Midpoints

July 3, 2016Leave a comment

July 3, 2016

A week after crash-go-boom in the stock market following Brexit, the British vote to leave the European Union, the market recovered most of the 5 – 6% lost in the two days following the vote. The reaction was a bit too intense, inappropriate to an exogenous shock, the vote, whose consequences would take several years to develop. In last week’s blog I had suggested that the market drop was a good time to put some IRA money to work for 2016. This was not some kind of magic insight. Each year’s IRA contribution amount is a small percentage of our accumulated retirement portfolio.

Buying on market dips can be an alternative strategy to regular dollar cost averaging since the market recovers within a few months after most dips, although the recovery is at a slower pace than the fall. Fear can cause stampedes out of equities; confidence grows slowly. As an example of an abrupt price decline, the SP500 index fell almost 7% in five days last August, then took more than two months to regain the price level before the fall. The 12% price drop at the beginning of this year was more gradual, occurring over six weeks. The recovery to regain that lost ground also took two months, from mid-February to mid-April. In the latter quarter of 2012, the market also took two months to erase a 7% price decline from mid-October to mid-November.

The price level of the SP500 is near the high mark set in May 2015, more than a year earlier. Only in the past year has the inflation-adjusted price of the SP500 surpassed its summer 2000 level (Chart and table). Nope, I’m not making that up. The stock market has just barely kept up with inflation for the past 15 years. The inability of the stock market to move higher indicates that buyers are not attracted to the market at current price levels. The absurdly low interest yields on bonds makes this caution especially puzzling. As stock prices recovered this past week, prices on long term Treasury bonds should have fallen as traders moved into more risky assets. Instead, bond prices have risen. As the price of long term Treasuries (ETF: TLT) broke through its January 2015 high on Friday, the last day of June, traders began betting against treasuries (ETF: TBF).

Those who are concerned about the return OF their money, the safety searchers buying bonds, are competing against those seeking a return ON their money. VIG is a Vanguard ETF that focuses on company stocks with dividend appreciation, and is favored by those seeking some safety while investing in stocks. TLT is an ETF of Treasury bonds for those seeking safety and, as expected, pays more in dividends than VIG. Rarely do we see a broad stock ETF like VIG have a yield, or interest rate, that is close to what a long term Treasury bond ETF like TLT has. At the end of this week, VIG had a dividend yield of 2.15%, just slightly below TLT. Why are investors/traders bidding up the price of Treasury bonds? Some 10 year government bonds in the Eurozone have recently crossed a dividing line and now have negative interest rates. The low, but positive, interest rates of U.S. Treasury bonds look like big open flowers to the busy bees of institutional investors around the world.

In a large group of investors, buy and sell decisions tend to counterbalance each other. Occasionally there are periods when such decisions reinforce each other and create a precarious imbalance that all too often rights itself in an abrupt fashion. Bubbles and – what’s the opposite of a bubble? – are iconic examples of this kind of self-reinforcing behavior.

In another week we will mark the middle of the summer season. The All-Star game on July 12th occurs near the halfway mark in the baseball season and advises parents in many states that there are still five to six weeks before the kids head back to school. Our mid-40s is about the midpoint of our working years, a reminder that we need to start saving for retirement if we have not done so already. It has been seven years since the market trough in March 2009. Let’s hope that this is the midpoint of a 14 year bull market but I don’t think so.

Next week will be chock full of data before the start of earnings season for the second quarter. We will get the June employment report as well as the Purchasing Managers Index. In this time of short, sharp reactions to news events, we can expect continued volatility.

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Earnings

Pew Research just released a comparison of earnings by racial group and sex that is based on Census Bureau surveys, the same data that the BLS compiles into their monthly employment reports. My initial criticism of the Pew Research comparison was that they used the earnings of full and part time workers. Women tend to work more part time jobs so that would skew the earnings comparison, I thought. Thinking that a comparison of full time workers only would show different results, I pulled up the BLS report which groups the data by sex, only to find out that the differences between the earnings of men and women was about the same. At the median, women earn 82% of men.

An even more depressing feature of the BLS report is that median weekly earnings have barely kept ahead of inflation during the past decade. This wage stagnation provides a base of support for the criticisms voiced by former Presidential contender Bernie Sanders in a recent NY Times editorial.
Like a truck stuck in the mud, households are spinning their wheels without making much progress. In the coming months, Donald Trump and Hillary Clinton will try to sell themselves as the tow truck that can pull average American families out of the mud. Well, it would be nice if they would conduct their campaigns in such a positive light. The truth is that each candidate will try to convince voters that voting for the other candidate will get American families stuck deeper in the mud. The conventions of both parties are later this month. Expect the mud to start flying soon after they are over. By election day in November, we will all be buried in mud.

Brexit

June 26, 2016Leave a comment

June 26, 2016

“Should I Stay Or Should I Go?” was a 1982 song by the Clash. For months, Brits have debated the question of whether to stay in the European Union (EU) ahead of a referendum vote held just this past week and nicknamed “Brexit,” a mashup of British Exit. Germany and Britain are the two strongest members of the EU and the loss of either from the union would weaken it’s political and economic ties. In the U.K., the campaigns turned vicious and sparked the murder of an MP (story) earlier this month. In the British Parliamentary system, an MP is similar to a Congressperson in the U.S. House.

In recent polling the advocates of separation, or Leave, appeared to be gaining momentum so that the outcome of the referendum vote seemed deadlocked at 50-50. A poll in the last days before Thursday’s vote reassured many that cooler heads would prevail and Britain would remain with the EU. Leaders from both the right and left belonged to this coalition, appropriately named “Remain.”

