The Long Road

September 25, 2016

Almost daily I read about the coming implosion in the stock market.  There are only two price predictions: up and down.  One of them will be right.  So far, no catastrophe, so why worry?  Should an innocent investor just Ease On Down the Road? (Video from the 1978 movie).

Unfortunately, the stock market road looks like Rt. 120 south of Mono Lake in California. The road is like a ribbon, marked by highs that are many years apart, more years than the majority of us will live in retirement.  In the graph from below from I have marked up the decades-long periods before the inflation adjusted SP500 surpassed a previous high.  It is truly humbling.

It took 23 years for the market to finally surpass the high set in 1906.  Happy days!  Well, not quite.  Several months later came the stock market crash of 1929.  In 1932, the market fell near the 1920 lows.  In 1956, 27 years after the ’29 crash, the market finally notched a new high. In more recent decades, the market spent 23 years in a trough from 1969 to 1992.  Lastly, we have this most recent period from the high set in 2000 to a new high set in 2015.

IF – yes, the big IF – a person could call the high in a market, that would sure be nice, as Andy Griffith might say. (Youngsters can Google this.)  Of course, Andy would be suspicious of any city slicker who claimed to have such a crystal ball.  Knowing the high mark in advance is magic.  Knowing a previous high is not magic.

Looking at the chart we can see that the price in each period falls below the high of the period before it.  In the period marked “1” in the graph, the price fell below the high set in 1892. In period marked “2”, the price fell below the high set in 1906.  In the period marked “3”, the price fell below the high set in 1929.  In this last period marked “4” the price – well, it never fell below the high set in 1969.  The run up in the 1990s was so extreme that the market still has not truly corrected, according to some. Even the low set in 2008 didn’t come close to falling below the highs of that 1969-1992 period.  An investor who used a price rule that had been good for more than a hundred years found that the rule did not apply this time.

In 2008-2009, why didn’t prices fall below the high of the 1969-1992 period? They would have had to fall below 500 and in March 2009, there were a number of market predictors calling for just that. On March 9th, the SP500 index closed at 676, after touching a low of 666 that day.  The biblical significance was not lost on some. Announcements from major banks that they had actually been profitable in January and February caused a sharp rebound in investor confidence.  The newly installed Obama administration had promised some economic stimulus and the Federal Reserve added their own reassurances of monetary stimulus.

Did these fiscal and monetary relief measures prevent the market from fully purging itself?  Maybe.  Are stock prices wildly inflated because the Federal Reserve has kept interest rates so low for so long.  Could be.  How low are interest rates?  In 2013 the CBO predicted interest rates of 3-4% by this time.  They are still less than 1/2%.

How much are stock prices inflated?  Robert Shiller, the author of “Irrational Exuberance,” devised a price earnings ratio that removes most of the natural swings in earnings and the business cycle. Called the Cyclically Adjusted Price Earnings ratio, or CAPE, it divides the current price of the SP500 index by a ten year period of inflation adjusted earnings.  The current CAPE ratio is just below the high ratio set in 2007 by a market riding a housing boom.  The only times when the CAPE ratio has been higher are the periods during the housing bubble (2008), the dot-com boom (2000), and the go-go 1920s when many adults could buy stocks on credit.  Each of these booms was marked by a price bust that lasted at least a decade.

Price rules require some kind of foresight, and crystal balls are a bit cloudy.  There is a strong argument to be made for allocation, a balance of investments that generally are non-correlated, i.e. one investment goes up in price when another goes down.  An investor does not have to frequently monitor prices as with price rules. A once or twice a year reallocation is usually sufficient.

In an allocation strategy, equities and bonds are the most common investments because they generally counterbalance each other. A portfolio with 60% stocks and 40% bonds, or 60/40, is a common allocation. (Some people write the bond allocation first, as in 40/60.)   Shiller has recommended that an investor shift their allocation balance toward bonds when the CAPE ratio gets this high. For example, an investor would move toward a 60% bond, 40% stock allocation.

To see the effects of a balanced allocation, let’s look at a particularly ugly period in the market, the period from 2000 through 2011.  The stock market went through two downturns.  From 2000-2003, the SP500 lost 43% (using monthly prices). The decline from October 2007 to March 2009 was a nasty 53%.  In  2011 alone, a budget battle between the Obama White House and a Republican Congress prompted a sharp 20% fall in prices. During those 12 years, the SP500 index lost about 10%, excluding dividends.

