Surging Bond Yields: A Wayne Angell Moment

SUMMARY: Perspective is a very difficult thing to maintain in the day-to-day grind of Wall Street.
A month ago, there was tremendous hang-wringing over the U.S. Dollar in freefall and The Twin Deficits were looming large. While upward pressure on bond yields was the obvious consequence, it had yet to become the Bogie Man because financial news tends to answer the “why did this happen” question of the day through the rear view mirror.
Bond yields have been ticking up for more than four years, so why did people pick this particular moment to freak?
Think of the market as a coal-powered cargo train sitting in the valley, one that must go up a mountain range. The beginning is always difficult. The crew must calculate the amount of coal needed for the journey, and as the train chugs and gains momentum, they hope there is enough fuel on board to power the whole thing over the top.
The villagers on the other side of the mountain never, ever see the train until it is at the summit, flying along with a full head of steam. It seems to be coming at them at a dangerous speed and they fear that it will come off the rails. It’s not their fault. This is the only perspective available from the foothills.
There was something to Wayne Angell’s philosophy when he was a Fed Governer back in 1989. After his stint at the Fed, he became chief economist at Bear Sterns. Working on Wall Street clearly had an effect on his perspective.
I remember seeing him on CNBC, demanding an intermeeting rate cut in 2001. I thought to myself, if Mr. Angell was a chocolate bar, he would be Almond “Sometimes You Feel Like a Nut” Joy even though he started out as a “Sometimes You Don’t” Mounds.
The lesson? None of us are immune.

Inflation: Managing Expectations

In recent speeches, Federal Reserve Governor Frederic S. Mishkin, Federal Reserve Governor Randall S. Kroszner, and Federal Reserve Bank of Cleveland President Sandra Pianalto all emphasized the role that long-term inflationary expectations of households play in policy decisions.
There is plenty of grumbling on Main street. There is no Greenspeak going on here: they know price increases related to food are going to be very sticky.
The reason is corn prices. Yep, the yellow stuff. Instead of driving smaller cars, SUVs are now filling up with ethanol. The giant sucking sound is of gas tanks competing with the human food chain.
While the average North American consumer can probably withstand price hikes related to real food by paring back on corn-based junk such as soda pop, chocolate bars and chips, it is not so for people in other countries like China where the government might begin tapping into the strategic pork reserves. This is surely a Peter Lynch moment for Fritolay, Coca-cola, Pepsi, McDonald’s, etc.
Still, if I were a central banker, I would remain extremely reluctant to hike rates. To be sure, as Greenspan would say, there are challenges. There is much more to the game than just quashing prices. If only it were that easy.
Rate hikes are taking a toll on the economy, and right now, central bankers are probably holding their collective breathes, praying that inflationary and deflationary forces can somehow offset each other.
The FOMC is doing what it did in previous junctures: jawbone and let the market tighten rates for them. For now, it might be best to let someone else take a turn at removing the next block in the Jenga tower.

Suggested Weekend Reading

Two recent articles from The Journal of Investing might be of interest. A reworked version of Portfolio Rebalancing in Theory and Practice was recently published by Vanguard Institutional [DOWNLOAD LINK], while an earlier version of Stupid Data Miner Tricks: Overfitting the S&P 500, can be downloaded [DOWNLOAD LINK], courtesy of the author at his blog, Nerds on Wall Street.

Inflation and Price Stability in the 3D Universe

Barry Ritholtz wrote a hilarious, mock summary headline yesterday to explain the recent stock dumpage.
At first, I laughed because I have written the same sort of stuff in the past. Then it got me thinking. Yes, soundbites are necessary because people have short attention spans. With enough repetition, a person learns to “explain” the day’s moves in the form of some simple equations whether they are true or not. The trouble is that there are virtually no linear cause and effect relationships in the stock market.
It is a three dimensional structure full of black holes and internal shadows, a diabolical game of Jenga where we can never be sure which block can be safely removed.
It was only three weeks ago that everyone was freaking out about new lows in the Dollar. All things being equal, rates rise as buyers of U.S. Treasuries demand higher yield to compensate. As rates rise, the Dollar goes up in response. That is exactly what has happened over the past few days, but because capital flow is not something lodged firmly in the public consciousness, it never makes the list of usual suspects.
Let’s look at the inflation example. On one hand, Barry is correct to say that an inflation gauge ought to factor in food and energy. If these were included, then inflation would be much higher, and price stability seems threatened. It is a very old argument that makes sense on the surface. And it has been repeated long enough for the man on the street to accept as gospel. So why would Fed officials and economists be so moronic as to continue using ex-food and ex-energy indices?
Because what lurks on the other hand is a new, and not obvious menace. These things take at least two minutes to contemplate. They cannot be compacted quickly — yet.
Mark Tinker from AXA Framlington, is one of my all-time favorites. He distinguishes the difference between the cost of living vs. the official rate of inflation, and notes that with floating rate mortgages, rising rates act like an immense tax burden which is deflationary, yet there is enough inflationary pressure in the form of the public sector wage-price spiral that could make increases in food and energy prices look trivial.
Perhaps the mass exodus from 30-year mortgages to ARMs and credit lines is doing the same in the United States, and therefore, raising rates in response to increases in the cost of living is not something that the FOMC considers appropriate to their long-term goals.