At about 3-4 AM London time, 11 PM New York City time on Thrusday night, a third of the vote had been counted and it was eerily close, with the Leave group having a teensy-weensy lead. Then half of the vote was counted and the Leavers were up 1% over the Remainers. As the vote tally continued, it became apparent that – surprise, surprise – the Remainers had won the vote.

Asian markets were active at that time and responded with a severe sell off of risky assets like stocks and rushed into the safe haven of bonds, cash and gold. Stocks were down as much as 12% initially on some Asian exchanges. Gold shot up 6%. Neither the U.S. or European markets were open but the Futures markets in the U.S. sank 6% and European futures plunged 9%.

While most Americans were sleeping European markets opened about 8- 9% down. Market makers in Italy could not establish an opening price for a number of Italian bank stocks, which had already been under pressure in recent weeks. When they did, these stocks had lost a third of their value. Everyone was selling, few were buying.

The referendum vote still needs to be codified into law before the Brits formally notify the EU that the country is leaving. After that negotiations begin over the trade and diplomatic terms of exit, a process that could take two years. A rational person might wonder why the panicked selling? The worry is that this vote may provoke similar votes in other EU countries, which might lead to the eventual dissolution of the EU. When in doubt, get out. Traders did.

Earlier this month the WSJ reported that legendary (and semi-retired) investor and billionaire George Soros had returned to his trading desk to make a series of bearish bets on global markets in anticipation of both political and economic turmoil. Soros became a household name when he made a $1 billion on a bet against the British pound in 1992. In several hours Thursday night/Friday morning, the British pound lost 10% of its value. Was this also another killing for Soros? Soros thinks the break-up of the EU is inevitable (Story)

What should the long term investor do? January’s dip of 5% was a good time to make an IRA investment. This may be an equally good opportunity.

Income Growth

June 19, 2016January 27, 2017Leave a comment

June 19, 2016

A few weeks ago (here) I wrote about trends in income growth and the difficulties of measurement because the growth of employee benefits and insurances are not included. As a follow up, I thought I would show you a chart of per capita income using a natural log scale, which shows a growth trend more clearly. In the graph below, we can see three distinct periods of growth:

1) the late 1960s through the mid-1980s, a period of strong growth following WW2;
2) a more moderate period of growth from the mid-1980s to the mid-2000s; and
3) a much more muted cycle of growth after the financial crisis and recession of 2007-2009.

On the right hand scale is the natural log of the Employment Cost Index, an index of total employee costs calculated quarterly by the BLS. This series is only sixteen years old but it does show the steep growth of these hidden costs.

Our government at all levels chooses to pay for social programs by sliding the costs under the rug. Politicians could tax everyone for the dozens of social support programs but Americans do not like paying taxes. As a rule, Europeans are more willing to make sacrifices for programs that benefit the group, although attitudes are changing as European populations become more diversified. People in general are less willing to pay into the group kitty when a society is less homogenous.

In America, there are fewer protests when politicians add program costs to the total value of a paycheck where employees do not see most of the costs. Workmen’s compensation insurance is a good thing but would voters be willing to pay 5% of their pay for it? Maybe not. The law is written so that the employer pays it and the employee never knows the amount.

The cost for workmen’s comp may be 10-20% or more in service and construction trades but only 1% for an office worker. Some people argue that such a disparity is appropriate; those who work in more dangerous jobs pay more into the insurance system. Employers are incentivized to create a safe environment for their workers in order to reduce costs.

On the other hand, the health of workers is a public cost. If all employees were taxed equally, the danger premium would be spread evenly across all employees.

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Savings Glut

Interest rates are near zero. One year CDs from major banks pay 1% or less. Interest rates have been falling since the early 1980s when savings accounts were earning an astronomical 12% or so. Interest rates are a price of sorts, the price a bank is willing to pay for someone’s savings. Lower interest rates = lower price = less demand for savings. So, people will respond to that lowered demand by putting less money in savings accounts and CDs, right? Wrong.

As interest rates decline, people actually increase the supply of savings they want to give to banks. Why? It seems counterintuitive till we take into account that the population is aging, and older people tend to get more conservative with their savings. Secondly, a larger pool of savings is needed to earn the same interest income.

So we would expect that “safe money” savings would increase somewhat in the past decade. However, the difference in the amount of savings is dramatically higher. In the 15 year period from 1980 to 1995, Money Market, savings accounts, and CDs grew by 50% per person. In the subsequent 15 year period from 1995 to 2010, safe savings grew by 150%, triple the increase of the previous fifteen year period.

By keeping interest rates low, the Federal Reserve is trying to force the public to take more chances with their money. Like the mule who resists going down a steep path in soft dirt, the American public stubbornly refuses to go where the Fed wants. It may take at least another ten years before Americans forget the financial crisis and are willing to take on more risk. The slow growth of this seven year recovery will persist until Americans lose their aversion to risk.

Caution: Under Construction

June 12, 2016January 27, 2017Leave a comment

June 12, 2016

As we travel the highways this summer we are likely to encounter many construction zones as crews repair wear and tear, and the damage that results from the temperature cycle of freeze and thaw. There are a few hitches on the economic road as well.

CWPI

I look to the Purchasing Manager’s (PM) Survey each month for some advance clues about the direction of the economy. Like the employment report, this month’s survey contains some troubling signs. I had my doubts about the low numbers in the employment report until I saw the results from this survey. PMs in the services sectors reported a 3.3% contraction in employment growth so that it is now neutral, matching the lack of growth in manufacturing employment.

