Some investors in global and emerging market funds are starting to become nervous that such markets have risen too far, too fast (see Asian Investor article). After a nice run since early March, investors in emerging market funds that are tracked by EPFR Global have seen investors pulling a net $1.87 billion out of Asia ex-Japan, Latin America, Europe, Middle East, Africa, and diversified global emerging markets equity funds as of June 24th. High-yield bond and global equity funds also saw their string of consistent inflows stop, with the funds flowing into money market and U.S. bond funds. The reversal of flows has been driven in part by investor worries as to when foreign demand for manufactured goods and commodity exports will increase. Russia and Brazil equity funds, which are commodity dependent, are also posting new outflows.

As a few examples, the yearly charts for both EEM (iShares MSCI Emerging Markets Index) and the EFA (iShares MSCI EAFE Index ETF) reflect some of this indecision in the second half of June, but the trends are not unlike what has been observed in the S&P 500 Index over the same period.

Source: Bigchart.com

This slowdown in the bullish trend comes just as the International Energy Agency cut its expectations for medium-term global oil demand (see Financial Times article), with the recession diminishing the medium-term risk of a supply crunch as the spare capacity cushion remains healthy. Natural gas storage is also up (see EIA article) and above the 5-year historical range.

Yet, not everyone appear as cautious or nervous, with many analysts and traders still bullish (see SeekingAlpha articles here and here and here). In addition, as hedge funds are near completing one of their best starts of the year since 1999, many managers expected capital to continue to flow into their funds, especially those funds that are focused on emerging markets (see The Australian article). Given that many emerging market funds are commodity driven, then next few weeks/months should be telling as data on the summer driving season, housing, and currencies markets will help signal if the commodity correction has indeed arrived (see SeekingAlpha article), and whether or not emerging markets will continue their recent strength.

A new proposed product from Macroshares will allow investors to purchase Up and Down ETF shares based on the movement of the S&P / Case-Shiller Composite Index (see WSJ article). Unlike some other similar ETFs, the proposed shares will not be backed by the physical asset, such as you might see with gold ETFs. Therefore, there will not be a specific artificial commodity bull market as the physical asset is bought to cover the demand for new shares (too bad for all those homeowners underwater). Here, the cash is put into government securities to ensure liquidity, creating a kind of zero-sum game as cash is moved from one account to another as housing prices, and the Case-Shiller index, move up and down in price. Obviously, if there is more demand for one type of share, this side of the bet is likely to trade for more than its net asset value, while the other side will trade at a discount. The zero-sum game structure also places a cap on profits since a positive move of 100 percent all but clears out the down shares, causing an automatic liquidation of shares.

While such a vehicle will get some attention given its tie in to the Case-Shiller index, not to mention offering a new and more liquid method for taking on housing exposure, it is likely that only a select set of builders and highly mobile executives on the coast who are looking to hedge their risks will find much use for this specific ETF (see article for past failed housing products). Speculators, of course, will be looking for significant daily liquidity before stepping their toes into the water. Time, and a potential housing recovery (or further bust), is probably needed before people will be encourage to bet with or against housing in this manner.

There is an interesting commentary by Michael Lewis (see the recent Bloomberg article). In the article, Lewis highlights how the hysteria over AIG is obscuring the real problems at the core of the current crisis, one of which are homeowners defaulting on homes they could not afford, and the government instead throwing money at opaque institutions, the workings of which no one really understands or can challenge. With one line, Lewis captures the problem and current situation:

"The guy who defaulted on mortgages on his six spec houses in the Nevada desert has turned himself into the citizen enraged by the bonuses paid to the AIG employees trying to sort out the mess caused by his defaults."

Here is hoping we can head Lewis's call for getting to the root of the problem, and quickly. It is not that we should turn a blind eye and forgive the guilty and the negligence on Wall Street, but instead should focus more of our energy on the solutions to our problems, beginning with identifying and admitting its root causes. As uncomfortable as it may be, for many of us the problem and solution begins with us.