G8 Summit: Here We Go Again

G8. 2 days. €100 million. 16,000 police. 11,000 demonstrators. 700 journalists. 1 Grand Hotel Kempinski located in the tiny seaside resort town of Heiligendamm, Germany, population 350.
I don’t pretend to know anything about globalization or anti-globalization. In my mind, years of media soundbites have somehow associated the clash with the age-old capitalism vs. socialism debate, complete with a mental image of Gordon Gekko making it at the expense of Third World subsistence farmers. Something like that.

Costco Delivers a Peter Lynch Moment

Costco just delivered numbers that blew out analyst estimates. This happens against a backdrop where there is a lot of worry that retail sales are weak across the board. Pardon me, but it can’t all be due to LCD TVs, wine and crab legs. Perhaps this is a classic example of the old Peter Lynch, One Up on Wall Street analysis. Yes, Costo is making it big as the purveyor of The Good Life, but there might be a more 2 + 2 = 4 sort of reason to their gangbuster sales: *ancillary businesses*.

Greenspan Explains Greenspeak Conundrum

Former FOMC Chairman Alan Greenspan was at Book Expo America 2007 last Friday, promoting the September publication of his memoirs, titled The Age of Turbulence: Adventures in a New World.
As the keynote speaker, he dished some dirt on past presidents and also provided some insight into why Greenspeak was a necessary evil throughout his tenure: […]

Debate: The Great American Savings Myth

Please note that an “articles by category” section has been added to the sidebar so that you can quickly access the blog entries you wish to read. The Ivory Tower category features academic debate on issues related to trading, investing, capital markets, and economics.
Let’s kick it off with Gene Epstein’s May 28, 2007 article in Barron’s called The Great American Savings Myth. Epstein has been Barron’s Economics Editor since 1993, writes a column called Economic Beat, and is the author of ECONOSPINNING: How to Read Between the Lines When the Media Manipulate the Numbers.
The rebuttal comes from Paul L. Kasriel, Senior Vice President & Director of Economic Research, The Northern Trust Company and the recipient of the 2006 Lawrence R. Klein Award for Blue Chip Forecasting Accuracy.
Additional food for thought is provided by Edward C. Prescott, senior monetary adviser at the Federal Reserve Bank of Minneapolis and professor of economics at the W.P. Carey School of Business at Arizona State University. He is a co-recipient of the 2004 Nobel Prize in economics.

Shooting Stars in the ETF Universe?

Yesterday, I provided the components of the model portfolio.
At first glance, you might expect to see more than 12 ETFs, but there are many good reasons to limit the number to only those necessary to fill the slots in the four major asset classes, i.e., achieve diversification. 1. Each ETF already represents a large number of stocks. 2. Management fees for large, generic ETFs are much, much lower than the niche players, sometimes by orders of magnitude. 3. Transaction fees are killer. Commissions drag on returns big time. And of course, there is also the liquidity issue.

Paradigm Shift

In the world of corporate governance (and maybe in life), being good is necessary, but often, it is even more important to appear to be good. Perception is everything, and it pays to know when market participants view a glass as half-full or half-empty and do your best to detect the moment of paradigm shift,

Hindenburg Omen

The market signal, named for a German airship that caught fire and crashed 69 years ago in New Jersey, appeared in April when unusually large numbers of stocks reached both one- year highs and lows as prices climbed. Since then, the Standard & Poor’s 500 has fallen 2.2 percent, including a 1.9 percent loss last

The Sentiment Cycle

You might be wondering why we need to take a detour to discuss The Sentiment Cycle. Surely mechanical trading is designed to do away with emotions, right? Yes, a good trading system helps us stay the course and do the right thing. It prevents us from chasing performance, from loading the boat at the top.

The Bond Crash: Who, Me Worry?

I don’t ever recall a plunge of this magnitude in such a small duration. Any word other than crash does not do it justice. Look at the bar for this month. Now there’s a new definition for confirmation after the harami spike pattern that formed in May and June! The only comparable chart is the