Author: sgstofka

Summer Swoon

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August 10, 2014

Consistent Investing

After two unsettled weeks and a 6% drop in the market, let’s revisit a prediction made in August 2010 – impending doom.  Even when doom does show up as it did in late 2008, there are inevitably predictions of even more doom.  When doom does not show up as scheduled, it is a bubble which portends catastrophic doom.  Those who sound a cautionary note do not seem to get the same headlines as the doom predictors.

Each year the Employment Benefit Research Institute (EBRI) analyzes the activity of more than 20 million 401(K) participants.  In their most recent analysis of 2012 data,   EBRI found that a third of participants are “consistent participants”, i.e. employees who participate regularly in 401(K) programs despite the market environment. The portfolios of consistent participants overwhelmingly outperformed the two-thirds who were not as consistent.

Analysis of a consistent group of 401(k) participants highlights the impact of ongoing participation in 401(k) plans. At year-end 2012, the average account balance among consistent participants was 67 percent higher than the average account balance among all participants” in the EBRI/ICI 401(k) database. The consistent group’s median balance was almost three times [my emphasis] the median balance across all participants at year-end 2012.

This data did not include the 30% rise in the stock market in 2013, which only reinforces the point – it pays to participate regularly in a 401(K).   EBRI found that the superior returns of consistent participants was not due to any asset selection.  Their allocation was about the same as the entire group, about 60/40 stocks and bonds.

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Investor Sentiment

An indicator of investor sentiment is the price reaction to upside and downside earnings reports.  If a company reports earnings that are better than average expectations, that is an upside.  Conversely, if a company’s quarterly earnings fall below mean estimates, that is a downside. As the majority of companies in the SP500 have reported earnings for the 2nd quarter that ended in June, FactSet compared investor reaction to this quarter’s  earnings surprises with the average reaction over the past five years.  The sentiment overall has been negative.  There has been little positive reaction to positive earnings surprises and a more than average negative reaction to disappointing earnings reports.

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Target Funds

Some funds, called Target Funds, designate a specific year when an investor will need to start drawing some or all of the money from the investment.  As the fund approaches its target year, the fund adjusts its allocation to a more conservative blend of bonds and stocks.  A fund with a target year that is 12 – 15 years in the future may have a stock bond mix of 75/25.  A fund with a target date 5 years in the future may have a 60/40 stock bond mix. Vanguard’s VTHRX (2030) and VTWNX (2020) are examples which illustrate the difference in allocations.

The appeal of “set it and forget it” has helped these funds grow in popularity.  According to the Investment Company Institute (ICI) the number of target funds has grown from 6 in 1995 to almost 500 in 2013 (Table 53)  At the end of 2008, assets in target funds totaled $160 billion.  Five years later, in 2013, total assets had almost quadrupled to $618 billion.  New investment in these funds peaked in 2007 at $56 billion, then fell to $42 billion per year from 2008 through 2011.  New investment rose again to $52 billion in 2012 and 2013.

Because these funds have a blend of stocks and bonds, most investors would assume that the risk adjusted return (RAR) would be better than a fund fully invested in the stock market.  The Sharpe ratio, a common measure of RAR, computes a ratio of excess return to the volatility of the investment.  Excess return is the extra amount an investment earns compared to a risk free investment like Treasury bills.  If an investment has a Sharpe ratio of 1, then the investor got what they paid for in worry.  A ratio greater than 1 means that the investor got more than they paid for.  The 5 year Sharpe ratio of the SP500 is 1.24, meaning that an investor got about 25% more return than the volatility of the market. Keep in mind that the bull market is almost 5-1/2 years old. Over ten years, the Sharpe ratio of the SP500 was less than .5, meaning that an investor got half as much return for the amount of worry it cost them.  Many target funds do not have a long enough history to compute a ten year ratio.

An investor comparing the 5 year Sharpe ratio of their target fund may be surprised if their fund has a lower RAR than the SP500. Check the expense ratios on the fund.  Target funds that use indexes as their underlying investment may charge as little as $170 per year on a $100,000 investment in the fund. Some funds may charge $800 or more on the same investment. Lastly, what is the correlation between a target fund and the stock market?  A correlation of 1.00 means that the prices of two investments move in lockstep. Stockcharts.com let’s an investor compare the one year correlation of their fund with the SP500. A target fund with a correlation of .99, a high expense ratio and a lower than market Sharpe ratio might lead an investor to question the value of that fund.

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Constant Weighted Purchasing Index

As anticipated, ISM reported strong numbers in July for both the manufacturing and service sectors.  Employment and New Orders, two key components of the Purchasing Managers Index (PMI), were robust in the manufacturing sector at a reading near 65.  In the service sectors, which comprise most of the nation’s economy, employment did not get the same high marks but remains strong at 56.  The combination of new orders and employment in the services sector stands just below 60.

The composite of both manufacturing and services rose to 63.3, continuing the upward climb in this part of a cyclic trend that has been in place for more than three years.

If this pattern continues, we could expect further strong reports into the fall, before declining in October or November.

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Takeaways

Production and employment numbers are strong, causing some worry that the Federal Reserve may raise interest rates sooner than mid 2015.  A growing number of mid and short term investors feel that any near term upside has already been priced into the market.


Employment, GDP and Construction

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August 3, 2014

Employment

The employment report for July was moderately strong but below expectations.  Year-over-year growth in employment edged up to 1.9%, a level it first touched in March of 2012.

The unemployment rate ticked up a notch after ticking down two notches last month.  Notches can distract a long term investor from the underlying trend, which is positive.  Comparing the year-over-year percent change in the unemployment rate gives a good overall view of the economy and  the mid term prospects for the stock market.

There was some slight improvement in the Civilian Labor Force Participation Rate this month.  The decline in the participation rate has been worrisome.  When we view the unemployment rate as a percentage of the Civilian Labor Force Participation Rate, we do see a continuing decline in this ratio, which is positive.  From early 2002 to early 2003, the market continued its decline even after the end of a fairly mild recession.  Employment gains were meager, prompting concerns of a double dip recession. Should this ratio start to increase over several months, investors would be wise to start digging their foxholes.

Employment numbers can hide weaknesses in the labor market. After falling to a low of 7.2 million this February, people working part time because they can’t find full time work has climbed up 300,000 to 7.5 million.  The good news is that the ranks of involuntary part-timers has dropped by 700,000, or 8.5%, from July 2013 to this July.

Employment in service occupations makes up almost 20% of the work force and usually peaks in July of each year after a January trough.  The numbers come from the monthly survey of business payrolls so it affects the job gains number to some degree, depending on the seasonal adjustments.  I expected this month’s report to show the normal pattern, rising up at least 50,000 from June’s total of 26.54 million.  I was surprised to see that employment in this composite had dropped by 170,000 in July.

Unlike the majority of years, this year’s trough occurred in February, one month later than usual.  This may be weather related.  1998, 2003, 2005, 2011 were also years in which the trough occurred one month late. Over the past twenty years, the peak has always come in July – until this year.

Hourly wages have grown 2% in the past twelve months, meaning that there is no gain after inflation.  That’s the bad news.  The good news is that weekly earnings for production and non-salaried employees this July bested July 2013 earnings by 2.9%.

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Auto Sales

July’s vehicle sales slipped 2.4% from June’s annualized pace of 16.9 million vehicles.  Robust vehicle sales are due in part to an increase in sub-prime loans, which have grown to 30% of new car loans.  A few weeks ago, the N.Y. Times published an article describing some auto loan application shenanigans.

The casual reader may not understand the significance of numbers in the millions so I created a chart showing numbers in the hundreds.  The manufacturing of cars is part of a broader category called durable goods.  If a 100 workers are employed making durable goods, we would like to see at least 11 of them making cars or parts for cars.  In a healthy economy, 5 people out of 100 buy a car or truck.  The chart below shows the relationship between the number of people buying cars and the percent of durable goods workers making cars.  The chart is a bit “busy” but I hope the reader can see that, despite talk of an auto bubble that could crash the market, the percent of the population buying cars is just barely above the minimum healthy level.

There may be a bubble in auto financing but not auto sales.  Secondly, a vehicle can be repossessed and resold much more easily than evicting a delinquent homeowner.

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GDP

The first estimate of 2nd quarter GDP was 4% annualized growth, above the 3% consensus expectations.  Under the hood, we see that 1.7% of that 4% is a build up of inventories.  This mirrors the 1.7% negative change in inventories in the first quarter, as I noted in last month’s blog.  It is not a coincidence and should remind us that these are human beings making a first estimate of the entire economic activity of a country.

Let’s put this early estimate in perspective.  The year-over-year percent growth is 2.4%, above the 1.6% average y-o-y growth of the past ten years.  Let’s get out our magic wand and take away the recessionary four quarters in 2008 and two quarters in 2009.  Let’s add some good numbers in late 2003 and early 2004 as the economy recovered from the dot com boom period.  Presto chango!  Well, not so presto.  We see that the average over these 37 quarters, just a bit more than 9 years, is still only 2.3%.

