Employment Growth

December 29th, 2013

In several past blogs here and here, I have noted a “rule of thumb” guide to recessions based on the unemployment rate.  When the year over year percentage change in the unemployment rate goes above 0, recession smoke alarms go off.  Sorry, no phone app for this alarm. This metric sometimes indicates a recession that doesn’t quite materialize in the economic data, a false positive, although the market may react to the possibility of a recession.  Employment is but one factor in a complex economy and no one indicator can stand as a fail safe predictor of a serious enough decline in the economy that it gets labelled “recession” by the NBER.

Another related measure is the total employment level.  This employee count comes from the Establishment Survey conducted by the BLS and is the source for the monthly headline job gains or losses. To show the correlation between payroll and economic activity, I took a measure of GDP – I’ll call it active GDP – that excludes changes in business inventories and net exports.  From this I subtracted the change in real household debt in each quarter.  This measure of economic activity reflects what consumers can actually pay for.  Below is a chart of the yearly change in this adjusted measure of GDP and the number of people working.  There is a remarkable correlation.

As I will show below, the employment market has not fallen into an unsafe zone but the decline in growth of domestic demand indicates a fragility that should not be overlooked.  Comparing the number of people working to the 12 month average reveals trends and weaknesses in the economy.  Historically, when the number of workers falls below its 12 month average we are almost certainly in a recession.  As of now employment is maintaining a healthy but not robust growth rate.

When the difference between the monthly count of people working and its 12 month average (I’ll call it DIFF) falls below 1% (I’l call it WEAK), it shows a pre-recession weakness in the economy. In past decades, this DIFF might fall to .75% before recovering, a temporary weakness.  Since June 2000, employment growth has been in a WEAK state, never recovering above 1%.  Following the dot com bust in 2000, 2001 included an 8 month recession, the admittance of  China to the World Trade Organization and the sucking up of low skilled manufacturing jobs, and the horrific events of 9-11.  For two years the country endured a painfully slow and fitful recovery, prompting a Republican Congress to pass  what are called the Bush tax cuts.  Neither tax cuts or the overheated housing market of the mid 2000s could kick the DIFF above 1% although it got very close for a number of months in late 2005 and early 2006 as the housing market peaked.

When the DIFF falls below 500, we can mark fairly closely the beginnings and ends of recessions as they are called by the NBER many months later.

It is important to note that historical data is already revised data.  We must make investment decisions with the data available at the time. (See an earlier blog for some examples of revisions to payroll data.)

This week’s reports were generally better than expected.  These included durable goods orders, sales of new homes, personal income and spending.  Housing prices, as shown by the FHFA purchase only index, are maintaining an 8% year over year change.  Over the past quarter century, housing prices have followed a 3.2% annualized growth rate.

In previous blogs, I have examined the PCE inflation measure that routinely produces the lowest rate of inflation.  This is not the headline CPI index but is used to produce what is called a chain type price index.  Inflation estimates based on this indicator showed 0% inflation in November and less than 1% for an entire year.  Isn’t that great?  Rents, food, utility bills, insurances have barely increased over the past year.  Yes, I know you are ROFL until you realize that the joke is on you, on all of us.


Let’s get in the wayback machine and go back to early 2007 when the Bush administration released their estimate of GDP for the years 2007 – 2013.  Every Presidential budget indulges in the folly of predicting the future economic growth of the largest economy in the world.  When we dig into the figures, the process is rather simple.  These estimates simply take actual figures from 2006 and calculate 5% annual growth in nominal GDP.  Any of us could do this with an Excel spreadsheet.   An unemployment rate below 5% is rather infrequent and unlikely to continue for very long but the Bush Administration projected that this sub-5%level would continue for another six years.  If your 12 year old came to you with these calculations, you would probably praise them for their effort and smile inwardly at the innocence of the projections.  You wouldn’t tell your twelve year old that things don’t stay rosy indefinitely because they will find that out in due time.  This kind of middle school mentality is what passes for wisdom in Washington.

In the course of our lives, how many times do we come to a carefully calculated answer only to step back and say “Well, that can’t be.  Something’s wrong.”  It seems that there are few in Washington who doubt themselves.  The polarization in Washington means that everyone in any position of responsibility has many critics on the other side of an issue.  Each one then surrounds themselves with others who support their position, their values, their calculations.  There is no stepping back and saying, “Wait, is that right?” The revolving door in Washington ensures that many politicians have little to lose even if they lose their seats.  Many soon find an even more lucrative position in the private lobbying industry.  What they do lose is the ability to wake up in the morning, look in the mirror and say, “I’m important.”  Lose a bit of arrogance, gain a bit of humility.  Not such a bad tradeoff.

The investor who puts his own money at risk, who has skin in the game, as the economist Nassim Taleb calls it, can not afford to NOT step back and take a second look at their investment strategies and allocations.  As we complete another lap, this is a good time to recheck and rebalance.  The 25+% gains in the stock market have probably skewed the allocations of many an individual’s portfolio.  Here’s hoping everyone has a good year!

GDP, Profits, Inflation

December 22nd, 2013

Merry Christmas!

