Author: sgstofka

Intervention

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August 27, 2017

Pew Research surveyed four generations of Americans, from the oldest Americans who are part of the Silent Generation, those who grew up during the Great Depression, to the Millennials, those born between the years 1983 – 2002. Pew asked the respondents to list ten events (not their own) or trends that happened during their lifetime that had the most influence on the country. 9-11 was at the top of the list for all four generations. Obama’s election, the tech revolution and the Iraq/Afghanistan war were the other events common on each list. Some differences among the generations were understandable. Some were a surprise to me. The Great Recession/Financial Crisis of 2008 was only on the Millennials list. Many in this generation were in the early stages of their careers when the recession began. Here is a link to the survey results. Perhaps you would like to make your own list. Keep in mind that the events must have happened during your lifetime.

I don’t think that the Boomer generation understands the long-term impact of the Great Recession. In another decade, many will discover how vulnerable the financial crisis left all of us, not just the Millennials. As we’ll see below, the crisis may be over but the response to the crisis is ongoing.

One of the trends common to each generation’s list was the tech revolution, which has reshaped much of the economy just as the last tech revolution did in the 1920s. The widespread use of electricity, radio and telephone in that decade transformed almost every sector of the economy and accelerated the mass migration of the labor force from the farm to the city.

Like today, a small number of people made great fortunes. Like today, the top 1% of incomes accounted for about 15% of all income (Saez, Piketty). The GINI index, a statistical measure of inequality of any data set, has risen significantly since 1967 (Federal Reserve). The GINI index ranges from 0, perfect equality, to 1, perfect inequality. Incomes in the U.S. are more equal than South Africa, Columbia and Haiti (Wikipedia) but we are last among developed countries.

For several decades, Thomas Piketty and Emmanuel Saez have collected the aggregate income and tax data of developed countries. Piketty is the author of Capital in the Twenty-First Century (Capital), which I reviewed here.  A recent NY Times article referenced a report from Piketty and Saez comparing the growth of after-tax, inflation-adjusted incomes from 1946-1980 (gray line labeled 1980) and 1980-2014 (red line labeled 2014). I’ve marked up their graph a bit.

IncomeGrowth1947-2014
The authors calculated net incomes after taxes and transfers to determine the effect of tax and social policies on income distribution. Transfers include social welfare programs like Social Security, TANF, and unemployment. Census Bureau surveys of household income include pre-tax income and it is these surveys which form the basis for the calculation of the GINI index and other statistical measures of inequality.

I am guessing that Piketty and Saez used their database of IRS post-tax income data then adjusted for transfer income based on Census Bureau surveys. The Census Bureau notes that people underreport their incomes on these surveys.  Is the IRS data more reliable?  Probably, but people do hide income from the IRS. Both Piketty and the Census Bureau note that the data does not capture non-cash benefits like food stamps, housing subsidies, etc.

From 1947 to the early 1960s, the very rich paid income tax rates of 90% so that would seem to explain the after-tax income data from Piketty and Saez. The federal government took a lot of money from the very rich, paid off war debts, built highways, flew to the moon and built a big defense network to fight the Cold War.  Those infrastructure projects employed the working class at a wage that lifted them into the middle class. So that should be the end of the story. High taxes on the rich led to more equality of after-tax income.

But that doesn’t explain the pre-tax income data from the Census Bureau. The very rich simply made less money or they learned how to hide it because of the extremely high tax rates.  In the Bahamas and Caymans, there grew a powerful financial industry devoted to hiding income and wealth from the taxman. In the first years of his administration, President Kennedy, a Democrat, understood that the extremely high tax rates were hurting investment, incentives and economic growth.  He proposed lowering both individual and corporate rates but could not get his proposal through the Congress before he died.  Johnson did push it through a few months after Kennedy’s death. The rate on the top incomes fell from 91% to 70%, still rather high by today’s standards.

An important component of income growth in the post war period from 1947-1970 was the lack of competition from other developed countries who had to rebuild their industries following World War 2. These two decades were the first when the government began collecting a lot of data, and this unusual period then became the base for many political arguments. Liberal politicians like Bernie Sanders and Elizabeth Warren advocate policies that they promise will return us to the trends of that period. It is unlikely that any policies, no matter how dramatic, could accomplish that because the rest of the world is no longer recovering from a World War.

We could enact a network of social support policies that resemble those in Europe but could we get used to a 10% unemployment rate that is customary in France? For thirty years beginning in the early 1980s, even Germany, the powerhouse of the Eurozone, had an unemployment rate that exceeded 8%. At that rate, many Americans think the economy is broken. Despite 17 quarters of growth, unemployment in the Eurozone is still 9.1%. Half of unemployed workers in the Eurozone have been unemployed for more than a year. In America, that rate of long term unemployed is only 13% (WSJ paywall).

The post-war period was marked by high tax rates and high federal spending, a period of robust government fiscal policy.  The federal government intervenes in the economy via a second channel – the monetary policy conducted by the central bank.  The Federal Reserve lowers and raises interest rates, and adjusts the effective money supply by the purchase or sale of Treasury debt.

The 1940s, 1970s and 2000s were periods of high intervention in both fiscal and monetary policy. The FDR, Truman, Eisenhower, Johnson and Nixon administrations exerted much pressure on the Fed to help finance war campaigns and the Cold War. In 1977, the Congress ensured more independence to the Federal Reserve by setting two, and only two, clear objectives that were to guide the Fed’s monetary policy in the future: healthy employment and stable inflation.

A rough guide to the level of central bank intervention is the interest rate set by the Fed. When rates are less than inflation, the Fed is probably doing too much in response to some acute or protracted crisis.