From 1970 – 2007, the average is 3.1%, or almost double the 1.6% average of the past ten years.  The Federal Reserve and other central banks around the world have employed the tactics at their disposal to avert deflation and to spur lending.  While low interest rates and bond purchases have accomplished some of those goals, they have created some distortions in the markets, putting upward pressure on both equity and bond valuations.  Higher stock prices pressure companies to produce the profits – on paper, at least – that will justify the increased valuation.  In the past this has induced some companies to pursue a course of – an appropriate term might be “aggressive” accounting – to meet investor demands.

So this first estimate of GDP for the 2nd quarter is slightly above the magic wand average of the past decade and way above the real ten year average.  Not bad.  I’m guessing that the second estimate of 2nd quarter GDP, released near the  end of August, will be revised downward but even if it is, economic growth is better than average.

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Construction Spending and Employment

Construction added 20,000 jobs in July, and are up 3.6% above July of 2013.  Total Construction spending includes residential and commercial buildings, public infrastructure and transportation. Spending in June declined almost 2% from a strong May but is up more than 5% from last year.  A casual glance at the spending numbers might lead one to observe that, after the housing boom and bust, the construction sector is on the mend.

The underlying reality is that further improvements in construction spending may be modest.  The chart below shows real, or inflation adjusted, per capita spending.  What was good enough in 1994 may be equally good in 2014 and beyond.

Residential construction has leveled off just slightly below what is probably a sustainable zone of $1200 to $1600 per person spending. At the height of the housing boom, per person spending was almost twice that of the midline $1400 per person.  Corrections to such severe imbalances are painful.

While many of us think that the boom was all in the residential sector, per person construction of public infrastructure had its own boom, growing almost 50% from the levels of the mid-90s.  Some economists and politicians continue to advocate more public construction as a Keynesian stimulus but we can see below that real per-capita public spending today is slightly more than the levels of the mid-1990s.

Spending on public infrastructure including highways helped buffer the downturn in residential construction.  As a percent of total construction spending, it is still contributing more than its share to the total.  If residential construction were just a bit stronger, this percentage would drop to a more normal range closer to 25%.

Workers in their thirties now came of age at a time when “normal” in the construction sector was far above normal. Policy makers grew to believe that this elevated level of spending was evidence of a strong economy.  They believed they were masters of the economy, ushering in a new normal of prudent fiscal policy that worked in tandem with assertive government policy to promote housing investment that would lift up those on the lower rungs of the economic ladder.

Today we don’t hear as much from those masters of economic and social engineering.  Their names include former Fed Chairman Alan Greenspan, former President George Bush, former Congressman Barney Frank, and current Congresswoman Maxine Waters.  Each of them might point to the mis-managers who helped pump up the housing balloon.  They include former Fannie Mae head Franklin Raines, and Kathleen Corbett, the former president of the ratings agency Standard and Poors which slapped a pristine AAA rating on the good and the bad. “Kathleen is an advocate of best practices, fiscal responsibility and effective management” reads Ms. Corbett’s page  at the New Canaan Town Council.

Then there are the crooks who knew what their companies were doing was dangerous, if not wrong. Topping that list is Angelo Mozilo, the head of Countrywide Financial, the largest originator of sub-prime loans.  “Crooks” is the term Mr. Mozilo once used to describe companies who wrote sub-prime mortgages.  If the suit fits, wear it.

A crook needs a fence to move the goods and there were two prominent ones in this side of the game: Dick Fuld, the former head of Lehman Bros, and Stan O’Neal, the former head of Merrill Lynch.  Both companies made a lot of sausage out of sub-prime mortgages.

Thank God that’s all behind us.  Hmmm, we said that after the savings and loan crisis of the late 1980s.  Well, thank God that’s all behind us till the mid-2020s, when we will repeat our mistakes.  A retiree should consider that during their retirement an episode of foolishness and downright dishonesty will likely have a serious impact on the value of their portfolio.

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Takeaways

Continued strength in employment, with some weaknesses.  Estimate of 2nd quarter GDP growth probably a tad high.  Construction spending still just a bit below the historical per-capita channel of spending.

Homes

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July 27, 2014

This week I’ll take a look at the latest home sales reports, a few trends in Social Security, and the latest reading in the Consumer Price Index.  Lastly, I’ll ask whether a home should be included in an investor’s bond allocation.

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Home Sales

Existing home sales rose in June, topping 5 million but are still down 2.3% on  a year over year basis.  The Federal Housing Finance Agency reported that home price increases have slowed slightly, notching a 5.5% year over year gain.

The bad news this week was the 12% year-over-year drop in single family new homes sold in June, falling from 459,000 in June 2013 to 406,000 in June of this year.

The comparison was a tough one because June 2013 was the best month for new home sales in the post recession period.  However, the year-over-year comparison of the three month moving average of new home sales shows a falling trend as well, down 6% from last year.  The decline began in January and shows little signs of improvement.

I will remind readers of a 2007 paper presented by economist Ed Leamer in which he demonstrated that falling new home sales tends to precede a recession by three to four quarters.  I wrote about it in February this year.

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Jobless Claims

In contrast to the disappointing report on new home sales, jobless claims fell unexpectedly to 284,000, dropping the 4 week moving average to a post-recession low of 302,000.  No doubt this will raise expectations for a strong employment report next Friday.

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Social Security Trust Funds

When the U.S. Treasury collects more in Social Security taxes than the Social Security Administration (SSA) pays out in benefits, the Treasury “borrows” the money from the Social Security Trust Fund by selling it non-marketable Treasury bonds that the SSA holds.  The interest rate for each new bond is an average of the yields on intermediate and long term Treasuries. The Treasury credits this interest to the trust funds every month.  SSA has a web page where a reader can select a year and month and see the average interest rate that the trust funds were earning on that date.  In December 2013, the average annual yield was about 3.6%, down significantly from the 5.25% being credited at the end of 2005, when interest rates were higher.  At the end of 2012, the trust funds had a balance of about $2.7 trillion, earning about $100 billion annually, enough to make up the $75 billion shortfall each year projected by the Trustees of the fund.

The Disability Insurance (DI) portion of the trust fund is projected to run out of money by 2016.  This Do-Nothing Congress will not resolve the problem in this mid-term election year,  promising to make the issue a contentious one for the 2016 election cycle.  If the problem is not resolved by then, current law requires that benefits be reduced accordingly.  The Trustees estimate that Disability beneficiaries will get about 80% of their scheduled benefit.  Democrats will likely use the issue to paint Republicans as Meanies who care only about the rich and big corporations while Republicans portray Democrats as tax-and-spenders who buy votes with government charity.  It’s all coming to a TV screen in our homes.  Can’t wait.

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Consumer Price Index

June’s inflation numbers from the BLS notched a 2.1% year-over-year gain, slightly above the Fed’s 2% target.  The core CPI, which excludes more volatile energy and food prices, is up 1.9% y-o-y.  Gasoline jumped 3.3% in June but year over year gains are at target levels of 2%.

Over the next few years, we will hear increasing calls for a switch to what is called a chained consumer price index, or C-CPI.  The chained index attempts to more closely replicate a cost of living index by taking into account the substitutions that consumers make in response to changes in price.  The CPI may calculate that the Jones Family bought the same amount of hamburger meat even when it rises 20% in price.  The Chained CPI calculates that the Jones Family may buy a little bit less hamburger meat and a bit more chicken if chicken remains relatively stable in price.  The two indexes closely track each other but the CPI tends to be slightly higher than the Chained CPI.

At various times in budget negotiations with the Republican controlled House over the past two years, President Obama has said that he was open to a discussion on transitioning from the CPI as it is currently calculated to the chained CPI.  Social Security payments are one of the many benefits indexed to the CPI.  The current political climate and the upcoming mid-term elections undermine the chances of any adult conversation on the topic.   Republicans are likely to retain the House and want to take the Senate.  A discussion of the CPI invites accusations from Democrats that Republicans – yes, The Cold Heartless Ones – are going to throw seniors under the bus if Social Security payments are decreased by even $5 a month because of a change in the calculation of the CPI.

The reason younger people don’t vote much may be that they hear the rhetoric of most political campaigns and realize that the discussions are much like those they heard in middle school.

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House = Bond?

Let’s crank up the wayback machine and travel to those heady days of 1999 when the stock market was booming.  Current profits did not matter.  New metrics were invented. Customers were revenue streams whose future value could be used to justify the present value of customer acquisition costs. Investments were made to position a company as the dominant player in the sector space of the internet frontier.  These metrics have some validity but the stumbling block was the simple fact that current profits do matter.

About that time some finance professors made the case in a Wall St. Journal editorial (sorry, no link.  WSJ doesn’t go back that far) that most households were overweighted in bonds. How so? A house is like a bond, they argued, relatively stable in price and pays the owner the equivalent of 6% – 7% annually.  House prices do average about 15 – 16 times annual rents according to the real estate analytics firm Jacob Reis.  At the height of the housing boom in the mid-2000s, houses were selling for 25x annual rents.