Last week I reviewed several decades of trends in corporate profits, as well as the 1990 change in measuring inflation that has helped increase corporate profits as a share of GDP.   (For those of you interested in the inflation controversy, here is an article that provides some additional insight.)  This week I’ll look at patterns in the economic growth of this country that sheds some light on recent events and provides some context to understand ongoing trends.

During the 30 years following World War 2, the economy grew at an annual rate of 3.7% after inflation.  Population growth was about 1% per year.  Productivity growth was about 1 – 1.5%.  Government spending, including debt, grew a bit more than 1%.  The chart below shows the compounded annual growth rate.

But I think the story is more clearly told by a different chart constructed from the same data.  The growth rate trend is more easily visible and it is the change in this trend that I will be focusing on.

During the 1970s, an economic trend known as staflation increasingly took hold. This period of high inflation, coupled with slowing growth and growing unemployment, was not thought possible by economists using theories proposed by John Maynard Keynes in the 1930s, during the Great Depression.  In 1974, economist Arthur Laffer first sketched out a theory that tax cuts would stimulate the economy.  As the Federal debt began to rise in the mid to late 1970s, few wanted to take a chance that lower tax rates would produce more revenue for the Federal Government.

The 1980s began with back to back recessions and the highest unemployment since the 1930s Depression. Big spending and tax cuts during the 1980s dramatically increased the federal debt but did little  to spur growth.

During this 13 year period, profit growth slowed to 2.4%.  The myth that the 1980s was a high growth era continues to live in the minds of political pundits.  In a WSJ op-ed on Dec. 18th, Daniel Henninger referred to “the high-growth years of the Reagan presidency.”  Myths live on because they serve a purpose to those who cherish them.  The cardinal rule of politics is “Disregard the Data.”

In 1990, economists at the BLS adopted what is called a hedonic methodology to computing the CPI.  Used by other OECD countries, this supposedly more accurate assessment of the growth of inflation shows a lower growth rate of inflation.  This naturally increases the growth rate of inflation adjusted GDP. (GDP dollars each year are divided by the inflation rate to get the real growth rate.)

The conventional narrative is that the 1990s was an explosive growth period of new technology and growing globalization.  From the beginning of 1990 to the start of 2000, stock market values grew four times.  After the bursting of the internet bubble, 9-11, and the recession of 2001, the economy recovered.  By the mid-2000s, the unemployment rate was less than 5%.  While that may be the conventional narrative, the growth of the economy from 1990 to 2007 was just as slow as the period 1978 – 1989.

Remember that this slow growth would have been even slower if the BLS had not changed their methodology for measuring inflation.  To recap, the 30 year real growth rate of GDP after WW2 was 3.7%.  The following 30 year growth rate was 2.3%.  But that later 30 period is marked by a sharp rise in consumer borrowing.   Without that escalation in borrowing, growth would have been meager.

Families with two incomes borrowed against their homes, drove up the balances on their credit cards and still GDP growth was slow.  Let’s construct a fairy tale, what economists call a counterfactual.  What if the BLS had not changed to this new methodology in 1990?  What would be the growth rate of GDP using an alternate measure of inflation?

The resulting growth pattern is 0% for the 18 year period and is more consistent with the experiences of many workers and families in this economy.  The change in the measurement of inflation has greatly helped mid-size and large size companies.  An understated inflation rate reduces labor costs by reducing cost of living adjustments to salaries and wages.  In addition, companies can borrow at lower rates since many corporate bonds are tied to the inflation rate.  American companies did not engineer this revised methodology of measuring inflation but they have been the largest beneficiaries of the new policy.

In 2008, the financial poop in the popcorn popper began to pop.  In the past 5+ years, we have experienced less than 1% real growth, not enough to keep up with population growth.  Of course, most people are wondering “what growth? It sure doesn’t feel like growth!”

The story may be told more accurately by looking once again at a comparison of inflation adjusted GDP with an alternate version of GDP, one that more realistically reflects inflationary pressures.  This chart shows a decrease of 2% per year.

Did the BLS adopt this methodology under political pressure?  Perhaps.  More likely, it was an alignment of econometric theory with political and corporate interests.  The reduction in published inflation rates did slow the growth of payments to Social Security recipients and reduced Medicare payouts to physicians and hospitals, thus shrinking budget deficits.  The government saves money, corporations make extra money, but – quietly and slowly – families lose money.

Annual cost of living adjustments to Social Security checks have been reduced but the decreased income has forced more seniors to seek assistance through the food stamp program, now called SNAP.  A politically neutral change in the measurement of inflation thus becomes a way for politicians to introduce a means testing component to Social Security income.  Instead of reducing payments based on income, payments are reduced to all recipients and poor seniors are targeted for additional benefits.  Congress has increased eligibility for the food stamp program so that seniors who are dependent on that extra income can receive it in the form of food stamps.  If the BLS had not changed their methodology, seniors would receive appoximately 60% more each month and many wouldn’t need the food stamps in the first place.

