August 25th, 2013

(First a little housekeeping: an anonymous reader commented that when they clicked the “back” button after viewing a larger sized graph they were returned to the beginning of the blog post instead of where they had left off when they clicked on the smaller image within the text.  I suggest that, after viewing a graph, try clicking the ‘X’ button on the top right of the graph page to return to where you left off.   This works in the Chrome browser.)

Since the onset of the recession in late 2007, I have read many articles on the lack of wage growth despite big gains in productivity.  Ideas become popular when they have a narrative, one that I took for granted.  Each quarter, the Bureau of Labor Statistics (BLS) issues a report on productivity and labor costs that I have taken at face value.

The 2001 manual of the OECD manual states “Productivity is commonly defined as a ratio of a volume measure of output to a volume measure of input use.”  They frankly admit that “while there is no disagreement on this general notion, a look at the productivity literature and its various applications reveals very quickly that there is neither a unique purpose for, nor a single measure of, productivity.” (Source)

The authors of a recent paper at the Economics Policy Institute cite BLS data showing that productivity has grown “by nearly 25 percent” in the period 2000 – 2012 while the median real, that is inflation adjusted, earnings for all workers has essentially remained flat.   Company profits are at all time highs and workers are struggling.  The narrative is familiar but I wondered: how does the BLS calculate productivity growth?

What the “headline” productivity numbers describe is labor productivity, the output in dollars divided by the number of hours worked.  The BLS Handbook of Methods, page 92, gives a detailed description of its methodology.  As the BLS notes, this often cited productivity figure disregards capital investments in output like machinery and buildings.  For this reason, the BLS also calculates a less publicized multifactor  productivity measure using methodologies which do incorporate capital spending.  How does capital investment influence the productivity of a worker?

Consider the simple case of a man – I’ll call him Sam – with a handsaw who can make 20 cuts in a 2×4 piece of lumber in an hour.  His company charges customers a $1 for each cut, the going rate, so that the company can sell Sam’s labor for $20 per hour. Due to increased demand for wood cutting, the company invests $1000 to buy an electric chop saw.  The company calculates that Sam’s productivity will rise enough that they can undercut their competition and charge 75 cents a cut.  With the chop saw, Sam can now make 60 cuts per hour at .75 per cut = $45 dollars in revenue per hour to the company.  Sam’s labor productivity has now risen 150%.  In our simple case, this would be the headline labor productivity gain – 150%.

A more complete measure of productivity including capital investments is quite complex.  The latest edition of the OECD handbook notes that “there is a central practical problem to capital measurement that raises many empirical issues – how to value stocks and flows of capital in the absence of (observable) economic transactions.”  To illustrate the point further, the asset subgroup listed in the BLS handbook includes “28 types of equipment, 22 types of nonresidential structures, 9 types of residential structures (owner-occupied housing is excluded), 3 types of inventories (by stage of processing), and land.”

You want simple?  Let’s go back to our kindergarten example.  At this rate of production, let’s say that the saw’s useful life is only 10 months.  The company has an investment of $100 per month in the saw, plus additional costs like electricity, a bigger workbench, etc.  To round out the numbers, let’s say that equipment related costs are $150 a month.  If Sam’s output is 8 hours a day x $45 an hour, Sam is producing $360 per day in revenue for the company, or close to $8000 a month. The $150 a month in equipment costs is trivial and multi-factor productivity is very close to labor productivity.

Sam knows he is making much more money from the company and goes to his boss and says he wants a raise.  Not only is he producing more for the company but the electric saw is much more dangerous than a handsaw.  The company gives Sam a raise from $7 an hour to $8 an hour, an almost 15% increase that Sam is happy with.  In addition to the raise, the company has an additional $2 in mandated labor costs, bringing the total costs for Sam’s labor to $10 an hour.  Even with the higher labor costs, the company is raking in huge profits – $35 an hour – from Sam’s labor.