Secondly, it did not matter whether the house was paid for or not.  To illustrate this rather dubious viewpoint, let’s consider a renter who pays $12,000 annually in rent for an apartment.  She has a $500,000 portfolio, $300,000 of it in stocks, $200,000 in bonds, a 60/40 allocation split.  The bonds generate a 6% annual return of $12,000 which she uses to pay her rent.  A responsible financial advisor would not say “Oh, those bonds don’t count to your allocation mix because the income they earn is used for rent.”

Now, let’s look at a homeowner with the same $500,000 portfolio and the same allocation, 60% stocks, 40% bonds.  She owns a home valued at $200,000 which, if she rented it out, would net her $12,000 annually.  Her PITI  (mortgage payment and taxes) and maintenance repairs is also $12,000 annually.  Like the renter, the homeowner uses the $12,000 in income from her bonds to pay the house costs.  Unlike the renter, she is building some equity in the house by paying down principal.  On average, the value of her house is gaining about 3 – 4% per year based on historical patterns.  In short, the house is generating an unrealized gain that is ignored in conventional allocation models.

So, how would one compute the asset value of the house?  By imputing it from the income and unrealized gains that the house generated.  So, if a homeowner paid $3000 annually toward principal reduction and the house appreciated 3%, or $6000, the house generates a value to the homeowner of $9,000.  Using the historical 6% average return on a house, this would make the asset value of the house $150,000.  Adding that to the stock and bond portfolio gives a new total of $650,000, $350,000 of which is in bonds and the house, a bond-like asset.  Using this method, the allocation mix is 46% stocks, 54% bonds, perhaps more conservative than the homeowner desired.

After reappraising their portfolio in this manner, the professors suggested that homeowners might sell some bonds and buy more stocks to get the desired allocation mix.  To achieve a true 40% bond mix in this example, the target total would be $260,000 in the house and bonds.  Subtracting the $150,000 house value, the homeowner would want to have $110,000 in bonds.  To achieve this, the homeowner would sell $90,000 in bonds and invest in the stock market.  The investor would then have $390,000 stocks and $110,000, slightly above a 75/25 stock/bond allocation mix.  Older readers may shudder at this mix, thinking that it is quite risky.

So, let’s come back to the present day, after the housing bubble.  The calculations are not based on the actual price of the house but 1) on the income that it would generate if it were rented out and, 2) the principal pay down.  The finance professors did not factor in homeowners who were “under water,” i.e. owing more on the house than its current market value, because the debt on a house or any asset did not count in this model.

Let’s say that a homeowner bought at the height of the market in 2005, paying an inflated $300,000 for a house that would later be valued for $200,000.  The principal paydown is so small in the early years of a mortgage that it has only a small effect on the calculation.  Secondly, rent prices were under pressure during the housing boom, making the calculation of the asset value of the house lower.  In fact, a person using this method and contemplating the purchase of a house at that time might have asked themselves “Why am I paying $300,000 for an asset whose income and unrealized gain generates an asset value of $200,000 at most?”

As to the timing, whoa, boy!  What a bad call, selling $90,000 in bonds and putting it into the stock market right before the dot-com bubble popped.  By June 2001, long term bonds (VBLTX as a proxy) had gained almost 10% in value and were paying about 6%.  Our homeowner was not a happy camper.  Over two years, she had lost about $9K in value and another $10K in dividends on that $90,000 in bonds that she sold.  At mid-2001, she had lost an additional  $4,000 in value on the $90K that she invested in stocks near the height of the dot-com boom.

By the end of 2013, twelve years later, she still had not made up for those initial losses.

By including a housing value in the allocation calculations, our investor had an approximately 75/25 mix of stocks and bonds.  During those 14 years, a 75/25 stock/bond mix had about the same total return as a 60/40 stock/bond mix.  There is one clear advantage to the 60/40 mix, however: the risk adjusted return is much better.  The average annual return as a percentage of the maximum drawdown, or the CAR/MDD ratio,  was much higher and the higher the better.

This ratio could be called the sleep ratio.  Let’s say an active investor makes $50K profit in a year on a $500,000 portfolio, but during the year, the investor’s portfolio lost half its value before recovering.  Then the sleep ratio is $50K/$250K, or .2.  Not much sleep for all that activity.  As a benchmark, a buy and hold strategy in the stock market had a CAR/MDD ratio of .2 from 2001 – 2013.

The conventional 60/40 mix had a sleep ratio of .6 during this period.  The 75/25 mix had a sleep ratio of .35, making it the poorer risk adjusted model.  Interestingly, a buy and hold strategy in long term bonds had a sleep ratio of .48, showing that some balance between bonds and stocks produces a better risk adjusted return.

While the rationale for including a house in one’s bond portfolio mix might seem to be a good one, there was a timing disadvantage over this 14 year period.  Long term investors should remember that the past 15 years have been a rather unique combination of two severe downturns in the stock market and a housing bubble.  Such a combination is sure to test even the soundest theory.

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Takeaways

New home sales are down while existing home sales continue their moderate growth trend.  Jobless Claims are at a post-recession low.  Fixes to the Disability trust fund and any transition to a chained CPI are off the discussion table till 2015, at least.  An allocation model that includes a home’s value in an investor’s bond portfolio may have merit over a long time horizon.

Next week come four reports that are sure to fire up the market if any of them surprises to either the upside or downside:  GDP growth for the 2nd quarter, Employment gains, Motor Vehicle Sales, and the Purchasing Manager’s Index for the manufacturing sector.  

Retail Sales and the Stock Market

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July 20th, 2014

This week I’ll take a look at the latest retail sales numbers and revisit a familiar valuation metric for the stock market.

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Retail Sales

Retail sales were a bit of a disappointment this week because of a monthly decline in auto sales.  As strong as vehicle sales have been, we can see a pattern that echoes a trend in employment – the best of this post-recession period is near the low of past recessions.  As a percent of the population, the number of cars and light trucks sold is tepid at best.

In total, retail sales gained more than 4% year-over-year but here again we can see a familiar pattern – declining yearly percentage gains.  Periods of rising gains are about half the length of periods of falling gains.  Over the next several months, we would like to see higher highs in the yearly gains.  Further declines, i.e. lower highs, would be a cause for concern.

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Malaysian Airline Disaster

Oil prices had fallen more than 5% over the past three weeks.  The news of an apparent missile strike on a Malaysian passenger jet over a conflict zone in eastern Ukraine sent oil prices up about 2.5% over two days this week before falling back slightly on Friday.  As families mourn the deaths of almost 300 people on the plane, a fusillade of accusations and denials were launched.  Some accuse Russia of launching the missile that struck the passenger jet flying at 33,000 foot altitude, some blame Russian-backed separatists in eastern Ukraine, others hold Ukranian forces accountable.  Economic sanctions already in place against Russia may be broadened.

Unrest in Ukraine, Iraq and Libya puts upward pressure on oil prices but the effect is moderated by a global supply that is able to meet demand with a safety buffer capable of absorbing these geopolitical conflicts.

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Stock Market Valuation

The stock market continues its two year run to try and meet up with the trend channel of the mid-2000s as though the financial crisis never happened.

Last month I wrote about the Shiller CAPE ratio, introduced by economist Robert Shiller in his book Irrational Exuberance. Some writers also refer to the CAPE ratio as PE10 or the Shiller P/E ratio.

Portfolio Visualizer (PV) has a free tool that lets viewers backtest portfolios using various strategies. An optional timing model based on the CAPE ratio flips the allocation of a portfolio from 60% stocks and 40% bonds (60/40) to a 40/60 mix when the CAPE is high, as it is today.  In the model, “high” is a CAPE above 22, but as I wrote last month, the CAPE has averaged 22.91 for the past 30 years.  In the relatively low interest environment of the past thirty years, investors are willing to pay more for stocks.  The 50 year average is 19.57, within the normal range of the timing model. One could make the point that “high” should be set upward about 3 points, which is the spread between the 30 and 50 year averages (22.91 – 19.57).  In that case, the trigger high would be 25.

Below is a chart of the CAPE ratio and the inflation adjusted or real price of the SP500 index.  As you can see we are far below the nosebleed valuation levels of the late 90s and early 2000s.

The current CAPE ratio is about 26, above even the modified high point.  Using this model, an investor with a $500,000 portfolio with $300,000 in stocks and $200,000 in bonds, would sell $100,000 of stocks and buy bonds with the proceeds.  Over the past twelve years, the Shiller model would have generated an 8.44% annual return vs the 7.21% return of a 50/50 balanced portfolio.  I included an additional two years to capture half of the downturn in the early 2000s when stocks lost 43% of their value.  More importantly, the risk adjusted return of the Shiller model is much better than the 50/50 portfolio.

