Heatlh Care

November 29, 2015


United Healthcare (UNH), the largest health insurance carrier in the U.S., announced that they may drop out of the state health care exchanges at the end of 2016.  The CEO indicated that it would review costs again in mid-2016 but was concerned that continuing losses on the state exchange plans would simply make it uneconomical for UNH to continue to offer these plans.

UNH says it has evidence of many individuals gaming the system by coming into and out of the health insurance system when they need medical services. {Bloomberg and Market Watch} It is not clear how patients would do this since the health care exchanges have enrollment rules similar to Medicare.  These restrictions are designed to make it difficult for individuals to game the system.  Are those rules being implemented consistently on the state level?  If the policy rules are in place, have the screening algorithms been reviewed?  Poor implementation and oversight have plagued some exchanges.

At the heart of Obamacare is the projection that costs for the newly insured stabilize after approximately two years, a metric derived from long experience with Medicare patients.  Individuals who have not had regular medical care often have chronic unattended conditions which need to be stabilized.  Medicare costs typically rise during this initial stage before leveling off.

Obamacare will certainly be an issue in the upcoming Presidential election.  The debate will intensify if other insurers express doubts about the economic feasibility of the system,


Productivity and Policy

Economists and policy makers continue to debate the causes, and solutions, for the slowdown in labor productivity that has occurred over the past several decades.  Larry Summers served as Treasury Secretary under President Clinton, Director of the National Economic Council under President Obama, and Chief Economist at the World Bank.  In other words, the guy’s got some chops.

In a recent speech Summers noted several trends:

1)  Dis-employment of unskilled workers.  The participation rate of those aged 25 – 54 has declined from 95% in 1965 to 85% now. (p. 3)  While this is often attributed to technical improvements, Mr. Summers makes the case that labor productivity should go up, not down, due to technical change.  That is not the case.  Summers says he doesn’t have the answer either but the contradiction between theory and data indicates that economists still don’t understand the underlying processes. (p. 4)

2) Mismeasurement.  Productivity measures are based on the calculation of real GDP which is dependent on the measure of inflation.  Summers asks whether differences in quality, or what are called hedonic measures, are captured in CPI data.  He asks “Which would you rather have for you and your family, 1980 healthcare at 1980 prices or 2015 healthcare at 2015 prices?  How many people would prefer 2015 healthcare at 2015 prices?”  If people prefer the 2015 variety at 2015 prices then inflation has been negative in healthcare.  As a percent of GDP, healthcare spending has increased.  Mismeasuring inflation in healthcare may negate all or most of this increase. (p. 5)

3) As we have transitioned to an economy dominated by services, mismeasurement of inflation has probably increased.  A leading technocat in Democratic administrations, Summers casts doubts on a staple of liberal rhetoric – that median family income has not changed since 1973.  This idea is a central tenet of Bernie Sanders presidential campaign.  What if the measurement of median family income is flawed?  This doubt is more often raised by conservative economists and policy makers.  Summers’ remarks crossed the ideological and political divide and surely raised a few eyebrows. (p. 6)

4) Developing the theme of measurement as it pertains to different types of economies, Summers refers to several statistical terms like “unit root” stationarity that may challenge casual readers.

When a time series (data observations over time like GDP) has a unit root it exhibits more deterministic behavior; it is more likely to adopt an altered path or trendline when shocked off its previous path.

Series without a unit root are more likely to exhibit stochastic behavior when subjected to some shock; that is, they will tend to return to their former path or trendline, not form a new trendline.

At mid-century, when our economy was much more reliant on manufacturing, it behaved in a stochastic way when subjected to economic shocks.  It rebounded to a previous trendline.  Our economy is now overwhelmingly service oriented, about 88%.  Summers makes the case (p. 9) that unbalanced economies like ours behave differently than a more balanced economy.  The growth path of GDP changes permanently in response to an economic shock like the financial crisis of 2008.  If that is the case, policy changes will be ineffective in returning GDP and employment back to the former trendline. (For more info on testing the deterministic and stochastic components of time series processes, see this).

Summers adds to the number of voices calling for a more accurate – but also objective – measurement of inflation. Poor measurement leads to imprecise data leads to inaccurate conclusions leads to ineffective policy leads to more problems leads to…

Policy debates often involve complicated issues of identification, measurement, and methods of analysis that are not readily explainable in a campaign speech.  On our way home from work, a complicated system of algorithms based on traffic data determines whether the traffic lights continue to trip green as we maintain a constant speed.  Much of this is hidden from us and incomprehensible to most of us.  All of that complexity is boiled down to a simple heuristic: we go when it’s green, stop when it’s red.