EffFundsRate-Infation

Let’s look at an odd – or not – coincidence. I’ll turn to the total return from stocks to understand the effects of central bank policies. There are two components to total return: 1) price appreciation, and 2) dividends. When price appreciation is more than 50% of total return, economic growth and company profits are doing well. Future profit growth looks good and more money comes into the market and drives up prices. When dividends account for more than half of total return, as it did in the 1940s and 1970s, both GDP and company profit growth are weak. Both decades were marked by heavy central bank and government intervention in the economy.

Here’s a link to an article showing the total return on stocks by decade. During the 2000s, the total return from stocks was below zero. An average annual return of 1.5% from dividends could not offset an annual loss of 2.4% in price appreciation. Hubris and political pressure following 9-11 led Fed Chairman Alan Greenspan to make several ill-advised interest-rate moves in the early 2000s that helped fuel the housing boom and the ensuing financial crisis. His successor, Ben Bernanke, continued the policy of heavy intervention. Following the financial crisis, the Fed kept interest rates near zero for nine years and has only recently begun a program of gradually increasing its key interest rate.

The price gains of the 2010s have lifted the average annual return of the past 18 years to 7.4%, and the portion from dividends is exactly half of that, at 3.72% per year.  It has taken extraordinary monetary policy to rescue investors, to achieve balanced returns  that are about average from our stock investments.  Some investors are betting that the Fed will always come to the rescue of asset prices.  That same gamble pushed the country to the financial crisis when the government did not rescue Lehman Brothers in September 2008.

The financial crisis should have been on each generation’s list.  Within ten years it will be.  It is still crouched in the tall grass.

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Debt

Happy days are here again.  Yes, girls and boys, it’s time to raise the debt ceiling!  By the end of September, the Treasury will run out of money to pay bills unless the debt ceiling is raised. This past week, President Trump hinted/threatened that he would not sign a debt increase bill unless it included money to build the wall between the U.S. and Mexico.

The Congress has not had a budget agreement in several years and is unlikely to enact one this year. People may sound tough on debt but a Pew Research study
showed that a majority do not want to cut government programs, including Medicaid.

Liberal economists insist that government debt levels don’t matter if the interest on the debt can be paid. This article from Pew Research shows the historically low rate on the federal debt. However, Moody’s reports that the U.S. government pays the highest interest as a percentage of revenue among developed countries. As a percent of GDP, we are 4th at 2.5%.

The Eclipse of Optimism

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August 20, 2017

We are coming up on an anniversary of sorts. Two years ago, the stock market had a series of sell offs in the last week of August. China devalued the yuan, commodity prices around the world swooned, and Greece was in imminent default on its loans. Pictures of empty cities in China prompted speculation that the building boom in China was coming to an end and would bring down the global economy. Over the course of 6 days, the SP500 shed 11%.

By year’s end the SP500 was still slightly below its level at the end of August and did not rise above its mid-2015 price till the summer of 2016. Long term assets at the end of 2015 declined slightly for the first time since the financial crisis (ICI 316 page pdf). There wasn’t a rush for the exits but clearly some investors were spooked. Should I get spooked when the next 10% drop comes?

In the past five years there were 73 daily declines of more than 2% in the SP500 index.  That’s more than one in twenty trading days or about one per month.  2% is more than 400 points on the Dow at current levels.  One bad day per month was relatively mild compared to the previous five-year period from August 2007 to August 2012. Bad days with greater than 2% declines occurred more than once a week!

I wondered if a bad week telegraphed a long term severe decline in stock market prices. Let’s say that within five trading days, the stock market fell 10%, averaging more than a 2% decline on each of those five days. I started my search twenty years ago and each bad week had its own story.

The list:
the LTCM financial crisis of October 1998,
the end of the dot com boom in April 2000,
the week following the attack on 9-11,
the bankruptcy of giant WorldCom and other accounting scandals in July 2002,
the winter months of 2008-2009 during the financial crisis,
the budget battle and fears of the U.S. government defaulting on its debt in August 2011, and the devaluation of the Chinese yuan in August 2015.

In each case investors were jolted by a surprise or some ongoing concern deepened into despair and a rush for safety. In some cases, the crisis ended or a solution was found and the dip was a good buying opportunity. In other cases, the fears signaled a severe and sustained repricing as in 2000–2003 and in 2008-2009.

Let’s say I interpreted a 10% dip as a good time to increase my equities. Imagine the sinking in my belly when stocks continued falling another 20, 30, or 40% as in the two repricing periods above. How could I have been so stupid?

Just as losses of 10% in a week are not reliable predictors of doom, gains of 10% in a week are inconsistent predictors of a market recovery. When bad weeks happen, financial pundits seem so sure that a 50% drop in the market is imminent. The data shows that this is not the case.

Now I’ll turn up the dial and see if I can find any consistency. A drop of 15% in a week is rare. In sixty years, the only instances of this are in October 1987, and October and November of 2008. In each case, there was more pain to come after that initial fall. So, if I happen to be alive when the next 15% weekly drop comes, the market has probably not finished correcting. The only 15% gain in a week was in November 2008, following an almost 20% fall the previous week. Boy, those were the good old days – not.

Since historical data does not give a clear guide for short to mid-term outcomes, my best strategy in reaction to a bout of market darkness may be – gulp! – do nothing. That can be so difficult when I am bombarded with forecasts of catastrophe at those times.  The sun will shine again.  It’s only an eclipse.

Wage Growth – Not

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August 12, 2017

Ratios are important in baseball, finance and cooking, in economics, chemistry and physics, and yes, even love. If I love her a lot and she kinda likes me a little, that’s not a good ratio. I learned that in fourth grade.

Each week I usually turn to one or more ratios to help me understand some behavior. This week I’ll look at a ratio to help explain a trend that is puzzling economists. The unemployment rate is low. The law of supply and demand states that when there is more demand than a supply for something, the price of that something will increase. Clearly there is more demand for labor than the supply. I would expect to see that wage growth, the price of labor, would be strong. It’s not. Why not?