During that period, a broad bond index mutual fund (VBMFX) more than doubled. Equities down, bonds up.  A rather routine portfolio composed of 60% stocks and 40% bonds had a total return of 3.75% per year.  Considering the stock market losses during that period, that return sounds pretty good. Inflation averaged 2.6% so that balanced portfolio had a real gain of about 1.2%.  Better than negative, we reason.  On the other hand, a portfolio weighted at 40% stocks, 60% bonds had a total annual return of 4.75%, making the case for Shiller’s strategy of shifting allocations.

There is also the nervousness of a portfolio, i.e. how much an investor gets nervous depending on one’s age and the various components of a portfolio.  During the 2000-2003 downturn in which the SP500 lost 43%, an investor with a 60/40 allocation had just 14% less than what they started with in the beginning of 2000. Not bad. 2008 was not pleasant but they still had 11% more than what they started with.  That is a convincing case for a balanced portfolio, then, even in particularly tumultuous times.

Can an investor possibly do any better by reacting to certain price triggers?  We already discussed one price rule that was fairly reliable for a hundred years till it wasn’t. The problem with rules are the exceptions and it only takes one exception to bruise an average 20 year retirement cycle.  Another price rule is a medium term one, the 50 day and 200 day averages.  These are called the Golden Cross and Death Cross.  Rules involve compromises and this rule is no exception.  In some cases, an investor may sell just when the selling pressure has mostly been exhausted.  Such a case was July 2010 when the 50 day average of the SP500 crossed below the 200 average, a Death Cross, and triggered a sell signal.  The market reversed over the following months and when the 50 day average crossed back above the 200 day average, a Golden Cross, an investor bought back in at a price 10% higher than they had sold!

The same scenario happened again in August 2011 – January 2012, buying back into the market in January 2012 at a price 10% higher than the price they sold at in August 2011.  These short term price swings are called whipsaws and they are the bane of strict price rules. In the past year there were two such whipsaws, one of them causing a 5% loss.  Clearly, this traditional trading rule needs a toss into the garbage can!  What works for a few decades may fail in a later decade.

For those investors who want a more active approach to managing a portion of their portfolio, what is needed is a flexible price rule that has been fairly reliable over six decades.  As a bull market tires, the monthly price of a broad market index like the SP500 begins to ride just above the two year average.  The monthly close will dip below that benchmark average for a month as the bull nears exhaustion.  If it continues to decline, that is a good indication that the market has run its course.  The price rule is an attention trigger that may not necessarily prompt action.

Let’s look at a few examples.  President Kennedy’s advisors were certainly aware of this pattern when the market fell below the two year mark in 1962.  They began pushing for tax cuts, particularly for those at the highest levels.  Rumors of a tax cut proposal helped lift the market back above the benchmark by the end of 1962   In early 1963, JFK made a formal proposal to lower personal rates by a third and corporate rates by 10% (At that time, corporations paid a 52% rate). An investor who sold after a two month decline suffered the same whipsaw effect, buying back into the market at about 10% higher than they sold.  However, at that selling point in 1962, rumors of tax cuts were helping the market rebound and might have caused an investor to wait another week before selling. The market had  in fact reached its low.

In mid-1966, the SP500 fell below its 24 month benchmark for seven months.  Escalating defense spending for the Vietnam War helped arrest that decline.

The bull market finally tired in the summer of 1969 and dropped below the 24 month benchmark in July.  The index treaded water just below the benchmark for a few months before starting a serious decline of 25%.  More than a year passed before the monthly price closed above the benchmark in late 1970.

The 1973 Israeli-Arab war and the consequent oil embargo threw the SP500 into a tailspin.  The price dipped below the average a few times starting in May 1973 before crossing firmly below in November 1973.  After falling almost 40%, the price finally crossed back above the benchmark in late 1974.  Remember that this was a particularly difficult fourteen year period marked by war, high unemployment and inflation, and a whopping four recessions.  The SP500 crossed below its ten year – not month, but year – average in 1970, again in 1974-75, and lastly in 1978.  Such crossings happen infrequently in a century and are great buying opportunities when they do happen.  To have it happen three periods in one decade is historic.

I’ll skip some minor events in the late 1970s and early 1980s.  In most episodes an investor can take advantage of these opportunities to step aside as the market swoons, then buy back in at a price that is 5-10% lower when the market recovers.

