Putting the spice back into investing.

I'm back

Monday, May 31, 2004
If you've been coming by here for the past couple of days you'll have noticed that there hasn't been any new stuff posted. The reason is quite simple - I was off on vacation for a couple of days (I got married as well - but no honeymoon for this blogger!). Regular service will resume as soon as I get back into a work mood (i.e. tomorrow).

See you then!
12:54 PM :: Karsten :: permalink ::

Things I love to hate

Monday, May 24, 2004
One of my pet hates is people - and especially investment consultants - using the term "tracking error" without actually knowing what it means. I go ballistic when I read definitions like this one (from Yahoo)
In an indexing strategy, the difference between the performance of the benchmark and the replicating portfolio.

Or this one from "SmartMoney University"
The difference between the return on a stock-index mutual fund and the performance of the stock index it tracks. An index fund's objective is to match the performance of an index such as the S&P 500. The tracking error for a small fund is usually greater than that for a larger fund because tracking errors to a large extent are caused by the costs that mutual funds incur in buying and selling stocks. See "Index Funds."
Almost. The tracking error is the volatility of the difference between returns. Tracking error is a measure of risk - it is supposed to help you judge if a portfolio manager is able to deliver superior (or inferior) performance consistently.

If a fund is always 5% better or worse than the index the tracking error is not 5% - it is actually zero. You can be almost certain that the manager will continue to out- or underperform (not that this will really help as reality has a great way of shattering predictions). Tracking error tells you alot about how a fund is managed - index funds should have low tracking errors - the difference in performance vs. the index is usually attributable to cost. So if costs remain the same we should see little variation in the return difference over time.

Actively managed funds have higher tracking errors - their aim is to outperform some sort of benchmark so they have to make bets which don't jibe with the structure of an index. Some of these bets will pay off, some won't - it stands to reason that any difference in returns will therefore be variable over time as the manager wins some and loses some.

Update: For all those visiting from CotC: I'd like to invite you to visit the main page of this blog as well!
10:26 AM :: Karsten :: permalink ::

Important News

Wednesday, May 19, 2004
I'm off for 1.5 weeks of vacation. Blogging will be very light during this time as I probably won't have access to the internet for most of this time. Thank you for reading and be sure to come by again in June.

Japanese GDP growth...

Tuesday, May 18, 2004
...grew - or better - exploded upwards at a rate not seen in ages. Nominal GDP was up 0.8% qoq. As prices are still soft real GDP growth adds up to a very healthy 1.4%. Economists were expecting something much smaller. The Japanese equities rose, reversing a trend of losses over the past two weeks.

The good news embedded in the number is the fact that investment by companies and expenditure by private households was up. This is a nice shift from a pure export-led recovery which would be very susceptible to a slowdown in China.

This might lead foreign investors to jump back into the market. I keep on saying that overseas investors are pure momentum players with regard to the far east so look for continuing (medium term) gains if this good news leads to further price appreciation over the next couple of days.
10:19 AM :: Karsten :: permalink ::

Very short update

Monday, May 17, 2004
Work is swamping me and I'm having trouble finding enough time to post. This is just a roundup of some stuiff that might interest you.

Money continues the series of under-diversified people living on leverage - aka "Tycoons in the Making". This particular family did the following:
Soon, the Cromers began leveraging the equity in their first house to buy a second house, then leveraging their second house to buy a third, and so on. In all, they have acquired eight properties in three different states with an estimated value of $3.4 million.
They are carrying debt with a face value of around $2 million - note that debt value is not estimated. That means that it will remain fixed until paid down. In sharp contrast, estimated house prices can fall in a snap. Now comes this little gem
...with monthly payments for their loans, taxes and insurance ringing in at $12,400 before rent checks come in. And while rental income adds up to about $9,300 a month, there are definitely times when the couple feels "house rich and cash poor."
"Cash poor" in a downturn can quickly turn to "broke" - especially if tenants move out and/or try to adjust the rent downwards. But don't worry, this family was smart - just look at how they structured their financing
Though the couple has more than $1 million in equity on their properties, they borrow as much as they can to still qualify for the best rates. "Then we ride the market until we can refinance with 20 percent equity," said Yvonne, adding that most of their loans are interest-only, five-year adjustable-rate mortgages.
Ahh yes, the ARM appears. And no paying down debt - why should they, prices will rise and they'll just see their equity grow that way.