Voters like simple.  The job of a politician is to convince voters and donors that if they are elected, they will implement the right policies, the correct algorithms that will move traffic, i.e. the economic fortunes of the families of America, faster.

Credit Spreads

November 22, 2015

The behavior of bonds, their pricing and their yields (the interest or return on the bond), can seem like a mystery to many casual investors.  As this Money magazine writer notes, the language is backwards.  Yields rise but that’s bad because prices are falling.  Prices rise but that’s bad for new buyers who are getting a low yield on their investment.   The article mentions a little trick to help keep it straight – convert the yield to a P/E ratio, something more familiar to many investors.

In Montana, a “spread” might be a large ranch but on Wall Street the term often refers to the difference in yield between a safe investment like a 10 year Treasury bond and an index of lower rated corporate bonds, or “junk” bonds. Investors want to be paid for the extra risk they are taking.  As investors get more worried about the economy and the growth of profits, they worry about the ability of some companies to pay their debts.  Debts are paid from profits.  Less profit or no profit increases the chance of default.

Some call the spread a “risk premium,” and when that premium is less than 5 – 6%, it indicates a relatively low to moderate sense of worry among investors.  Anything greater than 6% is a note of caution.  In the chart below a rising spread above 6% often signals the coming of stock market swoons.  When I pulled this chart earlier in the week, the rate was 6.19%.  On Friday, the rate was climbing toward 6.3%.

This 2004 paper from the research division of the Federal Reserve gives a bit more depth on credit spreads and their movements.


Inventory-To-Sales Ratio

In a September blog post I noted the elevated inventory to sales ratio, meaning that manufacturers, merchants and wholesalers had too much product on hand relative to the amount of sales.  There is a bit of lag in this series; September’s figures were released only a week ago.  At 1.38, the ratio continues to climb.


The Social Security Annuity

In the blog links to the right is an article by Wade Pfau comparing the “annuity” that Social Security provides with those available on the commercial market.  He also analyzes the extra return one can achieve by delaying Social Security until age 70.

Portfolio Allocation and Timing

November 15, 2015

Gone Fishin’ Portfolio

I found this portfolio in a pile of old paperwork.  The idea is to allocate investment dollars in a number of buckets, then more or less forget about it, rebalancing once a year.  The portfolio is 60% stocks, 30% bonds, 10% other

I compared this broadly balanced portfolio #1 with a simpler version #2: 60% stocks, 40% bonds.  Because the Vanguard mutual fund VTSMX is weighted toward U.S. large cap stocks, I split the stock portion of the portfolio with an index of small cap value stocks VISVX.  The 40% bond component is an index of  intermediate-term corporate grade bonds VFICX.  I also included a very simple portfolio #3 without the split in the stock portfolio.  The 60% stocks is represented by one fund VTSMX.  The results from Portfolio Visualizer  include dividends.

Note that there is little difference between Portfolios #2 and #3 over this time period.  Although the Gone Fishin’ portfolio lagged the other two during this time period, it did do better during the period 2000 – 2006.


Market timing

Another approach is a fairly simple market timing technique as shown in this paper “A Quantative Approach to Tactical Asset Allocation”  There is no heavy math in the paper.  The timing rule is simple:  buy the SP500 when the monthly close is above the 10 month moving average; sell when the monthly close is below the 10 month average.  Using this system, an investor would have sold an ETF like SPY on the first trading day of September this year  because August’s close was below the ten month average.  After the index rebounded in October and closed above the 10 month average, an investor would have bought back in on the first trading day in November. The average “turnaround,” a buy and a sell signal, is less than one a year.  These short term swings are sometimes called “whipsaws,” where an investor loses several percent by selling after a quick downturn then buying in after prices recover quickly.  The payoff is that an investor avoids the severe 50% drawdowns of 2008 and 2000.

The author of the paper performed a 112 year backtest on this system. He excluded taxes, commissions and slippage in the calculations and used the closing price on the final day of the month as his buy and sell price points. He notes some reasons for these omissions later in the paper which I found inadequate. I recommend using the opening price (ETF) or end of the day price (mutual fund) of the day following the end of the month as  a practical real world backtesting strategy.  Very few individual investors can buy or sell at the closing price and there can be a lot of price movement, or slippage, in the final trading minutes before the close.