I’ll take a look at an unemployment ratio. There are several rates of unemployment and there is no “real” rate of unemployment, as some non-economists might argue at the Thanksgiving dinner table. The rates vary by the types of people who are counted as un-employed or under-employed. The headline rate that the Bureau of Labor Statistics (BLS) publishes each month is the narrowest rate and is called the U-3 rate. It counts only those unemployed people who have actively searched for work in the past month. In the same monthly labor report, the BLS publishes several wider measures of unemployment, U-4 and U-5, that include unemployed people who have actively searched for a job in the past 12 months. U-6 is the widest measure of unemployment because it includes people who are under-employed, those who want full-time work but can only find part-time jobs. Included in this category would be a person working 32 hours a week who wants but can’t find a 40 hour per week job.

The ratio that helps me understand the underlying trends in the labor market is the ratio of this widest measure of unemployment to the narrowest measure. This is the ratio of U-6/U-3. In the chart below, this ratio remained in a narrow range for 15 years. Unemployment levels grew or shrank in tandem for each group. By 2013, the ratio touched new heights, climbing above 1.9 then crossing 2 in 2014. The two groups were diverging. The U-3 rate, the denominator in the ratio, was improving much quicker than the U-6 rate that included involuntary part-time workers.

U-6-U-3Ratio

What would it take to bring this ratio down to 1.85? About 1.5 million fewer involuntary part time workers. What does that involve? Let’s say that those involuntary part-time workers would like an average of 15 more hours per week of work. That is more than 20 million more hours of work per week, which seems like a lot but is less than a half percent of the approximately 6.1 billion hours worked per week in the 2nd quarter of 2017.  These tiny percentages play a significant role in how an economy feels to the average person.

Let’s turn to a ratio I’ve used before – GDP per hour worked. I don’t expect this to be a precise measurement but it reveals long term trends in productivity. In the chart below, GDP per hour has flatlined since the end of the recession.

GDPPerHour201706

There are two ways to increase GDP per hour: 1) productivity gains, or more GDP per hour worked, and 2) reduce the number of hours worked more than the reduction in GDP. Door #1 is good growth. Door #2 is the what happens during recessions. GDP per hour rises because hours are severely reduced. I would prefer slow steady growth because the alternative is painful. Periods of no growth can be wrestled out of their torpor by a recession, a too common pattern. There were two consecutive periods of flat growth followed by recession in the 1970s and from the mid-2000s to the present day.

GDPPerHour1971-1984

The economy can withstand two years of flat growth without a recession as it did in the early 1990s. It is the long periods of flat growth that are most worrisome. In the early 1970s and late 2000s, the lack of growth lasted three years and were followed by hard recessions. The lack of growth in the late 1970s led to the worst recession since the 1930s Depression. GDP per hour growth has been flat for eight years now and I am afraid that the correction may be hard as well. Maybe it will be different this time. I hope so.

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Participation Rate

Some commentators have noted the relatively low Civilian Labor Force Participation Rate (CLFPR). This is the number of people who are working or looking for work divided by the population aged 16 and older. (BLS). The rate reached a high of 67% in 2000 and has declined since then. For the past few years, the rate has stabilized at just under 63%.

A graph of the rate doesn’t give me a lot of information. Starting in the 1960s, the rate rose slowly as more women came into the workforce and the large boomer generation came into their prime working years. So I divide that rate by the unemployment rate to look for long term cyclic trends. Notice that this ratio peaks then begins a downward slide as recessions take hold.

CLFPR-UI1947-2017

In mid-2014 this ratio finally broke above a long term baseline average and has been rising since. Today’s readings are nearly at the peak levels of early 2007.

CLFPR-UI

Some pundits use the CLFPR as a harbinger of doom that includes: 1) too many people are depending on government benefits and don’t want to work; 2) there is a shrinking pool of workers to pay for all these benefit programs; 3) thus, the moral and economic character of the nation is crumbling. During the 1950s and 1960s, when the participation rate was lower than today, our parent’s generation managed to pay off the huge debts incurred by World War 2. It is true that benefit programs were much less than those of today.

In “Men Without Work” Nick Eberstadt documents a long term decline in the percentage of prime age (25 – 54) males who are working.  Some interesting notes on shifting demographics: foreign born men of prime working age are more likely to be working or looking for work than U.S. born males. According to the Census Bureau’s time use surveys, less than 5% of non-working men are taking care of children.

In 2004 the participation rate for white prime age males first fell below those of prime age Hispanic males and has remained below since then.  In 1979, 10% of black males aged 30-34 were in jail.  In 2009, the percentage was 25%.

So why should I care about participation rates and wage growth? Policies initiated in the 1930s and 1960s instituted a system of inter-generational transfer programs.  In simple terms, younger generations provide for their elders. Current Social Security and Medicare benefits are paid in whole or in part by current taxes. We are bound together in a social compact that is not protected by an ironclad law.  Beneficiaries are not guaranteed payments.

For 40 years, from 1975-2008, the number of workers per beneficiary remained steady at about 3.3 (SSA fact sheet). In 2008, the financial crisis and the retirement of the first wave of the Boomer generation marked the beginning of a decline in this ratio to the current level of 2.7.

In their annual reports, both the SSA and the Congressional Budget Office note the swiftly changing ratio.  Within twelve years, the ratio is projected to be about 2.3.  In 2010, benefits paid first exceeded taxes collected and, in 2016, the gap had grown to 7% (CBO report) and will continue to get larger.

Policy makers should be alert to changes in the participation rates of various age and ethnic groups because the social contract is built partly on those participation rates.  As with so many trends, the causes are diffuse and not easily identifiable.  Economic and policy factors play a part.  Cultural trends may contribute to the problem as well.