But now an inspector comes in and tells the company that, because an electric saw makes much more dust than a handsaw, the company will have to install a ventilation and filtering system so that the employees and neighbors won’t have to breathe sawdust.  The company gets bids that average $100,000 to install this system and the company estimates that the system will equal $1000 a month in additional capital costs.  Despite the additional costs, the company still continues to make substantial profits from Sam’s labor.  To the company, the capital costs for this new system represents about 60% of an additional worker’s labor costs, yet that additional cost is largely not included in measuring labor productivity because Sam’s hours and the revenue generated by Sam’s labor remain the same.

A multifactor productivity comparison of handsaw vs. chopsaw production would show a percentage growth of 40%, far below the 150% labor productivity growth.

All of us have our biases (except my readers who are perfectly rational beings) which cause us to look no further than the narrative that clearly supports our previous conceptions.  If we generally agree with the narrative of companies taking advantage of workers, we read of 25% productivity gains for companies and 0% gains for workers in the past twelve years, and we look no further – for the data has confirmed what we previously had concluded.  Big companies = bastards; workers = victims.

In June 2013, the BLS released revisions to their productivity figures for 2012 and included historical productivity gains for various periods since 1987.  During the past 25 years, multifactorial productivity, including capital investment, has averaged .9% per year – less than 1%.

While labor productivity has grown 25% since 2000, multifactorial productivity has been half that, at about 12%.   Dragging the 25 year average down is a meager .5% growth rate since 2007.  Even more striking is the growth rate of input into that recent tepid productivity growth; the BLS calculates 0% net input growth since 2007.  For the past 25 years, capital investment has grown at more than 3% but since the recession capital growth has slowed to 1.3% per year.  I wrote last week that there is an underlying caution among business owners and this further confirms that caution; companies have been cutting back on both labor and capital investment.

If multifactorial productivity rose by 12+ percent over the past 12 years, and the profits did not go to workers, where did the money go?  For a part of the puzzle, let’s look to inflation adjusted dividends of the SP500.

From the beginning of 2000 through 2007, when the recession began, inflation adjusted dividends grew at an annual rate of almost 3.8%, eating up most of the profits from productivity growth.  As bond yields continued to decline, I would guess that investors pressured companies for more of a share of the profits from productivity growth.

As workers lost manufacturing jobs during the 2000s, many were able to switch to construction jobs in the overheating real estate market and unemployment stayed low.  This should have pressured management to give into labor demands for an increased share of the productivity growth but it didn’t.  I suspect that the labor mix contributed to the lack of pressure on management.  Fewer manufacturing jobs meant fewer union jobs; a reduced labor union influence meant less demand on management.

Looking past the headline labor productivity gains, overall productivity is slow.  Capital and labor investment is slow, which means that future overall productivity is likely to remain slow.

While walking a trail in the Colorado Rockies years ago, my brothers and I complained about having to dodge moose poop on the trail.  Then we ran into the bull moose that made the poop.

Investment, Savings and Income

August 18th, 2013

Gross Private Domestic Investment (GPDI) consists of capital spending on factories and equipment, improvements in rental properties, and changes in inventory.  Changes in GPDI reflect expectations by the business community.  Companies and landlords continue to increase investment after the precipitous fall of 2008.  Below is the long term view.

Let’s zoom in on the past five years to show some comparisons.  In 2010 there was a slight decline in investment.  In 2011 and 2012 came short periods of a levelling off of investment.  So far this year, the trend is upward.


Declines in investment accompany recessions but do not consistently precede recessions.  However, declines in the year over year (y-o-y) percent change do signal an aggregate caution among businesses.  The attentive investor would do well to notice these signals.  Investment growth remains positive.

Percentage changes in investment and the market loosely track each other, as we can see below.  Both investment and the market ride on anticipation of future business conditions but the market reacts and overreacts much more than investment. I dampened the percent change of the market to show a bit more clearly both the correlation and the divergences.