In case you have not seen it, Rick Santelli, reporting for CNBC from the floor of the Chicago Board of Trade, gives his two cents regarding the recent housing bailout (CNBC video here). I would not be surprised to see future bailouts, and subsequent rants, get worse going forward. Given that housing often leads us into and out of recessions, there is no doubt that the housing problem needs to start being resolved before people will begin believing that the economy will recover. Unfortunately, there is no easy answer. Just about any of the proposed solutions that has the slightest chance of speeding up the recovery seems to reward bad behavior, while at the same time further penalizing those that acted responsibly. Do we continue bailouts, or simply let the chips of capitalism fall where they may? Santelli, as well as many others, seem to have already chosen sides.

The Treasury and FDIC are considering a plan to guarantee about $500 billion of bad mortgages in an attempt to reduce the total number of foreclosures, with an estimated cost of about $50 billion to be paid by the bailout package - i.e., you, Joe and Jane taxpayer (see Bloomberg article). The plan would allow banks to restructure as many as 3 million loans into ones that homeowners would actually be able to afford (imagine that). In other words, the mortgages would be restructured based on a borrower's ability to repay, and not their ability to afford the home. If homeowners also took out a home equity line of credit, no problem. The plan being considered would also cover these second mortgages as well. I guess that will teach those of you that recently bought a home within the last year or two and actually put down the "required" 20% down payment. If you live in Florida, California, or Nevada, that 20% is probably gone. Your neighbor, who put nothing down, will now end up paying back what you have left on your loan, which is about 80% of the original value, or 100% of the current value. Their repayment amount could possibly be even less than you if their ability to repay is still not sufficient. I hoped you learned your lesson. Next time buy a bigger house. And of course, don't forget to remodel the kitchen and bathroom while you are at it.

Fortunately, the plan is still being discussed, so hopefully some steps will be put in place to reduce moral hazard, such as having rates and payments increase as the borrower becomes better able to make payments, or allowing taxpayers to recover some or all of the lost and forgiven loan principal once prices recover and loan to equity values become more favorable. Otherwise, no matter how good the intentions are, or how necessary the plan is, the unintended consequences of rewarding bad behavior and poor decision making will cause confidence in the banks and the housing market to take much longer to recover.

Even with the downturn in the residential housing market, and credit issues that continue to make front page news, as of the end of September REITs have generated total returns including dividends of about 1.8 percent year-to-date (see Investment News article). During the same time the S&P 500 was down 19.3 percent, the Nasdaq was down 21.1 percent, and the DJIA was down 18.2 percent.The REITs that are outperforming include the self-storage REITs, which are up 33.8%, health care REITs, which have risen 18.5 percent, and apartment REITs, which are up 17.4 percent. Not surprisingly, the worst-performing REITs are those tied to mortgages, with returns down 31 percent. Other poor performers include the lodging REITs, down 26.7 percent, and the industrial REITs, down 25.4 percent. The wide range in returns continues to illustrate that not all REITs are created equal, in part due to their varying levels of exposure to the current credit issues that are gripping the market.

In fact, if you still find the US market a little too uncertain, looking outside the US may prove beneficial. The Canadian real estate market appears to not have the same level of exposure to the recent US housing-related problems due to their real estate market having a more stringent regulatory structure (see Seeking Alpha article). Unfortunately, many of the REITs in this market have already had a nice run after being oversold last year, and may provide less current opportunity (see past Trader's Narrative blog post for a listing of Canadian REITs). On the other side of the globe, Northern Trust has recently launched a new Japanese REIT, although it is also not clear if the timing is right given possible credit exposure in the Japanese markets, along with the low liquidity and volatility of the product (see Seeking Alpha articles here and here). Nonetheless, many Japanese REITs do have exposure to commercial real estate, as opposed to residential real estate, making them currently more attractive. Analysts are also speculating that the market has finally reached rock bottom in Japan and is therefore due for a correction, although many have been making this call for a while now.