Congress has a well-established record of not acting until there is an emergency, a habit they are unlikely to change.  Fixing blame wins more votes than finding solutions, but  I’m sure it will all work out somehow, won’t it?

 

Storage Costs

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August 6th, 2017

Last week I discussed the concepts of present and future money. This week I’ll look at the costs involved in storing our money for future use. When I store my fishing boat over the winter, I pay storage costs. When I store money for the future I also pay storage costs. Some of these costs are outright fees. If I have a financial advisor, I may pay them a percentage based on the amount of money they manage for me. All mutual funds charge a fee which is clearly stated in the fund’s prospectus. Pension funds charge fees as well and that is not always as clearly stated.

In addition to fees, there are implied costs. My bank lowers the interest rate they pay me for savings and CD accounts to take care of their operating costs and profits. I could put my future money under my pillow but inflation eats away at my store of future money like rats in a granary bin.

Let’s turn to another cost that is more of a packaging cost– income taxes. But wait, taxes come out of my present money, my income. How can that be a cost of my future money? In the progressive income system that we have in this country, my income is taxed. If I make more money than my neighbor, I will pay a higher rate. My neighbor may pay an effective tax rate of 5% and I pay 15%.

We pay taxes on our leftover income – what we could put away into our store of future money. Let’s say that the median household income is $50K and my family makes $70K. The difference is $20K more than the median. It’s money that I could put into my store of future money. On the other hand, my neighbor’s household makes $40K, or $10K less than the median. Part of my family’s income that I could have put away for the future is going to be taken by the government in taxes.  Some of it will be used as a fee to pay for today’s common expenses like defense, police and courts, research, and infrastructure. Part of it will be given to my neighbor as a transfer payment. My future money becomes my neighbor’s present money.

How did I get my present money, my income? Invariably, it came from someone else’s future money which was previously saved and invested in a business that either hired me or contracted with me. All this money is on a merry go round of time.

Now let’s turn to the prospects for my future money. This article lists 22 reasons for not investing more money in equities at current valuations. I have mentioned several points covered in this article. One is the percentage of household wealth that is invested in the stock market. This past month, that percentage surpassed the level at the peak of the housing boom in 2006-2007.

StocksPctFinAssets201706

Maybe this time is different but I won’t count on it. The heady peaks of the dot-com boom in the late 1990s shows that this can go on for some time before the whoosh! comes.

Housing prices continue to grow above a sustainable trend line. I’ve marked out a 3% annualized growth rate on the chart below. This housing index is for home purchases only and does not reflect refinances.

PurchaseOnlyHPI201706

Check out the growth in commercial real estate loans.  The 10% annual growth of 2015 and 2016 has cooled somewhat in the first two quarters of 2017 but is still a torrid 7.6%.  (Source)

CommlRELoans

Several years ago, I thought that real estate pricing would not get frothy again for several decades. We had all learned our lesson, hadn’t we? Maybe I was wrong. The worth of an asset is what the next buyer will pay for it.  Zillow tells me I am growing richer by the day but there’s a problem.  If I did sell my home, what would I buy?  Everywhere I look, housing prices are so expensive.  Now I come back full circle to another storage cost – storing the future me.

A Choice of Money

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July 30, 2017

Gresham’s law states that an overvalued form of money will drive out an undervalued form of money. Let’s say that both gold and silver are accepted as money and the government fixes a ratio of 1:20 between the two metals. One ounce of gold thus equals twenty ounces of silver. Let’s say that people and businesses hold ten times as much silver as gold. The exchange ratio that the government has set is higher than the ratio of the stores of the two metals. Gold is overvalued. Gresham’s law states that people will start using gold as an exchange medium to the extent that eventually silver will be driven out of circulation.

I wanted to explore this concept and substitute two things that are not currencies or commodities: liquidity and debt.  Liquidity is today’s money.  Debt is tomorrow’s money. Today’s money is stable and available.  Tomorrow’s money is not. As soon as money is loaned, it can’t be readily converted to cash.  It’s future money.

Gresham’s law is about people’s preferences and the value of money.  When millions of individual circumstances are added up,  a preference for liquidity or debt emerges. When tomorrow’s money is overvalued, people use it, and drive down the use of present money. “Don’t save up to buy what you want.  Buy it now with future money.  Here I’ve got some,” say businesses and banks.

Let’s look at two representations of present and future money.  M2 is a broad measure of the money supply that includes cash, checking and savings accounts, as well as money market accounts and CDs that can be quickly converted to cash. Future money is the amount of business and household debt.

During recessions (gray areas in the chart below), M2, the numerator in the ratio, goes up and debt goes down. Economists call this a greater preference for liquidity. Banks are more reluctant to lend money, which tightens credit and restrains the growth of debt.  People charge less and stick more money in checking and savings. Businesses don’t borrow to expand their operations and keep more cash on hand to pay present obligations.

In the chart below, I chart the ratio of the yearly change in today’s money, or what the Federal Reserve calls M2 money, and tomorrow’s money, the amount of business and consumer debt.

M2DebtCLIRatio1960-2007

In the recessions of the 1970s and 1980s, the graph shows what I would expect. There was a greater preference for liquidity and the ratio of present to future money rose above 1, a clear sign that people and businesses were worried about the future.  As the recessions ended, the ratio declined as debt, the denominator in the fraction, grew at a faster rate than M2 money, the numerator. The recessions of the early 1990s and early 2000s were fairly mild in comparison and the uptick in a preference for liquidity was mild.

The chart ends in 2007, just before the recession and financial crisis. Let’s now turn to that period. During the early part of 2008, the ratio began to climb to 1, indicating that people and businesses were preferring liquidity over debt. During the first six months of 2008, 700,000 jobs had been lost but this was only 1/2% of the workforce. Almost 300,000 of those lost jobs were in construction, which had become overheated by the building of so many homes. Retail sales growth had gone flat but was probably just a pause in the normal course of the business and credit cycle. Not to worry.

