. But according to a celebrated study by Harvard professor John Lintner in 1983, have a surprisingly calming effect on both stock and bond portfolios. Lintner found that  “the improvements from holding an efficiently-selected portfolio of managed accounts or funds are so large–and the correlation between returns on the futures portfolios and those on the stock and bond portfolio are so surprisingly low (sometimes even negative)–that the return/risk tradeoffs provided by augmented portfolios…clearly dominate the tradeoffs available from portfolio of stocks alone or from portfolios of stocks and bonds.”

A follow-up study by – of course – Managed Futures World—suggested a 7% allocation to managed futures would increase your risk-adjusted return. The results make some intuitive sense. Futures managers typically invest in a wide array of contracts, from beans to precious metals and interest rates. They don’t really care whether the trend is up or down: They just care that it’s a tradable trend. Most modern commodity pools are run by people who don’t care about the forecast for soybeans: They’re technical traders, not fundamental ones.

For a long time, a managed futures account was not for the bootless and unhorsed. These professionally managed accounts are limited partnerships, often with high minimum investments, high fees and limited liquidity. Many have some downside protection in that they will liquidate if losses get beyond a certain point.

In recent years, however, some open-ended funds and exchange-traded funds have dipped their toes into the managed futures arena. Of the four ETFs, only one – First Trust Morningstar Managed Futures Strategy ETF (FMF) – is in the black, up 3.3%. Its expense ratio is 0.95%. (Full disclosure: I write on a freelance basis for Morningstar, which produces the index that this fund follows.)

Among traditional open-ended funds, nearly all available to individuals come with sales charges and hefty annual fees. The largest managed futures fund, the $2.4 billion Nataxis ASG Managed Futures Strategy A, charges 1.7% in annual fees, as well as a maximum 5.75% sales charge. You have to be a firm believer in managed futures to swallow those kinds of fees.

Are they worth it? Currently, none of the funds really have a long enough track record to prove that they are as salubrious as the Lintner studies – and others – claim. And until that happens, and fees go down, it might be best to leave managed futures to those who can afford them.

What if they had a crash and nobody came?

Back when the dinosaurs were roaming the earth — ok, 1999 — I remember taking a day off and waiting to sign in at the local community center’s gym. (This is unusual enough for me to remember it.) The middle-aged guy in front of me was hitting on the receptionist, who was clearly a very polite woman. “I’m retired,” he said, in a last-ditch effort as the line grew behind him. “You know. AOL stock.”

Remember this guy?
Remember this guy?

AOL was, in fact, located nearby, so this was remotely plausible. A bubble year is a thing of miracles and wonders, and many things seem plausible that don’t seem so now. Not only were stocks soaring in 1999, but incomes were growing faster than inflation as well. (This was true to a lesser extent in 1987, another bubble year). Jobs were plentiful: The unemployment rate was 4%, low enough for the Federal Reserve to start fretting about the specter of inflation.

And people loved stocks. Investors poured a net $188 billion into stock mutual funds in 1999 and another $316 billion in 2000 — a record that stands today.

Despite a six-year bull market, however, there just doesn’t seem to be the kind of old-fashioned irrational exuberance among individual investors that would define a bubble. Consider this: According to a survey released today, investors consider — wait for it — housing to be the best long-term investment. Next up? Good old cash, currently yielding zilch. Stocks are in third place, with just 17% of those asked considering them to be the best long-term investment.

Investors have yanked an estimated $17.5 billion from open-end stock funds the past 12 months, according to the Investment Company Institute. For U.S. stock funds, the outflow is a fearsome $128 billion.

Part of that is a reflection of the popularity of exchange-traded funds, which have seen inflows of $100 billion or so. While impressive, it’s nowhere near the inflows of 1999-2000.

The ICI notes that nearly all inflows to mutual funds in the past few years have been into no-load institutional funds, which is the primary designation for funds in the 401(k) retirement market. In other words, investors are dutifully shoveling money into their retirement accounts, but with no particular enthusiasm for stocks.

At this point, the real danger lies in institutional panics — a short-term correction in stocks because money managers are worried about Greece, the Federal Reserve, Congress or corporate earnings. And, while stock prices are high relative to earnings, we won’t reach bubble territory until the rest of the public storms in. And that seems to be a ways off yet.

Back to business

About four times a year, Wall Street forgets its obsessions — Greece, inflation, deflation, Greece — and focuses on earnings, which is what generally drive stock prices. This is one of those times. And, while all eyes will be on technology this week, you should keep watch on financials as well.

J. P. Morgan

This season, tech stocks are making the headlines. Consider what happened to Google stock after it reported earnings. The stock soared 16.3% in after-hours trading Thursday as it reported $6.99 a share on revenue of $17.73 billion. Analysts expected $6.70 a share on revenue of $17.75 billion.

Apple and Microsoft report tomorrow, and the earnings report from the two arch-rivals will probably dominate the headlines. At the moment, Apple is the largest company by market value, and Microsoft is in third place. Microsoft hasn’t been the largest company since 2002.

Americans are good at technology, and tech stocks typically pay off during a bull market. Since the bear-market bottom, technology stocks in the Standard and Poor’s 500 stock index have soared 264.5%, vs. 259.46% for the index itself, with dividends reinvested.

But financials have soared 308% since the bull market began. One reason, of course, is that they were clobbered so badly in the financial crisis. Many  cut or suspended their dividends, either voluntarily or by government intervention. According to the Federal Deposit Insurance Corp., 512 banks have failed since 2008.

The failure rate has slowed dramatically: 18 FDIC-insured banks sang with the Choir Invisible last year. At the same time,  financials are increasing their dividends. In the past 12 months, 43 out of 63 financial services stocks raised or initiated dividends. (I excluded real estate investment trusts from the category, because dividends are pretty much all they do). And, for the first time since the financial crisis, financial stocks are once again the largest aggregate dividend payers.

Despite their runup, financial services stocks are still 29% below their October 2007 highs, a reflection of how badly the industry was pummeled. At the moment, the group sells for 14.3 times estimated earnings. That’s lower than the S&P 500, but bank stocks usually sell for less than the market as a whole.

While most of Wall Street will watch Apple and Microsoft (and Yahoo) tomorrow, you might want to keep an eye on the financials as earnings season progresses.