Now, we are looking at a world where the Treasury isn’t AAA/Aaa anymore and things don’t look all that good. Standard and Poor’s have decided today to cry wolf on the US debt situation by changing the outlook for US debt from stable to negative. Well duh!
The situation hasn’t materially changed in the last several months as we continue to print money as fast as possible and turn the Fed into the government’s lender of last resort. So why today? Maybe it just took S&P that long to finish the report or screw up their courage enough to take the whack they are going to take from the Treasury for stirring up controversy? Maybe this is a response to the debate on the debt ceiling or to the budget (see below).
But, we are down some 200 Dow points this morning because S&P said the outlook for Treasury debt wasn’t as benign as it was last Friday. Surprise!
What we find particularly interesting today is that while S&P is warning about undue confidence in US bonds, those bonds today are trading flat to higher as the risk-off trade overcomes S&P’s warning. People are out there selling relatively attractive stocks, with income similar to Treasuries, growth prospects more dependent on the rest of the world than Congress, and improving cyclical prospects, while buying Treasuries which S&P has labeled as unworthy of this very same confidence. Bizarre!
The NASDAQ 100 is undergoing a rebalancing or reweighting. The reason is that the index was reconfigured back in 1998 to make it more diversified to meet IRS standards so an ETF could be created to track the index. Back then, the three largest stocks in the index each had a weight of over 10% and the top ten were over 50%. What the NASDAQ did was add a factor for the number of shares a company has to the market cap calculation to limit the weight of the largest stocks and raise the weighting of virtually all the others.
That calculation has come back to haunt them as Apple has come to dominate that index more so than Microsoft, Intel and Cisco used to. Due to the fact that Apple has allowed their share price to balloon while the stock has advanced in recent years, their weight in the index has gone to over 20% while no other stock has a weight above 5%. Reworking the index will sort-of level the playing field with Apple getting closer to its market cap weight and many other stocks bulking up.
As it is, Apple will lose about 40% of its index weight, from above 20% to 12.3% while many of the same stocks that were penalized before will get some of their weight back. Microsoft will be the second largest index weight at 8.3%, Oracle will come in at 6.7%, Google will be 5.8%, and it will trend down from there.
Each of the indexes has its own quirks. There are differences is how income is handled, how increases in shares are computed and how changes in price impact the index value. There are total return indexes that track both price change and income. There are price indexes that don’t account for income at all, or only indirectly. If there is a funky way to calculate an index, someone somewhere has done it.
This wouldn’t matter so much if indexes didn’t affect our lives in the investment world so much. We are compared to indexes all the time. Many folks blindly follow indexes as their chosen investment vehicle. There are trillions of dollars invested in index funds and ETFs that track these indexes. Indexes are ubiquitous.
There are indexes for different countries, different currencies, and different commodities. Imagine just those three variables and you could get myriad combinations and permutations. Believe us; someone has come up with an index for nearly every combination. Consider the simple bond, Morningstar has 45 indexes from Barclay’s Capital alone to cover the bond market and has only scratched the surface. We get the Principia service which only gets a small fraction of the available bond indexes. There are literally tens of thousands of indexes. There are entire families of indexes from Standard and Poor’s, Dow Jones, the aforementioned Barclay’s Capital, Morgan Stanley Capital International (in case you didn’t know what MSCI stood for), Citigroup, J P Morgan, Merrill Lynch, and many, many others. We are awash in indexes. Did we remember to note the Russell Indices?
What is important is that there are problems with all of them if you dig deep enough. The reason there are so many is that there are disagreements on nearly every aspect of the index construction, maintenance and reporting. Every difference of opinion on the right way to do something spawns a new set of indexes.
Issue of the Week
Okay, where are we on this whole budget deal? Right now, we are probably moving backwards from where we were just about a week ago. Last week, Congressman Paul Ryan (R, WI) introduced his plan for a 2012 budget which presumably cut $6.2 trillion over 10 years (though there were disagreements about just where some of those savings came from). Then we had President Obama propose not throwing grandma under the $6.2 trillion bus, but instead reduce deficits by $4.0 trillion over 10 years, about a third of which would come from increased taxes. Just last Thursday, Alan Simpson and Erskine Bowles, of deficit commission fame, got together with Obama so they could endorse his plan and instead they called for a review of their plan. We have the so-called “gang of six” senators who are working on a bipartisan plan (and whenever anyone in Washington says bipartisan they are grabbing for your wallet) to cut the deficit. Then, just to make matters interesting, Joe Biden, remember him (?), veep (?), was charged by Obama to lead the charge on yet another budget group (maybe that’s just Obama’s way of designating him the guy to ask question of since Obama’s grasp of budget issues and things economic is rather weak).
So, we’ve gone from having no budget (even for the current fiscal year which ends in October) to having six or seven budgets vying for attention. This is ludicrous.
The Ryan budget had no tax increases and tried to at least address Medicare and Medicaid. Obama’s budget relies on taxes and deep cuts in all sorts of spending, but especially defense, plus stopping waste, fraud and abuse. The Simpson/Bowles agenda pointed the finger squarely at entitlements as where the action would have to be.
