Depending on the investor, answers are likely to be all over the map. And perhaps that’s reasonable, since we left out a critical piece of information for answering intelligently: time horizon.

What’s the single-most important investment decision driving return? We can’t respond shrewdly unless we know the length of time we’ll be investing. If we’re managing money with an end point of, say, next year, or even a few years down the road, the critical variable may be different (is likely to be different) than if you’re investing for results 20 years on.

This isn’t terribly surprising, although the time horizon distinction is often minimized, if not ignored in discussions of everything from security selection to asset allocation. Part of the problem is that in theory we’re all long-term investors but we’re destined to make the journey on a tick-by-tick, daily basis. Even the self-proclaimed day trader has a horizon beyond the next 24 hours. A 35-year-old who trades furiously during the day still wants a comfortable retirement 40 years hence. Perhaps the only investors with truly short, or shorter time horizons are older folks, although even that’s debatable, depending on your estimate for longevity.

In any case, back to our question: What’s the single-most important variable that influences portfolio return? If we’re investing with an eye on maximizing return 20 years from now, the answer is one of basic asset allocation: stocks vs. bonds vs. cash. Assuming some reasonable level of diversification in stocks and bonds, choosing individual securities will have a minimal impact, if any. And it probably won’t matter much if you overweight U.S. stocks vs. foreign stocks, or vice versa.

Consider, for instance, a few statistics. For the period 1970-2008, the annualized total return for domestic stocks (S&P 500) was 9.5% vs. 9.7% for foreign stocks (MSCI EAFE), according to the Ibbotson SBBI Classic Yearbook. Not a huge difference for that 38-year stretch. The future’s always uncertain, of course, but generally over long periods it’s likely that regional differences in equity beta will be minimal relative to the global stock market beta.

In the shorter term, however, it’s a different story. Looking at returns by decade for the S&P 500 and MSCI EAFE shows a wider array of results. For the 10 years through 2008, EAFE gained an annualized 1.2% vs. a 1.4% annualized loss for the S&P 500. In the 1990s, the relative performance tables were turned, with a much bigger divergence. U.S. stocks earned an annualized 18.2% for the decade through the end of 1999, more than double the annualized rise for MSCI EAFE, which gained 7.3% during the 1990s on an annual basis. (For a slightly more technical analysis of this trend, see William Bernstein’s 1997 treatment of this topic.)

Meantime, we can also show that bond returns over time tend to be quite modest relative to stocks. Again, no big surprise. What’s more, assuming reasonable diversification, your choices on short vs. long term bonds, or domestic vs. foreign, probably isn’t going to matter so much. Yes, there’s the foreign currency factor to consider, particularly when it comes to bonds. But over time, the capacity for forex to add or subtract from equity and bond returns tends to be a wash (i.e., the expected return for currencies proper is zero). In the short run, however, lots of forex volatility, and therefore lots of risk, which may or may not be helpful, depending on the investor and the strategy.

What’s the lesson in all of this? Your overall stock/bond/cash allocation is where the action will be over the long haul. But there’s a glitch. Although we’re all long-term investors, at least in theory, the long-run future arrives one day at a time. In fact, almost no one builds a portfolio today and lets it roll on, unattended, over the next 20 years. That’s true even for foundations, which theoretically have an infinite time horizon. Actually, a passive strategy that’s broadly diversified would probably fare quite well over time, assuming we chose a reasonable mix of stocks and bonds, such as 60% equities/40% fixed income.

But the set-it-and-forget mentality is hard to do. We’re all constantly buffeted by the daily barrage of headlines and other mental matters that compel us to act. For those with discipline and an above-average level of financial analytical abilities, short-term trading can be productive. But adding value over the long haul is rare by way of short term trading, especially after deducting for taxes, commissions and other frictions. In other words, most of us will end up with middling results. The problem is that everyone thinks they’re above average when it comes to money.

So what’s the big-picture message here? First, don’t lose sight of the fact that in the long run, your overall stock/bond/cash mix will perform the heavy lifting for generating performance results, for good or ill. (We might add in REITs and commodities, if we’re inclined to embrace a bit more nuance for matters of portfolio design). But getting from here to there is complicated, which is to say that you’ll be faced with numerous tactical decisions. There’ll be opportunities to add as well as subtract value from your end result, and so we must proceed cautiously on a day-to-day basis.