The most recent episodes were in November 2000 when the SP500 fell below its benchmark at about 1300. When it crossed  back over the benchmark in August 2003, the index was at 1000, a nice bargain.  This was another crossing below the ten year average.  The last one was in 2008 when the monthly price fell below the benchmark in January.  Although it skirted just under the average it didn’t cross back above the 24 month average.  In June it began a decline that steepened in September as the financial crisis exploded. Again the index fell below its ten year average. By the time the price closed back above the benchmark in November 2009, an investor could buy in at a 20% discount from the June 2008 price.

In September 2015 and again in February of this year, the index dropped briefly below its 24 month average. They were short drops but it doesn’t take much of a price correction because the index is riding parallel with the benchmark, above it by only 100 points, or less than 5%.  Corporate profits have declined for five quarters.  The bull is panting but still standing.

As we have seen in past exhaustions, there is a lot of political pressure to do something.  What could refuel the bull market? Monetary policy seems exhausted.  The Federal Reserve has indicated that they will use negative interest rates if they have to but they are very reluctant to do so.  Just this past week, the Bank of Japan (BOJ) indicated that their policy of negative interest rates is not helping their economic growth.  The BOJ had started down a negative interest rate path and has now warned other central banks not to follow.

What about fiscal policy? The upcoming election could usher in some fiscal policy changes but that seems unlikely.  Donald Trump has joined with Democrats advocating for more infrastructure spending but that is unlikely to pass muster with a conservative House holding the purse strings and a federal public debt approaching $20 trillion.  Only sixteen years ago, it was less than $6 trillion.  Democrats keep reminding everyone that the Federal Government can borrow money at very cheap rates.  However, the level of debt matters and Republicans will likely control the money in this next Congress.

Managing an entire portfolio with a price rule is a bit aggressive but might be appropriate for some investors who want to take a more active approach with a portion of their portfolio.  This price rule – or let’s call it guidance – is more a pain avoidance tool than a timing tool.

The Fed Feints

September 18, 2016

This week I’ll cover several topics, most of them concerning personal finances.

Social Security and COLA

 Sometime in mid-October the Social Security Administration (SSA) will announce the cost-of-living adjustment (COLA) for social security benefits in 2017 and it will probably be less than 1% (History of previous COLA adjustments).  The COLA is based on the year-over-year increase in the Consumer Price Index (CPI).  In 1982, Congress specified that the SSA use the CPI version for urban workers, called CPI-W. (Info from SSA).  Each month the BLS releases their estimate of inflation, and this week they published their calculation for August – a yearly increase of just .66%.  September’s inflation number may be slightly different but the reality for the average SS recipient is a monthly increase of less than $10 in the average benefit of $1340.

Gas prices fall

For years senior advocacy groups like AARP have argued that a different CPI measure should be used to calculate the COLA.  The alternative measure, the CPI-E, puts more weight on health care expenses and less weight on gasoline and transportation costs because seniors don’t drive as much. So far, Congress has not adopted any changes to the methodology of calculating inflation for retirees.

In late 2014 gasoline prices began to fall and this had a significant impact on measured inflation in 2015, as we can see in the chart below. Although gas prices remain low, they have stabilized so that they will have less of an impact on yearly inflation growth in the future.

Reaching For Yield

Investors who are reliant on the income from their investments, including giant pension and endowment funds, typically desire fairly safe investments that will give them a decent return while preserving their principle.  These include high grade corporate bonds (Johnson and Johnson, for example), Treasury bonds, CDs and savings accounts. Abnormally low interest rates have made those traditional investment choices less desirable.

Like a stream diverted, investors have wandered to riskier assets, bidding up the prices of stocks which are considered more likely to retain their value because they pay dividends.

Dividend ETFs 

 As one example, Vanguard’s VIG is a Dividend Appeciation ETF containing of stocks that  have a consistent record of dividend growth of almost 5% per year.  The growth rate is 5%, not the dividend yield. The companies in this basket are household names: Johnson and Johnson, Microsoft, Pepsi, McDonald’s, and Walgreens, to name a few.  Vanguard has an added benefit: a very low expense ratio.  At the end of August, the Price-Earnings (P/E) ratio on this basket of stocks was 24.5 (see here). In the first two weeks of September, the prospect of an interest rate hike in the next few months has put a small dent in the price, and lowered the PE ratio slightly.  Clearly, investors are willing to pay extra for income, and extra for reliability.  The yield on this basket of reliability is 2.1%, just .4% more than a 10 year Treasury.


iShares’ DVY is a popular dividend ETF that has a less selective basket of stocks.  This basket also includes oil and energy companies that have a 5 year record of paying dividends but may not have a consistent record of dividend growth because of declining oil prices.  Because the criteria is less restrictive, this ETF is cheaper – it has a higher yield of 3.2% and a lower PE ratio of 20.8.

