This holiday weekend marks the traditional start of the summer driving season.

In the upper Midwest, a couple of big refineries went down for maintenance at the same time this spring, resulting in gasoline prices in the region going vertical.  The top panel in the chart above shows the average prices for regular from the Energy Information Administration in California and Minnesota over the last five years.  At bottom is the comparison between the two, which clearly shows the spike in relative terms.

For those of us in the heartland, it has been a shock to see prices go up day after day.  My road trip this weekend will take me to North Dakota, where the prices have also skyrocketed.  That’s ironic given the state’s rise as the darling of the U.S. energy resurgence (chronicled in a January posting), but with refinery capacity tight, this is what can happen.  (Chart:  Bloomberg terminal, using EIA data.)

the best analysts

Publications regularly offer rankings purporting to show the best analysts on Wall Street.  But do they, really?  Some thoughts on expertise and misdirection by the numbers.

The above chart marks the fastest repeat visit of any chart on this site; the first instance of it appeared here less than three months ago.  The image of a snake’s mouth has grown ever wider since then.

The jaws are the Japanese stock market, as measured by the Nikkei, and the yen.  The flitting tongue is the Japanese market in dollars.

It is worthy of a repeat this soon because it is affecting so many aspects of the investment world right now.  There are adjustments and adaptations and anxieties aplenty, all because of this chart and the policies it represents.

The lines are indexed to 100 on November 14, so the Nikkei is up 65% since then.  If you are interested in a longer view, the same three series are shown in the chart at the bottom of the page since the start of 1976.  It would take a good long while to review all of the chapters in the Japanese economic saga since then.  The latest one could never have been imagined twenty years ago.  (Charts:  Bloomberg terminal.)

emotional finance

How does your investment manager feel as he goes about his job?  There seems to be a widespread belief that they are much less prone to “humanness” in decision making than the rest of us.  A CFA monograph provides a window onto their world and the realities of emotional finance, covered in my latest essay.

new issue, old issues

The latest edition of The Prudent Fiduciary Digest is out, and it features great reads on ways of addressing “the loser’s game” that asset owners tend to play, assessing “the blame game” at investment manager organizations, and the battle between momentum and value over time.  (The newsletter is free.  Sign up and view past issues here.)

There’s one-upmanship everywhere, including at the regional banks of the Federal Reserve.  A recent Reuters article by Matthew Goldstein examined the “new and improved” financial stress index from the Cleveland Fed.

The chart shows that index plus ones from the St. Louis and Kansas City districts.  As noted, the Cleveland index is daily, while the others are weekly and monthly.  It also includes additional inputs, including the securitization markets, the machinery for which is once again being lubed up and “cranked up” by the Street.

Notice how close the bottom two are in profile and even in terms of their scales.  The Cleveland index is much different and it doesn’t give a sense that the financial crisis was all that extraordinary, in contrast to the others (and how it felt at the time).

I’m sure the quants have run all the numbers already, but looking at the financial crisis in particular, these all look like coincident measures of stress rather than leading indicators.

Don’t they know we’d like a little advanced warning?  (Chart:  Bloomberg terminal.)

I’m off to the Atlanta Federal Reserve District, to give a presentation on “Investment Beliefs and Actions.”  If your firm, organization, or association is interested in exploring that topic, let me know.  (Or if you’re in Birmingham and want to get together, I have some free time.)

The chart above is a nice summary a couple of key aspects of the interest rate environment during the last sixteen years.  There have been some notable changes of late, although sizable earlier moves in the chart make the recent ones seem like mere blips.

Top:  After bottoming in December at just under 1.60%, ten-year yields moved a half percent higher by March 8, only to fall considerably since then.  Yields on TIPS also bottomed in March and moved higher, but have stayed negative.

Middle:  The “breakeven” rate, which is the difference between the two series in the top panel, is used as a gauge of the market’s expectations for inflation in the coming years.  It has dropped hard since March, down almost a third of a percent.  (For a Federal Reserve that wants higher inflation expectations, that’s not good news.)  Each of the previous two declines (also marked by arrows) in this spread have coincided with stock market weakness.

Bottom:  Another gauge of the interest rate environment is the so-called “real yield,” the difference between the yield on the Treasury note and current rates of inflation.  The measure has crawled back from negative territory, due to a decline in year-over-year inflation (as measured by the CPI).  Interestingly, the arrow in this panel marks the bottom in real rates, which coincided with a top in gold.

These are critical indicators for policy makers and market participants — and not just fixed income investors, given their inter-market importance.  (Chart:  Bloomberg terminal.  Monthly observations except for final data point of April 19.)

plug and play

The latest essay on the flagship site concerns our use of models in the investment world.  Whether we are institutional investors or analysts or portfolio managers or advisors, our tendency is to plug and play — to presume answers are what should come out of models.  On the contrary, what should come out are questions.