With this history in mind, let’s turn to this week’s revisions of GDP and corporate profits for the third quarter ending in September.  The real, or inflation-adjusted, growth of 3rd quarter GDP was raised to a 4.1% annualized growth rate in the third quarter, largely on upward revisions of consumer spending.  Contributing to stronger GDP growth has been a worrisome increase in company inventories, which probably influenced the Federal Reserve’s decision this week to keep any tapering of their QE bond purchases to a minimum.

Corporate profits for the third quarter were revised higher as well.  As a share of GDP, corporate profits continue to reach all time highs.

How likely is it that economists at the BLS will change their methodology to reflect inflationary pressures before we make choices in response to rising prices?  The subject is not easily encapsulated in a sound bite or a short slogan on a placard.  In the 1992 presidential race, independent candidate Ross Pierot was able to use charts to make a point with many voters but few politicians are very good at the easel and unlikely to bring up the subject in the public forum.  Families and workers will continue to suffer and politicians will create more social benefit programs to help those hurt by problems that politicians themselves have either created or failed to address.  Large and mid sized businesses will continue to enjoy the additional slice of pie.

Retail Sales and Inflation

December 15th, 2013

Retail sales rose .7% in November, posting year over year (y-o-y) gains of almost 5%.  The twenty year average of y-o-y gains is 4.6%.  When we remove the eleven monthly outliers with gains of more than 10% or less than -10%, the average is 5.0%

Now let’s compare the percentage change in GDP with the change in retail sales.

The change in GDP is like a smoothed average of the change in retail sales, so the continuing willingness of consumers to spend is a positive for both GDP growth and the market in the mid-term outlook.


In March 2009, incoming President Obama pledged that his administration was going to support small businesses which employ 1/2 the workforce and contribute 40% to GDP. (CBS News article  Note: The article incorrectly states that small businesses employ 70% of the workforce.) A recent report, short and written in plain English, by the Cleveland Federal Reserve compares levels of lending to small businesses in 2013 vs 2007.  Five years after the financial crisis, six years after the start of the recession, loans to small businesses are only 80% of 2007 levels.  Impacting the start up of small companies has been the decline in home values.  Home equity provides the funding for most small business start ups.

A graph from the report illustrates the long term decline of small business lending.  As the banking sector has consolidated over the past twenty years, the mega-banks have less incentive to “take a chance” on small businesses.

As I watch Senate and House hearings on C-Span (yes, I know I have a problem), I am struck by how many members of Congress appear to be on a mission.  While at times Washington seems to be a town of political prostitutes, it may be more accurate to describe it as a town of missionaries.  These dedicated men and women come to Washington with a plan to save the souls of the American people – or at least that’s the way they like to present themselves.  Nancy Pelosi and other prominent Democrats give voice to the plight of the long term unemployed but rarely mention small business owners.  A 50 year old guy who can’t find a job because his skills are out of date is a topic of concern to Democrats.  But what about the 50 year old who can’t start up a business because the drop in housing prices has diminished the equity of many home owners?  Republicans mention small businesses only when bashing Obamacare.  Why has there been so little attention paid to this rather large part of the economy?  Why aren’t the banks being subpoenaed to appear before a Congressional subcommittee?  Many Presidents seem to spend their second terms answering for the broken promises of their first term.  Finally, after eight years, voters turn to a new guy, hoping that this one will be different.  Hope, or foolishness, triumphs in the hearts of voters.


Now I’ll take a look at a contentious subject, the measurement of inflation.  A comprehensive review of the inflation measurement is far beyond my skills and a blog.  The CPI produced by the Bureau of Labor Statistics is the official measurement of inflation to adjust Social Security payments each year.  I want to come at the subject from a different viewpoint – corporate profits. Starting in 1990, the Bureau of Labor Statistics (BLS) adopted a new way of measuring inflation, introducing what is called a hedonic adjustment. Coincidentally, corporate profits began to surge shortly thereafter.  Below is a graph showing inflation adjusted profits.

Adjusting for population growth, the surge in per capita profits confirms the trend.

As I noted in September, corporate profits as a percent of GDP are at historically high levels.

In a FAQ sheet, the BLS explains their methodology in plain language and refutes the claim that hedonic adjustments have any significant impact on the CPI measurement. I have also discussed another measure of inflation, the PCE deflator.  Here is a working paper by an economist at the Federal Reserve on the PCE measurement.

For years, John Williams of Shadow Government Statistics (SGS) has painstakingly maintained an alternate data set of the CPI.  Here’s a graph from that page to give you an idea.

As you can see, the official measure of inflation is about 2 – 3% below the CPI that Williams produces using the pre-1990 methodology.  Essentially, hedonic adjustments measure inflation after consumers have adjusted to inflationary price pressures.  Let’s say that a family eats steak twice a week.  Steak then goes up in price by 20%.  To stay within their budget, a family might substitute hamburger for one of those meals.  The old method of measuring inflation would capture the 20% rise in the price of steak.  The post-1990 method does not capture all of that rise because it allows for the substitution effect.

Several reasons have been given for the dramatic rise in corporate profits since 1990.  These include globalization, technology, and increased productivity of both labor and capital.  As I wrote about in August, multi-factorial productivity has only increased 12% in the 12 years from 2000 – 2012, an annual gain of less than 1%.  Technological progress occurred in almost every decade of the past century, yet average economic growth is about 3% over those one hundred years – a remarkable consistency.  Globalization has helped and hurt domestic companies, enabling them to reduce costs but also increasing the competition from firms around the world.  Have companies found some magic key in the past twenty years?

