Author: sgstofka

Income, Housing and Durable Goods

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In this week’s downturn, prices of the SP500 almost touched the 26 week, or half year, average of $203.90.  Since August 2012, when the 50 day average crossed above the 200 day average, these price dips have been good buying opportunities as the market has resumed its upwards climb after each downturn.

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Manufacturing and Durable Goods

Preliminary readings of March’s Purchasing Managers’ Index (PMI) showed an uptick back into strong growth.  Survey respondents were concerned about weak export sales as the dollar’s strength makes American products more expensive overseas.  The full report will be released this coming Wednesday.

This past Wednesday’s report that Durable Goods had dropped 1.4% in February caused an already negative market to fall another 1.5% for the day and this marked the close of the week’s activity as well.  New orders for non-transportation durable goods have steadily declined since the fall.  Although the year-over-year comparisons are consistent with GDP growth, about 2.3%, the downward trend is concerning.

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Housing

Existing home sales in February rose almost 5% in a year over year comparison, the best in a year and a half but still below the 5 million annual mark. The positive y-o-y gains during the past six months has prompted some optimism that sales may climb back above the 5 million mark in the spring and summer season.

New home sales in February surged back above a half million.  In a more healthy market, sales of new homes are 6% – 7% of existing homes.  In 2006, that ratio started climbing above the normal range, getting increasingly sicker until it reached almost 18% in May 2010.  February’s ratio was 9%. If the ratio were in the normal range, existing home sales would be over 8 million, far above the current 4.9 million units actually sold.

In a 2014 report the National Assn of Realtors noted that boomers tend to buy new or newer homes to avoid maintenance headaches while younger buyers buy older homes because they are less expensive (page 3).  38% of all home buyers are first timers but the percentage is double for those younger than 33 (Exhibit 1-9 in the report).  As the supply of existing homes is inadequate to meet the demand, prices climb and suppress the demand, forcing first timers to either buy a smaller new home or continue renting.

Sales of new homes and the fortunes of home builders are based on the churn of existing homes.  Since October, the stocks of home builders (XHB) have climbed 20% in anticipation of growing sales, but weak existing home sales may prove to be a choke point for growth.

The larger publicly traded homebuilders also build multi-family units.  Real investment in this sector has tripled from the lows of early 2010 but are still below pre-crisis levels.

The housing market in this country is still wounded.  63% of the population are white Europeans (Census Bureau) but are 86% of home buyers (Exhibit 1-6).  While few will admit to racial prejudice in the current housing market, the numbers are the footprints of this nation’s long history of racial discrimination and socio-economic disparity.  Mortgage companies that made – let’s call them imprudent – credit decisions that helped precipitate the housing crisis are especially cautious, making it more difficult for younger buyers to purchase their first home, despite the historically low mortgage rates.  This market will not heal until mortgage companies relax their lending criteria just a bit and that won’t happen while rates are so low.

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Income

The Bee Gees might have sung “Words are all I have to take your heart away” because they were singing about love, not economics and finance.  Graphs often tell the story much better than words.  A milestone was passed a few years back.  For the first time since World War 2, the growth in income crossed below the growth in output.

This past week, the Bureau of Labor Statistics released a revision to their initial estimate of multi-factorial productivity in 2013.  There is a lot of data to gather for this series.  An often quoted productivity growth rate calculates the GDP of the nation divided by an estimate of the number of hours worked, a statistic that is accessible through payroll reports submitted monthly and quarterly.  The contribution of capital to GDP is much more difficult to assess and is largely disregarded by those like Robert Reich, former Secretary of Labor under President Clinton, who have a political axe to grind.  Truth is on a path too meandering for politics.

Total output in the years 2007 – 2013 was just plain bad, growing at an annual rate of only 1%, a third of the 2.9% growth rate from the longer period 1987 – 2013.  In the BLS assessment, the growth rates of both labor and capital inputs were poor by historical norms but capital input accounted for all of the meager gains in non-farm business productivity.  People’s work is simply not contributing as much to growth as before.  That reality means that income growth will be meager, which will prompt louder political rhetoric to make some kind of change, any kind of change, because voters like to believe that politicians have magic wands.

Steady As She Goes

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March 22, 2015

Monetary Policy

The FOMC is a committee of Federal Reserve members who meet every six weeks to determine the course of monetary policy.  A statement issued at the end of each two day meeting is carefully parsed by traders in an orgy of exegesis.  And thus it was so this past week.  Recent statements by the Fed included the word “patient” as in low inflation and some lingering weaknesses in the labor market allow us to take a patient approach with monetary policy.  If the Fed removed the word patient, then it was a good bet that they would start raising rates at their mid June meeting.  By the end of the year, the thinking was, the benchmark Fed funds rate could be 1%-1.25%.