Then a funny thing happened to the economic engine of the country, something that had never happened before in post-WW2 America. The ratio spiked upward, registering nosebleed readings.

M2DebtCLIRatio2006-2008

The preference for present money continued upward but the change in debt, the bottom number in the ratio, plunged downward and this drove the ratio higher. The Federal Reserve began buying some of this debt until it held about $2 trillion.

Debt2008-2010

As the change in debt turned negative, the ratio turned negative, a post Depression first. Month after month, old debts soured.  People and businesses shunned new debt. People who were saving more of today’s money were being offset by those who had to tap their savings accounts to make up for lost income. Toward the end of 2008, the economy lost as many jobs each month as it lost in total for the first six months of 2008. Retail sales dropped a few percent each month.

M2DebtCLIRatio2008-2011

Like a car whose brakes have failed, the ratio continued its downward slide. In a program called Quantitative Easing (QE_, the Federal Reserve began buying more debt in an effort to get this ratio into the positive zone.

By the middle of 2012, the ratio broke into the positive zone as debt stopped contracting. The preference for liquidity was strikingly high, going up above 8, more than three times higher than the 2.5 level of the 1980s recession.

M2DebtCLIRatio2012-2014

The Federal Reserve continued to buy debt as the economy staggered to its feet.  In 2013, the stock market finally surpassed its inflation adjusted value at the start of the recession.  In the early part of 2014, the ratio of liquidity to debt, of present money to future money, finally fell below 2. At mid-2014, the Fed had accumulated $4.5 trillion in debt, $3.7 trillion of which had been added during the financial crisis. After 6-1/2 years, the number of people employed finally rose above its pre-recession level.  The Fed ended its debt buying program.

So where do we stand today? The stock market and house prices continue to make new highs but the current reading of this ratio show that people continue to prefer today’s money over tomorrow’s money.

M2DebtCLIRatio2014-2017

In short, the economy is still healing. During the expanding economy of the 1960s, the ratio was a bit over 1 for half the decade.  People who had grown up during the Depression were understandably a bit cautious. However, both present and future money grew at a steady rate during the 1960s. Today’s households and businesses have been scarred by the financial crisis and are cautious.  Into this cautious confidence, the Fed has a lot of debt to unload.  It must maintain a balance between money preferences as it feeds the debt it bought during the crisis back into the economy.

Reading the Signs

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July 23, 2017

This week I begin with market volatility, or VIX, an index that reflects the price range of short term options on the SP500 index. As I wrote last week, the market has been on a wonderful ride down the river. The waters are strong but calm. No nasty rocks that might upset my raft. As Alfred E. Neuman of Mad Magazine asked, “What, me worry?”

How low can volatility go? The VIX is below 10, a level not seen since a brief moment in November 1993. The market makes new highs while volatility makes historic lows. Some warn of impending doom as though the market were the Titanic. Others predict Dow 30,000.

I’ll look at a 20 year period of both the VIX and the SP500 index, from 1990 to 2010. (If you are reading this on a cell phone, the few charts below will be more easily viewed by turning the phone sideways.) The period is marked by 3 strong price trends: 1) the extraordinary price rise in the late 1990s during the dot-com boom; 2) the 50% fall in prices from 2000 – 2003 as the bubble punctured and investment declined; and 3) the recession and financial crisis that began in 2008.

According to models, volatility should move inversely to stocks.  When one zigs, the other zags. By inverting a chart of volatility, I should see a volatility pattern that is somewhat similar to the pattern of SP500 index prices. I’ve added a chart of correlation between the two. I should expect to see a correlation of greater than 50 if things go according to the model.

For most of the twenty years, I do see what we expect. It’s those periods of unusual moves in the SP500 that the relationship breaks down. There is no consistency when the correlation breaks the model.

SPYVIXCorrelation
The green circle highlights the run up in prices of the dot-com boom. If I were to try to form a rule based solely on this mid-1990s behavior, I might say that when the VIX doesn’t behave inversely to prices, I should anticipate a run up in prices.

I’ll now take a look at the financial crisis years 2007 – 2009, the second red circle above. Just as in the late 1990s, the correlation veered away from expectations but this time prices moved in the opposite direction, falling 50%.  So much for my rule making.

The behavior is more complicated still when I look at the correlation pattern in the early 2000s.  The correlation wandered away from what I expected but never fell into the negative, yet prices also fell 50%.

Short-term options on the direction of the SP500 may offer no consistent clues to the long-term casual investor. But then again….maybe I should go long – averages, that is.

Below is a chart of SPY, a popular ETF that mimics the SP500.  Visual presentations can help me digest a lot of information and relationships. I have divided SPY by the VIX to get a ratio. If the top part of the fraction is supposed to go up when the bottom part of the fraction goes down, the resulting ratio should emphasize any price moves. Here I see a bit more predictability if I concentrate on the 12 and 24 month averages and disregard the noise. There is a lot of noise.

SPY-VIX1995-2017

The 12 month average (blue) runs higher than the 24 month average (green) in upturns and lower during downturns. The transitions may not always be as evident until I turn to the noise. When the current ratio runs below the 12 month average for several months, a downturn is likely. The opposite is true for an upturn. Here’s a chart with these turning points highlighted.

SPY-VIXTurnPoints

Some readers may occasionally want to check this pattern on their own. Without an account at stockcharts.com, someone can still call up weekly charts for free. Type in SPY:$VIX and call up the default daily chart. Above the chart, select the weekly button, then click the Update button to the right. Below the graph, change the default 200 day average to 100 and click Update. You should get a chart similar to the one below.

SPY-VIXWeeklyTurnPts

I have highlighted the turning points. Notice that there is a fairly consistent pattern. For the not so casual investors, you can bring up a daily chart and see similar turning points.