The Fed

After eight years of near zero interest rates, the Federal Reserve has put itself in a corner. Whatever actions or adjustments it takes must be in small increments to avoid causing a sudden repricing of the very asset prices it has helped lift by maintaining a low interest rate environment.

The financial crisis was so severe that the Fed thought it must lower rates to near zero, which choked income flows from savings.  Such a policy could be justified as an emergency measure. The economy had suffered the equivalent of a heart attack and the Fed need to shock it alive.  However, the recovery that followed was so weak that the Fed thought it must continue to keep rates low.  After eight years of ZIRP (Zero Interest Rate Policy), the Fed finds that it has effectively been picking winners and losers. Debtors win, savers lose. The Fed was forced into the role by the inability of a bitterly divided and ineffective Congress to pass fiscal policy solutions.

To fully grasp the effects of Fed policy, let’s take a trip up into the mountains.  Imagine a high mountain lake reservoir with a dam at one end to contain the water.  On the mountains surrounding the lake falls snow and rain that drains into the reservoir.  The dam is opened enough so that it releases a measured stream of water for users downstream.  The lake is a stock. The release of water is a flow.

Now let’s say that there is a drought for a year or two.  The water level in the reservoir begins to fall.  The dam operators reduce the amount of water released and this has a negative impact on downstream farms and businesses who depend on the water. The price for water rises as farms and businesses bid to get more water, a simple case of supply and demand. Land, another store of value, decreases in value because the lack of adequate water has made the land less productive. Assuming the same demand, prices for produce from the land rises.  This is the flow from the land, So the flow from the land rises while the stock value of the land falls.  Water is a different kind of asset, a consumable.  In the case of water, both the flow and the stock value rise during a drought.

Eventually the rainfall increases and the reservoir refills with water.  Now the dam operators release more water and the price per unit of water naturally declines. Now the stock value and the flow value of the water have declined. A greater supply of produce leads to price declines in the flow of produce from the land, while the price of the land itself, the store of land’s value, increases in anticipation of more productivity from the land.

After the crisis is over, flows from both types of assets declines.  The extra stock value of the water is transferred back to the land. The flow of water from the reservoir has been the catalyst for this transfer of value.

Let’s take this simplified situation and use it as an analogy to understand the Fed.  When the Fed adjusts interest rates, it transfers a store of value from one asset class to another. (It involves a number of asset classes.  I’ll keep it simple.) That’s the transfer of stock value.  But there is also a raising or lowering of the price of the flows from each of those assets.

Now let’s imagine that the Fed raises interest rates by 1%, effectively opening up the dam’s sluice gates a little more.  The flow of income shifts from debtors, who must pay more for borrowed money, to savers, who receive more for their savings.  Debt is a store of value and this is where the transfer of value happens.  New debt competes with old debt and lowers the price of existing debt, both corporate and government, so that old debt can generate the same income flows as new debt. Assets like bonds, which generate income flows at lower interest rates are now worth less.  Why buy a safe bond paying 2% when I can buy a safe bond paying 3%?  Dividend paying stocks are worth less unless they can realistically increase their dividend to compete with higher interest rate expectations. Buyers and sellers of these instruments adjust the prices to reflect the new expectations.

The change in flows acts as a catalyst for the transfer of the stock values between assets.  When we are younger and working, we don’t pay much attention to income flows from our savings.  We look at our portfolio statements, check our 401K or savings balances to see how much of a stock of assets we have built up.  We measure these assets in dollars, not value and may come to think that dollars and value are the same.  Income flows are measured in dollars.  The stock those flows come from are measured in value.  In the future, I hope to explore the ways that we try to convert value to dollars.

The Supply Chain Sags

September 11, 2016

Fifteen years ago almost three thousand people lost their lives when the twin towers crumpled from the kamikaze attack of two hijacked airplanes.  Over the fields of rural Pennsylvania that morning, the passengers of a another hijacked plane sacrificed their own lives to rush the hijackers and prevent an attack on Washington.  We honor them and the families who endured the loss of their loved ones.