The magic key may be the change in the CPI methodology. What if the CPI understates inflationary pressures by 2 – 3% each year?  What effects would that have?  Interest rates would be reduced, lowering the costs of borrowing for companies.  There would be less pressure from labor for wage increases.  These two factors figure heavily in the profits of many large companies. (Interest expense for GE is more than a third of their operating income ).  There is yet another effect: real profits adjusted for this higher inflation rate, would simply not be so dramatic.

Since 1990, per capita corporate profits have risen about 7.6% per year.

Now let’s adjust per capita profits for inflation using the official CPI and a higher inflation rate that is closer to the inflation measures that SGS compiles.

What we see is approximately 3% real growth in per capita profits since 1990.  This is quadruple the .75% growth rate of corporate profits for the thirty year period from 1959 – 1989.

The 30 year average was hurt by the 4% decline in inflation and population adjusted profits during the 1980s.  This decline undermines the conventional narrative that the 1980s were a big growth boom for companies.  The 50 year average of this real profit growth is 2.5%.  As a rule of thumb then, we can guesstimate inflationary pressures on consumers as the nominal rate of profit growth less 2.5%.  Let’s look at a chart I showed earlier.

The 7.6% nominal growth rate of profits less 2.5% gives us an average inflation rate of close to 5% for the past 23 years.  This different methodology lends more credence to the higher CPI calculations that SGS presents. Compare this to the 2.5% average that the BLS calculates for this time period.

Small changes in methodology add up over time.  While this “back of the envelope” method of computing inflation does not meet the rigor that Williams brings to his calculations, it does illustrate the difference in inflationary pressures that many families feel.  Here’s a comparison of the two indexes.

Now comes the juicy part and I will keep my voice low.  There is a conspiracy theory floating around that, in the late 1980s, the politicians in Washington were pressured by businesses to have the BLS revise their methodology to reduce rising labor costs which were hurting profits. Another theory says that Congress wanted to curb the annual CPI increases in Social Security and Medicare payments and secretly ordered the BLS to come up with a way to revise the CPI down.  In 50 years, financial historians may discover that both of these theories have some substance.

Whatever the “real” reason for the change in methodology, those who are dependent on retirement income indexed to the CPI should keep in mind that unmeasured inflationary pressures may eat an additional  2 – 3% out of their retirement savings base and income.

Winter Wonderland

December 8th, 2013

The Bureau of Labor Statistics rode down like Santy Claus on the arctic front that descended on a large part of the U.S. The monthly labor report showed a net gain of 203,000 jobs in November, below the 215,000 private job gains estimated by ADP earlier in the week, but 10% higher than consensus forecasts.  Thirty eight months of consecutive monthly job growth shows that either:

1) President Obama is an American hero who has steered this country out of the worst recession – wait, let me capitalize that – the worst Recession since the Great Depression, or

2) American businesses and Republican leadership in the House have overcome the policies of the worst President in the history of the United States. 

Hey, we got some Hyperbole served fresh and hot courtesy of our radio and TV!

The unemployment rate dropped to 7.0% for the right reasons, i.e. more people working, rather than the wrong reasons, i.e. job seekers simply giving up.  The combination of continued strong job gains and a big jump in consumer confidence caused the market to go “Wheeee!”


A broader measure of unemployment which includes those who want work but haven’t looked for a job in the past four weeks declined to 7.5%.  This is still above the high marks of the recessions of the early 90s and 2000s.


Construction employment suffered severe declines after the collapse of the housing bubble.  We are concerned not only with the level of employment but the momentum of job growth as the sector heals.  A slowing of momentum in 2012 probably factored into the Fed’s decision to start another round of QE in the fall of last year.


Job gains were broad, including many sectors except federal employment, which declined 7,000. Average hours worked per week rose by a tenth to 34.5 hours and average hourly pay rose a few cents to $24.15.

Discouraged job seekers are declining as well.  The number of involuntary part time workers fell by 331,000 to 7.7 million in November.  As shown in graph below, the decline is sure but slow.


There are still some persistent trends  of slow growth.  Job gains in the core work force aged 25 -54 are practically non-existent.


The percentage of the labor force that is working edged up after severe declines this year but the trend is down, down and more down.


The number of people working as a percent of the total population has flatlined.


Let’s turn to two sectors, construction and manufacturing, which primarily employ men.  The ratio of working men to the male population continues to decline.  Look at the pattern over 60 years: a decline followed by a leveling before the next decline, and so on.  Contributing to this decline is the fact that men are living longer due to more advanced medical care and a fall in cigarette smoking.


The taxes of working people have to pay for a lot of social programs and benefits that they didn’t have to pay for thirty years ago.  Where will the money come from?  A talk show host has an easy solution: tax the the Koch Brothers, cut farm subsidies to big corporations and defense.  Taking all the income from the Kochs and cutting farm subsidies and defense by half will produce approximately $560 billion, not enough to make up for this year’s budget deficit, the lowest in 4 years.  What else?