In other news: the Empire State manufacturing survey was OK with good employment data whilst stocks are down because of "geopolitical fears". Those fears and especially stock's reaction caused my coworker to mutter angrily about all those sissy-type investors - I'm sure that the muttering has nothing to do with the fact that he is sitting on some very lopsided option positions. But not to worry - here comes Ken Tower to the rescue. The chief strategist of Cyber Trader (CyberTrader? Come on, get a better-sounding name somewhere, CyberTrader is sooo 90ies) says
"These are things that people can be nervous about and, yes, they're concerns," said Ken Tower, chief market strategist at CyberTrader. "But let's face it: the world has trouble almost every day. It's probably not a major factor for our market."
No. That's why we've been selling off. Of course it's not a factor - it's an excuse to get rid of overvalued stocks. And as most stocks are too expensive people are hitting the "sell" button and blaming conflict and strife.

What says the consumer?

Friday, May 14, 2004
UMich consumer confidence data came in unchanged with the expectations component dropping while the opinion of the current situation rose. Could be that all the negative vibes boiling off the Iraq situation and rising gas prices are dampening consumer's view of the future. I do have to admit that I don't think that the consumer confidence data are all that important as they don't tell us much that other data doesn't. As long as employment keeps rising and people have more money in their pockets they should continue to spend.

Data cornucopia

Traders were subjected to a virtual barrage of data this afternoon. Inflation numbers caused some head scratching with the core number being larger than the headline number. Energy prices didn't rise as much as generally expected - we shouldn't expect this trend to last though. Much of the rise came from higher costs of shelter with hotel prices jumping upwards and owner equivalent rent up as well. Inflation is now up to 2.3% yoy with core prices rising by 1.8%.

Markets seesawed after the number and then (at the time of writing) decided that it was ok news for equities and bad news for yields.

Industrial production was much stronger than expected coming in at 0.8% (vs. 0.3% expected). Some of this output is replenishing depleted inventories as business continue to restock. No big cause for concern because sales-to-inventory levels are still low and falling. People seem to be emptying shelves quicker than companies can fill them.

On the whole things look as if the positive data provided by the ISM indices is feeding through into hard production and capacity utilization data.

We should be happy that that the CPI came in the way it did - a large gain in the headline number might have done more to spook the market. I now believe that we will most certainly see a (25bp) hike in rates by August at the latest - and no, I do not believe that the election will play a role here.

CPI data watch

The big number out today is the CPI release. The number is being watched with much interest because very many people suspect that inflation is just about to jump up and smack the economy in the face.

Yesterday's data on producer prices has led some economists to reexamine their predictions ahead of today's number. Consensus seems to be expecting a rise of 0.2% in the core number.

Any stronger rise will inject even more rate jitters into an uncertain market. I do not really think that rate-panic is at all warranted. The market's reaction to the Fed changing it's stance looks like overreaction to me but - in the end - the market's perception more often than not mutates into market (and economic) reality.
11:18 AM :: Karsten :: permalink ::

Mankiw speaks

White Hiuse economic advisor Gregory Mankiw is the next in a series of administration figures to comment on the effects rising rates and higher energy prices are having on the economy. He comes hot on the heels of Sec. Snow who reassured us at the beginning of this week. Needless to say that Makiw agrees with the Secretary.

You can find most of the comments here. In summary: everythings is fine, no need to worry, move along.
11:12 AM :: Karsten :: permalink ::

New Postcard

You can read my newest Postcard from Old Europe over at Angry Bear's place. This week I continue my obsessing with US household debt.

No one does a better job...

Thursday, May 13, 2004
...of explaining economic goings on than the folks at Pimco.

The latest Fed Focus by Paul McCulley gives us a real world look at the near-rational bubble in asset prices which has been pumped up by the Fed over the past couple of years. Here is an excerpt, but please rtwt.
A rational bubble in asset valuation?!?! How can a bubble be rational? Let me give you an example.