The Shiller model also did better than the 8% annual returns of a crossing strategy. This is a variation of the 50 day/200 day “Golden Cross” strategy, which I wrote about in February 2012, a week or so after the occurrence of the last Golden Cross.  In this monthly variation using the Shiller model, an investor exits the market when the SP500 monthly index drops below its 10 month moving average.

Keep in mind that a backtested portfolio generates higher than actual returns since they often don’t include trading fees, slippage or a real life re-balancing.  In backtest simulations, an investor may re-balance all in one day following the signal day.  While that may be the case sometimes, many investors are not so quick and some financial advisers will recommend making a gradual transition when re-balancing.  Still, backtests can be useful in comparing strategies.

An investor who puts money into the stock market today is – or should be – more concerned about what that money will be worth 5, 10 and 20 years from today when they might need the money for retirement, children’s college, or other events in a person’s lifetime.

There is a definite negative correlation between the CAPE and the 10 year return, without dividends, of an investment in the SP500.  Since World War 2, the correlation is -.70.  Since 1902, the correlation is -.65, reflecting the greater portion of earnings that were paid out as dividends to investors before WW2.  In short, it is likely that an investor will experience lower returns the higher this CAPE ratio.

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How much can I take each year from the piggy bank?

There is also a Shiller model for sustainable withdrawals from a portfolio based on the CAPE ratio.  You can read about it here.  Keep in mind that this model uses a 30 year horizon for retirement.  The same author, Wade Pfau, has a separate article on the various time horizons used in withdrawal models.

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Takeaways

Two steps forward, one step back is a familiar trend in this post-recession period.  Retail sales are healthy but below the 5% threshold of a strong upward trend.

Using the Shiller CAPE ratio as a metric of market valuation, stocks are overvalued.

Summer Signs

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July 13, 2014

Small Business

Optimism has been on the rise among small business owners surveyed monthly by the National Federal of Independent Businesses (NFIB).  Anticipating a growing confidence, consensus estimates were for a reading of 97 to 98, topping May’s reading of 96.8.  Tuesday’s disappointing report of 95 dampened spirits.  The fallback was primarily in expectations for an improving economy.  Mitigating that reversal of sentiment was a mildly positive uptick in hiring plans. The majority of job growth comes from small and medium sized companies.

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Job Openings and Labor Turnover Survey (JOLTS)

Speaking of job growth…There is a one month lag in the JOLTS report from the Bureau of Labor Statistics so this week’s report summarized May’s data.  The number of job openings continues to climb as does the number of people who feel confident enough to voluntarily quit their job.  Job openings have surpassed 2007 levels. If I were President, I would greet everyone with a hand shake and “Hi, job openings have surpassed 2007 levels.  Nice to meet you.”

Still, the number of voluntary quits is barely above the low point of the early 2000s downturn.  Let’s not mention that.

We can look at the number of job quits to unemployment, or the ratio of voluntary to involuntary unemployment.  This metric reveals a certain level of confidence among workers as well as the availability of jobs.  That confidence among workers is relatively low.  The early 2000s look like a nirvana compared to the sentiment now.  The country looks positively depressed using this metric.

If I were President, if I were a Congressman or Senator, I would post this chart on the wall in my office and on the chambers of Congress where it would remind myself and every other person in that chamber that part of my job is to help that confidence level rise.  Instead, most of our elected representatives are voicing or crafting a position on immigration ahead of the midterm elections.  Washington is the site of the largest Punch and Judy show on earth.  Like the little train, I will keep repeating to myself “I think I can, I think I can…stay optimistic.”

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Government Programs

Most social benefit programs are on autopilot, leaving Congress with little discretion in determining the amount of money that flows out of the U.S. Treasury.  These programs include Social Security, Temporary Assistance to Needy Families, Food Stamps, Unemployment Benefits, etc.   Enacted over the past eighty years, the ghosts of Congresses past are ever present in the many Federal agencies that administer these programs.

During the recent recession, payments under social programs shot up, consuming more than 70% of all revenues to the government.  Political acrimony in this country switched into high gear as the U.S. government became the largest insurance agency in the world. As the economy improved, spending fell below the 60% threshold but has hovered around that level.

 That percentage will surely rise as the boomer generation retires, taking an ever increasing share of revenues to pay out Social Security, Medicare and Medicaid benefits.  As the percentage rises again toward the levels of the recession, we can expect that social benefit spending will take center stage in the 2016 Presidential election.

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Indicators

Back in ye olden days, soothsayers used chicken bones and tea leaves to foretell the future.  We now have powerful computers, sophisticated algorithms and statistical techniques to look through the foggy glass of our crystal ball.  Less sophisticated algorithms are called rules of thumb.  In the board game Monopoly, a good rule of thumb is that it is wiser to build hotels on St. James, Tennessee and New York Ave than on the marquee properties Park Place and Boardwalk.

I heard a guy mention a negative correlation between early summer oil prices and stock market direction for the rest of the year. In other words, if one goes up the other goes down. I have a healthy skepticism of indicators but this one intrigued me since it made sense.  Oil is essentially a tax on our pocketbooks, on the economy.  If oil goes up, it is going to drive up supplier prices, hurt the profits of many companies, reduce discretionary income and drag down economic growth. The market will react to that upward or downward pressure in the next few quarters. But a correlation between six weeks of trading in summer and the market’s direction the rest of the year? Is that backed up by data, I wondered, or is that just an old saw?   I used the SP500 (SPY) as a proxy for the stock market, the U.S. Oil Fund (USO) as a proxy for the oil market and threw in Long Term Treasuries (TLT) into the mix.  I’ll explain why the treasuries in a minute.

A chart of recent history shows that there is some truth to that rule of thumb.  When oil (gray bars) has dropped in price in the first six weeks of summer trading, the stock market has gained (yellow bars) during the rest of the year in five out of the past seven years.   A flip of a coin will come up heads 50% of the time, tails 50% of the time. An investor who can beat those 50/50 chances by a margin of 5 wins to 2 losses will do very well.

Whether this negative correlation is anything but happenstance is anyone’s guess.  If you look at the chart again, you’ll see that there is also a negative correlation between long term Treasuries (TLT) and oil the the first half of summer trading. When one is up, the other is down.  The last year these two moved in tandem was – gulp! – in the summer of 2008.  Oh, and this year.  We know what happened in the fall of 2008.  So, is this the sign of an impending financial catastrophe?  Let me go throw some chicken bones and I’ll let you know.

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Takeaways

Small business sentiment eased back from its recent optimism.  Spending on government social programs exacerbates political tensions and aging boomers will add fuel to the fire.  Job openings and confidence continue to rise from historically low levels.  Do summer oil prices signal market sentiment?

Wage and Industrial Growth

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July 6, 2014

This week I’ll take a look at the monthly employment report, update the CWPI and introduce a surprising medium term trading indicator.

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Employment

On Wednesday, the private payroll processor ADP gave an early forecast that this month’s labor report from the BLS would be robust, near the tippy-top of estimates of job gains that ranged from 200K to 290K.  The BLS reported $288K i net job gains, including 26K government jobs added. 17,000 of those jobs were in education at the local level.  Rising sales and property tax revenues have enabled many city and county governments to replace education jobs that were lost during the recession.

Job gains may be even better than the headline data shows.  ADP reports that the large majority of hiring is coming from small and medium sized firms.  The headline number of job gains each month comes from the BLS Establishment Survey, which underestimates job growth in really small firms.  The Household Survey estimated about 400K job gains this past month.  Usually, the Establishment Survey is thought to be the more reliable estimate but in this case, I would give a bit of a bump up toward the Household Survey estimate and guesstimate that job gains were closer to 330K this past month.  The BLS also revised April and May’s job gains upward.

The unemployment rate decreased .2% to 6.1% and the y-o-y decline in the rate has accelerated.

Excellent news, but let’s dig a bit deeper. The BLS tracks several unemployment rates.  The headline rate is the U-3 rate.  The U-4 rate includes both the unemployed who have looked for work in the past month, and those who have not, referred to as discouraged workers.  The trend in discouraged workers has been drifting down, although it is still above the normal range of .2 to .3% of the work force.

I would be a whole lot more optimistic about the labor market if the employment rate of the core work force aged 25 – 54 were higher.

Slowly and inexorably the employment level of this core has been rising in the past few years but the emphasis is on the word slowly.

The number of workers who usually work part time seems to have reached a high plateau, close to 18% of the Civilian Labor Force (CLF).  The CLF includes most people over the age of 16.  June’s Household Survey shows a historic jump of 800,000 additional part time jobs added in the past month.

A closer look at the BLS data makes me doubt that number. The unseasonally adjusted number of part timers shows only a 400,000 gain, leading me to question any seasonal adjustment that doubles that gain.  Secondly, the BLS did not seasonally adjust last month’s tally of part time workers, leading me to guess that June’s figure includes two months of seasonal adjustment.