So here’s what happened while you were at work, or at lunch or picking up the kids on Wednesday afternoon when the Fed meeting concluded. The initial reaction was negative, or at least that’s how the HFT (high frequency) algorithms parsed the Fed’s statement.  “Patient” was gone.  Sell, sell, sell. Then some human traders noticed that the Fed was also saying that they did not have to be impatient either – the perfect neutral stance.  Buy, buy, buy.  The SP500 jumped 1.5% in a few minutes.  The neutral stance of  the Fed caused many to revise their estimates of the Fed rate at the end of the year to .75% or less.  The broad market index ended the week at the same level as it was when the month began.  Volatility as measured by the VIX is rather low but there has been a lot of  positioning since Christmas and a net gain of only 1% in those three months.

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Earnings Recession


The analytics firm FactSet projects a year-over-year decline in the earnings of the SP500 companies for this first quarter of 2015.  Here is a good review of the historical response of the stock market to earnings recessions, defined as two quarters of year-over-year declines in the composite earnings of the SP500.

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Oil

Oil is an international commodity that trades on world markets in U.S. dollars.  A prudent strategy for countries which are net importers of oil is to stock up on dollars to pay for its short term oil needs.   As the demand for dollars climbs so does its price in other currencies, a self-reinforcing mechanism.  Half of the drop in the price of oil is due merely to the appreciation of the dollar, which has spiked some 25% since the beginning of the year.

For decades, many in academia and government have advocated the adoption of an international currency called the SDR, already in use by the International Money Fund.   Here is an article from last May, before the price of oil started its slide.  The dollar is the latest in a series of reserve currencies over the past 500 years and has been the dominant currency for almost 100 years (History here). The reliance on one country’s currency works – until it begins to cause more problems than it solves.  The  largest producer and consumer of oil, Saudi Arabia and the U.S., have formed a decades long agreement to price oil in U.S. dollars, binding the rest of the world to the movements in the U.S. dollar.The recent volatility in the dollar in threatening the economic stability of many nations, who are increasing their calls for a change in international monetary policy.

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Sticky CPI

In a survey of newspaper articles, inflation was mentioned more than unemployment or productivity.  In the U.S., inflation is often measured by the Consumer Price Index (CPI).  A subset of that measure is called the core CPI and excludes more volatile food and energy items to arrive at a fundamental trend in inflation.  (IMF primer on inflation ) Critics of the core CPI point out that food and energy items are the most frequent purchases that consumers make and have a fundamental effect on the economic well being of U.S. households.  Responding to some of the inherent weaknesses in the methodology of the CPI, the Atlanta branch of the Federal Reserve began development of an alternative measure of inflation – a “sticky” CPI. (History)  This metric gives a statistical weight to the components of the CPI by how much prices change for each component.  The Atlanta Fed has an interactive graph that charts both the sticky measure and a more volatile, or flexible CPI that is similar to the conventional CPI.  The sticky CPI tends to measure expectations of future changes in inflation and moves rather slowly.

Over a half century, the clearest trend is the closing of the gap between the regular CPI and the sticky CPI.

When we compare all three measures, core, sticky and regular CPI, we see that the sticky CPI is usually above the core CPI.  January’s readings are 2.06% for the sticky index, 1.64% for the core index and -.19% for the headline CPI index.

A private project called Price Stats goes through the internet comparing prices on billions of items.(WSJ blog article here)  This data is more timely and shows an uptick in core inflation that is approaching 2%, the Federal Reserve’s target rate.  When asked why the Fed uses 2%, chair Janet Yellen answered that inflation indexes do not capture improvements in products, only prices, so they tend to overstate inflation as a matter of design and practical data gathering.  Secondly, the 2% mark gives the Fed a statistical cushion so that they are able to take appropriate monetary steps to avoid deflation.

Why is deflation a bad thing?  In answering this question, we discover the true benefit of the core CPI.  Food and energy are regularly consumed.  Demand for these goods is relatively “sticky”.  A family may change what types of foods it buys in response to price changes but it is going to buy food. Deflation in these core purchases can be a good thing as it takes less of a bite out of the average household’s wallet.

On the other hand, deflation in less frequently purchased goods, which the core CPI tracks, is not good because it leads to a self-perpetuating cycle in which consumers delay making purchases in the expectation that tomorrow’s price will be lower than today’s price.  If I expect that the price of an iPhone will be lower next week, how likely am I to buy one this week?  As consumers delay purchases, suppliers lower prices even more to move their goods.  Seeing the price competition among vendors, consumers are even more likely to delay purchases, waiting for prices to come down even further.  As sales drop, vendors and manufacturers begin to layoff employees.  Lower prices no longer entice consumers who become concerned about keeping their jobs and purchase only what they need.