In a healing job market, those aged 16 and up who are not in the labor force as a percent of the total population  continues to climb.


A familiar refrain is the steady decline in manufacturing employment.  Recently the decline has been arrested and there is even slight growth in this sector.  Although construction is regarded as a separate sector, construction is a type of manufacturing.  Both employment sectors appeal to a similar type of person.  Both manufacturing and construction have become more sophisticated, requiring a greater degree of specialized knowledge.  Let’s look at employment trends in these two sectors and how they complement each other.

During the 90s, a rise in construction jobs helped offset moribund growth in manufacturing employment.

In 2001, China became a member of the World Trade Organization (WTO) , enabling many manufacturers to ship many lower skilled jobs to China.  At the same time, a recession and the horrific events of 9/11 halted growth in the construction sector so that there was not any offset to the decline in manufacturing jobs.

As the economy began recovering in late 2003, the rise in construction jobs more than offset the steadily declining employment in the manufacturing sector.  People losing their jobs in manufacturing could transition into the construction trades.

As the housing sector slowed, construction jobs declined and the double whammy of losses in both sectors had a devastating effect on male employment.

In the past three years, both sectors have improved.

Although the Labor Dept separates two sectors, we can get a more accurate picture of a trend by combining sectors.


In the debate over the effectiveness of government stimulus, there is a type of straw man example proposed:  what if the government were to pay people to dig holes, then pay other people to fill in the holes?  Proponents of Keynesian economics and government stimulus argue that such a policy would help the economy.  Employed workers would spend that money and boost the economy. Those of the Austrian school argue that it would not.  Digging and filling holes has no productive value.  Ultimately it is tax revenues that must pay for that unproductive work.  Therefore, digging and filling holes would hurt the economy.

So, let’s take a look at unemployment insurance through a different set of glasses.  Politicians and the voters like to attach the words “insurance” and “program” to all sorts of government spending.  Regardless of what we call it, unemployment insurance is essentially paying people to dig and fill holes – except that the holes are imaginary.  IRS regulations state that unemployment benefits are income, that they should be included in gross income just as one would include wages, salaries and many other income.

If unemployment is income, how many workers do the various unemployment programs “hire” each year?  Unemployment benefits  vary by state, ranging from 1/2 to 2/3 of one’s weekly wage. (Example in New Jersey)  As anyone who has been on unemployment insurance can verify, it is tough to live on unemployment benefits. I used the average weekly earnings for people in private industry and multiplied that by 32 weeks to get an average pay, as though governments were hiring part time workers.  I then divided unemployment benefits paid each year by this average.  Note that the divisor, average pay, is higher than the median pay, so this conservatively understates the number of workers that are “hired” each year by state and federal governments.

What is the effect of “hiring” these workers?  I showed the adjusted total (blue) and the unadjusted total of unemployed and involuntary part time workers.  The green circle in the graph below illustrates the effect that extensions of unemployment insurance had on a really large number of unemployed people.

At its worst in the second quarter of 2009, the unemployed plus those involuntary part timers totaled 24 million, almost 16% of those in the labor force.  8 million were effectively “hired” to dig imaginary holes.  In the long run, what will be the net effect of paying people to dig holes and fill them?  First of all, a politician can’t indulge in long run thinking.  In a crisis, most politicians will sacrifice long run growth so that they can appease the voters and keep their own jobs.

In the long run, ten years for example, paying people to do nothing productive will hurt the economy.  The argument is how much?   Keynes himself wrote that his theory of stimulus and demand only worked when there was a short run fall in demand.  At the time Keynes wrote his “General Theory,” the world economy was floundering around in a severe depression.  The severe crisis of the Depression birthed a theory that divided the economists into two groups: the tinkerers and the non-tinkerers.  Keynesian economists believe in tinkering, that adjusting the carburetor of the economic engine will get that baby purring.  Austrian or classical economists keep asking the Keynesians to stop messing with the carburetor; that all these adjustments only make the economy worse in the long run.


The November report from the Institute for Supply Management (ISM) showed strong to robust growth in the both the manufacturing and services sectors.  As I noted this past week, I was expecting the composite CWI index of these reports that I have been tracking to follow the pattern it has shown for the past three years.  Within this expansion, there is a wave like formation of surging growth followed by an easing period that has become shorter and shorter, indicating a growing consistency in growth.  The peak to peak time span has decreased from 13 months, to 11 months to 7 months.  The index showed a peak in September and October so the slight decline is following the pattern.   IF – a big if – the pattern continues, we might expect another peak in April to May of 2014.

To get some context, here’s a ten year graph of the CWI vs the SP500 index.


As the stock market makes new highs each week, some financial pundits get out of bed each morning, saddle up their horses, load up their latest book in the saddle bags and ride through TV land yelling “The crash is coming, the crash is coming.”  Few people would listen to them if they shouted “Buy my book, buy my book.”  They sell a lot more books yelling about the crash.