Purchasing Managers Index

Each month a private company ISM surveys the purchasing managers at companies around the country to assess the supply chain of the economy. Are new orders growing or shrinking since last month?  Is the company hiring or firing?  Are inventories growing or shrinking?  How timely are the company’s suppliers?  Are prices rising or falling? ISM publishes their results each month as a  Purchasing Managers Index (PMI), and it is probably the most influential private survey.

ISM’s August survey was disappointing, especially the manufacturing data.  Two key components of the survey, new orders and employment, contracted in August. Both manufacturing and service industries indicated a slight contraction.

For readers unfamiliar with this survey, I’ll review some of the details The PMI is a type of index called a diffusion index. A value of 50 is like a zero line.  Values above 50 indicate expansion from the previous reading; below 50 shows contraction. ISM compiles an index for the two types of suppliers, goods and services, manufacturing and non-manufacturing.

The CWPI variation

Each month I construct an index I call the Constant Weighted Purchasing Index (CWPI) that blends the manufacturing and non-manufacturing surveys into a composite. The CWPI gives extra weight to two components, new orders and employment, based on a methodology presented in a 2003 paper by economist Rolando Pelaez.  Over the past two decades, this index has been less volatile than the PMI and a more reliable warning system of recession and recovery, signaling a few months earlier than the PMI.

Weakness in manufacturing is a concern but it is only about 15% of the overall economy.  In the calculation of the CWPI, however, manufacturing is given a 30% weight.  Manufacturing involves a supply chain that produces a ripple effect in so many service industries that benefit from healthy employment in manufacturing. Because there may be some seasonal or other type of volatility in the survey, I smooth the index with a three month moving average.  Sometimes there is a brief dip in both the manufacturing and non-manufacturing sides of the data. If the downturn continues, the smoothed data will confirm the contraction in the next month.  This is the key to the start of a recession – a continuing contraction.

History of the CWPI

The contraction in the survey results was slight but the effect is more pronounced in the CWPI calculation. One month’s data does not make a trend but does wave a flag of caution. Let’s take a look at some past data.  In 2006 there was a brief one month downturn. In January 2008, the smoothed and unsmoothed CWPI data showed a contraction in the supply chain, and more important continued to contract. The beginning of the recession was later set by the NBER at December 2007. ( Remember that these recession dates are determined long after the actual date when enough data has been gathered that the NBER feels confident in its determination.)  The PMI index did not indicate contraction on both sides of the economy until October 2008, seven months after the signal from the CWPI.  During that time, from January to October 2008, the SP500 index lost 30% of its value.

The CWPI unsmoothed index showed expansion in June 2009 and the smoothed index confirmed that the following month. The PMI did not show a consistent expansion till August 2009.  The NBER later called the end of the recession in June 2009.

The Current Trend

Despite the weak numbers, the smoothed CWPI continues to show expansion but we can see that there is a definite shift from the wave like pattern that has persisted since the recovery began.

With a longer view we can see that an up and down wave is more typical during recoveries.  A flattening or slow steady decline (red arrows) usually precedes an economic downturn.  The red arrows in the graph below occurred a year before a recession.  The left arrow is the first half of 2000, a year before the start of the 2001 recession.  The two arrows in the middle of the graph point to a flattening in 2006, followed by a near contraction.  A rise in the first part of 2007 faltered and fell before the recession started in December 2007.  The current flattening (right arrow) is about six months long.

New Orders and Employment

Focusing on service sector employment and new orders, we can see the weakness in this year’s data.

With a long view, a smoothed version of this-sub indicator signals weakness before a recession starts and doesn’t shut off till late after a recession’s end.  The smoothed version has been below the 5 year average for seven months in a row.  If history is any guide, a recession in the next year is pretty certain.

The 2007-2009 Recession

 In August 2006 this indicator began consistently signaling key weakness in the service sectors of the economy (big middle rectangle in the graph below). Stock market highs were reached in June 2007 and the recession did not officially begin till December 2007, a full sixteen months after the signal started.  That signal didn’t shut off till the spring of 2010, about eight months after the official end of the recession.

The 2001 Recession, Dot-Com Bust and Iraq War

The recession in 2001 lasted only six months but the downturn in the market lasted three years as equities repriced after the over-investment of the dot-com boom.  The smoothed version of this indicator first turned on in January 2001, two months before the start of the recession in March of that year.   Although, the recession officially ended in November 2001, the signal did not shut off till June 2003 (left rectangle in the graph above).  Note that the market (SP500) hit bottom in September 2002, then nosedived again in the winter.  Weak 4th quarter GDP growth that year fueled doubts about the recovery.  Concerns about the Iraq war added uncertainty to the mix and drove equity prices near that September 2002 bottom.  In April 2003, two months before the signal shut off, the market began an upward trajectory that would last over four years.