New orders in both manufacturing and services are still growing but slowed considerably in the services sectors. The slowdown in both employment and new orders in the services sectors is apparent from the graph below. While this composite is still growing (above 50), it has been below the five year average for four out of five months.

This recovery has been marked by, and hampered by, a familiar peak and trough pattern of growth. Last month I wrote:

“A break in this pattern would indicate some concern about a recession in the following six months. What is a break in the pattern? An extended trough or a continued decline toward the contraction zone below 50.”

The CWPI, a custom blend of the various parts of the ISM surveys, shows a continued weakening that is more than just the periodic trough. If there are further indications of weakness this summer, get concerned.

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LMCI

A few years ago the Federal Reserve introduced the Labor Market Conditions Index, or LMCI, a composite analysis of the labor market based on about twenty indicators published each month by several agencies. Because the report is released a week after the headline employment report, this composite does not receive much attention from policy makers, which is a bit of puzzle. Janet Yellen, chair of the Fed, has indicated that she and others on the rate setting committee of the Fed, the FOMC, rely on this index when determining interest rate policy.

One business day after the release of this month’s unexpectedly weak employment report, the LMCI showed an almost 5% decrease and is the 5th consecutive monthly decrease in the index.

Although this composite is fairly new, many of the underlying indicators have long histories and enable the Fed to provide several decades of this index. As a recession indicator, the monthly changes in this index tend to produce a number of false positives. However, if we shift the graph upwards by adding 7 points to the changes, we see a familiar 0 line boundary. When the monthly change in the index drops below 0 on this adjusted basis (actually -7), a recession has followed shortly.

We are not at the zero boundary yet, but we are getting close and the pattern looks ominously familiar. Don’t play the Jaws music yet, though.

Housing Heats Up

June 5, 2016January 27, 2017Leave a comment

June 5, 2016

In parts of the country, particularly in the west, demand for housing is strong, causing higher housing prices and lower rental vacancy rates. For the first quarter of 2016, the Census Bureau reports that vacancy rates in the western U.S. are 20% below the national average of 7.1%. At $1100 per month, the median asking rent in the west is about 25% above the national average of $870 (spreadsheet link).

With a younger and more mobile population, home ownership rates in the west are below the national average (Census Bureau graph). Housing prices in San Francisco have surprassed their 2006 peaks while those in L.A.are near their peak. Heavy population migration to Denver has spurred 10% annual home price gains and an apartment vacancy rate of 6% (metro area stats).

From 1982 through 2008, the Census Bureau estimates that the number of homeowners under age 35 was about 10 million. These were the “baby bust” Generation X’ers who numbered only 70% of the so-called Boomer generation that preceded them.

Shortly before the financial crisis in 2008, a new generation came of age, the Millenials, born between 1982 and 2000, and now the largest age group alive in the U.S. (Census Bureau). Based on demographics, homeownership should have increased to about 13 million in this younger age group, but the financial crisis was particularly hard on them. Starting in 2008, homeownership in this younger demographic began to decline, reaching a historic low of 8.8 million in 2015, a 15% decline over seven years, and a gap of almost 33% from expected homeownership based on demographics.

In response to lower homeownership rates, builders cut back and built fewer homes. I’ll repost a graph I put up last week showing the number of new homes sold each year for the past few decades.

Look at the period of overbuilding during the 2000s, what economists would euphemistically call an overinvestment in residential construction. Then, financial crisis, Great Recession and kerplooey!, another technical term for the precipitous decline in new homes built and sold. As the economy has improved for the past two years, the demand for housing by the millennial generation, supressed for several years by the recession, has shifted upwards. More demand, less supply = higher prices. This younger generation prefers living closer to city amenities, culture and transportation, causing a revitalization of older neighborhoods. In Denver, developers are buying older homes, scrapping them off, and building two housing units where there was one. Gentrification influences the rental market as well as affordable single family homes and pushes out families of more modest means in some parts of town.

The housing market really overheats when rentals and home prices escalate at the same time. During the housing boom of the 2000s, many tenants left their apartments to buy homes and cash in on the housing bonanza. Rising vacancies put downward pressure on monthly rents. Move-in specials abounded, announcing “No Deposit!”, “First Month Free!” or “Free cable!” to attract renters. This time it’s different.

Rising rents and home prices put extraordinary pressure on working families who find they can barely afford to live in central city neighborhoods which offered low rents and affordable transportation. They consider moving to a satellite city with lower costs but face longer commute times and additonal transportation costs to get to work. Demographic trends shift more slowly than building trends but neither moves quickly so we can expect that housing pressures will not abate soon until the supply of multi-family rental units and single family homes increases to meet demand.

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Incomes

For the past four decades, household income has declined, as Presidential contender Bernie Sanders is quick to point out. Some economists also note that household size has declined greatly during that time as well so that comparisons should take into account the smaller household size. A recent analysis by Pew Research has made that adjustment and found that middle class incomes had shrunk from 62% of total income in 1970 to 43% in 2015.

But, again, comparisons are made more difficult because some categories of income, which have risen sharply in the past few decades, are not included. Among the many items not included are “the value of income ‘in kind’ from food stamps, public housing subsidies, medical care, employer contributions for individuals (ACS data sheet). Generally, any form of non-cash or lump sum income like inheritances or insurance payments are excluded. There is little dispute with the exclusion of lump sum income but the exclusion of non-cash benefits is suspect. An employer who spends $1000 a month on an employee health benefit is paying for labor services, whether it is cash to the employee or not.