How frothy is the market?  I took the log of the SP500 index since January 1980 and adjusted it for inflation using the CPI index.  I then plotted out what the index would be if it grew at a steady annualized rate of 5.2%.   Take 5.2%, add in 3% average inflation and 2% dividends and we get the average 10% growth of the stock market over the past 100 years.  The market doesn’t look too frothy from this perspective.  In fact, the financial crisis brought the market back to reality and since then, we have followed this 100 year growth rate.

Now, let’s crank up the wayback machine.  It’s November 1973.  Despite the signing of the Paris Peace accord and an act of Congress to end the Vietnam war, thousands of young American men are still dying in Vietnam.  The Watergate hearings continue to reveal evidence that President Nixon was involved in the break in of the Democratic National Committee and the subsequent attempts to cover it up.  Rip Van Winkle is disgusted.  “This country is going to the dogs,” he mutters to himself.  He lies down to take a nap in an alleyway of the theater district of New York City.  The SP500 index is just below 100.  Well, Rip doesn’t wake up for 20 years.  In November 1993, he wakes up, walks out on Broadway and grabs a paper out of nearby newspaper machine.  The SP500 index is 462.  Rip doesn’t have a calculator but can see that the index has doubled a bit more than twice in that time.  Using the rule of 72 (look it up), Rip estimates that the stock market has grown about 8% per year.  Which is just about normal.  But normal is what Rip left behind in 1973.  “Normal” is SNAFU.  So he goes back into the alleyway and goes back to sleep for another twenty years, waking up just this past month.  He walks out on Broadway and reads that the index has passed 1800.  “Harumph” Rip snorts.  That’s two doublings in twenty years, a growth rate of a little over 7%.  Rip reasons that eventually he’ll wake up, the country will have mended its ways and Rip will notice a growth rate of 9 – 10% in the market index.  He goes back to sleep.

In the 40 years that Rip has been asleep, we have had three bad recessions in the 70s, 80s and 2000s, a savings and loan crisis in the 80s, an internet bubble, a housing bubble, and the mother of all financial crises.  Yet the market plods along, slowing a bit, speeding up a bit.  Long term investors needs to take a Rip Van Winkle perspective.


And now, let’s hop in the wayback machine – well, a little ways back.  Shocks happen.  During periods when the market is relatively well behaved as it has been this year, investors get lulled into a sense of well being.  From July 2006 through February 2007, the stock market rose 20%.  Steadily and surely it climbed.  Housing prices had already reached a peak and the growth of corporate profits was slowing. Some market watchers cautioned that fundamentals did not support market valuations. At the end of February 2007, the Chinese government announced steps to curb excessive speculation in the Shanghai stock market (CNN article).  The stocks of Chinese companies tumbled almost 10%, sending shocks through markets around the world.  The U.S. stock market dropped more than 5% in a week.

“Here comes the crash” was the cry from some. The crash didn’t come.  Over the next six months, the market climbed 16%.  Finally, continuing declines in home sales and prices, growing mortgage defaults and poor company earnings began to eat away at the market in October 2007.  Remember, there is still almost a year to the big crash in September and October of 2008.


Next week I’ll put on a different shade of glasses to look at inflation.  Cold air, go back to the North Pole.

Investing, New Orders, Small Business

December 4th, 2013

This will be a mid-week post of various items I thought were interesting.  The private payroll processor ADP is showing private employment growth 215,000, about 15% above expectations.  This weekend, I’ll cover the employment situation and some long term trends.

When we buy bonds, we are buying someone’s debt. Really what we are buying is the likelihood that they will pay that debt.  When we buy stocks, we are buying someone’s profits – or the future prospects of those profits.  The S&P500 is an index of the 500 largest domestic corporations.  The BEA tracks the profits of all domestic corporations, not just the 500 largest, before tax adjustments. It is rather interesting to look at the ratio of the SP500 index to corporate profits, in billions.

Using this metric, the exuberance of the internet bubble is striking, far surpassing the housing bubble of the 2000s. It was a time when investment was high in the new digital economy.  The ingenuity of man had finally overcome the business cycle.   The ratio of stock prices to profits didn’t matter because profits were about to go through the roof, man!

Well, it would take a while but eventually profits did go through the roof.  It took a few years.  As a percentage of the nation’s GDP, corporation profits are near 11%.

So pick the story you want to tell.  1) Stocks are undervalued based on historical ratios of prices to profits.  2) Stocks are going to crash because corporate profits are too much a percentage of the economy, an unsustainable situation.  Both narratives are out there in the business press.


New orders for non-defense capital goods excluding aircraft has been declining of late.

Below is a chart showing the year over year percent gains in new orders and the SP500 index.  There is a loose correlation.  The stock market is usually responding to predictions of future activity as well as political and financial news.   I modified the changes in the SP500 by a little more than half to show the overall trend.


In 2012, households finally surpassed 2007 levels of net worth.   In the past five years, household assets have risen by a third, more than $14 trillion dollars. More than half of that increase is the rise in stock asset values. In that same period, liabilities have decreased slightly from the $20 trillion.  All of the decrease and more is in mortgages.  This table shows the unsustainable growth in net worth during the housing boom.

Check out the growth in household debt during the housing boom.  Over 10% per year!  Now look at the growth in Federal debt.  There are only two years where it falls below 5%.  Someone once said something like “What can’t go on forever, won’t”.  How long can a government increase its debt 4x, 5x, 10x the rate of inflation or the rate of economic growth?