No one indicator can serve as a crystal ball into the future, but this is a reliable cautionary tool to add to an investor’s tool box.


Stocks, Interest Rates and Employment

There are 24 branches of the Federal Reserve. This week, presidents of two of those banches indicated that they favored an interest rate hike when the Fed meets later this month (Investor’s Business Daily article).  On Friday, the stock market dropped more than 2% in response.  One of those presidents, Rosengren, is a voting member on the committee (FOMC) that sets interest rates.  I have been in favor of higher interest rates for quite some time so I agree with Rosengren that gradual rate increases are needed. However, Chairwoman Janet Yellen relies on the Labor Market Conditions Index (LMCI) to gauge the health of the labor market.

Despite an unemployment rate below 5%, this index of about 20 indicators has been lackluster or negative this year.  There are a record number of job openings but employees are not switching jobs as the rate they do in a healthy labor market.  This is the way that the majority of employees increase their earnings so why are employees not pursuing these opportunities?

The Federal Reserve has a twin mandate from Congress: “maximum employment, stable prices, and moderate long-term interest rates.” (Source) There is a good case to be made that there are too many weaknesses in the employment data, and that caution is the more prudent stance.  The FOMC meets again in early November, just six weeks after the upcoming September meeting. Although the Labor Report will not be released till three days after the FOMC meeting, the members will have preliminary access to the data, giving them two more months of employment data. Yellen can make a good case that a short six week pause is well worth the wait.

Stuck in the Mud

In 18 months, the SP500 is little changed.  A broad index of bonds (BND) is about the same price it was in January 2015.  The lack of price movement is a bit worrying.  There are several alternative investments which investors may include in their portfolio allocation.  Since January 2015, commodities (DBC)  have lost 15%, gold (GLD) has gained a meager 1%, emerging markets (VWO) are down 5%, and real estate (VNQ) is literally unchanged.  A bright note: international bonds (BNDX) have gained almost 6% in that time and pay about 1.5%.  1994 was the last time several non-correlated assets hit the pause button.  The following six years were good for both stocks and bonds.  What will happen this time?  Stay tuned.

Investment Declines

September 4, 2016

The market seems awfully quiet leading into September, a month that is the most consistently negative for the past century. LPLResearch notes that it has been about 35 years since the market was this quiet for this long.  It has been 30 trading days (at the end of August) since the SP500 had strayed more than 1% from its 10 day average.  A year ago in August 2015 the market spent 17 trading days in this quiet zone then fell 6% in 3 days. In September 2014, the market acted like a sailing ship in the horse latitudes before sinking 6% over the following ten days.  We wish the market went up after these long quiet periods, but the trend is usually down.


Let’s look at a disturbing long term trend – a decline in private investment in housing (residential), as well as factories, equipment and office buildings (non-residential).  What is private?  Non-government, i.e. companies and individuals in the private market.

First, let’s look at private investment as a whole before we look at the parts.  As a percent of GDP, we are near post-WW2 lows.

“Oh, that was the housing bubble and financial crisis,” we might say.  Everytime we think we’ve got it figured out, that is the beginning of the journey of learning, some Zen master probably said at some time.  Be humble, little tree frog, or wax on, wax off.  Something like that.

Only this year has the economy surpassed the 2008 level of inflation adjusted private investment.  To get a sense of the damage done by the financial and housing crisis, the chart below is a rolling 5 year sum of investment and covers most of the post-WW2 period.  Look at the historic dip – not a pause, not a flattening, but a genuine crater in investment growth.  Here we can see the over-investment during the tech bubble of the late nineties when the 5 year sum climbed at a 60 degree angle, followed by the 45 degree climb as the housing bubble climaxed. Even scarier is the possibility that we may still be above the growth trend of the 70s, 80s and early 90s – that there is still a bit of correction left.

Housing Investment

Seven years after the official end of the recession, ten years after the height of the housing bubble, investment in residential housing is still near all time lows.  As a percent of the economy (GDP) it has been rising but from a great depth.