The lack of valid comparison provokes debate among economists, confusion and contenton among voters. The political class and the media that live off them thrive on confusion. Those who want the data to show a decline in middle class income cling to the current methodology regardless of its shortcomings.

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Employment

The BLS reported job gains of only 38,000 in May, far below the gain of 173,000 private jobs reported by the payroll processor ADP and below all – yes, all – the estimates of 82 labor economists. The weak report caused traders to reverse bets on a small rate increase from the Fed later this month.

Almost 40,000 Verizon employees have been on strike since mid-April and just returned to work this past week. On the presumption that a company will hire temporary workers to replace striking workers, the BLS does not adjust their employment numbers for striking workers. However, most employers of striking employees hire only as many employees as they need to, relying on salaried employees to fill in. Do strikes contribute to the spikes in the BLS numbers? A difficult answer to tease out of the data. In the graph below we notice the erratic data set of the BLS private job gains (blue line; spikes circled in red) compared to the ADP numbers (red line; spike circled in blue).

Each month I average the BLS and ADP estimates of job gains to get a less erratic data swing. The 112,000 average for May follows an average of 140,000 job gains in April – two months of gains below the 150,000 new jobs needed to keep up with population growth. Let’s put this one in the wait and see column. If June is weak, then I will start to worry.

Subsidies

May 29, 2016January 27, 2017Leave a comment

May 29, 2016

Housing

On Tuesday came the announcement that new one family homes sold in April had jumped to 619,000, just beating the low point set in 1995. Yes, you read that right. The high point of this recovery just passed a 20 year ago low. The spring season certainly contributed to the jump, but the prospect of higher interest rates may have spurred many buyers to close the deal. Here’s a graph of new home sales for the past two decades:

The housing boom took a decade to build but the total damage of overinvestment is only now being felt in the slow growth that has characterized this recovery. I’ll turn to the monetary economists at Alt-M.org:

“During the housing boom, investible resources that could have gone into augmenting human capital, building useful machines and sustainable enterprises, and conducting commercial research and development, were instead diverted to housing construction. In the crisis it became evident that the housing built was not worth the opportunity cost of the resources allocated to it.” (Source )

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Energy Subsidies, or Not?

Many of us don’t like subsidies to giant oil companies like Exxon and Chevron. Why are taxpayers subsidizing these rapers of the environment? The marketing of this idea is that bad, bad oil companies get good taxpayer money that could be put to better uses. But then we find out that when a poor family gets heating oil for a very reduced amount, the folks in Washington call that a “Consumer Subsidy” to the oil company (Source). Why is this not classified as a subsidy for poor families? Welcome to the ugly politics of Washington where subsidies are allocated across several departments, and House and Senate committees, so that our elected representatives can feel important and wield influence in order to collect more campaign money. If the voters are confused, that’s the point. Politicians use a technique ommon in used car sales: baffle the customer with B.S.

In 2010, Federal (not including states) subsidies totaled $11.6 billion for coal, natural gas and oil. Coal got $3.9 billion for R&D. (Source spreadsheet) Much of that money was to develop technologies for carbon capture and sequestration, which is what we told politicians in Washington we wanted. (Source) The energy companies didn’t want the money because they didn’t want to develop the technology. Now we blame the energy companies for spending the money?

Unfortunately, fracking has produced so much natural gas at such a low cost that many energy companies find it more cost efficient to simply shut down power stations that rely on coal. The largest coal company in the U.S., Peabody Energy, recently declared bankruptcy after 130 years in business (WP article)

Let’s turn to the oil and natural gas portion of this sector since that accounts for 2/3rds of Federal subsidies. $7.6 billion in subsidies includes:
$3.5 billion, almost half of the total subsidy, is for the LEAP program, which pays for heating fuel for low income families, not a subsidy for the oil companies;
$1 billion for fuel used by farmers, who lobby heavily for their subsidy, and it helps to keep food prices down for consumers across the country;
$1.1 billion for the Federal gov’t to buy oil for the Strategic Petroleum Reserve. Why is this called a subsidy to the oil companies?
$1 billion for accelerated write-offs on development costs, land, equipment.

Providing consistent, reliable energy in any form is messy. Every year, wind power kills thousands of eagles, a threatened species, yet there seems to be little outcry because wind power is a favorite of the environmental community and gets a pass.

Many years ago, I was selling tools to the mechanics at San Juan Coal Co. in a remote area of New Mexico and Arizona. Giant earth movers with tires that were twice as high as a man dug up the coal deposits there. Reaching up to the blue sky were giant erector set towers hung with huge cables that sizzled and spit with the sound of electricity surging through them. Stretching toward the western horizon, I asked where the wires went. Southern California, I was told. California wanted the electricity but not the pollution from creating the energy so they paid to have the electricity produced in this remote area and “shipped” hundreds of miles away. The process was very wasteful and expensive. The additional cost though was counted as a subsidy to the energy company because the accounting that is done in government has little to do with the day to day reality of most households and businesses.

Timing Models

May 22, 2016January 27, 2017Leave a comment

May 22, 2016

Long term moving averages can confirm the shifting trends of market sentiment and market watchers customarily watch for crossings of two averages. The 50 week (1 year) average of the SP500 index just crossed below the 100 week (2 year) average, indicating a broad and sustained lack of confidence. Falling oil prices since mid-2014 have led to severe earnings declines at some of the large oil companies in the SP500. The index is selling for about the same price as the two year average.