The good news is that there are some things to do that are likely to add some value, even if you’re no financial wizard, starting with rebalancing and owning multiple asset classes. Beyond these two factors, however, things get messy, at least for most investors, and that includes the issue of time horizon. In effect, we’re all short term traders with a long-term horizon. This is the original sin that comes prepackaged with investing. We can’t escape it, but neither can we fully solve for it.

Balancing the short and long term is a key element in the art of investing—the intertemporal risk for asset allocation, as it’s known in the literature. Robert Merton formally identified this risk in the early 1970s in a series of seminal papers and financial economists have been grappling with the related challenges ever since. So, too, have investors, for that matter, even if they don’t recognize the risk on those terms.

Yes, we’ve picked up a few clues in the game of managing money for the long run while juggling short-term risk. We know, for instance, that expected returns vary, and so reversion to the mean is likely, even though the reasons are hotly debated (i.e., market efficiency vs. irrational investing decisions). But there’s still no hard and fast solution beyond some general rules of thumb, such as own a broad mix of stocks and bonds, perhaps with some cash and so-called alternative betas. There’s also compelling evidence that active management won’t help much over the long sweep of time.

The debate, however, is a Wild West show for the short term. Or, as J.P. Morgan, once said, prices fluctuate, proving, if nothing else, that there’s at least one concept in finance that’s universally accepted.

First a little background. Whenever the Federal Reserve buys an asset or makes a loan, it simply credits new reserve deposits to the account that the receiving bank maintains with the Fed. The bank would then be entitled to convert those deposits into physical dollar bills that it could ask the Fed to deliver in armored trucks. Banks currently hold $1.2 trillion in such reserves, or more than a hundred times the average level of these balances in 2006, and more than the total cash the Fed has delivered since its inception a century ago. The traditional way the Fed would bring those reserves back in (and thus prevent them from ending up as circulating cash) would be to sell off some of its assets.

The Treasury’s Supplementary Financing Program was introduced in the fall of 2008 to assist the Fed in its massive operations to prop up the financial system at the time. The SFP represents an alternative device by which the Fed could reabsorb the reserves it created. Essentially the Treasury borrows on behalf of the Federal Reserve, and simply holds the funds in the Treasury’s account with the Fed. When a bank delivers funds to the Treasury for purchase of a T-bill sold through the SFP, those reserve deposits move from the bank’s account with the Fed to the Treasury’s account with the Fed, where they now simply sit idle, and aren’t going to be withdrawn as cash. In a traditional open market sale, the Fed would sell a T-bill out of its own portfolio, whereas with the SFP, the Fed is asking the Treasury to create a new T-bill expressly for the purpose. But in either case, the sale of the T-bill by the Fed or by the Treasury through the SFP results in reabsorbing previously created reserve deposits.

The Treasury’s press release says only this:

Treasury anticipates that the balance in the Treasury’s Supplementary Financing Account will increase from its current level of $5 billion to $200 billion. This will restore the SFP back to the level maintained between February and September 2009.

This action will be completed over the next two months in the form of eight $25 billion, 56-day SFP bills. Starting tomorrow, SFP auctions will be held each Wednesday at 11:30 a.m. EST, unless otherwise noted.

So this is going to be implemented immediately and on a large scale. But why? If the goal were indeed to drain reserves, the Fed could do this by selling some T-bills out of its own holdings, currently some 3/4 trillion, or could do this with reverse repos or the Term Deposit Facility, not to mention selling some of its trillion dollars worth of MBS. And just two weeks ago Fed Chair Ben Bernanke seemed to be saying that such steps were still far in the future, and did not even mention the possibility of a surge in the SFP.

You want more information? We’ve got this:

“We’re committed to working with the Federal Reserve to ensure they have the flexibility to manage their balance sheet,” a Treasury official said on background.

Anonymous and on background in order to say nothing at all? What’s the big secret?