Our guess is that none of this has much to do with running the government over the next year or two. It is all about politics and trying to set the debate for the 2012 presidential and congressional elections. Democrats will come out for Mom, apple pie and Chevrolet. Republicans will announce they are better at managing the disaster which is public finance in 21st century America than the other guys.
Do we really need to have this master design in place to get a budget done? Oh, heck no. Once any budget gets to Congress (the opposite of progress) it gets bastardized beyond all recognition in committee after committee and amendment after amendment. The real question is whether we want government to be 20% of GDP in the future or 24%. To put this into perspective, over the last 50 years or so the government slice of GDP has averaged 18%, but has been on a persistent upward trend. To further put this into perspective, in much of Continental Europe government is upwards of 40% of GDP (but then they run healthcare, the transportation network, often the electric and gas utilities, garbage disposal, and a ‘cradle to grave’ welfare system.) In the US, before World War I, government spending was more like 6%.
The US Trade Deficit fell in February, which should come as no surprise as February is the shortest month of the year and we had almost 10% fewer days to sell stuff overseas and unload stuff from abroad. But, the decline wasn’t anywhere big enough at 2.6% rather than 10%. Our exports fell a mere 1.4% (in 10% fewer days), while imports fell 1.7%. This might indicate that the pace of both imports and exports are expanding so that when the next report comes in next month, we will see a pretty dramatic jump in trade. Or, we might see slower oil imports, due to higher prices, weakening demand, and high inventories. It could go either way.
Retail Sales rose 0.4% in March, despite higher gasoline prices and an apparent slowing of the overall economy. Of course, higher gasoline prices themselves helped buoy retail sales, as those are counted along with groceries and apparel sales in the total. Gasoline sales alone boosted retail sales by 0.3% and the remainder of the categories totaled a gain of 0.1%. Since these sales numbers are not adjusted for price increases, there was probably a ‘real’ decline in retail on the month. If we remove auto sales from the total, the gain in sales was 0.8%. So, rising gas prices evidently hurt automobile and truck sales, but hardly anything else? Oh well, nobody ever went broke, underestimating the intelligence of the American public.
Producer prices in March rose for the umpteenth month in a row according to the Bureau of Labor Statistics. Gasoline prices were the culprit again this month. Food prices actually looked like they fell for the first time in almost a year. The gain of 0.7% follows a gain of 1.6% in February. Year over year wholesale prices have risen 5.8%. That’s s lot of inflation for the Fed to blithely ignore.
Consumer prices rose 0.5% in March, in line with expectations, but also very fast said the Bureau of Labor Statistics. The core rate (excluding food and fuel) rose a more modest 0.1%. Energy prices were a big piece of the pie rising 3.5% in one month. The trend has been accelerating over the last six months especially. The 12-month rate of change is 2.7%, but only 1.2% for the core rate.
Industrial production was higher in March according to the Federal Reserve’s announcement. The gain of 0.8% beat economists’ estimate of the likely gain. Over the last year, industrial production has risen 5.9%, a faster pace than the economy in general.
The same report says capacity utilization has reached recovery highs at 77.4%. We are getting closer to the level of 80% that has marked the beginning of inflationary pressures in the past.
Consumer sentiment gained in early April according to the Reuters/ University of Michigan survey. The newest report pegs sentiment at 69.6 up from 67.5 in March. It took revolutions in the Middle East and a tsunami in Japan to get sentiment down to 67.5, so some bounce was widely expected.
Last week we slipped after not setting new recovery highs the week before. There were all sorts of reasons why the market stopped where it did: civil war in Libya, $108 oil, political gridlock, early disappointing earnings, too much investor enthusiasm, etc.
Stocks usually don’t go up or down in a straight line. There are far too many factors at work to allow an unending stream of good or bad news from day to day to day. What we expect to hear and what actually is said are usually two different things. So, we meander either higher or lower in a halting, stumbling way. What has been described as the route of a drunken gorilla trying to negotiate a hill while wearing roller skates. There are about as many explanations for the journey as there are observers.
Stock prices are the culmination of a long series of inputs that are ever-changing. There is no reason to believe that we know the right price for any single issue let alone the entire market. The best we can do is an intelligent guess. That guess is subject to numerous caveats but biggest among them is the idea that things are not going to be markedly different this time. Though patently false, this is still the best forecast we can make. Oh well, we never said this was going to be easy, just rewarding.
Stocks fell pretty much across the globe and by roughly similar magnitudes. Developed markets were uniformly down, with Japan’s drop being the biggest and America’s among the smallest. Developing markets were less uniform and had a wider scale of change from outright gains in Korea and China, to drops an order of magnitude bigger. On average, it wasn’t pretty.
Bonds were generally higher most everywhere. Europe is in for more austerity, which bonds like, while Japan isn’t going to face a funding crisis. Developing market bonds were a mix, but on balance gained. The dollar was down.
Real estate markets were surprisingly strong as even modest hints at recovery were greeted enthusiastically by the markets. Commodity markets were broadly lower as we digest our orgy of speculation.
Have a great week.
Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.