What to do? These crossings or junctions can mark a period of some good buying opportunities – unless they’re not – and that’s the rub with indicators like this one. Downward crossings typically occur after there has already been a 5 – 15% decline from a recent high. If an investor sells some stocks at that time, they wind up selling at an interim low, and regret their action when the market rises shortly thereafter. They should have bought instead of sold. AAAARGHHH, a false positive! Twice in the 1980s, the sentiment shift was less than a year long and an investor who did act lost 10 – 20% as the market climbed after several months.

Conversely, after a 10-15% decline, some investors do buy more stocks, figuring that the excess optimism, or “fluff,” has been shaken out of the market. Then comes that sinking feeling as the market continues to decline, and decline, and decline. In April 2001 and July 2008, the 50 week average crossed below the 100 week average. Investors who lightened up on stocks at those times saved themselves some pain and a lot of money as the broader market continued to lose another 30% or so.

There are not one but two problems with timing models: timing both the exit from and entry back into the market. Over several decades the majority of active fund managers – professionals who study markets – did not get it right. They underperformed a broad index like the SP500 because the index is actually a composite of the buying and selling decisions of millions of market participants. John Bogle, the founder of the now gigantic Vanguard Funds, made exactly this point in his dissertation in the 1950s. A half century later, this “wacky idea” of index investing has taken over much of the industry.

Consistently successful timing is very difficult and has tax consequences in some accounts. Investors are encouraged to focus instead on their investment allocation to match their tolerance for risk and volatility, and to consider any prospective income that they might need from a portfolio.

Since 1960, the average annual price gain of the SP500 index has been 6.7%. Add in an average yield (dividend) of 3% and the total return is almost 10% that an investor gains by doing nothing, a formidable hurdle for any timing model.

Within an allocation model, though, is the idea that an investor might shift a small portion of a portfolio from stocks to bonds and back in response to market signals. In several previous articles I have looked at a Case-Shiller CAPE10 model (here, here, here, and here) as well as another crossing model using the 50 day and 200 day moving averages, dramatically named the Golden Cross and Death Cross (here, here, and here.) As already mentioned, we want to avoid some of the false signals of crossing averages.

Instead of a crossing, we can simply use a change in direction of both averages. When not just one, but both, long term averages turn down, we would move a portion of money from stocks to bonds, and in the opposite direction when both averages turned up.

Over the course of several decades, this strategy has been suprisingly successful. The market sometimes experiences a decade when prices may be volatile but are essentially flat. From 2000 – 2012 the SP500 index went up and down but was the same price at the beginning and end of that 12 year period. 1967 to 1977 was another such period, a stagnant period when an investor’s money would be better put to use in the bond market rather than the stock market.

In recent decades, this long term weekly model would have favored stocks from 1982 to March 2001 while the market gained 850%, an annual price gain of 11%. The model would have shifted money back to stocks in August 2003 at a price about 25% less than the exit price in March 2001. In March 2008, the model would have favored an exit from stocks to bonds. The stock market at that time was about the same price that it had been 7 years earlier in March 2001. The model captured a 30% gain while the index went nowhere.

In the 1967 – 1977 period, the model did signal several entries and exits that produced a cumulative 8% price loss over the decade but the model favored the bond market for half of that period when bonds were earning 8% per year, a net gain.

In almost two years, the SP500 has changed little; the yield is less than 2%, far lower than the 3% average of the past 50 years. However, the broader bond market has also changed little in that time and is paying just a little over 2%. There are simply periods when strategies and alternatives have little effect. Although the 50 week average crossed below the 100 week average earlier this month, they are essentially horizontal. The 100 week average is still rising, but barely so, a time of drift and inertia. In hindsight, we may say it was the calm before a) the storm (1974), or b) the surge (1995). Usually the calm doesn’t last more than two years so we can expect some clear direction by the end of the summer.

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It’s the economy, stupid!

One of the myths of Presidential politics is that Presidents have a lot to do with the strength or weakness of the economy, a superhero narrative carefully cultivated by the two dominant parties. Here’s a comparison of GDP growth during Democratic and Republican administrations. The Dems have it up on the Reps since 1928, chiefly because the comparison starts near the beginning of the Great Depression when the Reps held the Presidency.

For several reasons, GDP data is unreliable during the Depression and WW2 years. First, the GDP concept wasn’t formalized till just before the start of WW2 so data collection was new, primitive and after the fact. Secondly, this 14 year period includes an extraordinary amount of government spending which warped the very concept of GDP. The WPA program that put so many to work during the depression years was a whopping 7% of GDP (Source), like spending $2 trillion dollars, or half the Federal budget, in today’s economy.

The Federal Reserve begins their GDP data series after WW2 when data collection was much improved. If you’re a Dem voter, don’t mention this unreliable data. Just tell friends, family and co-workers that the Dems have averaged 4% GDP growth since 1927; the Reps only 1.7%. If you’re a Republican voter, exclude the 20 year period from 1928 to 1947 and begin when the Federal Reserve trusts the data. Starting from 1947, Republicans have presided over economies with 2.75% annual growth during 36 Presidential years. During the 30 years Dems have held the Presidency, there has been a slighly greater growth rate of 3.1%.

In short, economic growth is about the same no matter which party holds the Presidency. Shhhh! Don’t tell anyone till after the election is over. Legislation by the House and Senate has a much greater impact on the economy.

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Small Business

“If America is going to dominate the world again, the country has to fix the spirit of free enterprise. Small-business startups are in serious decline.”