An alternative hypothesis is that the Fed intends not to retire reserves but instead to expand its balance sheet without increasing reserves, that is, use the funds to make new asset purchases or loans with the SFP sterilizing the operations. But what loan is the Fed about to make or asset is it about to purchase? WSJ Real Time speculates:

The practical effect of this move is that the Fed will be able to finish $1.25 trillion of purchases of mortgage backed securities by the end of March without printing more money. Instead, it will have the cash on hand from the Treasury deposits to fund the purchases. As of February 17, the Fed’s portfolio of mortgage backed securities had reached $1.025 trillion, roughly $200 billion short of the objective.

But I’m puzzled with how that reconciles with this statement from the Federal Reserve Bank of Atlanta on February 10 (hat tip: Calculated Risk):

The Fed purchased a net total of $12 billion of agency-backed MBS through the week of February 3, bringing its total purchases up to $1.177 trillion, and by the end of the first quarter 2010 the Fed will have purchased $1.25 trillion (thus, it is 94% complete)…. the Fed needs to purchase only about $9.2 billion per week through March 2010 to reach its goal.

The discrepancy seems to arise from the fact that the Fed’s February 18 H41 release listed its MBS holdings on Feb 17 as $1,025 billion, or $152 billion less than the $1,177 billion that the Federal Reserve Bank of Atlanta claimed the Fed had purchased as of Feb 3. The Atlanta numbers seem to be the accumulation of weekly net MBS purchases (that is, gross purchases minus gross sales) reported by the Federal Reserve Bank of New York. Perhaps it takes a while between the time the NY Fed executes the purchases and the time they are settled and show up on the Fed’s H41 balance sheet, or perhaps there is some separate device for accounting for maturation and prepayment on the MBS. If the latter, then at a minimum the WSJ and FRB Atlanta had a different understanding of how far the Fed intended to go with its MBS program. And under either interpretation, if the $200 billion in new funding is just for something that was already etched in stone weeks ago, the sudden announcement that it is going to be implemented with an immediate resurrection of the SFP seems all the more mysterious.

WSJ Real Time offers this perspective from Lou Crandall:

The intention always was to resume SFP issuance when the debt ceiling was increased on a permanent basis, which finally happened earlier this month.

So maybe this has been in the cards for a while, with the apparent suddenness and clunkiness from the perspective of an outsider like me having an explanation in the fact that the political negotations behind such a move may in fact force a certain suddenness and clunkiness on steps that the Federal Reserve on its own might wish to see implemented with more transparency and predictability.

Still, one is led to wonder whether there might be a connection between today’s announcement about the SFP and last week’s announcement of an increase in the Fed’s discount rate. Numerous Fed officials encouraged us to interpret the latter as a routine and technical management tool. Are the discount hike and SFP renewal separate and purely technical developments, or is something more involved?

Perhaps Bernanke’s remarks tomorrow will give us more to go on.

First, let’s take a look at the nominal interest rates, both the risk free and risky.

Figure 1: Ten year constant maturity yields (blue) and AAA corporate debt yields (red). Observation for February is 2/17. NBER defined recession dates shaded gray; assumes last recession ends 09M06. Source: FRED II, and NBER.Second, we can adjust these nominal interest rates by expected inflation rates over a ten year horizon. Here we use the Survey of Professional Forecasters predictions, which apply to the second month of each quarter.

Figure 2: Ten year constant maturity yields (blue) and AAA corporate debt yields (red), adjusted by ten year expected inflation. Observation for February is 2/17. NBER defined recession dates shaded gray; assumes last recession ends 09M06. Source: FRED II, Survey of Professional Forecasters via Philadelphia Fed, and NBER.Real interest rates appear to be relatively low, lower than in the previous recession. Since these estimates of the ex ante real interest rate rely upon survey based measures of inflationary expectations, one could criticize them as being mismeasured.

Figure 3: Ten year constant maturity yields adjusted by ten year ahead expected inflation (blue squares) and ten year constant maturity TIPS (red). Observation for February is 2/17. NBER defined recession dates shaded gray; assumes last recession ends 09M06. Source: FRED II, Survey of Professional Forecasters via Philadelphia Fed, and NBER.However, the Treasury inflation protected securities (TIPS) yields suggest a similar pattern for real rates, excepting the period right after the Lehman bankruptcy, during which time TIPS and other yields behaved erratically).