We have not had a 5% price correction in stocks for the past year. Here’s a chart showing twenty years of average performance during the year. We should not be surprised if we see a correction in the next few months but this market continues to befuddle even the most experienced investors.

Across the plains of Africa, the annual migration of wildebeest has crossed into Kenya. To tourists riding in jeeps through the grasslands, the movements of these animals may seem quite random and fragmented.  Tourists riding in hot air balloons above the plains can see the relationship between geography and the animals.  They can see the patterns of movement as the wildebeest follow the valleys and cross the rivers through the grasslands.  Likewise, a few charts of price and volatility can help us visually understand some part of investor behavior.

River Rafting

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July 15, 2017

After a good year of snowfall in the Rockies, the rivers run strong. A popular spot for rafting is the Colorado River as it runs through the dramatic scenery of the Glenwood Canyon in western Colorado. Investing is a lot like rafting. We can’t control the amount of snowfall, the change in elevation, where the rocks are or the streams that feed into the river.

Our individual and group behavior on the river can help or hinder our progress. In a good year, rafting companies charge more for a rafting adventure. As more people come onto the river, we must pause in quiet water at the river’s side to give a safe distance between rafts. This crowding effect is made worse by stretches of river that require more caution to navigate. We can steer right or left to avoid some rocks but we are largely at the mercy of the river and each other.

Since the budget crisis in the late summer of 2011, the stock market has enjoyed a fairly strong run, more than doubling since that time. The financial crisis nine years ago was like a winter of extraordinarily deep snowfall. The Fed has kept interest rates abnormally low to thaw that snow, and equity investors have had a wonderful ride.

The Federal Reserve has committed to a series of gradual rate increases. Despite the low rates, people continue to pour their extra money into savings accounts and CDs. Wells Fargo is paying almost 1% below the Fed discount rate on their savings accounts. Why? As long as their customers are willing to accept savings rates of .3%, Wells Fargo has no incentive to raise rates. Discover, Goldman Sachs, American Express, Ally and Synchrony are paying about 1.15%, the Fed rate. (Bankrate) Savings account balances are near $9 trillion, more than double the balances in late 2007 before the recession began. The fear lingers.  Many people stand on the shore, too cautious to ride the river’s tumble and flow.

Until 2015, retail sector stocks (XRT) have been on a fast raft, quintupling from the market lows of March 2009. Over the past two years they have drifted into a side pool, losing about 20%. This year the stocks have been quite volatile as investors gamble on the future of the retail industry. Will Amazon continue to take sales from traditional brick and mortar stores?

June’s retail sales (RSXFS) were disappointing. Year over year growth was 3%, less than the 5 year average of 3.3%, and far below the near 5% growth of the 1st quarter. Excluding auto sales and auto parts (RSFSXMV), annual growth was only 2.4%, a 1/2% below the five year average and half of the 1st quarter rate.

The Trump administration and the Republican Congress have aimed for 3% real – inflation adjusted, that is – GDP growth. In an economy that depends so heavily on consumer sentiment, slowing retail sales will make that growth goal difficult to achieve.

For now, the sun is shining, the river is running strong and I am enjoying myself.  As long as I don’t look around the next bend in the river, everything looks fine!

 

Package Me

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July 9, 2017

Two weeks ago I looked at a long term trend of consolidation and concentration. Technology companies now dominate the top spots in the SP500, the number of retail outlets is shrinking, the number of banks is dwindling, and the population itself is concentrating in urban areas. This week, I’ll look at a companion trend – categorization.

The essential business model of some leading technology companies is the selling of advertising to us and the selling of us – our interests and choices – to other companies. We are the consumers and the products. We are the components of the business models of companies like Facebook (FB) and Google.

A business model is a plan to provide and capture value. FB and Google provide value by connecting us to each other and to a vast trove of information, most of which we ourselves provide. FB and Google capture value by selling us. To sell us, the unique composite of all of our choices must be packaged into algorithmic categories.

We consume information and we are information. We are part of the network of information. When I travel, Google Maps tells me where I am and how to get where I want to go. Where is a grocery or sporting goods store along the way? Google knows. Within hours, Google has sold that information to companies who offer me deals on hotels and restaurants. I am part of the network.

Listen to a forty year old song from Pink Floyd, Welcome to the Machine. It is a cynical vision of being absorbed into the dream machine of the entertainment industry. This is a brave new world of information – and maybe some disinformation and some anger and scams and sexploitation but I want to focus on the positive.

As I drive to work or the store, I give a wave to the mobile purchasing unit in the car next to me. Hi, neighbor! I don’t mind that my entertainment, dining and transportation choices are for sale. I do mind that my political and religious beliefs are packaged and sold like commodities. That is the price that I pay for being in the information club.

Talking about travel….annualized sales of autos and light trucks has fallen below 17 million for several months now. On a per capita basis, sales never reached the levels of past economic recoveries. We are buying about 5 cars for each 100 people, and that is less than the 5.8 cars we have bought in previous periods of economic strength. The auto industry would have to sell almost 19 million cars and light trucks each year to meet those per capita levels.

AutoSalesPerPop

I heard someone remark that cars are becoming like appliances. As I drive down the highway, I see that there are only a few body styles. Engineers have gradually perfected those designs that minimize wind resistance in order to increase gas mileage enough to meet EPA requirements. I drove next to a Ford Fairlane 500, a boat of a car from the era when car designers and advertising guys – always guys – teamed up and let their creative juices flow. Those were the days when a car was a signature. Now I drive down the highway in a category of vehicle. Hey, ma, look at me!

In order to sell me stuff, Google and FB need my attention. Unfortunately, I must devote a lot of my attention to driving. As a mobile purchasing unit, this is an unproductive use of my attention. A self-driving car will be the final step in the appliancification of the automobile. “Google, when will I arrive at work?” “In approximately 8 minutes.” Beam me up, Scotty.