That same survey shows a one month loss of more than 500,000 full time jobs lost (Table A-9 BLS Employment Situation).  The year-over-year percent change in full time workers is 1.8%.  As you can see in the graph below this is in the respectable range.  The unseasonally adjusted y-o-y gains is close to the seasonally adjusted gain, leading me to believe that the losses, if any, have been overstated due to month-to-month fluctuations in seasonal adjustments.

However, if you are selling a newsletter that says the stock market is grossly overvalued and the end is coming, then you would want to highlight the change in June’s seasonally adjusted numbers, to wit:  500,000 full time jobs lost;  800,000 part time jobs gained.

While the Civilian Participation Rate has steadied, it is rather low.  The Participation Rate is the number of people working or looking for work as a percent of most of the population above 16. Below is a chart showing the declining participation rate and the unemployment rate.

Now let’s divide the Participation Rate by the Unemployment Rate and we see that this ratio is still below the 34 year average.

                                                                                      
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Wage Growth

Each month the BLS reports average weekly earnings as part of the labor report. Year-over-year inflation adjusted wage growth is flat but has probably declined below zero.

An investor would have done very well for themselves if they had paid attention to this one indicator.  (There is a week lag between the end of the month price of SP500 and the release of the employment report for that month but it is close enough for this medium to long term analysis.)

The SP500 has gained almost 50% since the first quarter of 2006.  An investor going in and out of the market when inflation-adjusted wage growth crossed firmly above and below 0% would have made 134% during that same period.  “Ah, ha!  The crystal ball that will give me a glimpse into the future!” The problem with any one indicator is that it may work for a period of time.  This one has worked extremely well for the past eight years.  This series which includes all employees goes back only to March 2006.  The series that includes only Production and Non-Supervisory employees goes back to 1964.  The two series closely track each other.  I have left the CPI adjustment out of both series to show the comparison.

However, an investor using this strategy in the mid-1990s would have been out of the market during a 33% rise.  She would have been in the market during half of the 2000-2002 downturn and been mostly out of the market during an almost 50% rise from 2003-2005.  In approximately twenty years, she would have made half as much as simply staying in the market.

The ups and downs of wage growth may not be a reliable indicator of the market’s direction but it does indicate positive and negative economic pressures.  Poor wage growth in the mid-2000s probably fueled speculation in real estate and the stock market.

From the mid-1980s to the mid-1990s, a decade of negative inflation adjusted wage growth exerted downward pressure on labor income, which naturally led to a stratospheric increase in household debt.

The stock market quintupled as inflation adjusted wages stagnated.  During this period an investor would have been better to do the opposite: buy when wage growth fell below zero, sell when it crossed above.  As long as workers were willing and able to borrow to make up for the lack of wage growth, company profits could continue to grow and it is profits that ultimately drive stock market valuations.

Wage growth ultimately influences retail sales which impacts GDP growth.  The difference between the growth in retail sales and wage growth roughly tracks changes in GDP.

If retail sales growth is more than wage growth for a number of years, the imbalance has to eventually correct.  We are in a period of little wage growth and modest sales growth which means that GDP growth is likely to remain modest as well.

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Constant Weighted Purchasing Index (CWPI)

Purchasing Managers surveyed by the Institute for Supply Management continue to report strong growth.  The CWPI index, based on both the Manufacturing and Services surveys, continues to rise as expected.

A composite of new orders and employment in the services sector remains strong.  February’s dip below 50 was an anomaly caused by the severe winter weather which coincided with inventory adjustments.

We see that this is a cyclic indicator, responding to the push and tug of new orders, employment, deliveries and inventories.  If the pattern continues, we would expect a decline in activity in the several months before the Christmas shopping season, a cycle that we have not seen since 2006.

The CWPI generates buy and sell signals when the index crosses firmly above and below 50 and has generated only 8 trades, or 16 separate transactions, in the past 17 years.  It is suited more to the long term investor who simply wants to avoid a majority of the pain of a severe downturn in the market.  Because it charts a composite of economic activity, it will not generate a signal in response to political events like the budget disagreement in July 2011 that led to an almost 20% drop in the market.  A strategy based on the CWPI gained 180% over the past 17 years as the market gained about 110%.

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Takeaways

Strong employment report but wage growth is flat and declining on a year over year basis.  CWPI indicator continues to rise up from the winter doldrums and should peak in two months.

GDP and Education

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June 29, 2014

This week I’ll review some of this week’s headlines in GDP, personal income, spending and debt, housing and unemployment.  Then I’ll take a look at some trends in education, including state and local spending.

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Gross Domestic Product First Quarter 2014

The headline this week was the third and final estimate of GDP growth in the first quarter, revised downward from -1% to -2.9%.  This headline number is the quarterly growth rate, or the growth rate over the preceding quarter.  A year over year comparison, matching 2014 first quarter GDP with 2013 first quarter GDP, shows an annual real growth rate of 1.5%, below the 2.5 to 3.0% growth of the past fifty years.  The largest contributor to the sluggish GDP growth was an almost 5% drop in defense spending.  Simon Kuznets, the economist who developed the GDP concept, did not include defense spending in the GDP calculation.

Contributing to the quarterly drop was the 1.7% decline in inventories.  Businesses had built up inventories a bit much in the latter half of 2013 in anticipation of sales growth only to see those expectations dashed by the severe winter weather.  Final Sales of Domestic Product is a way of calculating current GDP growth and does not include changes in inventory.  Let’s look at a graph of the annual growth in Real (Inflation-Adjusted) GDP and Real Final Sales of Domestic Product to see the differences in the two series.

Note that Real GDP growth (dark red line) leads Final Sales (blue line) as businesses build and reduce their inventory levels in anticipation of future demand and in reaction to current and past demand.
  
The Big Pic: if we look at these two series since WW2, we see that ALL recessions, except one, are marked by a year over year percent decline in real GDP.  The 2001 recession was the exception.

Secondly, note that in half of the recessions, y-o-y growth in Final Sales, the blue line in the graph, does not dip below zero.  We can identify two trends to recession: 1) businesses are too optimistic and overbuild inventories in anticipation of demand, then correct to the downside, causing a reduction in employment and a lagging reduction in consumer spending; 2) consumers are too optimistic and take on too much debt – selling an inventory of future earnings to creditors, so to speak – then correct to the downside and reduce their consumption, causing businesses to cut back their growth plans.  In case #1, a decrease in consumer spending follows the cutbacks by businesses.  In case #2, businesses cut back following a downturn in consumer spending.

In this past quarter, employment was rising as businesses cut back inventory growth, indicating more of a rebalancing of resources by businesses rather than a correction.  Consumer spending may have weakened during the first quarter but, importantly, did not decline.  We have two hunting dogs and neither is pointing at a downturn.

For a succinct description of the various components of GDP, check out this article written for about.com by Kimberly Amadeo.  Probably written in the first quarter of 2014, her concerns about the inventory buildup in 2013 were proved accurate.

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Income and Spending

Personal Income rose almost 5% on an annualized basis in May but consumer spending rose at only half that pace,  2.4%.  The spending growth is only slightly more than the 1.8% inflation rate calculated by the Bureau of Economic Analysis, revealing that consumers are still cautious.

I heard recently a good example of how data can be presented out of context, leading a listener or reader to come to a wrong conclusion.  Data point: the dollar value of consumer loans outstanding has risen 45% since the start of the recession in late 2007. Consumer loans do not include mortgages or most student loan debt. If I were selling a book, physical gold, or a variable annuity with a minimum return guarantee, I could say:

My friends, this shows that many consumers have not learned any lessons from the recession.  They are living beyond their means, running up debts that they will not be able to pay. Soon, very soon, people will start defaulting on their debts and the economy will collapse.  This country will suffer a depression that will make the 1930s depression look tame.  Now is the time to protect yourself and your loved ones before the coming crash.

Data is little more than an opportunity to spread one’s political message.  Data should never lead us to reconsider our message, our point of view.  If I were penning a politically liberal message, I could write:

The families in our country are desperate.  Without enough income to satisfy their basic needs, they are forced to borrow, falling ever deeper into debt while the 1% get richer.  We need policies that will help families, not the financial fat cats on Wall Street.  We need a tax structure that will ensure that the 1% pay their fair share and not have the burden fall on the shoulders of most of the working Americans in this country.


Selling a political persuasion and selling a car brand often employ similar techniques.  Data should never lead us to question our loyalty to the brand.  If I were crafting a conservative message, I could write:


The misuse of credit indicates an immaturity fostered by cradle to grave social programs, which are eroding the very character of the American people, who come to rely less on their own resources and more on some agency in Washington to help them out.  People steadily lose their sense of personal responsibility, becoming more like children than self-reliant adults.

However, the facts behind the data point lead us to a different story. In the spring of 2010, consumer loans spiked, rising $382 billion in just two months.