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Indicators

The Conference Board, a business association, released their monthly index of Leading Indicators this week but it has a spotty history of forecasting trends. Doug Short puts together a nice snapshot of the Big Four indicators, Employment, Real (inflation-adjusted) Sales, Industrial Production, and Real Income.

Glootch or Glut?

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March 15, 2015

Retail

Indicators of business activity and confidence have all been strong.  The Purchasing Managers Index, the monthly employment report, and the NFIB small business index have shown exceptional strength in the past several months.  A week after a strong employment report came the worrisome news that retail sales declined for the third month.

A 2% drop in auto sales was the primary driver of February’s decline but the lack of demand is evident in the broader economy.  Excluding auto sales this is the second three month period of declining sales since the recovery began.  Following the slump in 2012, the SP500 sagged about 7%.  The market’s response to this slump has been muted so far.

American businesses had hoped that their customers would spend the dollars saved at the gas pump but consumers may be tucking away some of that cash. The slowdown in retail sales may be partly due to the harsh winter in the east, or a lack of income growth.  The strong dollar has made American products more expensive to export so businesses are especially dependent on domestic demand. Since last summer, prices at the wholesale level have declined steadily.  Commodities other than oil are also showing slack demand.

The inventory to sales ratio has climbed abruptly in the last half of the year.  Businesses make their best guess in anticipating future demand.  A capitalist economy is based on the decision making of millions, not a central committee of a few.  If inventories continue to mount, we can expect that businesses will adjust to the new environment and rein in production and expansion plans.

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Retirement

Twenty years ago I read articles on portfolio diversification like this one and was glad that I wasn’t old enough to be concerned about that kind of stuff.  Then one morning I was shaving and noticed that I was developing a slight turkey wattle in my neck, the same thing I had noticed in my Dad. OMG! I was getting old!
A Bankrate.com blog post features a chart of savings goals that a person at each stage of life should have accumulated to ensure that they can maintain their living standard in retirement.  The benchmarks are based on one’s current income.  Many Americans do not even meet these modest goals.  According to the chart, a person making $60K  who retires at 67 should have $500K in savings and investments.  
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Apple
Telephone and radio were the high tech firms of the early 20th century.  In 1916, ATT was added to the Dow Jones Industrial Average (DJIA), acknowledging that the company had become a pillar of the American economy. 
At the close of trading on March 18th, almost a hundred years later, ATT will be dropped from the DJIA and replaced by Apple, a high tech firm of the 21st century.  Apple’s projected earnings growth for this year may cancel out the anticipated negative earnings growth of the DJIA but Apple is a more volatile stock than stodgy ATT so daily price changes in the index are likely to be a bit more dramatic.
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Budgeting
Last week, economist Greg Mankiw wrote a piece in the New York Times explaining the recent change from static to dynamic budget scoring in the new Congress.  These are two different methods for estimating the effects of proposed tax changes on the budget over the following ten years.  Static scoring, the previous system, has been in place for decades and assumes no changes to the economy resulting from the proposed tax changes.  Dynamic scoring estimates changes in GDP and revenues resulting from the tax changes. Several examples illustrate differences between the two types of scoring.  The article is well written and easy to understand without the use of complicated economic models.

Winter Wanders

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March 8, 2015

Labor Market

If you are reading this and have not set your clock forward, that’s OK.  March to your own drummer!

On Wednesday, payroll processor ADP released their data for February, showing private payroll gains of 212,000.  This confirmed estimates that total job gains from the BLS would be about 230,000.  The bothersome data point in the ADP report was the huge upward revision of job gains in January, bringing it close to the BLS estimate.  ADP is working with a lot of hard data – actual paychecks – so was this revision a discrepancy in seasonal adjustments?

On Thursday, the BLS issued revised figures for labor productivity in the 4th quarter of 2014. The report includes this: “The 4.9 percent increase in hours worked remains the largest increase in this series since a gain of 5.7 percent in the fourth quarter of 1998.” 4th quarter productivity sagged 2.2% from the 3rd quarter,  and was essentially unchanged from the 4th quarter of 2013.  Labor productivity is often a lagging indicator but it narrowed Thursday’s trading range as investors crossed bets on the Fed’s plans for raising interest rates later in the year.

The BLS report of 295,000 job gains in Febuary was so over the top that many traders punched the sell button.  Government employment increased 7,000, meaning that private job gains as reported by the BLS was almost 290,000, a difference of almost 70,000 between the BLS and ADP reports.  When in doubt, traders get out.

For mid to long-term investors, the continuing strength in the labor market is an optimistic sign.  Employees add to costs and commitments.  If businesses are adding jobs, it is because they anticipate higher revenues in the near future.  Some analysts pointed to the high number of jobs gained in the leisure and hospitality sectors as a sign of weakness in the labor market.  These are jobs that pay on average about 25% less than the average of all production and non-supervisory employees and a third less than the average for all employees.  However, higher paying jobs in professional services and construction also showed strong gains.