So, what is one to make of these data? In a standard model of portfolio crowding out (see derivation here), budget deficits should induce higher interest rates, and hence lower investment. Of course, not all else is held constant. In particular, the Fed has aggresively purchased Treasurys and other longer term assets, including mortgage backed securities. This manifests itself in continuous shifts rightward in the LM curve.

Chapter 5 of the Economic Report of the President, 2010, notes:

…In the current situation, as discussed in Chapter 2, monetary policymakers are constrained because nominal interest rates cannot be lowered below zero, and so they are unlikely to raise interest rates quickly in response to fiscal expansion. As a result, the fiscal expansion attributable to the Recovery Act is likely to increase private investment as well as private consumption and government purchases. …

A relevant question, is what happens when the Fed exits from quantitative easing (and relatedly, as slack in the economy declines). That being said, extreme upward pressure on interest rates, and reduction in investment expenditures, is not a foregone conclusion.

Crowding out has a strong hold on many people’s imagination. Some equate crowding out in the financial market with crowding out in the real side of the economy. Let me make a couple observations on why this simplistic equation need not hold.

First, the empirical magnitude of investment crowding out depends critically on the interest sensitivity of investment expenditures.

Second, if investment depends upon the change in GDP, as in a simple accelerator model (see a discussion of competing investment models here), then government spending that induces an increase in GDP can result in higher investment, despite an increase in interest rates.

Third, when one assumes three (or more) outside assets instead of two, then money and bonds are not necessarily substitutes. Benjamin Friedman laid out a model with money, bonds and equities/capital. Depending upon whether bonds are closer substitutes with capital or money, one can obtain crowding out or crowding in (see this powerpoint presentation).

I teach crowding out in the context of the IS-LM model. For those who want to work in the loanable funds framework, see DeLong, and Krugman.

It all sounds reasonable on the surface, but the details are tangled. Suffice to say, definitive, all-or-nothing explanations, one way or the other, are far more elusive than a casual discussion on the matter suggests. That includes the issue of distinguishing irrational behavior from genuine but otherwise rational mistakes and miscalculation. Even proponents of EMH concede that the market isn’t perfect, at least on an ex-post basis. All’s clear in hindsight; it’s the ex-ante challenge that’s slippery.

Or as Warren Buffett likes to say, it’s only obvious who’s swimming naked after the tide goes out. Speaking of Buffett—widely hailed as the uber-investor par excellence—Investopedia’s Financial Edge published a story last week that reviews “Buffett’s Biggest Mistakes.” It comes as no shock to learn that the master is fallible. He may be the world’s greatest investor, but he’s only human.

That brings up the subject of irrational behavior, or what appears to be so. No one would call Buffett an irrational investor. That implies that he’s making rational investment decisions. Perhaps he’s an anomaly in an otherwise irrational world. But here’s the thing. If a rational investor can make mistakes when it comes to valuing securities (e.g., paying too much, selling too early), how does one distinguish that from similarly flawed decisions by so-called irrational investors?

Yes, it’s easy to say, Well, he’s Warren Buffett, ergo, his investment decisions are rational. But what about the average mutual fund manager? Or the guy down the street trading from his bedroom? Could you tell if one’s irrational and the other’s rational? Clearly, it’s no quick clue to simply declare that someone paid too much, or sold too early. We need something more than that. But what?

Alas, there are no easy answers, if any. There are no econometric tools that separate rational investors who make mistakes from irrational types who stumble. On the other hand, there’s no shortage of subjective opinion, rules of thumb, and a truckload of hyperbole.

Meanwhile, the market may collectively be irrational at times, if not continually. Or maybe not. Could the market (and individual investors) be making rational decisions that are sometimes wrong? Or is it a matter of degree? Does irrational behavior equate with making really big mistakes, vs. relatively modest ones? Okay, how do we define big and modest? Is that determined solely by, say, price relative to earnings? Is a 15 p/e too high? Or is it 16? And do we need to adjust that for inflation, interest rates, the outlook for economic growth, the possibility of war, etc.? Or does the mere presence of mistakes (defined after the fact, of course) constitute irrational investing, regardless of valuation?