That surge represents more than a $1000 in additional debt per person. Consumers did not suddenly go crazy.  Banks did not open their bank vaults in a spirit of generosity. Instead, banks implemented accounting rules FAS 166 and 167 that required them to show certain assets and liabilities on their books. $322 billion of the $382 billion increase in consumer loans during those two months in 2010 was the accounting change. If we subtract that accounting change from the current total, we find that real consumer loan debt increased only 5.5% in 6-1/2 years.  And that is the real story.  Never in the history of this series since WW2 have consumers restrained their borrowing habits as much as we have since December 2007.  We had to.  In the eight years before the financial crisis in 2008, real consumer debt rose 33%, an unsustainable pace.

About two years ago, loan balances stopped declining and since then consumers have added $80 billion, much of it to finance car purchases. $25 billion of that $80 billion increase has come only since the beginning of this year.  On a per capita, inflation adjusted basis, consumer loan balances are still rather flat.

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Housing

New home sales in May were up almost 20% over April’s total, and over 6% on an annual basis.  Existing homes rose 5% above April’s pace but are down 5% on an annual basis.  Each year we hope that housing will finally contribute something to economic growth.  Like Cubs fans, we can hope that maybe this year….

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Unemployment Claims

New unemployment claims continue to drift downward and the 4 week moving average is just below 315,000.  Our attention spans are rather short so it is important to keep in mind that the current level of claims is the same as what is was last September.

It has taken this economy six months to recover from the upward spike in claims last October.  The patient is recovering but still not healthy.

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Minimum Wage

The number of workers directly affected by changes in the minimum wage are small.  We sympathize with those minimum wage workers who try to support a family.  The Good Samaritan impulse in many of us prompts us to say hey, come on, give these people a break and raise the minimum wage.  What we may forget are the implications of any minimum wage increase.  Older readers, stretch your imagination and remember those years gone by when you were younger. Workers in their early working years often see the minimum as a benchmark for comparison.  The much larger pool of younger workers who make above minimum wage may push for higher wages in response to increases in the minimum wage.

Fifty years ago, Congress could have made the minimum wage rise with inflation, ensuring that workers in low paid jobs would get at least a subsistence wage and that increases would be incremental.  Of course, there are some good arguments against any nationally set minimum wage.  $10 in Los Angeles buys far less than $10 in Grand Junction, Colorado.  Ikea recently announced that they will begin paying a minimum wage that is based on the livable wage in each area using the MIT living wage calculator .  Several cities have enacted minimum wage increases that will be phased in over several years but none that I know of are indexed to inflation as the MIT model does.

Congress could enact legislation that respects the differences in living costs across the nation.  For too long, Congress has chosen to use the minimum wage as a political football.  Social Security payments are indexed to inflation because older people put pressure on politicians to stop the nonsense.  There are not enough minimum wage workers to exert a similar amount of coordinated pressure on the folks in Washington so workers must rely on the fairness instinct of the larger pool of voters if any national legislation will be passed.

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Education

Demos, a liberal think tank, recently published a report recounting the impact of rising tuition costs on students and families.  Student debt has almost quadrupled from 2004 – 2012.  Wow, I thought.  State spending per student has declined 27%.  More wows.  How much has enrollment increased, I wondered?  Hmmm, not mentioned in the report.  Why not?

The National Center for Education Statistics, a division of the Dept. of Education, reports that full time college enrollment increased a whopping 38% in the decade from 2001-2011.  Part-time enrollment increased 23% during that time.  Together, they average a 32% increase in enrollment. Again, wow!  Ok, I thought, the states have been overwhelmed with the increase in enrollment, declining revenues because of the recession, etc.  Well, that’s part of the story.  Spending on education, including K-12, is at the same levels as it was a decade ago.

From 2002-2012, states have increased their spending on higher ed by 42%.  Some argue that the Federal government should step up and contribute more.  In 2010, total Federal spending on education at all levels was less than 1% ($8.5B out of $879B).  Others argue that the heavily subsidized educational system is bloated and inefficient.  As much cultural as they are educational institutions, colleges and universities have never been examples of efficiency.  Old buildings on college campuses that are expensive to heat and cool are largely empty at 4 P.M.  Legacy pension agreements, generously agreed to in earlier decades, further strain state budgets.  We may need to rethink how we can deliver a quality education but these are particularly thorny issues which ignite passions in state and local budget negotations.

Although state and local governments have increased spending on higher ed by 42% in the decade from 2002-2012, the base year used to calculate that percentage increase was particularly low, coming after 9-11 and the implosion of the dot-com boom.  Nor does it reflect the economic realities that students must get more education to compete for many jobs at the median level and above.

Let’s then go back to what was presumably a good year, 2000, the height of the dot-com boom.  State coffers were full.  In 2000, state and local governments spent 5.14% of GDP (Source).  By 2010, that share had grown to 5.82% of GDP (Source). That represents a 13% gain in resources devoted to education.  But that is barely above population growth, without accounting for the rush of enrollment in higher education during the decade.

Let’s take a broader view of educational spending, comparing the total of all spending on education, including K-12, to all the revenue that Federal, state and local governments bring in.  This includes social security taxes, property taxes, sales taxes, etc.  As a percent of all receipts, spending on education has declined from 30% to under 18%.

Many on the political left paint conservatives as being either against education or not supportive of education.  Census data shows that Republican dominated state legislatures, in general, devote more of their budget to education than Democratic legislatures.  W. Virginia, Mississippi, Michigan, S. Carolina, Alabama and Arkansas devote more than 7% of GDP to education, according to U.S. Census data compiled by U.S.GovernmentSpending.com.  Only two states with predominantly Democrat legislatures, Vermont and New Mexico, join the plus-7% club (Wikipedia Party Strength for party control of state legislatures).

In the early part of the twentieth century, a high school education was higher education.  In the early part of this century, college may be the new high school, a minimum requirement for a job applicant seeking a mid level career.  What are our priorities?  In any discussion of priorities, the subject of taxes arises like Godzilla out of the watery depths.  People scramble in terror as Taxzilla devours the city. Older people on fixed incomes and wealthy house owners resist property tax increases.  Just about everyone resists sales tax increases.  Proposals to raise income taxes are difficult to incorporate in a campaign strategy for state and local politicians running for election.

Let’s disregard for a moment the ideological argument over Federal funding or control of education.  Let’s ask ourselves one question:  does this declining level of total revenues reflect our priorities or acknowledge the geopolitical realities of today’s economy?

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Takeaways

Reductions in defense spending, inventory reductions and a severe winter that curtailed consumer spending accounts for much of the sluggishness in first quarter GDP growth.

A surge in new home sales is a sign of both rising incomes and greater confidence in the future.

Consumer spending growth is about half of healthy income gains.

Spending on education has grown a bit more than population growth and is not keeping up with surging enrollment in higher education.

How Much Is That Doggie In the Window?

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June 22, 2014

This week I’ll look at interest rates and various models of evaluating both the stock market and housing.

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GDP Growth Revised

This past Monday, the International Monetary Fund (IMF) cut estimates for this year’s economic growth in the U.S. to 2% from 2.8%.  IMF cited a number of headwinds: the severe winter, weakness in housing, some fragility in the labor market.  It recommends that the central bank keep rates low through 2017.  Expectations were that the Federal Reserve would begin raising interest rates in mid 2015.  Some recommendations in the report will be met with antipathy or a polite “thanks for letting us know”: raising the minimum wage and gasoline taxes.

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Fed Don’t Fail Me Now

As expected, the Federal Reserve decided to leave the target interest rate at the extremely low range of 0% to .25% that it has held in place since the beginning of 2009.  Congress has given the Fed a dual mandate:  keep inflation reasonable and promote full employment.  It is this second half of the mandate that presents some problems as the FOMC looks into their crystal ball.  The Labor Force Participation Rate is the percentage of those working to those old enough to work.  It has declined from 66% at the beginning of the recession to less than 63% today.

As economic conditions improve and job prospects brighten, how many of those who have dropped out of the labor force will return?  If workers return to the labor force, actively seeking work, that increased supply of labor will naturally curb wage increases and reduce upward pressure on inflation.  However, if the decline in the participation rate is more or less permanent for several years to a decade, then a stronger economy will create more demand for workers, who can demand more money for their labor, which will contribute to inflation.

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401K Retirement Plans

The Financial Times reported projections  of negative cash flows in 401K plans by 2016 as boomers convert their pension plans to IRAs when they retire.  Retirees tend to have a much more conservative stock/bond allocation and may force institutional money managers to liquidate some equities to meet the outgoing cash flows.  An ominous speculation at the end of the article is that regulations could be put in place to slow the conversion of 401Ks to IRAs.  Whenever the finance industry needs a friend in Washington, they can be sure to find one.

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Stock Market Valuation

It has been 32 months without a 10% correction in the SP500 market index.  The post World War 2 average is 18 months. Is the stock market overvalued?  I will review a common metric of value and develop an alternative model of long-term value.