As I have mentioned before, the Federal Reserve compiles a Labor Market Conditions Index (LMCI) which summarizes 24 employment trends and one which chair Janet Yellen uses as her gauge for the fundamental strength or weakness of the labor market.  Next Wednesday, the Fed will release the LMCI updated for February but a chart of the past twenty years shows longer term trends.

While the index itself is still in negative territory, the momentum (red line) of the index is strong and consistent.  We can understand Yellen’s cautious optimism when recently testifying before the Senate Banking Committee.  This index was only developed a few years ago so this chart includes revised data and methodology that is backward looking.  If history is any guide, a long term investor would be ill advised to bet against the momentum of this index when it is positive.

A key indicator for Ms. Yellen is the Quit rate, the number of employees who quit their jobs to go to another job or who feel confident that they can find another job without much difficulty.  That confidence measure continues to rise and is currently in a sweet spot.  It is not overly confident as it was at the height of the housing boom in 2006 and the dot com boom of the late 1990s.  It is neither pessimistic as it was in the early 2000s or darkly apocalyptic as in the period from 2008 – 2012.

The number of new claims for unemployment as a percentage of the Civilian Labor Force is at historic lows.  One could argue that new claims are too low.

Wage growth in this month’s report was minimal.  However, wage growth since 2006 has not done too badly, growing more than 25% and outpacing the 16% growth in inflation during the period.

Benefits have grown more than 20% in the same period and showed no decline during this past recession.  Many employees are simply not aware of the costs of their benefits.  They may think that vacations and holidays and health care are the only benefits they get.  There are several mandated taxes and insurance that an employer is required to pay.

Because some benefit costs are “sticky,” and not responsive to changing business conditions, the continued strength in the labor market shows an increasing commitment on the part of employers, a growing confidence that economic conditions are fundamentally improving.  Several years ago, many employers were reluctant to take on new employees because positive news was regarded with a healthy skepticism.  “We won’t get fooled again,” as the Who song lyric goes.  Despite improving fundamentals, the market is likely to be somewhat volatile this year as investors and traders speculate on the timing and aggressiveness of any interest rate moves from the Fed.

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Purchasing Managers Index

Based on the monthly survey of purchasing managers, the Constant Weighted Purchasing Index (CWPI) declined slightly again this month as expected.  The manufacturing sector slid a bit this past month but employment in the service sectors popped up, keeping the composite index up above the benchmark of strong growth.  If the post-recession trend continues, we might see one more month of softening within this growth period.

New orders and employment in the service sectors are the key indicators that I highlight to get a more focused analysis of growth trends.  When this blend of the two factors stays above 55, the benchmark of strong growth, the economy is strong.  Except for a slight dip below that mark (54.4) last month, this blend has been above 55 for ten months now.

We can also see the brief periods of steady decline in these two components in 2011, 2012 and the beginning of 2013, causing the Federal Reserve to worry about a further decline into recession. The Federal Reserve enacted a series of bond buying programs called QE.  Continued economic strength may prompt a slow series of interest rate hikes.  The key word is “slow.”  Under former chairman Alan Greenspan, the Federal Reserve adjusted interest rates up and down too quickly, which produced small shock waves in the financial system.  Banks, businesses and investors may make unwise choices in response to rapid rate changes.  Live and learn is the lesson.

Stock and Housing Valuations

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March 1, 2015

There are several popular methods to evaluate stocks.  The P/E ratio is probably the most quoted metric.  This is a stock price divided by its current earnings.  A conservative variation of this popular methodology is Professor Shiller’s Cyclically Adjusted Price Earnings (CAPE) ratio.  The basis for this metric is the observation that all data reverts to its mean.  Professor Shiller’s method adjusts the past ten years of reported earnings for inflation, then averages those earnings and divides the current price by that average to get a CAPE ratio.

Any well-regarded valuation method has its detractors. This Economist blog points out objections to the Shiller CAPE ratio. In a 2014 blog I tackled an objection to Shiller’s methodology: a ten year average can include a severe downturn in earnings that does not reflect current conditions. I massaged away the 2008 to 2010 downturn to show that Shiller’s CAPE ratio was little changed by the downturn.

Some object that the CAPE ratio uses reported earnings, which includes depreciation (lowers earnings) and interest (increases or decreases earnings).  Operating earnings exclude these items and more accurately reflect the profits generated by ongoing operations.   Operating earnings may be a valid basis for evaluating a single company and Warren Buffet uses this method, among others, to get a sense of sustainable earnings.

