In the wake of the 2008 financial meltdown, it was easy to look the other way as governments and regulators considered nearly every course of action for keeping the engines of the economy from totally falling off the tracks, let alone from moving too fast in the wrong direction. But now, after massive stimulus spending, failures, and private-company ownership stakes, governments are dealing with numerous unintended consequences, forcing them to perform a difficult balancing act between immediate stimulus and long-term growth and stability.

This is now becoming evident in the Treasury market, where rising interest rates are putting pressure on the Fed's plan to bring down borrowing costs and help revive the housing market (see Bloomberg article). Mortgage rates, which have been increasing recently (see Bloomberg article and Reuters article), are now reaching high enough levels (if 5.25% is high) where they are beginning to decrease the number of new refinancing, not to mention making new home purchases more expensive and less attractive. While the increasing yield curve has been good for the net interest margins of the banks, the higher rates are coming at a bad time. It was recently reported that the number of homeowners who are getting behind on their mortgages is increasing, causing a spike in foreclosures (see NY Times article). Also, while the median price of a new home was up 3.7 percent in April, the general longer-term trend is still down, and will require a few more positive months to confirm a reversal. Sales of new homes also rose less than expected in April, with a downward revision of the March figures adding additional concern. Durable goods orders did see their largest gain in 16 months in April, but the March number was revised down sharply, causing concern for the accuracy of the current April reading.

Commodities and commodity-related stocks, on the other hand, have been rallying, with gold marching towards $1,000 an ounce, and oil rising above $65 a barrel (see WSJ article), up nearly 50 percent over the last five weeks (see Reuters article). The moves have come in part due to the falling greenback, with the dollar index down 10 percent over the last 3-months. Higher commodity prices have helped resource-rich emerging markets, lifting specific international indexes and causing a rally in emerging market bonds as the higher prices reflect an improved outlook concerning these nations ability to repay their debts (see Bloomberg article). Yet domestically, rising crude oil prices may slow down consumer spending as U.S. consumers find they once again have less disposal income (see Reuters article). Further increases in commodity prices, especially crude oil, will certainly draw concern from the Federal Reserve as it wrestles with the balancing act of growth and inflation, and subsequent worries about stagflation, making it difficult to raise rates. Capacity utilization is still low enough to make one believe that broad-based inflation is at least a year away, yet higher gasoline prices will influence consumer spending - which is vital to GDP and growth - with higher market rates adding extra pressure on spending.

In the area of "the news is good since it was not as bad as expected" camp, reported revisions highlight that GDP only contracted 5.7 percent in Q1, less than expected and previously reported, while corporate profits after taxes increased by 12.9 percent after falling 28.4 percent in Q4 (see WSJ article). Yet, not everything is rosy. Within the last few days, Tiffany posted a 64 percent drop in Q1 earnings, as margins slumped (see WSJ article). Cintas, the uniform maker, gave a weak Q4 outlook, saying that it also expects to have another round of layoffs, bringing its total workforce reduction to 12 percent over the past year (see WSJ article), and signaling further expected weakness in the broader labor market. As for technology, Dell warned that the PC market has not yet hit bottom (see WSJ article). Isolated, insignificant, and cheery-picked? Possibly. But certainly cause for concern.

All of this leaves the Fed and the Treasury with a difficult balancing act going forward. Fortunately for the Fed, or maybe unfortunately depending on your perspective, they may be off the hook, as investors and the markets take action themselves, and in the process drive up Treasury yields on debt and inflation fears (see Financial Post article). As equities enter the summer and currently appear to be stuck in a range as traders collectively make a market, the Fed may also find that it too could benefit from a little monetary consolidation. Unfortunately, the dollar, Treasuries, and commodity prices seem to have a mind of their own, with traders spotting the handwriting on the wall, and taking matters into their own hands. Quite possibility, the inflation train may have already left the station. Maybe the most the Fed can hope for is to make sure it simply arrives later than expected. Even those that feel inflation is a distant reality, see it as a reality, nonetheless. As investors and traders, we can prepare, and maybe make a little money along the way. Gold and commodity traders, as well as those shorting the dollar, are off to a good start.

As the Obama Administration considers ways to pay for their proposed universal health care system, and everything else for the matter, old habits like cigarettes, and growing ones like soda consumption, are being considered for new and/or higher taxes. While it seems like everything is currently on the table, the administration may only need to look up for inspiration, and another source of revenue. Greg Mankiw and Matthew Weinzieri, both from Harvard, have proposed taxing people based on their height (see the Fox Business News article). Crazy and arbitrary? Maybe not.

To backup their proposal, Mankiw and Weinzieri cite studies that show a correlation between height and income. As it turns out, previous research found that each inch of height added about 2 percent to a man's income on average (sorry ladies, only men were considered in the study). Statistical data snooping? Once again, maybe not. According to the theory, it is believed that exhibiting height early in life allows adolescences to develop characteristics such as self-esteem that are later rewarded in the labor market. Others, conducting similar studies, hypothesize that proper pre-natal and childhood nutrition also helps to explain the correlation between growth (height) and cognitive ability (also helpful in the labor market).

Carrying things forward, since tall people are more desired by the labor market, they of course will earn more money, and subsequently pay higher taxes. So who cares you might say. Even if tall people do make more money, they are already paying more taxes. How do you generate more revenue? Simple. Tax those who are tall, regardless of their current income level. After all, as the researchers mention, if the goal is to “maximize the level of happiness through a redistribution of income,” then why not tax those people who are not only already happy (i.e., rich), but also those that are most likely to eventually be happy down the road.