Over a million people in the U.S. die in automobile accidents each year, and approximately 10% of the entire population are injured in a year. The major car companies have committed to having a driverless car by 2020 or soon after. The cost to add driverless capabilities is only a few thousand dollars. Some research companies are predicting (Motley Fool article) a gradual transition to driverless cars with 10% being fully autonomous in 15 years.

I think that the changeover will happen more quickly because Google and FB need my attention. Thousands of vendors want the dollars in my pocket to join the network. For the next 10 minutes only I can get a deal on a fresh pastry and a coffee at the Starbucks just down the street. Say or press “Yes” to accept this deal and my car will drive itself into the Starbucks’ drive-up lane.  Would I like to order ahead?  The car can do that for me. Well, sure.  Hey, I like this new world.

I wrote about consolidation and concentration a few weeks ago. Soon to come will be an integration to package us as mobile purchasing units. A big technology company could partner with or absorb a finance company to help me buy a driverless car in order to market to me. Google could subsidize a better interest rate on my auto loan or lease as a cost of packaging my choices to other vendors. I hear the sound of dollar bills stirring in my pocket. They want to be part of the network as well.

Next week, the stream and the pool…

Healthcare Quicksand

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July 2, 2017

Last week I looked at the ten year anniversary of the iPhone. This week I’ll take a brief holiday look at a five year anniversary.

In June 2012 the Supreme Court ruled on the constitutionality of Obamacare. As expected, the vote was a close 5-4 decision. Many Republicans expected the five conservative justices to overturn the ACA on the grounds that the Federal government could not force people to buy insurance. John Roberts, the head justice on the court, sided with fellow conservative justices on this position at first, but the arguments of the liberal justices convinced Roberts that, regardless of the language in the ACA, the penalty for not having health insurance was a tax no matter what it was called. Roberts’ vote was the deciding vote in upholding the constitutionality of the act.

This interpretation was not without precedent. In 1937, the cout ruled that the Federal government could force people to pay Social Security insurance premiums. The reasoning was the same. Payments could be called an insurance premium or a penalty or an incentive. No matter the language that legislators used, the payments were a tax and well within the rights of the Federal government.

In 2012, Republicans released a position paper on healthcare legislation. The key features were: Affordable and accessible, no refusal of insurance based on pre-existing conditions, and allow people to keep the plan they have. Five years later, Republicans hold the Presidency, House and Senate, and are discovering the difficulties of implementing those simply stated principles.

Health care is almost 20% of the nation’s economy. There are many stakeholders. They are vocal and well funded. Because Republicans do not have a 60 vote majority in the Senate, the legislation must conform to budget rules that will permit a simple majority vote. In 2009, the Democrats had a 60 seat majority when they began the process of crafting the ACA and found that they had to make a lot of compromises. When Massachusetts Senator Ted Kennedy died in August 2009 and Republican Scott Brown won the special election to replace Kennedy, the Democrats lost their filibuster proof majority and had to make more compromises to get the ACA passed.

For seven years Republicans in both the Senate and House have run quite successfully on repealing Obamacare. Strong and principled opposition to the ACA has become less fervent.  Senators must appeal to a broader constituency than House members.  Some were reluctant to vote for legislation that could jeopardize the availability of health care for vulnerable seniors, children and low income families.

Senate Majority Leader Mitch McConnell had set a deadline for a Senate vote before legislators went to their home districts for the July 4th holiday but could not assemble the votes needed to pass the legislation. McConnell is still committed to the joint task of repeal and replace. He has rejected calls from some in his party to pass a repeal bill now and continue to work on replacement legislation.

There remain more legislative hurdles in the next few months but the most pressing is the raising of the debt limit.  The Treasury is already doing a few accounting tricks to pay bills but has notified Congress that even those tricks will no longer suffice by October.  For now, the market continues to shrug.

Last week I finished up with a teaser and I hope to have that fully developed by next week. For now, Happy Independence Day!

A Decade Of Change

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June 25. 2017

This week I will review a decade of change to help illustrate a fundamental fact about investing:  most of us are clueless about the future because we are bound by comfortable habits of thinking.

Ten years ago this month, June 2007, Apple launched the iPhone. The touch screen was innovative but I found the keyboard had a lack of responsiveness. The ability to use the internet was cool but the connection was slow. There was no camera built into the phone. Cameras took pictures, not phones.  Apple did not introduce the App Store till July 2008 so users got whatever Apple thought they needed. Apple controlled both the hardware and software. People stood in line when the first phone was released because Apple people are a little bit nuts. The phone was suitable for geeks who had money to burn.  Or so it seemed.

Phones were tools, not toys. People who used their phones for work used a Blackberry, a phone with a keyboard that kicked butt over the iPhone and had a great email interface to boot. The low cost workhorse phones were Nokia models. They stood up to daily wear and tear and the little screen was adequate for reading text messages.

The previous year, a relatively new company called Facebook notched 12 million monthly users (Guardian) and their user count was growing fast. Facebook was a social networking site for people who had time on their hands and the desire to connect with their friends. A passing fancy for the kids, no doubt, just like rock and roll was to an earlier generation of parents.  Or so it seemed.

That same year, the internet search company Google developed a beta version of a phone operating system (OS) that could compete with Apple’s iOS.  In the fall of 2008, a year later, Google released version 1 of the OS.  It was built with an open source code that Google called Android. That same month, the wheels came off the global economy. As millions of people lost their jobs, they worried more about paying their bills than a phone operating system.  By November 2008, both Google and Apple had lost half of the value they had in the summer.  Blackberry lost 2/3rds of its value.

In June 2009, two years after the launch of the iPhone, the electronics division of the conglomerate Samsung introduced the Galaxy smartphone.  The phone used the new Android OS and, to compete with Apple’s App Store, hundreds of apps were available for the phone.