Some prefer to use forward operating earnings, which are estimates of profits for the next twelve months.  These estimates come in two varieties: top down and bottom up.  Top down estimates are calculated by estimating a growth percentage of profits for the coming year and applying that percentage to the sum of current profits.  Bottom up estimates are painstakenly compiled by taking the forward earnings guidance given by each company.  Top down estimates tend to be optimistic and are usually revised downward with the passage of time.

I prefer Shiller’s method as a more realistic approach for a long term investment in a stock index like the SP500.  Successful businesses should be able to generate enough profit in their operating margins to account for depreciation, which is included in reported earnings.

Another valuation method is the flip side of the Price Earnings or P/E ratio – an E/P ratio, or earnings yield.  As of a week ago, the current earnings yield was 5.02%.  This is then compared to the 10 year Treasury rate, 2.13%, as of Feb. 20, 2015.  The difference between the earnings yield of stocks and a risk-free investment like U.S. Treasuries – currently about 3% – is called the risk premium for owning stocks.  Often, this risk premium is quoted in basis points, which are 100ths of a percent.  So 3% = 300 basis points.  In 2007, the risk premium was over 4%.  The average from 2002 – 2006 was about 2% as stocks climbed out of a prolonged slump following the dot com bust and 9-11.  So, using this method, we could say that stock valuations are somewhere in the middle, neither frothy or pessimistic.

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Housing

Sales of New Homes remained brisk at just under 1/2 million.  The supply of new homes on the market indicates historically strong demand.

The latest Case-Shiller home price index increased 4.3% year-over-year, below the 4.7% growth curve of the past forty years.  From 1975-2000, home prices increased 5.5% annually.  During the boom years of the 2000s housing prices surged above that growth curve only to fall swiftly in the crash of 2008.  The bust in the housing market has more than taken out the excess, bringing the forty year growth curve to 4.7%.

The home price index does not take into account the larger homes being built over the past two decades.  The median square footage of new homes has grown from 1555 SF in 1975 to 2457 SF in 2013. (Census Bureau data)

A greater percentage of today’s homes include air conditioning, extra bathrooms and other amenities that the homes of forty years ago did not have, skewing the long term effective growth curve even lower.  While some metropolitan areas on both coasts may be overvalued, national averages suggest that housing prices are fairly valued.

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Economic Summary

Twice a year the chair of the Federal Reserve testifies before the Senate Banking Committee.  Chair Janet Yellen’s testimony this past week was a concise distillation of economic trends.  Investors bombarded with an avalanche of articles and blogs may sometimes find it difficult to synthesize all the information they absorb.  Ms. Yellen’s initial summary cuts through the clutter:

The unemployment rate now stands at 5.7 percent, down from just over 6 percent last summer and from 10 percent at its peak in late 2009. The average pace of monthly job gains picked up from about 240,000 per month during the first half of last year to 280,000 per month during the second half, and employment rose 260,000 in January. In addition, long-term unemployment has declined substantially, fewer workers are reporting that they can find only part-time work when they would prefer full-time employment, and the pace of quits–often regarded as a barometer of worker confidence in labor market opportunities–has recovered nearly to its pre-recession level. However, the labor force participation rate is lower than most estimates of its trend, and wage growth remains sluggish, suggesting that some cyclical weakness persists. In short, considerable progress has been achieved in the recovery of the labor market, though room for further improvement remains.

At the same time that the labor market situation has improved, domestic spending and production have been increasing at a solid rate. Real gross domestic product (GDP) is now estimated to have increased at a 3-3/4 percent annual rate during the second half of last year. While GDP growth is not anticipated to be sustained at that pace, it is expected to be strong enough to result in a further gradual decline in the unemployment rate. Consumer spending has been lifted by the improvement in the labor market as well as by the increase in household purchasing power resulting from the sharp drop in oil prices. However, housing construction continues to lag; activity remains well below levels we judge could be supported in the longer run by population growth and the likely rate of household formation.

Financial Obligations

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February 22, 2015

Consumer Debt

On the one hand, the economy continues to grow steadily and moderately.  Sales of cars and light trucks are strong.

Housing Starts of new homes are slow.  While homebuilders remain confident, there is a noticeable decrease in traffic from first time home buyers.

The debt levels of American households have not reached the nosebleed levels of 2007 before the onset of the financial crisis.  However, they are more than a third higher than 2005 debt levels.

Historically low interest rates have enabled families to leverage their monthly payments into higher debt.  As a percent of disposable income, monthly morgage, credit card and loan payments are the lowest they have ever been since the Federal Reserve started tracking this in 1980. As long as the labor market grows at a moderate pace and interest rates remain low, families are unlikely to default on these higher debt loads.

In addition to household debt, the Federal Reserve includes other obligations – auto leases, rent payments, property taxes and insurance – to arrive at a total Financial Obligations Ratio (FOR), currently about 15%. (Explanation here)  The highest recorded FOR was 18% in 2007. The amount of income devoted to servicing the total of these obligations – 15.28% –  is near historic lows.  (Historical table ) In the past, when this rato has climbed above 17% there has been a recession, a stock market crash, or both.