While some may be thinking that this is just another academic study, and therefore a waste of time, it does offer some important points, even if we never tax people based simply on height (at least I hope not, given that I am over 6 feet tall myself). Weinzieri asked the question: "Does government have the right to ask those who have the ability to earn more to pay more?” When taxes on cigarettes and soda are consider to pay for health care, are we not in many cases penalizing healthy individuals because we think that they have a higher chance of getting sick down the road? Could we do the same for tall people, in the name of spreading the wealth and happiness? Carried further, why should someone buying a new car pay more personal property tax than someone with an older car, when the new one is probably more fuel efficient and better on the environment (and the health of everyone)? Are we taxing the correct source, or promoting the behavior we desire?

In conducting and publishing their latest research, Mankiw and Weinzieri have not simply pointed out a statistical correlation, or helped to justify a new tax system. Instead, they have done something far greater and more useful. They have introduced new questions for everyone impacted by the existing tax code, or those looking for new ways to justify taxing one group over another. In short, they have created a dialog. Socrates would be proud ......... as would a few flat tax proponents.

More Money Flowing Into Equity Mutual Funds and ETFs

Posted by Bull Bear Trader | 5/28/2009 08:37:00 AM | , , | 0 comments »

According to a Financial Research Corporation report, equity funds and ETFs posted April net inflows of $8.5 billion and $6.9 billion, respectively, reversing the trend of outflows in March (see Investment News article). Corporate-bond funds had the largest net inflow in April at $16.6 billion, while international fixed-income funds had the largest net outflows at $447 million. As posted earlier, risk taking is back - at least it was in April.

The State Street Global Investor Confidence Index rose 3.1 points from the April reading of 103.2 (see Hedge Fund Review article). The North American version of the index rose 9.6 points to 104.9. For the index, anything over 100 indicates that institutional investors are increasing allocations to risky assets, indicating that investors in North America, and in general across the globe, are adding more risky assets (i.e., more equities) to their portfolios. On the other hand, the indexes for Europe and Asia are still below the 100 benchmark. While the Europe index rose 7.5 points to 84.3, the Asia index fell 4.9 points to 93.1. Time will tell which regions are leading or lagging indicators of the global markets, or if a contrarian move is in order.

Even though on average hedge funds had a down year last year, they still outperformed the broader market and many other asset classes. As a result of this out-performance, the money allocated to hedge funds had become one of the larger positions within many investment portfolios, causing portfolio managers with defined asset weighting to reduced exposure to their hedge fund investments in order to get portfolio allocations back in-line. Now, as a result of broader market and other asset classes rallying over the last few months, the allocation to hedge funds is smaller than required, reducing redemption requests which began increasing last fall (see the NY Times article). With fewer redemption requests, hedge funds can quit hording cash (in anticipation of new withdraws), and instead start putting capital to work in the market. As mentioned by the authors of the NY Times article, given their high fees, new regulations, and negative press, it may take some time before new money makes it way into hedge funds at the same pace managers saw just a few years ago. Nonetheless, the reduced selling alone could be enough to start increasing returns and attracting new interest among investors. This alone could be good for all investors, regardless of their individual exposure to hedge funds and other alternative investments.

Andrew Lo, the director of the MIT Laboratory for Financial Engineering, and founder of the AlphaSimplex hedge fund, believes the next big meltdown will be in commercial mortgages (see Reuters article). While many traders and investors have been predicting that the CMBS market would be the next one to take a hit after blowups in the residential market, Lo is predicting that the losses will accelerate later this year as rates begin to be reset higher. Also of note is how Lo believes that it will be pension funds, and not the banks, that will be hurt the most when commercial real estate comes under additional pressure. In an effort to increase yield when the markets were more static, pension funds loaded up on CMBS in the years before the market meltdown. There is an expectation that many pension funds will now have a difficult time meeting liabilities, forcing the government to once again step-in with some type of bailout. While this is certainly not good news for the economy if the commercial real estate market was to play out as predicted by Lo, given the hits commercial real estate has already taken, the pressure pension funds are already under, and the number of bailouts which have already occurred, it is difficult to know - even in general terms - what the reaction and impact on the markets will be. Maybe this is the saddest realization of all.

While companies seem to spend a lot of time and money on finding the proper valuation for the company being acquired during mergers and acquisitions, boards can increase their chances of getting the deal done and approved by focusing on one simply, and very public benchmark. Researchers at Harvard finds that the 52-week high of the stock price of the company being acquired seems to be what matters most when valuing a company during M&A negotiations (see WSJ article). As it turns out, regardless of data from other valuation measures and techniques, many boards will insist that any purchase price is at, or above the 52-week high. To make their case, researchers at Harvard looked at 7,500 deals from 1984 to 2007 and found that psychology and irrationality helped to drive price, and that the company's 52-week high stock price seems to be the starting point for valuation negotiations. In fact, approximately three-fourths of the deals studied were priced above the 52-week high (it should be more random), with those deals also having about the same three-fourths chance of getting shareholder approval. The findings may help to explain why many deals in hindsight seem to not work out for the acquiring company - who appear to be over-paying and/or buying at the high. For traders, the time honored tradition of selling on the news seems justified once in the trade, with the 52-week high helping to provide a reference point when considering risk and return before taking a position. For companies and boards, the most rational thing, as written by the WSJ, it to "use the market's irrationality to its advantage," and not let the opportunity pass. Just ask Yahoo!'s board.