By now you’ve probably seen the year-by-year  progression of “How Quickly the U.S. Got Fat” from 1985 onward.  (If not, here’s the animated map from the Atlantic.)

Notice how the food and beverage stocks have done over the last few years, shown above.  Strong absolute performance in the top panel (with that noticeable kick higher of late), and great relative performance.  Sure, the big bursts of outperformance came in weak market periods, but notice that the relative gains weren’t given back when the market did better, as you might expect.

(That series has only been around since just before 2000, so a bonus chart appears below, adding another decade, but also another vice in the mix — tobacco.  Even given the very weak relative performance during the go-go years of 1997-1999, food, drink, and smokes trounced the market.)

It doesn’t take a giant leap of imagination to see a connection between the great stock performance by those peddling food and drinks to the crowd — and the crowd getting fatter every year.  They have it down to a science.  (Chart:  Bloomberg terminal.)

If you haven’t seen the new puzzle pieces on Tumblr, the recent topics have included Peter Bernstein on gold, Jim Grant on everything, structured products for sale on the Street, and investment managers pressing the edges when it comes to credit risk.

An item in the March 19 edition of the Wall Street Journal was titled, “For Apple Investors, a Line is Broken.”  The graph that accompanied it was essentially the top panel of the chart above, showing the stock price and the trend line of its decline.  (For some reason, a low-quality version is used in the online story.  The vertical line in the chart above shows the close prior to the article.)

It’s been a time of trend lines.  Mostly ones slanted up, given that lots of U.S. stocks have been heading higher of late (yesterday notwithstanding).  And the blogosphere has been dominated by trend-following advice, as it is during market advances.

I also saw it as something of a trend that the Apple story and chart appeared in the Journal, because mainstream publications haven’t historically published trend line charts of this sort.  (There are, it seems, vogue traders everywhere.)

The chart above starts last April 26, the day I published a piece about distortions in investment process that occur when there’s an elephant in the market room like Apple.  It charged ahead into September, but beat the market at a much more muted rate than it had been doing (shown in the lower panel).  Beginning to end, it’s an ugly picture; the stock underperformed by over 38%.

Since the downtrend in the stock was broken, it has fallen further on an absolute basis — and relative to the market — although it’s only been four weeks.  We’ll see how good this simple signal looks in a few months.  (Chart:  Bloomberg terminal.)

out of the woods

When I last saw Adam Scott in person, he was out of sorts and out of position.

I was taking photographs at the PGA Championship in 2009 and he had just hit one of the worst shots I’d ever seen by a professional golfer.  In the fairway at the famous 16th hole at Hazeltine, he bent over in pain — not physical pain but mental pain.  He couldn’t putt and his famously pretty swing had left him too.  He shot 82-79 to miss the cut by miles.  I remember telling someone, “He can’t play a lick.”

On Sunday he won the Masters.  Remember that the next time you get in a slump.

The five years that came to a close at the end of March will go down in financial history — and it was an extraordinary period for the group of bonds variously known as high yield, low grade, or junk.

The colors in the chart are carried from panel to panel, representing the Merrill Lynch indexes for BB, B, and CCC bonds.  (Here’s a crowd-sourced summary of the most common ratings systems.  The three categories shown here extend from “speculative” to “highly speculative” to “extremely speculative.”)

The top panel shows the returns and is interesting in several respects.  First, notice how the market held together for many months up until the Lehman debacle.  Not much warning from the market pricing mechanism even as the environment was deteriorating rapidly.  Second, these bonds bottomed well in advance of stocks.  (For your scorecard, from that bottom to 3/31, the CCCs returned 247%.)  Finally, notice that the junkiest bonds produced the best return and the least junky the next best; those in the middle had the worst returns.  That’s unusual.

In the middle panel are the absolute yields.  They are, of course, the foundation of subsequent returns.  The smart money that stepped up when the CCCs were at 40% yields had an opportunity for out-sized profits (and had nerve, which is not easy to come by) that are definitely not available today.  The yields on BBs and Bs are now half what they were in March of 2008, making it virtually impossible to replicate the returns you see in the chart.  (Yields on CCCs have only come down from 15.3% to 9.3%.)

The bottom panel plots the spread versus Treasuries for each part of the market.  As the yields on junk bonds were skyrocketing, they were plummeting on Treasuries.  Spreads in the thousands of basis points are unusual even for these low quality bonds.

Today we have a situation where investors have flocked in, even as the valuation picture has worsened as the yield cushion against inevitable problems has been depleted.  Nothing will necessarily happen tomorrow or the next day, but there’s no margin for error if something untoward does occur.  (Chart:  Bloomberg terminal.)