A short and very informative book on investing by William Bernstein.

Deep Risk: How History Informs Portfolio Design (Investing for Adults)
William Bernstein


Words of caution:

“A government big enough to give you everything you want is a government big enough to take from you everything you have.” – Gerald Ford


Gallup’s survey of consumer spending in November was the strongest November in 5 years.  On the other hand, early reports of the y-o-y gains in retail spending over the 4 day Thanksgiving weekend indicated a meager 2.3%, barely above inflation.  Same store sales at department stores declined -2.8% in the Thanksgiving/Black Friday week, although they are up 2.5% year over year.  As I wrote about two weeks ago, online shopping is now a significant portion, 20%, of total retail sales.  A more complete feel for the consumer’s mood must include sales on Cyber Monday, the Monday after Thanksgiving.  These showed exceptional gains of 17% over last year’s numbers.


ISM’s Manufacturing index was 57.3, the strongest in 2-1/2 years.  I’ll update the CWI after I input today’s numbers from the non-manufacturing report.  I was expecting a slight tapering in the composite.  As we saw a few weeks ago, there has been a positive wavelike action and it appeared as though the economy had hit a crest in October.


In 2010, the Census Bureau reported that there were 5.7 million employers (those with payroll, as opposed to sole proprietors), a decrease of 300,000 from the 6 million employers the Census Bureau counted in 2007.  About 5.1 million employers had less than 20 employees and accounted for 14% of the $5 trillion in payroll. Those small to mid-size companies with 20 to 99 employees accounted for another 14% of payroll.  Mega-employers, those with 500 or more employees, paid out about 57% of total payroll in 2010 and constitute a little more than half of private employment.  These large employers naturally have more influence on policy makers in Washington and in state capitols throughout the nation.


The National Federation of Independent Businesses’ (NFIB) recent monthly survey reported a fairly sharp decline in sentiment among small business owners. A hopeful sign in this report is the improvement in expectations for future sales.  Sentiment was particularly depressed over the shenanigans in Washington and pessimism towards the regulatory environmnent is near all time highs. A blend of small cap stocks has risen about 36% in the past year.  Small cap value stocks have soared 40%.

An interesting historical note from the Social Security administration.  As  preamble, Social Security taxes are collected and put in a “separate” accounting fund before they are immediately “borrowed” for the general spending needs of the Federal government.

 President Roosevelt strenuously objected to any attempt to introduce general revenue funding into the program. His famous quote on the importance of the payroll taxes was: “We put those payroll contributions there so as to give the contributors a legal, moral, and political right to collect their pensions and unemployment benefits. With those taxes in there, no damn politician can ever scrap my social security program.” 

In 1937, the Supreme Court ruled that the Social Security Act was constitutional.  The majority opinion, penned by Justice Cardozo: “The hope behind this statute [the Social Security Act] is to save men and women from the rigors of the poor house as well as from the haunting fear that such a lot awaits them when journey’s end is near.”


Quite often, our auto or homeowner’s insurance company changes insurance plans on us.  The insurance company sends us a notice that, due to legislative changes or revised company policy, there is a new codicil to all insurance contracts.  Premiums may go up.  The insurance company’s liability may be reduced. Your old plan is being cancelled and reissued with a “-1A” after the policy number. Some of us may skim read the new changes, most of us shrug and sign the new contract and that is the end of the story.  Imagine the headlines: “MINIMUM DEDUCTIBLE RAISED TO 1% OF HOME’S VALUE.  ALL HOMEOWNERS’ INSURANCE CONTRACTS CANCELLED.”  This is what happens.  The old insurance contract is no longer available.

What is the response when the same thing happens to private health insurance  plans under Obamacare?  “Obamacare Forces over 800,000 in N.J. to change insurance plans” is the bold caption of one news story.  People who are unsympathetic to the new health care law will not make the distinction between “insurance plan” and “insurance carrier.”

Investment Allocation and Housing

December 1st, 2013

While cleaning up some old files, I found a 1999 “Getting Going” column by Jonathan Clemens in the Wall St. Journal.  That year was rather turbulent, rocked by Y2K fears that the year 2000 might play havoc with older computers still using a two digit date,  and a intensifying debate about the valuation of stocks.  Looking away from the hot internet IPOs of that year,  Clemens interviewed several professors about the comparatively mundane subject of home ownership.

 “A house is not a conservative investment,” says Chris Mayer, a real-estate professor at the University of Pennsylvania’sWharton School. “Any market where prices can fall 40% in three years is not a safe investment.” 

Remember, this is 1999.  At that time, what 40% decline is he talking about?  It would not be till 2009 or 2010 that house prices tumbled down the hill.  In the past, declines of this magnitude were confined to particular areas of the country where a fundamental shift  in the economy occurred.  The Pittsburgh area of Pennsylvania, the Pueblo area of Colorado and the Detroit area of Michigan come to mind. In the first two examples the collapse of the steel industry had a profound effect on home prices as people moved to other areas to find work.  In case a homeowner thinks “it can’t happen here,” I’m sure many homeowners in Detroit felt the same way during the 1960s when the car industry was at its peak.