“Gallup finds that one-quarter of Americans say they’ve considered becoming business owners but decided not to. ”

These foreboding quotes are from a recent Gallup poll. Small businesses employ more than 50% of employees and are responsible for the majority of job growth yet many politicians and most voters pay little attention to the concerns of small business owners. The giant corporations get most of the press, praise and anger. Could the lack of small business growth be responsible for the lackadaisical growth of the entire economy during this recovery? As the population continues to age, growth will be critical to fund the dedication of community resources to both the old and young.

The BLS routinely tracks the Employment-Population Ratio, which is the percentage of people over 16 who are working, currently 60%. But this ratio does not fully capture the total tax pressures on working people since it excludes those under 16, who require a great deal of community resources. When we track the number of workers as a percent of the total population, we see a long term decline. As this ratio declines, the per-worker burdens rise for it is their taxes that must support programs for those who are not working, the young and the old.

Regulatory burdens hamper many small businesses. A recent incident with a Denver brewery highlights the sometimes arbitrary rulemaking that business owners encounter. Agencies protest that their mission is to ensure public safety. An unelected manager or small committee in a department of a state or local agency may be the one who decides what is the public safety. As the rules become more onerous and capricious, fewer people want to chance their savings, their livelihood to start a small business. As fewer businesses start up, tax revenues decline and the debate grows ever hotter: “more taxes from those with money” vs “less generous social programs.” Policy changes happen at a glacial pace, further exacerbating the problems until there is some crisis and then the changes are instituted in a haphazard fashion. Since we are unlikely to change this familiar pattern, the issues, anger and contentiousness of this election season are likely to increase in the next decade. Keep your seat belts buckled.

Global Portfolio

May 15, 2016January 27, 20172 Comments

May 15, 2016

Picture the poor investor who leaves a meeting with their financial advisor followed by a Pig-Pen tangle of scribbled terms. Allocation, diversification, small cap, large cap, foreign and emerging markets, Treasuries, corporate bonds, real estate, and commodities. What happened to simplicity, they wonder? Paper route or babysitting money went into a savings account which earned interest and the account balance grew while they slept.

For those in retirement, it’s even worse. The savings, or accumulation, phase may be largely over but now the withdrawal phase begins and, of course, there needs to be a withdrawal strategy. Now there’s a gazillion more terms about withdrawal rates, maximum drawdowns and recovery rates, life expectancy, inflation and other mumbo jumbo that is more complicated than Donald Trump’s changing interpretations of his proposed tax plans.

Seeking simplicity, an investor might be tempted to put their money in a low cost life strategy fund or a target date fund, both of which put investing on automatic pilot. These are “fund of funds,” a single fund that invests in different funds in various allocations depending on one’s risk tolerance. There are income funds and growth funds and moderate growth funds within these categories. For a target date fund, what date should an investor use? It is starting to get complicated again.

Well, strap yourself into the mind drone because we are about to go global. Hewitt EnnisKnupp is an institutional consulting group within Aon, the giant financial services company. In 2014, they estimated the total global investable capital at a little over $100 trillion as of the middle of 2013. Let’s forget the trillion and call it $100.

Could an innocent investor take their cues from the rest of the world and invest their capital in the same percentages? Let’s look again at the categories presented by the Hewitt group. The four main categories, ranked in percentages, that jump off the page are:

Developed market bonds (23%),
U.S. Equities (18%),
U.S. Corporate Bonds (15%),
and Developed Market equities (14%).

The world keeps a cushion of investable cash at about 5% so let’s throw that into the mix for a total of 75%. Notice how many categories of investment there are that make up the other 25% of investable capital!

In the interest of simplification let’s consider only those four primary categories and the cash. Adjusting those percentages so that they total 100% (and a bit of rounding) gives us:

Developed Market bonds 30%,
U.S. Corporate Bonds 20%,
U.S. Equities 25%
Developed Market equities 19%,
Cash 6%.
Notice that this is a stock/bond mix of 44/56, a bit on the conservative side of a neutral 50/50 mix. Equities make up 44%, bonds and cash make up 56%.

I’ll call this the “World” portfolio and give some Vanguard ETF and Mutual Fund examples. Symbols that end in ‘X’, except BNDX, are mutual funds. Fidelity and other mutual fund groups will have similar products.

International bonds 30% – BNDX, and VTABX, VTIBX
U.S. Corporate Bonds 20% – BND and VBTLX, VBMFX
U.S. Equities 25% – VTI and VTSAX, VTSMX
Developed Market equities 19% – VEA and VTMGX, VDVIX

According to Portfolio Visualizer’s free backtesting tool this mix would have produced a total return of 5.41% over the past ten years, and had a maximum drawdown (loss of portfolio value) of about 22% during this period. For a comparison, an aggressive mix of 94% U.S. equities and 6% cash would have generated 7.06% during the same period, but the drawdown was almost 50% during the financial upheaval of 2007 – 2009.

There have been two financial crises in the past century: the Great Depression of the 1930s and this latest Great Recession. If the balanced portfolio above could generate almost 5-1/2% during such a severe crisis, an investor could feel sure that her inital portfolio balance would probably remain intact during a thirty year period of retirement. During a horrid five year period, from 2006-2010, with an annual withdrawal rate of 5%, the original portfolio balance was preserved, a hallmark of a steady ship in what some might call the perfect storm.