So there are three components of a family’s monthly obligations: mortgage payments – currently less than 5%; credit card and loans, currently 5.25%; and other obligations, also about 5.25%.  Should interest rates rise in the next two years, credit card and loan payments will rise above the current 5.25% but are unlikely to cause a crisis in household finances.  The percentage of home mortgages which are adjustable have been rising in the past few years but the growing number of these mortgages have been so-called jumbo loans to households with larger incomes. (Daily News  and Wall St. Journal ).  Rising rates will put increasing pressure on homeowners with these types of mortgages but are unlikely to generate a crisis similar to 2008.

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Currency Market

When someone says the dollar is strong, what does that mean?  Investopedia has a fairly concise explanation of the foreign exchange market (Forex) and the history of attempts to structure this market, the largest in the world.

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Medicare Spending

Costs for Medicare and private insurance have grown at annual rates more than double inflation since 1969, as shown in a 2014 analysis of 35 years of Medicare (CMS) data by the Kaiser Family Foundation.  The only good news is that Medicare annual growth has been 2% less than private plans.

The majority of the benefits go to a small group of patients.  “Medicare spending per beneficiary is highly skewed, with the top 10% of beneficiaries in traditional Medicare accounting for 57% of total Medicare spending in 2009—on a per capita basis, more than five times greater than the average across all beneficiaries in traditional Medicare ($55,763 vs. $9,702).”

In its 2013 annual report (highlights) CMS noted that Medicare spending for the past five years had grown at a relatively tame 4% or less – almost double the inflation rate.  This is what passes for good news in federal programs – spending that is only slightly out of control.  Medicaid costs are growing at 6% per year.  Congress and CMS know that they have got to improve spending controls but the players in the health care industry spend a lot of money in Washington so elected and non-elected officials tread carefully when proposing any reforms.

Last month, Health and Human Services (HHS) announced that, by 2018, they would like to make half of Medicare payments to doctors based on the quality of care they provide, not the number of procedures they do.  Under the ACA, 20% of Medicare payments are based on outcomes, not fee for service.  Although HHS says it has saved $700 million over the past two years, few provider organizations meet the guidelines to share in the savings as originally designed.

When Medicare Advantage programs were introduced in 2003, Congress approved additional subsidies to health care providers to reimburse providers for promoting the new plans.  Like all “temporary” subsidies, no one wants to give them up. Because of the subsidies, the plans are relatively low cost and provide a good benefit for the dollar.  Uwe E. Reinhardt, a Princeton professor writing in the NY Times economics blog, referred to a 2010 report on the cost of the popular Medicare Advantage (MA) program: “In 2009, Medicare spent roughly $14 billion more for the beneficiaries enrolled in MA plans than it would have spent if they had stayed in FFS [Fee For Service, or regular] Medicare. To support the extra spending, Part B premiums were higher for all Medicare beneficiaries (including those in FFS).”

As the population ages, Medicare will consume an ever larger percentage of total health care spending.  CMS noted that Medicare’s portion of health care spending in 2013 has been relatively steady over the past few years. A pie chart from 2009 spending illustrates the cost breakdown.  In 2013, we spent 17.4% of GDP on health care, a figure that has remained stable for a few years.  In 2001, the U.S. spent a shocking (at the time) 13.7% of GDP on health care (CMS Source).

The Gathering

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February 14, 2015

In January of this year, the SP500 finally rose above the inflation adjusted high set in 2000.  Here is a chart from multpl.com that I have overlaid with a few boxes.  Long term market trends are dubbed “secular” to contrast them with the shorter cyclical swings in valuation.  A secular bear market is a prolonged market downturn in which the inflation adjusted price of the SP500 never gets above a certain historical peak.

These long term periods are easier to define in hindsight.  They have begun with some peak and ended at some trough.  Years after the trough when the market has made a new inflation adjusted high price, market watchers get out their crayons and set the end of the bear market just after that trough.  Based on that historical rule, we would then say that the secular bear market that began in 2000 ended in 2009 at a market low six months after the onset of the financial crisis.

If history is any guide, an investor could expect further price increases for another 2 years (as in the late 1920s), or another 10 years (as in the late 1950s to late 1960s), or another 8 years (as in the 1990s).  In other words, history may not be much of a guide.

If the market tanked in 2017, two years after setting a new high, some sages would nod soberly and say it was just like the 1920s and was to be expected.  If the market continued rising another eight years before falling, ah yes, just like the 1990s.  The signs were all there if you knew where to look.