“William Reichenstein, an investments professor at Baylor University in Waco, Texas, suggests treating your mortgage as a negative position in bonds.”  

What does this mean?  Let’s say a person has $100K in stock mutual funds, $100K in bond mutual funds, owns a house valued at $200K with $100K still left on the mortgage.  Subtract the remaining balance of the mortgage from the amount in bonds and that leaves $0 invested in bonds.  Why do this?  When we buy a bond we are buying the debt of a company, or some government entity.  A mortgage is a debt we owe.  So, if a person were to pay off the mortgage, trading one debt for another, they would sell their bonds to pay off the mortgage.

Should the house be included in the investment mix?  There is some disagreement on this.  An investment portfolio should include only those assets which a person could access for some cash flow if there was a loss of income or some other need for cash.  An older couple with a 5 BR house who intend to downsize in five years might include a portion of the house in the portfolio mix.

For this example, let’s leave the house out of the investment portfolio to keep it simple. Using this analysis, this hypothetical person has 100% of their assets in stocks, not a 50/50 mix of stocks and bonds.

Now, let’s fast forward ten years from 1999 to 2009.  An index mutual fund of stocks has lost a bit more than 20%.

A long term bond fund has gained about 100%.

[The text below has been revised to reflect the above bond fund chart.  The original text presented numbers for a different bond fund.]

Let’s say the mortgage principal has been paid down $60K over those ten years.  Assuming that no new investments have been made in the ten year period, what is this person’s investment mix now?  The stock portion is worth $80K, the bonds $200K less $40K still owed on the mortgage for a total of $240K, with a net exposure in bonds of $160K.  The person now has 33% (80K / 240K) in stocks and 67% in bonds, a conservative mix.  If we didn’t account for the mortgage as a negative bond, the mix would appear to be 29% (80K / 280K) for stocks and 71% for bonds.  What is the net effect of treating a mortgage balance as a negative bond?  It reduces the appearance of safety in an investment portfolio.

Now let’s imagine that this person is going to retire and collect a monthly Social Security check of $1500.  To get a 15 year annuity paying that monthly amount with a 3% growth rate, a person would have to give an insurance company about $220K (Calculator)   There are a lot of annuity variations and riders but I’ll just keep this simple.  Throughout our working lives our Social Security taxes are essentially buying Treasury bonds that we start cashing out during retirement.

If we were to add $220K to our hypothetical investment mix,  we would have a total of $460K: $80K in stock mutual funds, $200K in bond funds, -$40K still owed on the mortgage, $220K effectively in Treasury bonds that we will withdraw as Social Security payments.  The $80K in stock mutual funds now represents only 17% of our investment portfolio, an extremely conservative risk stance.  If we have a private pension plan, the mix can get even more conservative.

The point of this article was that many people in their 50s and 60s may have too little exposure to stocks if they don’t account for mortgages, pensions and Social Security payments into their allocation calculations.


In October 2005, the incoming Chairman of the Federal Reserve, Ben Bernanke, indicated to Congress that he did not think there was a bubble developing in the housing market. (Washington Post Source)

In September 2005 – a month before – the Federal Reserve Bank of New York published a report on the rapid housing price increases of the past decade:

Between 1975 and 1995, real [that is, inflation adjusted] single-family house prices in the United States increased an average of 0.5 percent per year, or 10 percent over the course of two decades. By contrast, from 1995 to 2004, national real house prices grew 3.6 percent per year, a more than seven-fold increase in the annual rate of real appreciation, and totaling nearly 40 percent in one decade. In some individual cities, such as San Francisco and Boston, real home prices grew about 75 percent from 1995 to 2004, almost double the national average. 

Remember, these are real, or inflation adjusted prices.  Now it is easy, in hindsight, to go “ah-ha!” but it should be a lesson to us all that we can not possibly hope to consume all the information needed to mitigate risk.  There is just too much information.  A professional risk manager, Riccardo Rebonato, discusses common flaws in risk assessment in his book “Plight of the Fortune Tellers” (Amazon). Written before the financial crisis, the book is surprisingly prescient.  The ideas are accessible and there is little if any math.

On Monday, the National Assn of Realtors released their pending home sales index. These are signed contracts on single family homes, condos, and townhomes. The index has declined for five months but is still slightly above normal (100) at 102.1.  At the height of the housing bubble, this index reached almost 130.  At the trough in 2010, the index was below 80.

This chart was clipped from a video by an economist at NAR (Click on the video link on the right side of the page).  The clear and simple explanation of trends in housing and interest rates is well worth five minutes of your time.  Sales of existing homes have surpassed 2007 levels and are growing.

Demographia surveys housing in m ajor markets around the world and rates their affordability.  Their 2012 report found that major markets in the U.S. are just at the upper range of affordable.  As Canada’s housing valuations have climbed, their affordability has declined and are now less affordable than the U.S.  Britain’s housing is in the severely unaffordable range.

Next Friday comes the release of the monthly employment report.  I’ll also cover a few long term trends in manufacturing and construction employment that may surprise you.