Probably the most widely used metric of stock valuation is the Price/Earnings, or PE, ratio.  If a stock sells for $100 and its annual earnings are $6, then the P/E ratio is 100/6, or a bit above 16.  The average PE ratio is 15.5 (Source).  Companies do not pay all of those earnings in the form of dividends to investors.  That is another metric, called the Price Dividend, or P/D ratio, that I wrote about last year.

Fact Set provides an analysis of the past quarter’s earnings of the SP500 companies, as well as projections of current  and next year’s earnings. Earnings growth estimates for this year range from 30% (yikes!) for the telecom sector to a bit over 3% for utilities. The health care sector tops estimates of revenue growth at about 8%, while the energy sector is projected to have negative growth.  The basic materials sector tops the 2015 list of earnings growth at 18% and the utilities sector again takes the bottom rung on the ladder with almost 4% growth.

The SP500 is priced at 15.6x forward 12 months earnings, which is above the five year and 10 year averages of less than 14x (Fact Set Report page)  but just about the 100 year average of 15.5.

Robert Shiller, a Yale economist and co-developer of the Case-Shiller housing index, uses a smoothing technique for calculating a Price Earnings ratio and makes his data spreadsheet available.  His team calculates the 10 year average of real, or inflation-adjusted, earnings and divides the inflation adjusted price of the SP500 by that average to arrive at a Cyclically Adjusted Price Earnings, or CAPE, ratio.

Using this methodology, the market’s CAPE  ratio is 25, above the 30 year ratio of 22.91 and the 50 year ratio of 19.57.  In 1996, the market was trading at this same ratio, prompting then Fed Chairman Alan Greenspan to make his infamous comment about “irrational exuberance.”  The market continued to climb till it reached a nosebleed CAPE ratio of 43 in early 2000.  It took another 7 months or so before the SP500 began its descent from 1485 to 900, a drop of 40%, over the next two years.  There is no automatic switch that flips when a market becomes overvalued.  People just get up from their seats and start to leave the theater.

In most decades, this methodology works well to arrive at a longer term perspective of the market’s price.  However, some argue that when severe downturns occur, this methodology continues to factor in the downturn’s impact long after it they have passed.  In 2008 and 2009, SP500 index annual earnings crashed from above $80 down to $60, a precipitous decline that is still factored into the ten year framework of the CAPE method.

So I took Mr. Shiller’s earnings figures and did some magic on them.  I took away most of the downturn in earnings during a 3 year period from 2008 – 2010.

Bye, bye earnings dive.  Hello, stagnating earnings.  The chart shows a slight downturn in earnings, then flat-lines in the pretend world of 2008 – 2010, where the steep recession never happened.

Instead of a deep crater formed in the markets by the financial panic in late 2008, the stock market slid downward over several years before rising again in early 2012.  Can you hear the soft sounds of flutes echoing in the mountain meadows of this pretend world?

Using this pretend data, I recalculated today’s CAPE ratio at 22, below the actual 25 CAPE ratio.  What should be the benchmark in this pretend world?  The 100 year average includes the Great Depression of the 1930s and World War 2, which naturally lowered PE ratios.  A 50 year average includes the Vietnam War and high inflation, particularly during the 1970s and early 1980s.  As such, it is less comparable to today’s environment marked by low inflation and the lack of major hostilities.

So, I ran a 30 year average of our pretend world, from 1984-2013, and calculated a 30 year average of 23, close to the real 30 year average of 22.9!  It shows the relatively small effect that even momentous events have on a long term average of the CAPE ratio, which is why Robert Shiller advocates its use to calculate value and establish a comparison benchmark within a longer time frame.  In the real world, the market’s CAPE ratio of 25 is above that 30 year average.

Let’s put aside the world of soft market landings and mountain meadows and look at what I call the time value of the market.  I picked January 1980, a point almost 35 years in the past, as a starting point.  Then I divided the SP500 index by the number of months that have passed since that starting point.  This gives me a ratio of value over time. If an investor buys into the market when its value is above a long-term average of that ratio, we can expect a lower long-term rate of return.

The 20 year average is 3.98, just a shade above the 20 year median of 3.91, meaning that the highs and lows of the average pretty much cancel out.  Note also that it is only in the past year that the market value has risen above the 20 year average of this ratio.

But we cannot look at a time value of any investment without considering inflation, which erodes value over time.  When we add the Time Value Ratio and the Consumer Price Index (CPI), we find that the current market is priced slightly lower than both the 20 year and 30 year averages.

Historically, as this ratio has risen more than 25 – 30% above its long-term average,  the market peaked.  Today’s ratio is just about average.

So, is the market overvalued?  Based on CAPE methodology, yes.  Fairly valued?  Based on expectations of earnings growth this year and next, yes.  Undervalued?  Probably not.

Common Sense recently published the best and worst 10 and 20 year returns on a 50/50 stock/bond portfolio mix.  This balanced approach had a 2 – 3% annualized gain even during the Depression years when the stock market lost 80 – 90% of its value.  It should be a reminder to all investors that trying to assess the true value of the stock market is perhaps less important than staying diversified.

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The P/E of Housing

Home builders broke ground on almost 1.1 million private residential units in April, a 13% increase over last year.  Called Housing Starts, the series includes both multi-family units and single family homes. The pace slowed a bit in May but still broke the 1 million mark.  As a percent of the population, we just aren’t building as many homes as we used to.

For most of us, our working years are about 60% of our lifespan.  Hopefully, our parents took care of our income needs for the first 20% of our lifespan. During our working years, we hope to save enough to generate a flow of income for the last 20% of our lifespan.  Those savings, which include private pensions and Social Security, are like a pool of water that we accumulate until we start turning on the spigot to start draining the pool.    We turn a stock or pool of savings into a flow of income.

The Bureau of Labor Statistics uses a metric called Owner Equivalent Rent (OER) in their calculation of the Consumer Price Index.  This concept treats a home as though it were generating a phantom income equivalent to the rents in that local real estate market.  We can use this concept to value a house.  The future flows from a stock can be used to generate an intrinsic current value for the house.

As an example:  a house which would generate a net $12000 a year in income, whether real or phantom, after taxes and other expenses, is worth about 16 times that net income, according to historical trends calculated by the ratings agency Moodys.  In this case, the house would be worth about $200K.

Coincidentally, this is the average P/E ratio of the stock market.  Historically, stocks have been valued so that the price of the company’s stock has been about 16 times the earnings flow from the company’s activities.  If a primary residence generates 6% in tax free income and 3% in appreciation, the total annual return on owning a house free and clear is more than the average annual return of the stock market.  The housing boom and bust may have given many younger people the impression that home ownership is a debt trap.  It may take a decade for the housing industry to recover from this perception.

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Takeaways

The Fed is likely to keep interest rates low past mid-2015 but is watching the Labor Participation Rate for early indications that rising wage pressures will spur rising inflation.
The stock market is slightly overvalued or fairly valued depending on the metric one uses.
On average, a house has a value multipler that is similar to the stock market but generates a higher after tax income.

Next week I’ll take a look at some long term trends in education spending and tuition costs.

Follow The Money

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June 14th, 2014

This week I’ll take a look at some near-term trends in small business, labor, oil and housing and a few long-term trends in income and debt.

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Small Business

Huzzah, huzzah!  The monthly survey of small business owners by the National Federation of Independent Businesses (NFIB) broke through the 96 level after cracking the 95 level last month.  Sentiment has not been this good since mid-2007.  Hiring plans have been on the rise for the past several months and owners are reporting rising sales.

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JOLTS (Job Openings and Labor Turnover Survey)

The Job Openings report from the Bureau of Labor Statistics (BLS) has a one month delay so the data released this past week was for April.  The number of job openings was 40,000 higher than expected, coming in close to 4.5 million.  As a percent of the workforce, job openings are approaching pre-recession highs.

The decline in construction job openings is a disappointment.  We are near the same level as 2003, a weak year of economic growth.  We should expect to see an uptick in job openings in next month’s report, confirming that projects put on hold during the severe winter in the eastern part of the country are again on track.  Further declines would indicate a spreading malaise.

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Gross Domestic Income

On a quarterly basis Gross Domestic Income, GDI, and Gross Domestic Product, GDP, differ somewhat but over the long run closely track each other.  Following up on two previous posts on Thomas Piketty’s book Capital in the 21st Century, I wondered what percent of GDI goes to pay employee compensation.  As we can see in the chart below, total compensation for human labor has been dwindling to post WW2 levels.

This is total compensation, including benefits.  Wage and salary income as a percent of total national income has declined steadily.

As a percent of total income, employee benefits have more than tripled since the end of World War 2 and now comprise more than 10% of the country’s income.

Demographic shifts have contributed to the decline of labor income.  The post war boomer generation, 80 million strong and 25% of the population, contributes to the trend as they save for retirement. As capital gains, interest and dividend income increase, this reduces the share of wage and salary income.