Finally, let’s look at a terrible ten year period, from January 2000 to December 2009, from the peak of the dot com bubble in 2000 to the beaten down prices of late 2009, shortly after the official end of the recession. This period included two prolonged slumps in stock prices, in which they lost about 50% of their value. A World portfolio with an initial balance of $100K enabled a 5% withdrawal each year, or $48K over a ten year period, and had a remaining balance of $90K. Using this strategy, one could have withdrawn a moderate to aggressive 5% of the portfolio each year, and survived the worst decade in recent market history with 90% of one’s portfolio balance still intact.

Advisors often recommend a 4% annual withdrawal rate as a conservative or safe rate that preserves one’s savings during the worst of times and this strategy would have done just that during this worst ten year period. Retirees who need more income than 4% may find the World portfolio a conservative compromise.

{ For those who are interested in a more granular breakdown of sectors within asset classes, check out this 2008 estimate of global investable capital.}

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Productivity

In a recent article, Jim Zarroli with NPR compared productivity growth with the weak growth of only the wages component of employee compensation. He did leave out an increasingly big chunk of total employee compensation: Federal and State mandated taxes, insurances and benefits. Since these are mandated costs, the income is not disposable. A term I have never liked for this package of additional costs and benefits is “employer burden.” The burden is really on the employee as we will see.

In the graph below are two indexes: total compensation per hour and output per hour. At the end of the last recession in the middle of 2009, the two indexes were the same. Seven years later, output is slightly higher than total compensation but the discrepancy is rather small compared to the dramatic graph difference shown in the NPR article. As output continues to level and compensation rises more rapidly, we can expect that compensation will again overtake output.

Over the past several decades, employees have voted in the politicians who promised more tax-free insurances and benefits. While the tax-free aspect of these benefits is an advantage, some employees may think they are freebies. Payroll stubs produced by more recent software programs enable employers to show the costs of these benefits to employees, who are often surprised at the amount of dollars that are spent on their behalf. While these benefits are welcome, they don’t pay school tuition, the rising costs of housing or repairs to the family car.

Many voters thought they could have it all because some politicians promised it all: more tax-free insurances and benefits, and higher disposable income. Total employee compensation, though, must be constrained by productivity growth. In the coming decade, legislators will put forth alternative baskets of total compensation. More benefits and insurances means less disposable income but a politician can not just say that outright and get re-elected. More disposable income means less insurances and benefits, which will anger other voters. In short, the political discourse in this country promises to only get more contentious.

Pickup and Letdown

May 8, 2016January 27, 2017Leave a comment

May 8, 2016

Based on ISM’s monthly survey of Purchasing Managers, the CWPI blends both service and manufacturing indexes and gives additional weight to a few components, new orders and employment. Last month we were looking for an upward bend in the CWPI, to confirm a periodic U-shaped pattern that has marked this recovery. This month’s reading did swing up from the winter’s trough and we would expect to see further improvement in the coming few months to confirm the pattern. A break in this pattern would indicate some concern about a recession in the following six months. What is a break in the pattern? An extended trough or a continued decline toward the contraction zone below 50.

Since the services sectors constitutes most of the economy in the U.S., new orders and employment in services are key indicators of this survey. A sluggish winter pulled down a composite of the two but a turn around in April has brought this back to the five year average.

Rising oil prices have certainly been a major contributor to the surge in the prices component of the manufacturing sector survey. The BLS monthly labor report (below) indicates some labor cost increases as well. Each month the ISM publishes selected comments from their respondents. An employer in the construction industry noted a severe shortage of non-skilled labor, a phenomenon we haven’t seen since 2006, at the height of the housing bubble.

Last week the BEA released a first estimate of almost zero growth in first quarter GDP, confirming expectations. Oddly enough, the harsh winter of 2015 provided an even lower comparison point so that this year’s year over year growth, while still anemic, is almost 2%.

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Employment

April’s employment data from the BLS was a bit disheartening. Earlier this week, the private payroll processor ADP reported job growth of 150,000 in April and lowered expectations for the BLS report released on Friday. While the BLS estimate of private job growth was slightly better, the loss of about 10,000 government jobs, not included in the ADP estimate, left the total estimate of jobs gained at 160,000. The loss of government jobs is slight compared to the total of 22 million employed at all levels of government but this is the fourth time in the past eight months that government employment has declined.

A three month average of job growth is still above 200,000, a benchmark of labor market health that shows job growth that is more than the average 1% population growth With a base of 145 million employees in the U.S, a similar 1% growth rate in employment would equal 1.5 million jobs gained each year, or about 125,000 per month. To account for statistical sampling errors, the churn of businesses opening and closing, labor analysts add another 25,000 to get a total of 150,000 minimum monthly job gains just to keep up with population growth. The 200,000 mark then shows real economic growth. In March 2016, the growth of the work force minus the growth in population was 1.2%, indicating continued real labor market gains.

Job growth in the core work force aged 25 -54 remains above 1%, another good sign. It last dipped briefly below 1% in October. This core group of workers buys homes, cars, and other durable goods at a faster pace than other age groups; when this powerhouse of the economy weakens, the economy suffers. In the chart below, there is an almost seven year period, from June 2007 through January 2014 where growth in this core work force group was less than 1%. From January 2008 through January 2012, growth was actually negative. The official length of the recession was 17 months, from December 2007 through June 2009. For the core work force, the heart of the economic engine, the recession lasted much longer.

In 2005, a BLS economist estimated that the core work force would number over 105 million in 2014. In December 2014, the actual number was 96 million, a shortage of 9 million workers, or almost 10% of the workforce. In April 2016, the number was almost 98 million, still far less than expectations.

Some economists and pundits mistakenly compare this recovery from a financial crisis with recoveries from economic downturns in the late 20th century. For an accurate comparison, we must look to a previous financial, not economic, crisis – the Great Depression of the 1930s.