As you can see, deciding if the EMH is reasonable or not isn’t quite so easy. At least not if you have to write down the rules. Then again, there are those pesky index funds, which generally perform as EMH predicts. But even that’s debatable, as we’ll discuss in a future post. It’s not an entirely persuasive argument, but that doesn’t slow the debate.

If you’re looking for quick, definitive answers, debating EMH isn’t likely to offer satisfaction. By comparison, you’ll probably have better luck with religion or politics.

Deciding how much it matters, why it matters, and under what conditions has spawned a fierce debate over the years, along with a small library of research analyzing the details. A paper a few years back from Ibbotson Associates (now a part of Morningstar) captured the spirit of the discussion with this title: “Does Asset Allocation Policy Explain 40, 90 or 100 Percent of Performance?” The answer? All three accurately summarize asset allocation’s influence, but it very much depends on how you define the question.

As the Ibbotson paper explains, “asset allocation explains about 90 percent of the variability of a fund’s return over time but it explains only about 40 percent of the variation of returns among funds. Furthermore, on average across funds, asset allocation policy explains a little more than 100 percent of the level of returns.”

Although the Ibbotson research helps clarify the dispute over how and why asset matters, it’s hardly the last word on the subject. Indeed, navigating the nuances of asset allocation research, and drawing practical conclusions, has is almost a full-time job in the 21st century. Clearly, this has become a broad and deep discipline in its own right, with the no shortage of reference material to consider. Skeptical? Type in “asset allocation” at Social Science Research Network’s home page and behold the result.

Asset allocation as a formal topic of inquiry has come a long way since the 1986 Brinson study launched the discipline, and it’s still evolving. Rapidly, in many directions. There are no easy answers, but at least we know where to start. Among the standard works that deserve a spot on every strategic-minded investor’s bookshelf:

•Asset Allocation: Balancing Financial Risk
•The Art of Asset Allocation: Principles and Investment Strategies for Any Market, Second Edition
• The Four Pillars of Investing: Lessons for Building a Winning Portfolio
• All About Asset Allocation

As valuable as these books are, they only scratch the surface. Indeed, a number of niches in asset allocation are worth exploring, such as tactical interpretations. Mebane Faber’s The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets is a recent contribution to this niche. And yours truly reviews some of academic literature in Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor.

Meanwhile, the discussion over GDP vs. market-cap weighting systems is another aspect of the debate over what constitutes an effective passive definition of structuring a portfolio. A new research briefing from MSCIBarra revisits the subject by considering the differences in weighting an international equity portfolio by the size of each country’s economy vs. the market capitalization of its stock market. This is a familiar topic for MSCI, which has long published a series of equity indices weighted by GDP. How have the two methodologies fared? The GDP methodology has recently posted a considerable edge over its market-cap equivalent on a broad basis that targets all the world’s stock markets, including the U.S. For the five years through February 19, 2009, the MSCI ACWI GDP Weighted Index earned a 2.8% annualized total return–comfortably above the slight 0.3% annualized rise for the conventional MSCI ACWI, which is market-cap weighted.

It’s tempting to declare GDP weighting as the winner, now and forever more. But investors should be wary of assuming the past will repeat. It may, but we need something more than blind extrapolation of the past as a compelling argument. Indeed, one of the reasons for the GDP weighting’s edge is that the strategy holds larger portions of emerging market stocks, which grab a bigger slice of assets in GDP-oriented indices vs. market-cap benchmarks. As such, one’s views on emerging markets are critical to assessing GDP weighting.

Notably, China’s large and growing economy is under represented in a market-cap index because its stock market is relatively small compared with its GDP footprint. At the opposite end of the extreme, the U.S. market is over represented via market cap because American stocks are highly valued relative to the economy. As our chart below shows, China’s stock market capitalization represents less than 10% of its GDP value. By that standard, the U.S. is over represented because its stock market capitalization trades at a premium to the dollar value of the economy.

Presumably, such gaps will close in the years ahead. If so, the trend implies a bullish tailwind for China equities and a headwind for U.S. stocks.