The y-o-y gain in investment has been positive since the latter part of 2009, indicating that business owners and managers have enough confidence in future business to increase their investment. A key component of the business landscape is the willingness of consumers to buy.  This past Tuesday came the monthly report on Retail Sales showing a .2% monthly gain for total retail sales, including food services.  At an annualized growth rate of 2.4%, sales  are positive but annualized gains of 3% or more would indicate strong consumer demand.  So far this year, earlier forecasts of negative real retail sales growth in response to sequestration policies have proved unfounded.  Below I’ve excluded the food services component which accounts for approximately 10% of retail sales.

When we look at retail sales as a percent of GDP, the total economic activity of the country, retail sales excluding food is still below 20 year averages.

Adjusting for inflation and population, we can see that it is food services that continues to show strong growth over a two decade period.  While the recession put a dent in that growth, it is more than 25% higher than it was two decades ago.

Each month the U. Of Michigan releases a consumer sentiment survey.  This past Friday’s report showed a surprising fall in sentiment from 85 to 80.

In the U.S. we can take a rough reading of the willingness of consumers to spend by looking at savings patterns – we don’t save as much.

We are down below a 5% savings rate again, indicating that people are confident enough to spend most of their income.  That is one reading.  Another is that many households have responded to the increase in the Social Security tax this year by reducing their savings.  The lack of savings by Americans has a long history.  Before the Social Security Act was passed in the 1930s, George Washington Carver wrote: “We have become ninety-nine percent money mad. The method of living at home modestly and within our income, laying a little by systematically for the proverbial rainy day which is due to come, can almost be listed among the lost arts. ”  Perhaps that is why some felt that Americans had to be put on a mandatory retirement program called Social Security.

The upward spike in savings at the end of 2012 has been attributed to higher dividend payouts and bonuses in anticipation of the “Fiscal Cliff” in 2013.  Per capita Disposable Personal Income continues its subdued but steady march upward, also rising dramatically in the last part of 2012 as a one time anomaly before the onset of higher taxes and sequestration.

On an inflation-adjusted basis, we are 10% higher than we were ten years ago.

But a longer term picture is a bit more sobering.  The decades longs rising trend of real income has clearly plateaued since the recession began at the end of 2007, over five years ago.

The recession has been a sobering experience for everyone, including the business community. While the growth signs are mildly positive, an underlying watchfulness seems to be the order of the day.

Price Dividend and CWI

August 11th, 2013

Last week I wrote about viewing trends in the market through the lens of hard cold cash; that is, the dividends paid by the companies in the SP500.  Today, I’ll revisit that subject in a bit more depth.  Beginning in the last quarter of 2008, reported earnings of companies in the SP500 dropped precipitously, plunging about 90% in the first two quarters of 2009.

The portion of those earnings paid as dividends fell 24% from peak to trough, far less than earnings.

Robert Shiller, a Yale economist and co-developer of the Case-Shiller housing index, uses a smoothing technique for calculating a Price Earnings ratio and graciously makes his data available.  He calculates the 10 year average of real, or inflation-adjusted, earnings and divides the inflation adjusted price of the SP500 by that average.  Because of the low inflation environment for most of the past decade, the difference between the two earnings figures, nominal and real, is slight.

The drop in corporate earnings was extreme, more so than any recession, including the Great Depression of the 1930s.   In the 2001 recession, earnings declined to about half of their prerecession peak.  In the recession of the early nineties, it was about 30%.  In the back to back recessions of the early 1980s, corporate earnings fell about 25%.

While Shiller’s method evens out earnings, it has one drawback, one that no one could have foreseen until 2008 simply because it had never occurred.  The severity of the decline in earnings skewed the ten year average of earnings down over the 2002 – 2012 period.  Since the earnings average is the divisor in the Shiller P/E ratio, it correspondingly makes the ratio of the price of stocks a bit higher than it might otherwise be.

For that reason, I’ll look at a less volatile ten year average of dividends; that is, the inflation adjusted price of the SP500 divided by the ten year average of inflation adjusted dividends.