While the recent bankruptcies and potential failures have generated concern for both Wall Street and Main Street, and the federal bailouts have offered some hope (as well as concern), the root cause of the problem - housing - is still a mess (see Reuters article). As mentioned by Wilbur Ross, the current federal plans do not really address the housing problem. In fact, while blame is being assigning to banks and the federal government, the blame should also be shared by the American consumer who for years has been living above their means. As mentioned by Ross: "In one sense, the American consumer is the victim; but on the other hand, the perpetrator of it." So the worry is that while the current bailouts may help to stabilize the market, the underlying housing problem will still keep the economy from growing anytime soon, with some analysts expecting the problem to carry into 2009 and possibly beyond, as excess housing inventory continues to be drained from the system.

Nothing too earth shattering here, and the Buffett interview is rushed as he on the baseball field at Boston to throw out the first pitch, but it nonetheless highlights how we all are in the same situation. When asked about the uncertainty of the markets, whether housing will recover, or whether Fannie and Freddie will be expensive to taxpayers, he basically says, "I don't know." Probably the most honest statement yet, and an illustration of how were are all just feeling around in the dark with regarding to the housing and credit crisis. There will be winners and losers in the end, as there already have been with Fannie and Freddie, but hope is still entering into the equation. Just ask Lehman.

Source: Wall Street Journal Online Video

There is an interesting article in the WSJ regarding recessions and productivity numbers. As seen in the figure below, the last six recessions have occurred at a time when productivity numbers were decreasing (although the numbers were still positive for the last two recessions, and productivity was relatively strong during the most recent recession in 2001).

Source: Wall Street Journal
While productivity has averaged 0.8% over the last six recessions, it is currently growing at an annual average rate of 2.5%. This is important since high productivity numbers allow the Federal Reserve to keep interest rates lower than normal since higher prices are being matched with higher productivity, at least to some extent. As an example, if workers are making x% more of a product in the same amount of time, then wages can increase by the same x% and the per unit labor cost will stay the same. Simplistic, but you get the idea. Productivity gains were the key to the 1990s, and one of the reasons Alan Greenspan was often espousing the benefits of high productivity, providing yet another reason to keep interest rates low, sub-prime notwithstanding.

Of course, higher productivity can allow you to keep from hiring new workers, or even allow you to reduce headcount, since now you can do more with less. Furthermore, the current high productivity numbers may just be an artifact of the recent environment. Housing, which is a less productive industry, is currently being shifted out of while higher productivity industries, like those exporting, are increasing in emphasis. The weak dollar is also having an effect in amplifying the export-based productivity numbers. Given that the U.S. is trading overseas more now than in the past, the higher export productivity numbers make sense.

So, if productivity is not cooperating for those talking recession, what about other numbers in comparison to previous economic conditions, such as the stagflation days of the 1970s that many analysts are comparing the current conditions to? Given higher energy costs, producer price increases for finished goods are worse now than during the 1970s, causing lower consumer confidence and higher levels of consumer credit as a percentage of GDP. The savings rate is down, as it has been for a while, and the number of vacant homes is increasing.

Yet, all is not bad, or falling off a cliff. The ISM index is hovering about the benchmark contraction / expansion levels, and disposal income has still not collapsed, even with increasing job losses. Industrial production, while flat, is also not severely contracting. Furthermore, core CPI (without food and energy) is not excessive, nor is core PPI. The unemployment rate, while rising, is also not yet close to approaching high single and low double digit levels. High productivity is keeping unit labor cost down (as discussed before), and wages have stayed in check for corporations. After-tax corporate profits as a percentage of GDP are also still good, and long-term Treasury yields are not excessive in comparison to the stagflation years.

So in short, is the picture rosy? No. But are we heading for another decade of stagflation with sustained lower growth and high inflation? Right now the data does not point to this conclusion, regardless of the continued comparisons. Housing and crude oil still seem to be ruling the day, the fallout of which is affecting nearly everything in the economy. When the former finally turns around, and the later sells off with conviction, we may be able to finally get rid of both the "stag" and "flation".