Commissions can be estimated at some small percentage.  To exclude commissions is to estimate them at 0% and present an investor with unrealistic returns, a common backtesting fault of many trading or allocation systems.  The same can be said for taxes.  Even if the guesstimate is a mere 1%, it is better than the 0% effective estimate of tax costs when excluded from the backtest.

The difference in annual real, or inflation-adjusted, return between this timing model and “buy and hold” is 4/100ths of 1% per year (p. 23) Because the timing model avoids the severe portfolio drawdowns of a buy and hold stratgegy (p. 28), that tiny difference translates into a difference in compounded return that is less than 1% which produces a huge 250%+ difference in portfolio balances at the end of the 112 year testing period.  None of us will be investing for that long a period but it does illustrate the effect of small incremental differences.

The author then combines an allocation model with the timing model using five global asset classes: US stocks, foreign stocks, bonds, real estate and commodities, assigning 20% of the portfolio to each class.  He backtested this allocation with the same timing strategy vs a buy and hold strategy (p. 30-31).  The advantages of the timing strategy are apparent during severe downturns as in 1973, 2000 and 2008.  A buy and hold strategy took eight years after 1973 to recover and catch up to the timing strategy.  The buy and hold strategy never caught up to the timing strategy after the 2000-2003 downturn in the market.  In 2008, it fell even further behind, highlighting the superiority of the timing strategy.

Returns are important, of course, but volatility and drawdown are especially critical for older investors who do not have as many years to recover.  From 1973 – 2012, the timing model has only one losing year – 2008 – and the loss for the entire portfolio was a mere 6/10ths of a percent (p. 32).


October jobs report

A few weeks ago I linked to an article on Reagan’s former budget director David Stockman.  On his web site, he presented a sobering and thorough analysis of the October jobs report.

Stockman breaks down the numbers into “breadwinner” higher paying jobs and the relatively lower paying leisure and hospitality jobs that account for too much of the jub creation in the past fifteen years.  Goods producing jobs – those in manufacturing, construction, mining and timber – are still far below 2000 levels.

“massive money printing and 83 months running of ZIRP [zero interest rate policy of the Federal Reserve] have done nothing for the goods producing economy or breadwinner jobs generally.”


Obama’s numbers

A president has far less effect on the economy than the political rhetoric would have one believe.  Despite that fact, each President is judged on his “numbers” as though he were a dictator, a one man show.  With one year to go in his second term, here are the latest numbahs from the reputable FactCheck.

Oh My Gawd!

November 8, 2015

There is the famous Tarzan yell by Carol Burnett and the iconic “Oh my Gawd” exclamation of Janice Lipman in the long running TV series “Friends.”  That’s what Janice would have said when October’s employment report was released this past Friday.


271,000 jobs gained – maybe. That was almost twice the number of job gains in September (137,000).  Really??!! ADP reported private job gains of 182,000.  Huge difference.  Job gains in government were only 3,000 so let’s use my favorite methodology, average the two and we get 228,000 jobs gained, awfully close to the average of the past twelve months.  Better than average gains in professional business services and construction.  Both of these categories pay well.  Good stuff.

At 34.5 hours, average hours worked per week has declined by 1/10th of an hour in the past year.  The average hourly rate rose 2.5%, faster than headline inflation and giving some hope that workers are finally gaining some pricing power in this recovery.

For some historical perspective, here is a chart of monthly hours worked from 1921 to 1942.  Most of those workers – our parents and grandparents – have passed away.  At the lows of the Great Depression people still worked more hours than we do today.  They were used to hard work.  There were few community resources and social insurance programs to rely on.

The headline unemployment rate fell slightly to 5%.  The widest unemployment rate, or U-6 rate, finally fell below 10% to 9.8%, a rate last seen in May 2008, more than seven years ago.  This rate includes people who are working part time because they can’t find a full time job (involuntary part-timers), and those people who have not actively looked for a job in the past month but do want a job (discouraged job seekers).  Macrotrends has an interactive chart showing the three common unemployment rates on the same chart.

The lack of wage growth during this recovery, coupled with rising home prices, may have made owning a home much less likely for first time buyers.  The historical average of new home buyers is 40%.  The National Assn of Realtors reported that the percentage is now 32%, almost at a 30 year low.

2.5% wage growth looks a bit more promising but the composite LMCI (Labor Market Conditions Index) compiled by the Federal Reserve stood at a perfect neutral reading of 0.0 in September.  The Fed will probably update the LMCI sometime next week.  This index uses more than twenty indicators to give the Fed an in-depth reading of the labor market.