But GDP is but one alternative weighting scheme, as a recent article by Rob Arnott and two co-authors reminds. It’s not always clear that an investor should assume that any one methodology will be superior in the years and decades ahead. “Our research shows that a combination of cap weight, economic scale and minimum variance creates a compelling risk/return profile,” Arnott and company write.

But there are several issues to consider. One is that passive indexes based on something other than market cap may incur higher management costs vs. a standard market cap indexing strategy. There are other details to review as well if we’re to understand why expected risk premiums might be higher for one weighting system vs. another. Overall, one can persuasively argue that higher expected returns come only by assuming different risks relative to the market cap portfolio, which is arguably the true passive definition for equities. Becoming comfortable with those risks in terms of their economic interpretation is essential before diving into alternative indexing systems.

It’s no surprise to learn that different portfolio construction techniques provide different return expectations. But these expectations, after adjusting for risk, may not be so surprising (or enticing) after all. Indeed, modern finance has identified an array of betas to consider, such as small-cap value. Is this a free lunch? No, absolutely not. Does small-cap value offer a higher expected return vs. the standard equity beta? Yes, or so it seems. But understanding why it offers a higher expected return is critical before overweighting the beta. No less is true for GDP weighting, or any other strategy that claims to capture a higher risk premium.

There are no short cuts to minting risk premiums in the money game, but there are lots of betas to consider. Choose wisely, but do your homework first.

In recent years, the Fed had gotten very good at communicating its intentions to the market. FOMC statements came down to a routine in which the Fed announced at each FOMC meeting a target for the fed funds rate that Fed watchers had usually figured out well before the meeting. But the fed funds rate has become an essentially irrelevant number for the last year, and given the Fed’s apparent intention to keep a huge volume of reserves outstanding, will likely remain irrelevant for some time to come. Hence one purpose of Bernanke’s statement was to communicate what we should be looking for in the way of a new format for policy decisions and announcements from the Fed:

As a result of the very large volume of reserves in the banking system, the level of activity and liquidity in the federal funds market has declined considerably, raising the possibility that the federal funds rate could for a time become a less reliable indicator than usual of conditions in short-term money markets. Accordingly, the Federal Reserve is considering the utility, during the transition to a more normal policy configuration, of communicating the stance of policy in terms of another operating target, such as an alternative short-term interest rate. In particular, it is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates. No decision has been made on this issue; we will be guided in part by the evolution of the federal funds market as policy accommodation is withdrawn. The Federal Reserve anticipates that it will eventually return to an operating framework with much lower reserve balances than at present and with the federal funds rate as the operating target for policy.

In other words, instead of watching for an announcement by the Fed of a target for the fed funds rate, we may be anticipating announcements about the interest rate that the Fed chooses to pay on reserves. Bernanke noted that the value chosen for interest on reserves might come to move other interest rates around in the same way that the fed funds rate used to:

By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally.

So perhaps instead of a fed funds futures contract on the Chicago Board of Trade, we’ll need an interest-on-reserves futures contract to tell the rest of us what the savviest Fed-watchers have figured out.

Bernanke signaled that the Fed may also dip its toes further with operations on reverse repos and the Term Deposit Facility, though I think he was cautioning us not to read too much into any initial steps in these programs, as the Fed may want to simply try using these facilities on a larger scale to see how they’re going to work out before making any real policy changes:

The sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments. One possible sequence would involve the Federal Reserve continuing to test its tools for draining reserves on a limited basis, in order to further ensure preparedness and to give market participants a period of time to become familiar with their operation. As the time for the removal of policy accommodation draws near, those operations could be scaled up to drain more significant volumes of reserve balances to provide tighter control over short-term interest rates. The actual firming of policy would then be implemented through an increase in the interest rate paid on reserves. If economic and financial developments were to require a more rapid exit from the current highly accommodative policy, however, the Federal Reserve could increase the interest rate paid on reserves at about the same time it commences significant draining operations.

Still, the Fed is seeing all of this as potentially still far in the future, with Bernanke’s statement repeating a phrase that has become boilerplate for recent FOMC statements:

economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

Both housing starts and industrial production posted higher levels last month. The annualized pace of new housing permits issued slipped, however, falling by 4.9% last month vs. December—the first decline since October and the biggest percentage drop since March 2009’s 7.1% tumble.