Today’s market prices are at the twenty year average of the real price dividend ratio, which is about 61.  For a number of factors, market prices as measured by this dividend ratio are higher for the past twenty years than the thirty year average of 51.  The tech and real estate bubbles over-inflated prices but investors have been willing to pay more for stocks as bond yields have declined steadily from their nosebleed levels of thirty years ago.

Let’s crank up the time machine and go back a year.  Here are a few quotes from an October 13, 2012 Reuters article after the market had dropped about 2%:

“Central bank-fueled gains took markets within reach of five year highs in September, but now U.S. stock market participants are shifting their focus back to corporate outlooks, and the picture is not pretty.”

The article quoted the director of investment strategy at E-Trade Financial, Michael Loewengart: “The overall tone is so pessimistic that we may see some upside surprises, but we could still suffer considerable losses if the news is bad.”

“Profits of SP500 companies are seen dropping 3% this quarter from a year ago, the first decline in three years”

It was close to being almost the end of the world.  As you read various comments in the news, keep in mind that these remarks are coming from active traders who see a 5% drop as catastrophic if they have not anticipated it through options and other hedging strategies.  For longer term investors, a 5% drop after a 5% rise over several months is more yawn provoking than cataclysmic.

Through the middle of November 2012, the market would drop another 5%.  Slowing corporate profits and the looming – yes, looming – fiscal cliff spooked investors.  Then, on the hopes that the Fed would do something to offset these negatives, the market regained the 5% lost in the previous month.  In mid-December, the Fed announced that it would double its bond purchasing program and the market has been rising since, gaining 20%.  Has this been a new bubble, one we’ll call the “Fed Bubble?”  Some say yes, some say no.

As we read the daily news, let’s keep in mind that in ten years we will have forgotten most of it.  Some fears will seem silly, some may seem prescient.  Each day there are many predictions, some like this one from December 30, 2001: “By the year 2003, there will be 2 types of businesses, those doing business on the internet and those out of business.” (Sorry, I didn’t write down the attribution).  Some predictions will seem rather silly like the one in March 2009 that the SP500 would be below 500 in a month.

Farmers and businessmen in ancient Rome consulted soothsayers who threw chicken bones and read the pattern in the bones to tell their clients whether there would be rains in the spring and how hot the summer would be.  Sometimes they were right, sometimes they were wrong.

Each day the market goes up – or it goes down.  For the past twenty years it has gone up 54% of the time, down 46% of the time.  Going up seems like an odds on favorite but this is complicated by the fact that the market usually goes down faster than it goes up.  There is also a well documented behavioral phenomenon of risk aversion; people respond more emotionally to loss than we do to gains.

This past Monday came the release of the ISM monthly survey of Non-Manufacturing businesses.  Like the manufacturing survey released a few days earlier, this index also surged upward in July, a welcome relief after the declining numbers in June.  I’ve updated the composite CWI that I introduced a while back and compared it to the SP500 and the Business Activity Index of the Non-Manufacturing Survey.

This composite index is weighted 70% to non-manufacturing, 30% to manfacturing.  Because this CWI relies on past months’ activity as a predictor of future conditions, it responds with less volatility to a one month surge in survey data.  As we can see, the tepid growth that began appearing this past spring is still showing in this index, although it is a strong 55.5, indicating sure footed, if not surging, growth.  It has been above the neutral mark of 50 since August 2009.

The Price is Right?

August 4th, 2013

First week of the month and several good monthly reports helped propel the SP500 through the 1700 mark this week, making an all time high.  Last week I wrote that the market would be cautious and the first few trading days of the week was exactly that, drifting sideways.  On Thursday the release of a suprisingly strong ISM Manufacturing report gave an upward jolt to the market.  In several recent blogs on the ISM and an alternative composite called the CWI, we could see that manufacturing has been sliding toward the neutral mark of 50 for the past several months.  On Monday, the ISM non-manufacturing index will be released and next week I hope to update the CWI.