Secular bear markets share characteristics other than long term price swings.  During past prolonged downturns there have been five recessions within each period.  We have had two recessions since 2000.  Price to earnings, or PE, ratios went really low – about 6 – at the lowest trough of past downturns.  This is also the approximate low in the Shiller CAPE ratio.  Since 2000, the PE ratio has fallen to 10; the CAPE ratio to 13.  The current PE ratio based on the trailing twelve months earnings is almost 20, about 25% above the average. The number of years from peak to trough has been 19.  2000-2009 would be only 9 years, the shortest secular bear period on record.  The number of years from peak to peak has been about 26 years, much longer than the current 15 year period.

 This has led some to predict a further final crushing decline in the market to end the secular bear.  If the doomsayers are correct and we are only two-thirds through a secular bear market, we would expect market prices to plateau this year.  Then will come some shock – China’s real estate market implodes, or its regional banks collapse.  The so called PIGS – Portugal, Ireland, Greece, and Spain – could exit the euro.  There could be a major armed conflict with Russia or Iran that causes investors to abandon equities in droves.  The stronger dollar can put strains on countries whose currencies are pegged to the dollar. Such strains can cause a financial crisis similar to the one in Mexico in 1995 and the Asian and Russian crises of 1997 – 1998.  In the summer of 1998, the SP500 fell 15% in one month as fears grew that regional monetary imbalances would infect the economies of the entire world.

Secular bear markets come in types.  The two that started in 1929 and 2000 arose from what I call discovery shocks.  Investors lose conviction in their own hopes of future gains and leave the market.   The bear market that began in the late 1960s was a series of conflict shocks that spurred erratic changes in inflation.   As the country borrowed money to fund the Vietnam war, inflation rose above 3%, peaking at 6% in the spring of 1970.  The 1970s was marked by domestic and international conflict: the Watergate scandal and the oil supply wars with OPEC drove inflation to a high of 12% in late 1974.  As oil prices quadrupled through the 1970s, inflation spiked at almost 15% in the spring of 1980.  Through most of the decade, inflation stayed above 5% – a low that was almost double the historical average.

The SP500 made new records again this week although FactSet notes that the blended earnings growth for the fourth quarter of 2014 was only 3.1%.  The forward P/E of the SP500 is 17.1%, substantially above both the five and ten year averages (see paragraph below for illustration of changes in forward P/E). FactSet reports that nine out of ten sectors have forward P/E ratios that are above their ten year averages.  Only the telecom sector is selling slightly below its ten year average.  The forward P/E of the SP500 is based on projected earnings over the next year and volatile oil prices have made such earnings estimations difficult.  First quarter earnings by energy companies have been revised downwards by 50%, resulting in a 7.4% decrease in earnings estimates for the SP500.

Small changes in earnings estimates are multiplied 10 to 30 times to reach an evaluation of fair market price.  If 2015 earnings for SP500 companies are estimated at $100, an index price of 2000 is a forward P/E of 20.  If estimates are revised upwards to $110, then an index price of 2000 reflects a forward P/E of 18.  If the forward P/E of the SP500 is above the five and ten year averages as it is today, it means that investors and traders are betting that estimates of forward earnings will be revised upwards, resulting in a lower forward P/E ratio.

Long-term Treasuries (TLT) rose up 11.5% in the five weeks from late December to the end of January – too much, too fast.  After falling back in the last two weeks from their peaks, they are priced at the same level as in July 2012.  In 2014, traders who bet against long term bonds in anticipation of rising interest rates got slaughtered as long term Treasuries rose 25%.  Investors who moved out of long term and into shorter term bonds were disappointed as well.

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Retail Sales

Investors regard the monthly employment report and the retail sales report as the most important barometer of a consumer driven economy.  As an example of the correlation, consider a graph of inflation adjusted retail sales and the SP500 index.

Retail sales in January declined slightly from December.  Investors were somewhat heartened by the 2.4% annual gain, at least 1% above inflation, but remember that last January was particularly poor and was an easy benchmark to beat.  On the other hand, lower gasoline prices lowered this year’s total,  offsetting the comparison with a weak benchmark.

Sales at food and drinking establishments rose more than 11% y-o-y in January.

Large y-o-y gains in food and drink usually occur in the winter months.  January 2000, 2001, 2004, 2006, December 2006, January 2012, and these past two months all peaked at more than 8% y-o-y gains.  Eating and drinking out are largely discretionary for most of us.  A change in the pace of growth in this behavior signals  changes in consumer attitudes that are more real than a consumer confidence survey.  Changes in this discretionary budget item is a survey of wallets. In the past year, the growth of food and drink sales has accelerated, indicating a more confident, less fearful consumer.

While the various consumer sentiment surveys indicate what we tell interviewers, the wallet survey indicates what we really think.  In early 2009, the U. of Michigan Consumer Sentiment Survey showed a rebound of confidence.  What the survey indicated was more a rebound of hope, not confidence.  Consumer spending on eating and drinking out was still declining.