As our chart below shows, the housing market is a pale shadow of its former pre-recession profile. The rebounding of late is certainly encouraging, but we shouldn’t kid ourselves that anything approaching a normal recovery is imminent in this sector. Short of a complete collapse in the economy, the housing market was destined to show signs of life after three years of virtual non-stop contraction. What’s unclear is what happens after the initial snapback fades.

As our chart above reminds, much has changed in the housing market, and not for the better. The rebound so far, if we can call it that, is still a marginal event with limited relevance to the broad economic trend. The main positive is that the housing market is no longer in freefall.

Industrial production, by contrast, is closer to what we might think of as recovering. As the second chart below shows, a broad measure of industrial activity in the U.S. shows that growth has been a constant since last July. But like housing, industrial activity is still in a deep hole relative to the days before the Great Recession.

Looking backward is encouraging, but the real test of the recovery awaits in the months and quarters ahead. Having stepped away from the brink, the economy has stabilized and started showing signs of life again. Industrial production and housing are but two examples. But the labor market has yet to offer signs that it too is set to join the party. Although job destruction is almost surely behind us, it remains to be seen how strong the job creation phase of the recovery will be. The answer will cast a long shadow on how the economy fares in the years ahead.

The natural forces of recovery are in force, supported by monetary and fiscal stimulus. But the headwind of debt, both in government and on household balance sheets, remains a potent force in keeping growth lower than it would be. The true test of just how problematic these negative forces will be is about to begin. For what it’s worth, we’re mildly optimistic that the expansion will continue. So too are a number of economists. The U.S. economy will grow at an annual rate of 2.7 percent over each of the next five quarters, according to 42 forecasters surveyed by the Federal Reserve Bank of Philadelphia.

Sounds good, but getting from here to there requires crossing a fair amount of treacherous economic ground. This rebound is likely to be far more prone to setback than any post-recession period since the 1930s. We already knew that, of course. The uncertainty is discovering exactly what that means over the coming months and quarters.

We’ve been writing about what appears to be a pivotal test for the labor market. After nearly a year of a decline in jobless claims, we’ve been wondering if the favorable winds have shifted in the early weeks of 2010, as we discussed here and here, for instance. Depending on the week, our concerns look inspired or naive.

Today’s update reports a hefty rise of 31,000 new filings for unemployment claims for the week ending February 13 (this and all jobs numbers reported here are seasonally adjusted figures). As our chart below shows, the uptick looks discouraging at this point, more so than usual. Relative to the linear trend over the past year, it’s getting harder to dismiss the idea that the recovery wind for the labor market has run out of steam.

It’s still too early to say for sure what’s going on with jobless claims, which are a valuable resource for anticipating the larger economic trend. For one thing, this data series is notoriously volatile from week to week. As such, the latest data point is still well within the range that would be consistent with on ongoing decline. At the same time, it’s also true that the trend may be setting us up for a period of sideways action, with jobless claims stuck in a range of, say, 450,000 to 500,000 for an extended period. If so, that spells trouble for expecting a robust rise in nonfarm payrolls any time soon. Our outlook for net job growth has been muted for some time and perhaps we’ll have to further reduce our expectations, depending on the numbers that arrive in the coming weeks.

Meantime, we’re not encouraged by the latest update on so-called continuing claims for jobless benefits, which is the tally for those who’ve been previously collecting unemployment checks. The trend on this measure has also stalled, as our second chart below illustrates. The latest number puts the continuing claims total at 4.563 million for the week through February 6. That’s unchanged from the previous week and about 2 million higher than what would prevail in a healthy economy. We’re still a long way from home.

Progress, in short, remains in some peril in the formerly recovering labor market. The problem, of course, is that the recovery so far has been virtually all about slowing the bleeding. The second phase of net job creation has yet to begin, and based on today’s numbers there’s reason to wonder if the day of salvation is further down the road than we thought a few months back.

