Markowitz’s portfolio theory, first introduced in a landmark paper published in 1952, continues to be influential in today’s financial landscape, just as it was five decades ago. However, one may question how well its core principles are understood and applied in 2008.
Markowitz has since reconsidered some of the original paper’s technical elements, particularly the notion of “optimizing” a portfolio by merely evaluating expected returns against expected volatility (standard deviation). Many experts now view this approach as too simplistic and in need of enhancement. Over the past 50 years, significant advancements have been made to introduce greater depth and sophistication into portfolio theory. There are countless methods for implementing a Markowitz-inspired portfolio strategy. Nonetheless, the fundamental ideas presented in his theory still hold value, bolstered by concepts such as the Capital Asset Pricing Model and the Efficient Market Hypothesis.
Currently, the capital markets are undergoing extensive stress-testing, with striking insights emerging. One notable revelation is that developing markets have exhibited resilience that many investors, including myself, had previously underestimated. While this durability could vanish at any moment, it remains impressive how well equities in emerging economies have fared to date.
Consider the table below, which compares major asset classes and ranks their performance based on total returns up to May 2008. Emerging markets were the clear front-runners, with a rise of over 3% last month. Besides commodities, emerging market equities have also led the pack in performance for the past year, through May 31, 2008.
As with all major asset classes, emerging markets have faced challenges, particularly dramatic downturns in January and March of this year. Still, in light of the turmoil affecting the global economy—from conflicts, volatile energy and food prices, to various political and environmental disruptions—this segment of the stock market has shown remarkable resilience.
Despite various methods of analysis, the reality remains unchanged: inflation-adjusted growth in consumer spending is elusive.
According to government reports, real personal consumption expenditures stagnated in April, down from a modest increase of 0.1% in March. Meanwhile, the longer-term trend continues to look lackluster.
Examining the three primary components of consumer spending—durable goods, nondurable goods, and services—does not provide any additional optimism. As seen in the second chart below, inflation-adjusted spending appears to be weakening on multiple fronts.
The struggle with Joe Sixpack’s spending habits is clear. Rising energy and food costs, a gradual uptick in overall inflation, and stress from housing and employment challenges are collectively affecting consumer behavior.
This raises an important consideration: how sustainable is this stress-testing? In my view, there is both good and bad news. The positive aspect is that the economic downturn may not evolve into a full-blown recession. A recent modest revision of Q1 GDP growth supports this notion. However, the less favorable aspect is that when a recovery does arrive, it may not feel like a traditional recovery.
We will explore this issue further in upcoming discussions, but for now, it’s evident that the economic ramifications of past decisions are coming back to roost.
The rise in inflation is a major concern across all sectors, and the bond market is taking note.
Take for instance the 10-year Treasury yield—it has surpassed 4% for the first time since December 31, 2007. Rising yields are also observed in shorter maturities, such as the 2-year Note, which recently climbed to 2.62%, marking its highest level since January.
It’s not difficult to pinpoint the cause behind this uptick: inflation fears are the bond market’s primary adversary. Securities with fixed coupon rates are the first to feel the pressure in an inflationary environment.
As highlighted by The Economist this week, inflation is increasingly problematic globally, particularly in emerging markets. What does this imply for the U.S., Europe, and other developed economies? According to the publication, food, energy, and raw material prices are likely to “remain elevated,” predicting this as a lasting relative-price shock rather than a temporary one. However, this doesn’t mean commodity prices will continue to rise at their current rate; increased supply could balance the market out. Regardless, even if prices hold steady, the rate of increase will likely decline, helping to mitigate global inflation.
The question of whether commodities are in a bubble continues to be debated, leaving strategic investors eager for clarity.
The media is rife with discussions of potential “bubbles,” including a recent piece in the Wall Street Journal, which suggests: High Oil Prices Spur Thoughts About Bubbles, But This Might Be Misguided. Earlier this month, Lehman Brothers’ energy analyst Edward Morse stated in a report that commodities are indeed in a bubble and that it might burst by the year’s end, as reported by Bloomberg News.
In contrast, many argue that the soaring commodity prices stem from fundamental supply and demand trends rather than speculative excess. Regardless of the truth, growing concerns about rampant speculation have prompted some in Congress to consider new regulations to limit commodity trading by institutional investors.
So, what should prudent investors do? The answer is not straightforward. However, we can begin with some fundamental facts: pricing commodities is inherently speculative. This stands in contrast to stocks, bonds, and real estate (excluding raw land), which generate measurable cash flows that can be assessed for valuation. In the case of commodities, they produce no income directly; one can only sell a barrel of oil or an ounce of gold to realize cash flow. The challenge remains in determining just how much cash such commodities will generate until the actual transaction occurs.