Suppose you went into Harry's Bar 'round the corner (which, I learned just earlier today, has been regrettably closed), and the bartender told you that he was offering happy hour prices and would continue to do so for a "considerable period," rather than simply an hour. It would be rational, would it not, for you to ring up friends and invite them to join you at Harry's? You wouldn't know just how long a "considerable period" would be, of course, but you would know that the bartender has a duty to give you a heads-up as to when happy hour prices will end, rather than just cavalierly hike prices. Thus, it would be rational to have all your friends come over, particularly as long as the bartender keeps saying that happy hour prices would continue for a "considerable period" or that he will be "patient" in lifting them.

Would there be a bubble in customers over at Harry's? Yes. Would it be a rational bubble? Also yes. It would be a stable disequalibrium: everybody having a good time quaffing cheap beer, which they know will not always be cheap, but which will be cheap for a long enough time to have a party, which will end when the bartender signals that it is over. Ergo, a rational bubble.
The only thing I keep asking myself is what will happen when the party ends. McCulley calls the process the "hand-off" between Wall Street (i.e. financial markets) and Main Street (i.e. the real economy). Will the real world invest and create jobs so that real incomes grow and consumption will be sustained? Or will this cycle falter just as soon as the Fed takes the punch bowl away?

1994 redux?

Tuesday, May 11, 2004
Buttonwood over at the Economist takes a look if the current market situation is (or will be) similar to 1994. The comparison is so inviting that even your humble author stumbled on the similarities here. Buttonwood comes to the conclusion that
Though they [investors] all claim to be more sophisticated these days, they are finding it ever harder to justify the claim that after the extraordinary rises of last year, risky assets are still worth buying. As investors discover the hard way that they aren't, events might turn out even nastier than they did in 1994.
He is of course referring to the possible meltdown in reflation trades. As long as everyone has the same trade on the speculator better hope that he'll be the first person sitting when the music stops!

Go over and read the whole thing. You do always read Buttonwood anyway - don't you?

News Roundup

Yesterday was a no news day which didn't stop equity markets from continuing their slide. Continuing fear of rising rates and a general feeling of - I can't find a better word - unease led to further selling.

We should therefore be thankful for having Treasury Secretary Snow tell us that
"The economy seems to be on a good course ... and we have a lot headroom in front of us for noninflationary growth."
Now the question is, "Mr. Secretary are you worried about inflation?" ... and, "Mr. Secretary are you worried about interest rates?" Snow continued. "No. We're not concerned about inflation and interest rates," he said.
Sec. Snow was nice enough to also explain how all this positive economic news we've been seeing has come to be
Snow told the banker's group the pickup in the economy evident since the middle of last year showed the sizable tax cuts championed by President George W. Bush were working.
Any questions?
10:20 AM :: Karsten :: permalink ::

If you are not part of the solution...

Monday, May 10, 2004
...you're part of the cause. This holds true for those pesky gasoline prices. April/May is the start of the traditional US driving season and this time of year kicks off a familiar routine. As US domestic refining capacity is pretty limited companies are scouring markets to find some fuel. The better economic outlook has further fueled (hah!) demand as companies are securing large futures positions.

Add in political instability in most oil producing regions and OPEC price controls, throw in a dash of Chinese demand and you get high prices. Not that the prices are high in real terms - you can see a historical chart here.

All these factors shouldn't distract from the aforementioned main reason: high demand for gas. Maybe car manufacturers should attach compulsory stickers "Driving this SUV may be hazardous to your wealth!".


Payrolls came in on Friday at a whopping 288k in April with the numbers of the previous months being revised upwards. This caused a "damned if you do, damned if you don't" situation in equity markets. Had the number been weak, markets would have sold off on the bad news, a strong number caused fears of an impending rate hike to escalate, thereby giving people a reason to dump equities.

I stand by my opinion that the Fed will start hiking in August. The amount of slack still in the economy is pretty high so we'll have to see a couple more strong payroll reports before we get all hot and bothered. Why am I so relaxed?