Slow household formation after the financial crisis, i.e. Johnny and Mary staying home or moving back in with Mom and Dad, has contributed to the slow recovery in housing investment.  The millennial generation, bigger in numbers than the aging Boomers, doesn’t have the same preference for owning their own home.  Census Bureau data shows that the home ownership rate in the under-35 crowd has declined from 39% in 2010 to 34% in 2016.  While it may be more noticeable in the millennial aged cohort, the data shows a decline in all age groups, and across incomes (page 10).   Competition for a dwindling stock of apartment rentals has caused a sharp rise in median rental rates across the country.

Why a dwindling number of rental units?  As home ownership rose in the 2000s, the investments in new apartment building began to decline in 2007, then fell abruptly during the crisis.  Only in 2011 did it finally start to rise up from its trough.  The drop in investment was so huge that just posting a number doesn’t do it justice.  Millennials are now being squeezed by a lack of rental housing stock.  Sharply rising home values in popular areas like Denver make it more difficult for millennials to shift preferences to home ownership.

The business Side

Now let’s look at investments in office buildings, equipment and factories.  These can be somewhat cyclical but the long term trend is down.  Since China was admitted to the WTO in 2001, the highs in the cycle have been trending lower.  During the 2000s Americans were not saving enough to fund business investment growth and our economy increasingly relied on foreign investment dollars.  Today we are on the decline in that investment cycle and we can expect further declines.

Does low inflation hurt investment?

It makes sense that a stable environment of low inflation should encourage business investment.  Low interest rates should encourage lending to business, etc.  This is the conventional narrative that has guided policy making at the Federal Reserve.  Stop an economist on the street and ask them if low interest rates encourage business investment and they will probably say yes. Here’s a quote from an economics course “If the expected rate of return [on the new investment] is greater than the real interest rate, the investment makes sense.”

Makes sense but what if it is partially wrong? Is it possible that low interest rates could, in some cases, discourage investment?  This is the opposite of the conventional narrative but let’s walk this path for a bit.  We often think of interest rates as a dependent variable, a response to something indicating a demand for money.  What if it is also an independent variable, a cause affecting the demand for money? Yep, it’s one of those interdependent cyclic things that might make you want to meditate on the universality of love and being, but stay with me 🙂

Interest rates can be a heuristic for investors, a signal of the demand for money, a weather vane of the underlying strength of the economy as seen by the top economists in the country, the folks at the Federal Reserve.  Low rates could be seen as a cautionary warning to investors.  If the economy were really getting stronger, would interest rates remain low?  Of course not, an investor might reason.  They would rise in response to stronger demand for money.  But they are not rising so better to be cautious, the investor reasons.  The dog chases its tail.

Do low interest rates cause reckless borrowing?

Are low interest rates prompting companies to borrow excessively?  Well, yes and no.  Yes, they are borrowing more but the growth trajectory, the rate of growth, is about the same as it has been since 1990.  As we can see in the chart below, each recession is a pause in the growth of corporate debt.  After each recession, the level rises again on approximately the same slope.  The “pause” in this last recession lasted a whopping four years, during which corporate debt declined as much as $600 billion, or about 5.6%.

The problem is what they are borrowing it for.  Companies typically buy back their own shares at their hghest, not lowest value.  By lowering the number of shares outstanding, buybacks raise the earnings per share even if there is no real growth in earnings.  Instead of buying low, selling high, companies tend to buy high, sell low. FactSet gathers and crunches a lot of market data.  Their mid-year analysis of share buybacks shows that total dollars spent on buybacks is approaching the highs of 2007.  Investment in real growth, in productive plants, equipment and office buildings, has declined the past three quarters but share buybacks, the appearance of growth, have increased.

A simple example

How could low inflation hurt investment?  If predicted inflation is rather low, about 2%, sales growth will not get that extra kick from inflation. Let’s say that a company’s sales are $1000 and the owners have an extra $50 to invest.  They are considering a plan to invest $50 and borrow $50 from the bank to expand in the hopes of making more sales.

First they consider the return by not expanding.  They put their $50 in the bank and make 2% interest or $1.  At 2% inflation, $1000 sales grows to $1020.  Let’s say that the company has a 30% gross margin, which gives an extra $6 profit on the extra $20 in sales.  The combined extra return to the owners is $7, a $6 profit and $1 in interest income.