America’s energy concerns don’t come with easy solutions, but a candid assessment of the facts is essential for progress. Unfortunately, confronting this reality is no simple task, especially in the politically charged world of energy policy.
Recent discussions in the U.S. Senate have not provided any contrary evidence. Take a look at these remarks made during a Judiciary Committee hearing featuring executives from some of the largest oil companies:
“Is there anybody here that has any concerns about what you are doing to this country, with the prices that you are charging and the profits that you are taking?”
—Sen. Dick Durbin
“Yet you rack up record profits, record profits, quarter after quarter after quarter, and apparently have no ethical compass about the price of gasoline.”
—Sen. Diane Feinstein
“Consumers are angry, and they have every right to be. You’re making more money than ever. It doesn’t seem fair, guys. It just doesn’t seem fair.”
—Sen. Herb Kohl
Even more compelling was this exchange between Sen. Patrick Leahy and the oil executives regarding their salaries. The Senator aimed to highlight the substantial compensation received by high-ranking oil executives. While this is a common occurrence across multiple industries, oil stands out for its importance and visibility.
It’s also worth noting that we are in an election year, and political tensions in Washington are running high. However, political grandstanding does little to foster an informed discussion about addressing America’s energy issues.
Concerns around inflation extend beyond food and energy, making the current situation even more alarming.
Core wholesale prices—excluding food and energy—are experiencing their fastest annual rise since the early 1990s, with April 2008 data showing a 3.0% increase—an alarming high since December 1991.
Conversely, the Labor Department reported that overall producer prices rose only a modest 0.2% in April, a significant decrease from March’s startling 1.1% increase. While this initially appears encouraging, the underlying issue remains concerning.
The crux of the problem lies in the fact that inflation at the wholesale level is permeating throughout the broader economy. Indeed, while overall wholesale prices increased by just 0.2% last month, core wholesale prices surged at twice that rate, 0.4%.
This was anticipated by those closely monitoring wholesale pricing trends. Earlier this year, I pointed out the troubling movement in core Producer Price Index (PPI), and the situation has since deteriorated further.
While studying history doesn’t guarantee easy profits, it often provides valuable insights during challenging times. Recent months serve as a prime example, particularly in relation to the real inflation-adjusted rate of the 10-year Treasury yield. According to my analysis, this real yield has dipped into negative territory recently, meaning that holding a 10-year Treasury bond results in a loss when factoring in inflation.
Such a negative real yield isn’t unheard of, although it is relatively rare. A similar occurrence happened in September 2005, but that was a brief episode. The last sustained period of negative real yields was between 1978 and 1980, a time when inflation impacted fixed-rate investments and high energy prices prevailed. (Does this sound familiar?)
Finally, some positive news from two critical economic reports.
According to the Census Bureau, housing starts and new housing permits saw a significant uptick last month, signaling a potential stabilization in the housing crisis after over two years of nearly uninterrupted declines.
The April data is particularly promising, showing an over 8% increase in housing starts—the highest level since last October. Additionally, new building permits issued surged nearly 5% last month, marking the highest point since December 2006. Both statistics exceeded experts’ forecasts by a notable margin, as noted by Briefing.com.
April’s improvement is especially noteworthy because these metrics are viewed as leading indicators, giving insight into potential future trends rather than merely reflecting past conditions.
Adding to the optimism is a better-than-expected report on inflation for April released by the Bureau of Labor Statistics.
However, caution is warranted. While it may seem that the economy is nearing a bottom, expecting a robust rebound is unrealistic. Evidence from a sharp decline in industrial production last month underscores that not all April’s news is positive.
The investment landscape is full of surprising insights, one of which is the unexpected alignment between the value strategies championed by Ben Graham and his disciples and modern portfolio theory (MPT).
While this may appear contradictory at first—since MPT has fostered the rise of index funds and the view that market prices are an accurate reflection of intrinsic value—Graham’s approach encourages investors to dig deeper for bargains, thereby enhancing the likelihood of achieving returns that surpass the market averages.
Historically, MPT and value investing have seemed like opposing forces, but recent developments in MPT have led to remarkable similarities. Although the academic interpretation of MPT has evolved, public perceptions remain rooted in the 1960s and 1970s, anchored by two foundational concepts: the efficient market hypothesis (EMH) and indexing. Yet, since the 1980s, a body of empirical research has reshaped financial economists’ perspectives on capital markets. Consequently, a new MPT has emerged that aligns more closely with Graham’s value-driven investing philosophy.
Why is this significant for investors? When the traditional strategies of both active and passive investing converge around value principles, it strengthens the validity of value-based approaches. Indeed, if two previously competing investment philosophies—each commanding substantial assets—now find common ground, it indicates a fundamental truth about capital markets and provides essential guidance for how investors ought to construct and manage their portfolios.