Well, there were a couple of things missing in the data. Weekly hours (worked) was mostly unchanged and hourly earnings were nothing to write home about either. I therefore really don't see much upwards pressure on inflation coming via the labor market.

This does not mean to imply that there is no inflation in the economy - on the contrary, the devaluation of the dollar and rising import prices are doing their bit. But keep in mind that these prices have been falling for the past five years. Most consumer goods have been getting less expensive over the past couple of years (most everything comes from foreign countries) thereby moderating rising prices for other goods. This relationship is now breaking down.

The problem with inflation is that perception can quickly turn into reality ("I'll see it when I believe it!"). Newspaper headlines screaming about rising prices and the shock of paying more at the pump leads to a somewhat skewed perception of inflation. The only thing that matters is if this will lead the public to form higher estimates of future inflation and thereby lead to further hikes in market interest rates.

Higher rates will quickly choke off the raft of carry trades which are betting on further reflation. In essence hedge funds and other leveraged speculators are playing a game of chicken with the Fed. If the Fed hikes too soon some people (and perhaps market segments) will go to the wall - if the Fed hikes to late inflation might start to creep into the real economy.
12:08 PM :: Karsten :: permalink ::

FOMC Statement

Thursday, May 06, 2004
I was out of town for a couple of days so I'm a little behind the curve in commenting on the FOMC statement.

Let me give you the statement first - as usual, changes from the last statement have been highlighted by yours truly:
The Federal Open Market Committee decided today to keep its target for the federal funds rate at 1 percent.

The Committee continues to believe that an accommodative stance of monetary policy, coupled with robust underlying growth in productivity, is providing important ongoing support to economic activity. The evidence accumulated over the intermeeting period indicates that output is continuing to expand at a solid rate and hiring appears to have picked up. Although incoming inflation data have moved somewhat higher, long-term inflation expectations appear to have remained well contained.

The Committee perceives the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. Similarly, the risks to the goal of price stability have moved into balance. At this juncture, with inflation low and resource use slack, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.
The most important point is the fact that the phrase "...can be patient in removing policy accommodation" was replaced by "...believes that policy accommodation can be removed at a pace that is likely to be measured". To me this reads like a template for several (two?) moderate hikes (25bp?) later this year. I guess that the Fed is trying to prevent a "1994 redux" moment by clearly signaling a modest amount of tightening. This is to prevent the market from getting too far ahead of the Fed with regard to interest rates.

This happened in '94 when the Fed tightened and the market continued to push yields higher at the long end thereby killing everyone who was invested in the longer maturities.

If you've been watching this space you'll know that I was skeptical about the Fed hiking at all this year. I still am and so is the FOMC - slack resource use is the fig leaf policy makers can hide behind. If the economy falters in the second half because of fading stimulus and low growth in disposable incomes the Fed can always choose not to hike.

Having said that I do have to admit that my worldview has changed after reading this statement. The official "CurryOpinion" is that we'll see one or two hikes totaling 50bp by the end of the year - the first one probably in August.

What do you think?

On hold - again

Monday, May 03, 2004
Thank you for visiting - I have to excuse myself until Thursday as I'll be out of town for two days. Normal service will resume ASAP.

Reflation Quo Vadis

The past couple of weeks has seen the price of many commodities fall - the notable exception being oil. Copper, gold, palladium, aluminium and the CRB are all off their highs. I have the nagging suspicion that too many people all have the same trade on.

What traders are effectively doing is playing a game of chicken with the Fed. At some point in time rates will rise effectively killing off very many of those people in highly leveraged speculative positions. Although I don't believe that a rate hike will come in the near term I still see the risks inherent in the markets shifting expectation re the timing of a policy shift.

Most of those piling into commodities have been momentum players - they don't really care about fundamentals or when the Fed will tighten. All they see is what the market is telling tham - and the market has decided that the recent strength seen in economic data warrants a 1994-type scenario. To add insult to injury momentum has been stalling out. This leaves very many people holding the proverbial bag of stalling (falling) price momentum and rising costs of leverage. Not fun.
11:32 AM :: Karsten :: permalink ::