Economic changes have been a major factor in the decline of labor income.  Capital investments in technology, both in hardware and software, have reduced the need for labor for a given level of production.  Capital investment demands income to pay back the investment. For most of the 20th Century, machines replaced human muscle in farming, manufacturing and construction.  In the past two decades, machines are increasingly replacing mental muscle.

How we count labor income has changed.  Tax law changes in 1986 and 1993 reduced the amounts that are included as compensation but the overall effect of these changes is relatively minor.

If we divide the country’s total employee compensation by the number of employees, we might ask “What recession?”  Average annual compensation has climbed from $38-54K in a dozen years.  That’s almost a 50% raise for every employee!

Of course, everyone has not had a 50% increase in income over the past 12 years.  Human capital, the educational and technical training that an employee has to offer, has earned an increasing premium in the past three decades. Those with more of this capital have captured more benefit from the dwindling pool of labor needed for the nation’s production.

Average disposable income tells a more accurate story of the majority of people in this country.  Disposable income is what’s left over after taxes.  The trend is downward.

How do we cope with flat income growth?  Charge it!  It’s the Amurikin way! Per capita Household Debt has increased 75% in the past 13 years.  After a decline from the rather high levels before the recession began in late 2007, per capita debt has leveled off in the past two years.

Rising house prices and stock market values have increased net worth.  As a percent of net worth, household debt has declined to the more sustainable levels of the 1990s.

The percentage of disposable income needed to service that debt is at thirty year lows, meaning that there is room for growth.

In response to the hostilities in Iraq, oil prices have been on the rise.  Historically, a rise in oil prices leads to a rise in prices at the pump which takes an extra bite out of disposable income and puts a damper on consumer spending growth.

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Oil Prices

A blog by Greg McIsaac at the Washington Monthly in May 2012 presents an interesting historical summary of oil prices and production.  The American love of simplicity leads many to credit one man, the President, for the rise and fall in gasoline prices, although the President has little, if any, influence on oil pricing. McIsaac notes “The combination of lower energy prices and increased energy efficiency in the 1980s reduced US expenditures on energy by nearly 6 percent of GDP.“  Deregulation of energy prices begun under the Carter Administration were largely credited to the Reagan administration.   He writes “crediting Reagan with falling energy prices of the 1980s exaggerates the roles of both Reagan and deregulation and obscures the larger influence of conservation and increased production outside the US.”  Production actually fell for several years after regulatory controls were lifted.

Further increases in oil prices will no doubt be blamed on this President.  The one thing that each outgoing President bequeaths to the newcomer before the inauguration is the Presidential donkey suit.

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Housing

Redfin Research Center reports a sharp decline in the number of houses sold through May. After a 7.6% year-over-year decline in April, home sales slid 10% from May 2013 levels.  Real estate agents are reporting a shift from a seller’s market to a buyer’s market.

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Takeaways

Small business accounts for approximately 60% of new jobs and optimistic sentiment among small business owners is growing.  The labor market continues to show continuing strength in the number of job openings and a decline in new unemployment claims.  Disposable income growth is flat but the portion of income needed to service debt is very low.  Rising oil prices and a slowing housing market will crimp economic growth.
Next week I’ll look at a complex topic – is the stock market fairly valued?  

Labor Trends

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June 8th, 2014

This week I’ll look at some long term trends in the labor market, short term economic indicators and an unusual move by the European Central Bank.

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May Labor Report

On Friday, the BLS reported job gains of 217K, in line with expectations.  The big headline is that we have finally recovered all the jobs that were lost during the recession.

That headline obscures the weakness in the recovery of the labor market.  The number of jobs gained comes from the monthly survey of businesses.  The household survey shows that the economy is still short about 1 million jobs from its mid-2007 high.  A million jobs is less than 1% of the workforce but we’ll see in a minute that the household survey may be giving us a truer sense of the labor market.  Like a fighter who has been knocked down a few times, the labor market is back on its feet but still maintains a defensive posture.

The number of involuntary part-time workers, those who want full time work but can’t find it, has declined in small increments over the past few years but remains stubbornly high.  Gone are the upward spikes in part-time employment, indicating that the labor market is at least more predictable.

7.3 million involuntary part-timers is about 2.3 million more than a more normal level of 5 million.  Half of that number means that there are effectively 1.2 million jobs still “missing.”  Add to that 1.2 million or more jobs needed each year just to keep up with population growth.  1.2 million x 6 years = 7.2 million.  Add in the 1.2 million jobs to reduce part-timers to normal levels and that is 8.4 million jobs still missing.  Let’s deduct a million jobs or so that were gained before the recession because of an overheated housing market and we still have a 7.5 million jobs gap, or 5% of the potential workforce.  As I will show next week, this job gap puts downward pressure on wages, on personal income, on consumer demand, on…well, just about everything.

This month marked the fourth month in a row that job gains have been higher than 200K.  Two of those four months of  consistently strong job gains came during a weak quarter of economic growth and particularly weak corporate profit growth.  More on that next week.

The narrow measure of unemployment remained unchanged at 6.3% but the widest measure, the U-6 rate, continues to decline from a high of (gulp!) 17% to a current level of 12.2%.

The number of long-term unemployed edges downward.

Although there is much variation in the monthly count of people who are classified as discouraged, the trend is downward from the hump in 2011 and 2012.

After breaking above the 95 million mark earlier this year and rising, the number of workers aged 25 – 54, what I call the core work force, has declined back toward the 95 million mark.

According to the monthly survey of businesses, half of all employees are women.  My gut instinct tells me that this is more out of necessity than desire.  Women do what they have to do to meet the needs of their families and many of those jobs may be part-time to accommodate family needs.

The decline in male-dominated employment in the manufacturing and construction sectors can be seen in the declining participation rate of men in the work force.

Earlier in the week, ADP reported private job gains of 180K, below the consensus estimate of 210K.  A graph of the past decade shows that private job growth has steadied during the past year.

We should probably keep this longer-term perspective in mind to balance out the monthly headlines. Zooming in on the past few years shows the dips, one of which was the recent winter lull.  The trick is to keep a balance between the short-term and the long-term.

The market is expecting growth this quarter that will offset the winter weakness and will probably react quite negatively if prominent indicators like employment, auto sales or housing should disappoint.

Over 10,000 boomers a day reach retirement age.   Not all of them retire but some back of the envelope estimates are that 100K or more do drop out of the labor force each month.  For the past eight months or so, new entrants and re-entrants into the job market has offset these retirees and the number of people not in the labor force has leveled off in the range of 91 to 92 million.

Construction employment finally crossed the psychological 6 million mark this month and for the past year or so has been on the rise from historic lows.  As a percent of the work force, however, employment in this sector is near all-time lows.  Let’s zoom out and look at the past fifty years to get some perspective on this sector.  A more normal percentage of the work force would be about 5%.  The difference is 1 to 1.2 million jobs “missing” in a sector which pays better than average.

In summary, there is a lot to like in the labor reports of the past few months.  But we should not kid ourselves.  The long-term trends show that the challenges are steep.  The question is not whether the glass is half empty or half full.  The question is how many small holes there are in the bottom of the glass.

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Central Banks

Helping to fuel the upward climb in the market this week was the message that central banks are willing to adopt whatever policies they can to support the economy.  In response to the threat of deflation in the Eurozone, the European Central Bank (ECB) made an unprecedented move this week, charging banks 1/10% to park their excess reserves with the central bank.  What does this mean?  Customary policy is that member banks must keep on deposit with the central bank a certain percentage of their outstanding loans and other securities to guard against losses.  For larger banks, this is about 10%.  In a simple example, let’s say that a bank makes another loan for $100.  It must keep an additional $10 on deposit with the central bank.  Let’s say it already has $12 extra on deposit with the central bank.  The central bank would then pay interest to the bank for the extra $2.  The policy change this week by the ECB reverses that policy:  member banks must now pay the central bank for any excess reserves.  Essentially the central bank is charging banks for not making more loans,  a policy which some monetary economists have encouraged the Federal Reserve to adopt.

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CWPI (Constant Weighted Purchasing Index)

On Monday, the Institute for Supply Management released their monthly survey of purchasing managers, then revised it shortly after the release, then revised it again later in the day.  This should remind us that economic gauges are not  like measuring a 2×4 stud with a tape measure.  Seasonal adjustments and other algorithms are applied to most raw data to arrive at a published figure.

The CWPI index I have been tracking for about a year showed further gains in May, rising up from the winter doldrums.  The composite index of the manufacturing and services sectors stands at a bit over 57, solidly in the middle of the strong growth range of 55 to 60.  If the pattern holds, we should expect to see this economic gauge rise during the next few months, peaking at the end of the summer.

An average of two key components of the economy, employment and new orders in the services sector, rose back above 55 this month, a level that hasn’t been seen since last October.

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Key Takeaways

The numbers from the labor market are cause for optimism – job gains are rising while new claims for unemployment are falling.  Auto sales are strong, an indication that consumers have more confidence.  New orders and employment are rising.  Weakness in the housing market bears a close watch.