Bonds and Gold

The strong employment report increased the likelihood that the Fed will raise interest rates at their December meeting and this sent bond prices lower.  A key metric for a bond fund is its duration, which is the ratio of price change in response to a change in interest rates.  Shorter term bond funds have a smaller duration than longer term funds. A short term corporate bond index like Vanguard’s ETF BSV has a duration of 2.7, meaning that the price of the fund will decrease approximately 2.7% in response to a 1% increase in interest rates.  Vanguard’s long term bond ETF BLV has a duration of 14.8, meaning that it will lose about 15% in response to a 1% increase in rates.  In short, BLV is more sensitive than BSV to changes in interest rates. How much more sensitive?  The ratio of the durations – 14.7 / 2.7 = 5.4 meaning that the long term ETF is more than 5 times as sensitive as the short term ETF.

What do we get for this sensitivity, this higher risk exposure?  A higher reward in the form of higher interest rates, or yield.  After a 2.5% drop in the price of long term bond funds this week, BLV pays a yield close to 4% while BSV pays 1.1%.  The reward ratio of 4 / 1.1 = 3.6, less than the risk ratio.   On September 3rd, the reward ratio was much lower, approximately 3.27 / 1.3 = 2.5, or half the risk ratio.

Professional bond fund managers monitor these changing risk-reward ratios on a daily basis.  Retail investors who simply pull the ring for higher interest payments should be aware that not even lollipops at the dentist’s office are free.  Higher interest carries higher risk and duration is that measure of risk.

The prospect of higher interest rates has put gold on a downward trajectory with no parachute since mid-October.  A popular etf  GLD has lost 9% and this week broke below July’s weekly close to reach a yearly low.  Investors in gold last saw this price level in October 2009.  Back then  gold was continuing a multi-year climb that would take its price to nosebleed levels in August 2011, 70% above its current price level.


CWPI (Constant Weighted Purchasing Index)

Manufacturing is hovering at the neutral 50 mark in the ISM Purchasing Manager’s Index but the rest of the economy is experiencing even greater growth after a two month lull.  No doubt some of this growth is the normal pre-Christmas hiring and stocking of inventories in anticipation of the season.

The CWPI composite of manufacturing and service sector activity has drifted downward but is within a range indicating robust growth.

Employment and New Orders in the non-manufacturing sectors – most of the economy – rose up again to the second best of the recovery.

Economists have struggled to build a mathematical model that portrays and predicts the rather lackluster wage growth of this recovery in a labor market that has been growing pretty strongly for the past few years.


Social Security

The Bipartisan Budget Act of 2015, passed and signed into law this past week, curtails or eliminates a Social Security claiming strategy that has become popular.  (Yahoo Finance – can pause the video and read the text below the video).  These were used by married couples who were both at full retirement age.  One partner collected spousal benefits while the “file and suspend” partner allowed their Social Security benefits to grow until the maximum at age 70.  On the right hand side of this blog is a link to a $40 per year “calculator” that helps people maximize their SS benefit.


Tax Cuts Anyone?

Former Senator, Presidential contender and actor Fred Thompson died this past week.  The WSJ ran a 2007 editorial by Thompson arguing that the “Bush tax cuts” that the Republican Congress passed in 2001 and 2003, when he was a Senator, had spurred the economy, causing tax revenues to increase, not decrease, as opponents of the tax cuts claimed.  Like others in the tax cut camp, Thompson looked at a rather small slice of time to support his claim: 2003 -2007.

Had tax cut advocates looked at an earlier slice of time – also small – in the late 1990s they would have seen the opposite effect.  Higher tax rates in the 1990s caused greater economic growth and higher tax revenues to the government, thereby shrinking the deficit entirely and producing a surplus.

Tax cuts decrease revenues.  Tax increases increase revenues.  That tax cuts or increases as enacted have a material effect on the economy has been debated by leading economists around the world for forty years.  At the extremes – a 100% tax rate or a 0% tax rate – these will certainly have an effect on people’s behavior.  What is not so clear is that relatively small changes in tax rates have a discernible impact on revenues.  A hallmark of belief systems is that believers cling to their conclusions and find data to support those conclusions in the hopes that they can use that to help spread their beliefs to others.

The evidence shows that economic growth usually precedes tax revenue changes; that tax policy advocates in either camp have the cart before the horse.  A downturn in GDP growth is followed shortly by a decline in tax revenues.