Clickety-click as we turn the time dial to the present.  At $10, Blackberry’s stock sells for 7% of its price in June 2008.  Hillary Clinton likes her Blackberry but too many people switched. Until the fourth quarter of 2016, Samsung sold more phones than Apple, but Apple makes more profit on their phones and is the largest company by market capitalization.   Since the iPhone launch Apple’s stock price has soared 900%. Together the two companies account for almost half of all smartphones. They have become wearable computers and cameras and music players and podcast devices.

The iPod was the marriage of a CD player and a portable radio – a consolidation of two functions. Following its introduction in 2001, the iPod became the dominant music player.  Umpteen million songs were available on the device through the iTunes store.  In April 2007, Apple announced that they had sold 100 million iPods in 5-1/2 years, and by the end of 2014, that figure stood at 390 million.  But smartphone users were now using their phones to play music.  In 2014, sales of the iPod fell by half to 15 million. In 2015, Apple stopped reporting the number of iPods sold.  Consolidation had been the key to the iPods success and its demise.

The iPhone and the various Android models of smartphones have depended on increasing network availability and quality – “can you hear me now?” – and the thousands, or millions, of apps available for the phones. I can read email on my phone as well as my newspaper, a book or magazine. Students can read their textbooks on their phones. In addition to music, I can listen to podcasts or radio stations from far away.

The sophistication and accuracy of Google maps is science fiction made fact. I was recently in the middle of beautiful Idaho. The topographic map published a few years ago indicated that a particular county road was improved but unpaved. Google maps marked the road as paved for about ten miles. Google was right. Portions of Nevada that were blurred a few years ago on Google maps now show roads that lead to where? Maybe some alien city in the middle of the desert.

As I mentioned last week, the top 5 companies in the SP500 are tech companies. Ten years ago, the top 5 were Wal-Mart, Exxon, GM, Chevron and ConocoPhillips (Fortune), a mix of retail, automotive and oil sectors. Now there is only one sector at the top: technology. As a rule, concentration is not a good thing.

Let’s turn from tech to banks.  Since 2007, America has lost a third of its banks, a continuation of a trend that began after the Savings and Loan crisis in the late 1980s. The number of commercial banks in the U.S. is about a third of what it was in 1990. New York has lost half of its banks in that time. California has lost about 60% of its banks. You can check your state at the Federal Reserve Database  and search for [postal abbreviation for state]NUM. As an example, Colorado is CONUM. New York is NYNUM. California is CANUM. The U.S. figures I mentioned earlier come from the series USNUM.

Consolidation is spreading throughout the economy. In the last 12 months, more retail stores closed than during 2008, the year of the financial crisis. The stocks of the retail sector (XRT) have fallen 20% from their highs.

Adding to the pressure on brick and mortar retail stores, Amazon recently announced that they were buying Whole Foods. Amazon’s sales have grown by more than 1000% since 2007, and America’s stores have felt the pain.

The consolidation in the retail space has been going on since the 2001 recession and the demise of the dot-com boom. The population has grown 14% since then but the number of employees in retail has grown less than 3%. Inflation adjusted sales per employee have grown by 61% in the past 16 years but the inflation adjusted wages of retail workers have declined 1%.

We ourselves are concentrating. For the first time in the nation’s history, more people live in urban areas than rural areas. That concentration has pushed home prices up in the larger metropolitan areas. The S&P/Case-Shiller 20 city home price index has doubled since 2000, easily outpacing the 45% gain in prices, averaging 2% better than inflation.
Smaller cities and rural areas have not done as well. Below is a 40 year chart of inflation adjusted residential prices for all of the U.S. The average yearly gain is 1.7% above the inflation rate, slightly below the 20 city gains of the past 16 years. But the ten year average tells a story of crisis, erratic recovery and migration. The 20 city price index has lost only 1/4% per year since the highs of 2007. The country as a whole has lost 2% per year.

ResPricePctGain

(Sources: National sources, BIS Residential Property Price database)

Where will this consolidation lead?
Less competition
Less responsiveness to customer needs
More political power to create a regulatory environment which guards against competition.

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Performance

Mutual funds and ETFs usually specify their historical performance for several time frames, i.e. 1 year, 3 year, 5 year, 10 year, Lifetime. Four years ago, I noted the diffiiculties of getting a reasonable appraisal of performance if the comparison period begins with a trough in price and ends near a peak.

It is best to disregard the five year performance of many large cap stock funds this year because they include the 13% gain of 2012 and the 33% gain of 2013. A more honest appraisal is the ten year performance. Comparisons start in 2007, near the highs of the market before the start of the 2007-2009 recession and the financial crisis.

Vanguard’s SP500 index fund VFINX reports a ten year average annual return of 7.39%.  Their blended corporate bond fund VBMFX has an annual return of 4.12% over the past ten years.  If I had nothing but these two funds in my portfolio since 2007, my portfolio of 60% stocks, 40% bonds would have gained about 6.1%.  With a conservative allocation of 40% stocks, 60% bonds the annual return was about 5.5%.  The .6% percent difference in returns is slight but it adds up over ten years.  In the first case, a $100,000 portfolio would have grown to $181,000.  In the second case, about $171,000.

Let’s compare those returns to two actively managed blended funds that Vanguard offers.  VWINX is a balanced fund oriented toward income.  The mix is about 40% stocks, 60% bonds and it has earned 6.7% per year over the past ten years.  The Wellington fund VWELX has a mix of 65% stocks, 35% bonds and cash and earned 7.13% each year since 2007.  Both funds have fees that are slightly higher than Vanguard’s index funds but are relatively low at .22% and .25%.  Depending on allocation preference, either fund could serve as a core “gone fishing” fund.  You can use these as a basis for comparison with products that your fund company offers.

Next week I’ll put my ear to the ground and listen for….