The unemployment rate in April remained the same, but more than a half million people dropped out of the labor force, reversing a six month trend of declines. It is puzzling that more people came back into the labor force during the winter even as GDP growth slowed.

Average hourly earnings increased for the second month in a row, upping the year over year increase above 2.5%. For the past ten years, inflation-adjusted weekly earnings of production and non-supervisory workers have grown an anemic .75% per year. In the sluggish winter of January and February 2015, earnings growth notched a recovery high of 3%, leading some economists and market watchers to opine that lowered oil costs, on the decline since the summer of 2014, would finally spur worker’s pay growth in this long, subdued recovery. A year later, earnings growth is about 1.2%, a historically kind of OK level, but one which causes much head scratching among economists at the Federal Reserve. When will worker’s earnings begin to recover?

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Hungry

A reader sent me a link to a CNBC article on food insecurity in the U.S. The problem is widespread and not always confined to those who fall below the poverty benchmark. Contrary to some perceptions, food insecurity is especially prevalent in rural areas, where food costs can be 50% higher than urban centers. How does the government determine who is food insecure? The USDA publishes a guide with a history of the project, the guidelines and questions. To point out the highlights, I’ll include the page links within the document. The guidelines have not been revised since this 1998 revision.

In surveys conducted by the Census Bureau, respondents are asked a series of questions. The answers help determine the degree of household food insecurity. The USDA repeatedly emphasizes that it is household, not individual, insecurity that they are measuring. The ranking scale ranges from 0, no insecurity, to 10, severe insecurity and hunger. An informative graph of the scale, the categories and characteristics is helpful.

In 1995, a low .8 percent were ranked with severe food insecurity (page 14) . To be considered food insecure, a household must rank above 2.3 (household without children), or above 2 .8 (with children) on the scale. Above that are varying degrees of insecurity and whether it is accompanied by hunger. (Table)

The USDA admits that measuring a complex issue like this one can provoke accusations that the measure either exaggerates or understates the number of households. What are they measuring? Page 6 contains a formal definition, while page 8 includes a list of conditions that the survey questions are trying to assess, and that a condition arose because of financial limitations like “toward the end of the month we don’t have enough money to eat well.”

Page 9 describes the rather ugly pattern of progressively worse food insecurity and hunger. At first a household will buy cheaper foods that fill the belly. Then the parents may cut back a little but spare the kids the sensation of hunger. In its most severe stage, all the family members go hungry in a particular day.

Those of you wanting additional information or resources can click here.

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Earnings

Almost a month ago the giant aluminum manufacturer Alcoa kicked off the first quarter earnings season. 87% of companies in the SP500 have reported so far and FactSet calculates a 7% decline in earnings. They note “the first quarter marks the first time the index has seen four consecutive quarters of year-over-year declines in earnings since Q4 2008 through Q3 2009.” Automobile manufacturers have been particularly strong while the Energy, Materials and Financial sectors declined. Although the energy sector gets the headlines, there has also been a dramatic decrease in the mining sector. The BLS reports almost 200,000 mining jobs lost since September 2014.

The bottom line for long term investors: the economic data supports an allocation that favors equities. The continued decline in corporate earnings should caution an investor not to go too heavily toward the equity side of the stock/bond mix.

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(Edited May 11th in response to a reader’s request to clarify a few points.)

Saving Trends

May 1, 2016January 27, 2017Leave a comment

May 1, 2016

Macroeconomists define saving as Income Less Consumption and Taxes. There are two distinctions – public, or government savings, and private, or household, savings.

From 1986 to 2000 inclusive, a 15 year period, gross private savings grew 78%. In the same length of time, from 2001 to 2015, it grew 112%. So why the higher savings rate?

Lower interest and inflation rates have persisted during this later period. One would think that consumers would be more likely to save when interest rates were higher in the earlier period. However, the reverse is true. Households respond to lower interest rates by saving even more. Why? Because their savings will grow more slowly at lower interest rates, they must save more, which only keeps interest rates low. Like so much of human activity, the process is self-reinforcing.

What else contributes to higher savings rates? 80 million Baby Boomers is more than a third of the population. As they neared retirement age, they saved more of their income. In 2012, the first boomers turned 66, a high point in the chart of savings below.

Richard Koo is the chief economist at Nomura, a gigantic Japanese financial holding company similar to Goldman Sachs. He introduced the idea of a balance sheet recession instigated by a large number of people and businesses paying down their debts to repair their balance sheets. Here is a recent paper.

Because trends in savings are affected by the decisions of mutiple generations, the primary causes can be difficult to establish. As the Boomers begin to spend down their savings in retirement, the equally large Millennial generation will start saving but it is unlikely that they will completely offset the spending rate of the Boomers. The glut of savings will be slowly draw down until new investment puts enough demand for savings, which will spur interest rates higher.

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Cadillac Purchasing Power

Last week, I looked at the relative purchasing power to buy a Ford F-150 pickup. In a trip to a car museum lately, I learned that a new 4 door Cadillac model cost $2000 in 1913. The average hourly wage was $2 per hour per the NBER, so it took the average person 1000 work hours, about half a year, to buy that Cadillac. A 2016 Cadillac 4 door ATS Sedan costs about $40,000, an amount that would take 1573 hours, about nine months, at an average $25.43 per hour (BLS).

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College Bound

A recent BLS study found that 70% of 2015 HS grads enrolled in college. Recent NAEP results show that only 37% of test takers are prepared for college reading and math.