Thompson’s editorial notes a favorite theme of tax cut advocates – that the “Kennedy” tax cuts, initiated into law in memory of President Kennedy several months after his assassination in November 1963, spurred the economy and increased tax revenues. Revenues did increase in 1964 but the passage of the tax act occurred during that year so there is little likelihood that the tax cuts had that immediate an effect.  Revenues in 1965 did increase but fell in subsequent years.  A small one year data point is all the support needed for the claims of a believer.

The question we might ask ourselves is why do tax policy and religion share some of the same characteristics?

Still Worried

November 1, 2015

Today is the day that U.S. readers fall back.  Let’s hope it’s the only thing that falls back!

Eight years ago, in October 2007, the SP500 index reached a pre-recession high of 1550. After this month’s 8% recovery the index stands at 2079, more than a third above that long ago high.  A decade long chart of the SP500 shows the inflection points of sentiment.  We can compare two averages to understand the shifts in investor confidence.  A three month average, one quarter of a year, captures short term concerns and hesitations.  A one year average reflects doubts or optimisms that have strengthened over time.  The crossing of one average above or below the other gives us a signal that a change may be coming.  Concerns may be temporary – or not.

After falling below the 12 month average, the 3 month average strained and groaned to pull its chin above that long average, notching five consecutive weekly gains.  Both China and the EU central banks have announced plans for lower interest rates or QE to spur their economies.  Oil prices continued to bounce around under the $50 mark.  OPEC suppliers announced they could not agree on production cuts.  Fearing a continuing oversupply of crude, oil prices fell 4 – 5%.  Then came the news that the number of oil rigs in the U.S. had fallen.  Prices went back up.

Commodities and mining stocks remain under pressure.  After falling over 18% in September, mining stocks gained back most of those losses in the first two weeks of October, then fell back in the last half of this month, closing the month with a 3% gain.  15 to 20% gains and losses in a sector during a month looks like so much scurrying and confusion.

Emerging market indexes lost ground this past week, slipping more than 4%.  Worries of a global recession continue to haunt various markets.  For large and medium U.S. companies, a slowdown in European and Asian markets is sure to have a negative effect on the bottom line.

The first estimate of 3rd quarter GDP growth was a paltry 1.5%, far below the 3.9% annual rate of the 2nd quarter.  Two-thirds of the SP500 companies have reported earnings for the 3rd quarter and FactSet estimates a decline of 2.2% for the quarter, the second consecutive quarter of earnings declines.


The Causes of Depression

The economic kind, not the emotional and psychological variety.  Economics history buffs will enjoy David Stockman’s critique of the extraordinary amount of monetary easing under former Fed chairman Ben Bernanke.  As President Reagan’s budget director, Stockman was at the forefront of supply side economics, a theory which promised an answer to the stagflation of the 1970s that drove many to question the assumptions and conclusions of Keynesian economics.

At first a champion of this new approach to economic policy making, Stockman grew disillusioned and later coined the term “voodoo economics” to describe the contradictory thinking of his boss and others in the Republican Party who stuck by their beliefs in supply side economics in spite of the evidence that these policies generated large budget deficits and erratic economic cycles.

In 2010, Stockman penned an editorial  that held some in the Republican Party, his party, culpable for the 2008 fiscal crisis.  He understands that politicians and policy makers become welded to their ideological platforms, disregarding any input that might upset their model of the world.

For those who have a bit of time, an Atlantic magazine December 1981 an article acquainted readers with David Stockman in his first year as budget director.  The budget process seems as broken today as it was 35 years ago when Stockman assumed the task of constructing a Federal budget.

 These “internal mysteries” of the budget process were not dwelt upon by either side, for there was no point in confusing the clear lines of political debate with a much deeper and unanswerable question: Does anyone truly understand, much less control, the dynamics of the federal budget intertwined with the mysteries of the national economy?

Stockman understands the political gamesmanship that permeates Washington.  He criticizes Bernanke’s analysis of the 2008 Great Recession as well as the 1930s Great Depression. Faulty analysis produces faulty remedies. Stockman goes still further, finding fault with Milton Friedman’s monetary analysis of the causes of the Great Depression.  In a 1963 study titled A Monetary History of the United States Friedman and co-author Anna Schwartz found that monetary actions by the Federal Reserve deepened and lengthened the 1930s Depression.  Friedman became the leading spokesman of monetarism in the late 20th century, the thinking that governments can more effectively guide a national economy by adjusting the money supply rather than employing an ever changing regime of fiscal policies.

Students of the great debate of the past 100 years – bottom up or top down? – will enjoy Stockman’s take on the matter.