This is hardly news, but it’s an ongoing feature in the struggle to make a buck in the capital markets. The latest smoking gun comes by way of Morningstar, which calculates asset-weighted investor returns. This study reflects what the average investor actually earned in various mutual fund categories vs. the average for the respective fund category. Unsurprisingly, the average investor tends to earn less than the average fund. Consider a few examples from Morningstar’s latest tally:

● The average investor in U.S equity funds earned 0.22% for the 10 years through the end of 2009, well below the 1.59% gain for the average fund in this category.

● For international equity funds, the average investor earned 2.64% vs. 3.15% for the average international stock fund for the decade through this past December 31.

Is it any wonder, then, that 401(k) investors can benefit from professional advice? This says as much about the quality of the advice as it does the poor investing decisions that so often pass as standard operating procedure for the man in the street. Yes, we must be careful of “advice,” which can sometimes be a cure that’s worse than the afflication. But simple recommendations, such as embracing broad-minded asset allocation, can do wonders for investors who are clueless as the to basics.

On that note, consider a study published last month by Hewitt Associates and Financial Engines that 401(k) participants who availed themselves of target-date funds, managed accounts and/or online advice earned higher returns—i.e., “help.” The study—“Help in Defined Contribution Plans: Is It Working and for Whom?”—advises: “On average, the median annual return for Help Particpants was almost 2% (186 basis points) higher than for Non-Help Participants, net of fees.”

The research goes on to report that “non-help participants often have inappropriate risk levels and/or inefficient allocations, both of which can significantly affect portfolio performance.”

No one should be surprised by any of this, although one can only guess how much of these types of studies promote thinking and investing strategically. The good news: the basic building blocks of shifting the investment odds in your favor isn’t rocket science. Owning multiple asset classes and engaging in some simple rebalancing from time to time offers a surprisingly durable risk-reward profile over time, as we’ve discussed. But what’s easy and obvious (at least to some) in the money game is rarely embraced by the masses. Documenting the supporting evidence is fairly uncomplicated. Explaining why this is so is something else altogether.

Yes, the hike is both small and primarily symbolic. Lending through the Fed’s discount window is relatively slight in the 21st century. It’s hardly surprising that Bernanke and company chose to ease back into monetary tightening quietly. Nonetheless, a similar rise is probably near for the Fed funds rate, which is the central bank’s primary benchmark for adjusting the price of money. Currently, the target Fed funds is in a range of zero to 0.25%.

The burning question this evening: How will the markets react in the morning? The initial reaction in Asia is modest selling. Japan’s Nikkei 225, for instance, is off by around 0.7% as we write.

It looks like the era of the Great Easing is over in America. This is merely the first installment. Although the economy’s far too weak to warrant a rapid return to normal policy, today’s minor adjustment is a signal of things to come. The long road back to a normal monetary policy has started and there’s likely to be a few bumps on this journey.

“The Fed’s action came as a surprise and enhanced speculation that it will withdraw stimulus ahead of major peers,” Tomokazu Matsufuji, at SBI Liquidity Market Co. in Tokyo, tells Bloomberg News. “This will drive the dollar higher.”

Meantime, Chris Rupkey at Bank of Tokyo-Mitsubishi UFJ tells the LA Times this evening: “The Fed can talk all day about how the discount rate hike is technical and not a policy move, but the market sees it as a shot across the bow.” He went on to opine: “Today they raised the discount rate, and not tomorrow or the next day, but soon, they will be lifting the fed funds rate target as well, as the economy is starting to regain momentum.”

Finally, a few excerpts from a speech given earlier tonight by Dennis Lockhart, president of the Federal Reserve Bank of Atlanta. He spoke after the Fed announced it would increase the discount rate:

Earlier today, the Fed announced an increase in the primary credit rate. The primary credit rate—also called the discount rate—is the rate at which the 12 Federal Reserve Banks across the country provide temporary liquidity to healthy banks. How should today’s announcement be interpreted? I would not interpret this action as a tightening of monetary policy or even a sign that a tightening is imminent. Rather, this action should be viewed as a normalization step.

..the public and markets should not misinterpret today’s move. Monetary policy—as evidenced by the fed funds rate target—remains accommodative. This stance is necessary to support a recovery that is in an early stage and, in my view, still fragile.