Then they consider a second scenario.  Let’s say that the interest rate on the borrowed money is 6%, or 4% above the inflation rate of 2%.  As in the first scenario, they assume that the savings rate, or opportunity cost, of the invested $50 is about 2%.  The owners can expect an extra $4 imputed and actual cost on that combined $100 of investment.  If inflation is averaging 2% per year, then they can expect sales of $1020 even if there is no real sales growth.  Again, they use a 30% gross margin to arrive at an extra profit to them of $6, the same as the first scenario. If the extra investment does not produce any real sales growth, then the owners will net an extra profit of about $2, much less than the scenario of no expansion.  To make the same extra profit as in the first scenario, the owners need to generate an extra $11 in profit.  Minus the $4 in costs, the extra profit will be $7, the same as the first scenario.  Note that the owners are now trying to break even with the extra profits of not expanding.  To do that they must have sales of about $1037, or almost 2% real sales growth in addition to the 2% inflation growth.

Now, let’s consider a higher inflation rate of 4%.  Let’s imagine that the cost to borrow money is 8%, or 4% higher than inflation, as before, so that the cost of borrowing the $50 for a year is $4. As before, we’ll assume that the savings rate, or opportunity cost, of the $50 from the owner’ pockets is the same as inflation, or 4%, so that the imputed cost of the owners’ investment is $2.  Borrowed and imputed cost of the extra $100 invested in the company is now $6. If there is no real sales growth, total sales will now be $1040, or $40 more.  A 30% margin gives a gross profit of $12, leaving the owners with about $6 extra profit on investment.

Note that a doubling of the inflation rate in this scenario has produced a tripling of extra profit even with no real sales growth. Still the extra profits are less than not expanding at all.  They must still have a real increase in sales, but it is very small.

So a stable higher inflation rate and interest rate encourages business investment.  The key word here is stable.  We could keep doing this calculation with higher and higher rates producing more net profits to the owners but….  As inflation gets higher, it becomes less stable, less predictable and this unpredictability actually hurts business investment.

The Federal Reserve has set a target inflation rate of 2%.  I think it is too low and the lackluster growth of the economy seems to bear that out. Since the 1970s, prominent economists (Taylor and Tobin, for example) have suggested alternative targets that the Federal Reserve could use to replace the “dual mandate” set by the Congress in 1977.

A prominent alternative is a growth target in nominal GDP, called NGDP,  There are several variations but the one most favored has been level targeting, the calculation of GDP targets over the following five years or so based on an agreed growth rate.  The Fed would then take action to offset deviations from those targets. Two prominent economists, Robert Hall and Greg Mankiw, wrote a paper in 1993 explaining these alternative targets and the policy tools that the Federal Reserve could employ to help reach those targets.  During the period called the “Great Moderation,” from 1985-2007 national income grew at a rate just a bit more than 5%.

Hall and Mankiw noted (pg. 5) that the consensus among macroeconomists at that time was in favor of a targeting of nominal national income because it was a transparent measure, a clear, simple target.  The authors commented (pg. 4): “A rule like ‘Keep employment stable in the short run but prevent inflation in the long run’ [the current rule, by the way] has proven to be hopelessly vague; a central bank can rationalize almost any policy position with that rule.”

So the idea of nominal income or production targeting is familiar to economists and policymakers for several decades but has never been adopted. We can only assume, as the Nobel winner James Buchanan posited, that there is a very good reason for that.  When an obscure policy remains in place, it does so for a reason.  Enough policymakers want the obscurity that the policy provides.  I’m reminded of a letter John Adams wrote to Jefferson lamenting some of the vague language used in the Constitution which both of them had helped to craft.  Adams noted that the vagueness was necessary to reach consensus at the Constitutional Convention.  Efforts to achieve more precision in language or attempts to add specific detail were sometimes met with hardened disagreement.  The “general Welfare” wording of the tax and spending clause, Section 8, was one example.  Some argued that the lack of precision would give future generations of lawmakers some flexibility in determining what, in fact, was the general welfare of the United States.

 Whatever the Fed is doing now is only partially working and a different approach might be in order.  The use of the Labor Market Conditions Index, a broad composite of over twenty employment indicators, in guiding monetary policy shows that the Fed is reaching for a broader set of guidelines.  As Hall and Mankiw indicated, nominal targeting might give the Fed that broad guide, one that is less influenced by the needs and whims of elected politiciams.

Investment decline and the stock market

Let me finish on a somber note.  The year over year growth rate in the SP500 and private investment have both gone negative this year, for the first time since the end of the recession in 2009. The SP500 data is copyrighted so here’s a link to that chart. Pay attention.


If you would like to read more on the relationship of investment to savings, check out this 2006 NBER paper.


Happy Labor Day and put a shrimp on the barbie as a toast to the summer passing!