Like other things that fit the “income plus momentum” theme, the iShares FTSE NAREIT Residential Plus Capped Index Fund (REZ) has been moving straight up of late.  In case you didn’t catch it in the middle of that eight-word name, the fund is the ETF for the residential portion of the FTSE NAREIT index series (PDF).

In the bottom panel of the chart is the total return on REZ since its inception.  Out of the gate, it dropped more than 60%.  From the bottom it has charged ahead 167%, for a net return of just over 42% from beginning to end.  (The chart is through last week; REZ tacked on 0.75% yesterday.)

The top panel shows the vacancy rate, which has plummeted since 2010, triggering a steady rise in rents (middle).

Following weak multifamily construction after the financial crisis, starts have rebounded strongly and vacancy rates should begin to increase in coming months, albeit slowly.

Will that changing dynamic alter the interest in REZ?  Or does the marginal (and/or margin) buyer right now even know about that or care about it?  (Chart:  Bloomberg terminal.)

I last posted a version of this chart in early September 2011, when the lines in each of the four panels were in the midst of noticeable drops.  Two weeks later, the Fed began “Operation Twist,” one of its many maneuvers over the last few years.

Since then (from top to bottom):  The Citigroup Liquidity Index has been in neutral other than a brief tumble in the second quarter of 2012 (the line moving lower equals less liquidity); the ten-year note had a big drop last week, although it’s lost given the scale of the rate decline since 1997; the S&P 500 has been resilient; and measures of volatility have not blown out to any degree during the last eighteen months.

In the fateful month of October, 2008, I wrote that, like love, liquidity has “a nasty habit of disappearing overnight.”  I’m not predicting that now (of course, I’m not in the prediction business), but it seems like a good time to think about the availability of liquidity and the effect on strategies of it being taken away.

Are there crowded trades out there?  Probably.  Is it painful to be on the wrong side of one?  Always.  But quick and sizable moves from the unwinding of those trades don’t necessarily require a lack of liquidity.  (The shorts in the ten-year got hammered of late, but I wouldn’t say a lack of liquidity was the reason.)

However, there are reasons to be on liquidity watch.  Many in the fixed income markets are concerned about the decline in liquidity in some sectors; for example, holdings in corporate bonds by primary dealers are lower than they were ten years ago and it’s unlikely you’re going to get much of a bid if things get dicey.

Also, there is great debate over the true liquidity in the stock market, given the propensity of high-frequency trading strategies to step out at times of stress and the increase in “dark” trading.  Moving size is a different process entirely from what it used to be.

At the margin, what does that mean?  I don’t know, but I have a sense that those considering the question will be better prepared for the next drop in all of those lines on the chart.  (Chart:  Bloomberg terminal.)

wicked environments

Regular readers and clients know that I love to triangulate — to come at ideas from a variety of angles.  My latest posting, on wicked environments and investment expertise, does just that based upon writings by Bill Gross, Daniel Kahneman, and Gary Klein.

You hear a lot about correlations between markets, so let’s take a look at them for the S&P 500 versus three key indicators.  All use the same scale and have a zero line for easy comparison.  These are 120-day trailing correlations.

The top panel shows the correlation with the U.S. dollar; it has been mired in negative territory since the financial crisis.  In fact, the correlation has been more negative since that time than it was for all of the previous sixteen years.  Yesterday, Sober Look examined recent changes in this relationship and wondered whether it is a sign that the risk-on, risk-off pattern is changing.

Another abrupt departure from history took place in 2008 for the stocks/commodities correlation, shown in the middle panel.  Prior to then, you can see why commodities got their reputation as uncorrelated with stocks.  The number chopped around zero in a narrow band until it didn’t.  Oops.  Yesterday’s Wall Street Journal had a headline proclaiming “Stocks, Commodities Break Up the Band.”  The article included a correlation chart as well as one showing the divergent returns on the two asset classes of late.

The bottom panel is a surprise to those who think of Treasury bond prices and stock prices as inversely correlated.  Much of the nineties (and the eighties too) featured positive correlations between the two, as the decline in very high interest rates pushed stocks and bonds together.  Flipping the situation over, could a rise from very low interest rates do the same thing?

That’s an important question, but only one of many that you could ask the next time someone uses a correlation to help you frame the future.  For example, the mean-variance optimizations that underlie financial planning and portfolio construction use correlations — as do the algorithms that executed during the last blink of your eyes.  After looking at the chart, what do you think they ought to be?

In addition to quantitative calculations, qualitative judgments about how markets work are formed by these relationships.  It’s good to look at history to see just how temporary our constructs turn out to be.

And this is only a bit more than twenty years of that history, likely not a representative sample of years to come.  The next time someone makes sweeping generalizations about correlations and recommendations about how to behave as a result, you might show them this chart.  (Chart:  Bloomberg terminal.)