Ultimately, the market rides up or down on the anticipation of future earnings.  However, earnings can be “managed,” to put it politely.  Further confusing the earnings picture for a casual investor are the several different types of earnings: operating, pro-forma and GAAP to mention a few.  There are two types of “future”, or projected, earnings: bottom up and top down.

A simpler approach that some investors use is to calculate the Price Dividend ratio.  There is no fudging of cash dividends to investors.  Robert Shiller, author of  the 2005 book “Irrational Exuberance”, updates the data used in his book.   These include the SP500 index, earnings, dividends, the CPI and a Price Earnings ratio that is based on the past ten years of earnings.  The current ratio of 23.80 is lower than the 2006 ratios which were in the high twenties.

But let’s look at the Price Dividend, or PD, ratio.  For the past ten years that ratio has averaged a bit less than 52, meaning that investors have been willing to pay almost 52 times the amount of the dividend to own the stock.  As of June 30th, the PD ratio stood at a bit more than 48, which means that stocks were a bit cheaper than average at this date.  Since then the market has gone up about 6% so that the PD ratio is now about 51, or just about average.

As the market makes new highs, investors are prone to ask themselves if the price they are paying for stocks is too high.  The long term investor might take a different perspective and ask themselves, “How will I feel in ten years if I continued to put money into the stock market now?”  Ten years from now, in the year 2023, the answer will be “Well, I didn’t get a deal and I didn’t overpay based on the information available at the time.  I paid about average.”

McGraw-Hill, the publisher of the SP500 market index, also keeps an index of dividends.

Dividend growth has plateaued and is about a third of earnings, which means that companies are paying a third of their earnings back to investors in the form of dividends.  This is just slightly more than the median for the past ten years.

There was a lot of data to digest in this past week.  The GDP estimates for the 2nd quarter was a sluggish 1.7%, more than the expectation of 1.1%.  But – always that but – the 1st quarter GDP growth was revised down from 1.7% to 1.1%.

On Thursday, the same day as the ISM manufacturing report, came the monthly report on auto sales.  Total sales of light weight vehicles, which includes cars and pickups, increased about 4% this past month to an annualized amount of 16 million vehicles.

When we look at auto sales on a per capita basis, auto sales are still below 5% of the population, a level that would show me that consumer demand and the construction industry (pickup trucks) is healthy.  As we can see from the chart below, the sale of autos stayed consistently above that 5% level for more than 20 years – until the last recession began.

Employment in the production of motor vehicles and related parts is very  weak.

Although vehicle sales includes both imports and domestics, I wanted to see how many autos are sold per person employed in automotive production.  Advances in manufacturing and the mix of import and domestically made vehicles have impacted employment.

And with that, I’ll look briefly at the Employment Report for July released this past Friday.  On Wednesday, ADP reported 200,000 private jobs gained, giving a brief upward impetus to the market.  As I noted last week, caution would be the watchword of this week and that caution showed in later trading on Wednesday.  The ADP report did give some hope that the BLS employment report would show an approximate gain of that many jobs.  Instead, the employment gains from the BLS were disappointing, at 162,000.   A further disappointment were the small downward revisons in May and June’s employment gains, totalling -26,000.

The unemployment rate declined, from 7.6% to 7.4%, but for the wrong reasons.  For any number of reasons – disappointment, frustration, going back to school, retirement – 240,000 people dropped out of the work force.  This is close to the reduction of 257,000 in the ranks of the unemployed.  After declines or relative stability in the number of “drop outs” in recent months, this month’s surge was particularly disappointing.

Job gains in the core work force aged 25 -54 remains relatively flat.

While older workers continue to add jobs

Business Services and Health Care jobs continued their strong job gains but gains in the health care field have slowed from 27,000 per month in 2012 to only 16,000 in 2013.  Sit down for this one – government workers, mostly at the local level, actually gained 1,000 in July.

Despite the decline in unemployment, the tepid employment and GDP growth reports likely reassured many that the Fed is unlikely to stop or reduce their quantitative easing program in the next few months.