2011 is an indication of the opposite – plunging sentiment according to a survey but growing spending at food and drink establishments, indicating that the volatile drop in sentiment might be short lived.  The plunge in confidence was a response to the budget battles between the Republican House and the President.

Low inflation, relatively low gasoline prices, strong employment and retail sales gains all point to steady moderate growth.  Judging by the PE (19.7) and forward PE (17.1) ratios, the market may have already priced in that growth.

Growing Signs

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February 8, 2015

Employment

Employment gains in January were at the midpoint of expectations but revisions to the gains of November and December were significant, adding about 70,000 jobs in each month.  After a decline in December, average hourly earnings rose to $24.75, for a year-over-year gain of 2.2% and a good 1% above inflation.

In a sign that people are becoming more optimistic about job prospects, the Participation Rate increased 2/10ths of a percent in January.  After 5 years of decline, this rate may have found a bottom over the past year.

The health or frailty of the core work force aged 25 – 54 years is  a snapshot of the underlying strength of the labor market.  This age band constitutes our primary working years.  In the first half of this thirty year period we build job skills, work and social connections, establish credit, and accumulate relationships and stuff.  Year-over-year growth in the 1 to 2% zone is the preferred “Goldilocks” growth rate.

As the graph below shows, the growth rate has been above 1% for most of the past year.

Monthly gains in construction employment have overtaken professional business services and the health care industry.

The construction industry accounts for less than 5% of employment but each employee accounts for a total of $160,000 in spending so changes affect other industries.  As you can see in the graph below, real or inflation-adjusted construction spending per employee was relatively stable during the 1990s.  As the housing market boomed, spending per employee rose dramatically in the 3-1/2 years from late 2002 to early 2006.  In the worst throes of the recession when the industry shed almost a quarter of its employees, per employee spending stabilized at the same level as the 1990s.

Stimulus spending and Build America projects helped cushion the decline in construction spending but as those programs concluded, spending fell to a multi-decade low in the spring of 2011.  Despite historically low interest rates and increasing state and municipal tax revenues, both residential and commercial construction are below the benchmark set in the 1990s.  Despite strong gains in the past two years, the industry still has room to run.

As the economy improves, those working part time because they can not get full time work has decreased significantly from the nosebleed heights of five years ago.

That total includes those whose hours have been cut back because of slack business conditions.  A subset of that total are the number of workers who are working part time because they can not find a full time job.  This segment of workers has seen little change during this recovery.

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Purchasing Manager’s Index

Each month I update a composite index of the ISM Purchasing Manager’s indexes (PMI) first introduced by economist Rolando Pelaez in 2003.  This composite, the Constant Weighted Purchasing Index, or CWPI, reached record highs in October 2014.  It is no surprise that, this month, the BLS revised November’s employment gains upwards by 70,000 to over 420,000.  As expected, the composite has declined but remains robust.

The wave like pattern of present and anticipated industrial activity has quickened since early 2013, the troughs and crests coming closer together.  If this pattern continues, we should expect gradual declines over the next two months before rising up again.  A combination of employment and new orders in the service sectors continues to show healthy growth, although it has also declined from the strong growth of the past few months.

GDP, Unemployment, Wage Growth

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Feb. 1st, 2015

GDP

The first estimate of 4th quarter GDP growth was 2.6%.  This figure is truly a guesstimate and is sometimes heavily revised in the following months. Last October, the first estimate of third quarter GDP growth was 3.5%.  As data continued to roll in, that estimate was revised upwards by a whopping 42% to 5.0%.

The year over year growth in inflation-adjusted, or real GDP was 2.5%, more or less following a trend that is four years old.

On a per capita basis, GDP growth is near 2%, the average rate of growth since World War 2.

Let’s get in the wayback machine and look at per capita GDP growth over the past four decades.  Reagan and Clinton groupies can leave the room now.  The adults are going to talk.  The 1970s and first half of the 1980s were a period of high inflation and erratic growth – up 5%, then down 3%.

Growth above 3% for any length of time leads to distortions in investment and the labor market which generates a subsequent downward correction lasting several years.  Above average growth in the late 1980s was followed by a three year period of below average growth in the early 1990s.  The strong growth of the late 1990s was fueled by a boom in dot-com investment and telecom coupled with ever rising house prices.  The above 3% growth of those years sparked an inevitable correction lasting three years, bringing us back to the 2% average.

The housing boom of the 2000s generated above average growth followed yet again by a three year correcting downturn. For those families who have struggled to recover from the recession, average growth may be too slow and too small.  On the other hand, average growth is less likely to lead to a rebalancing recession.

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Unemployment

Much ado this week when the Labor Dept announced that new claims for unemployment dropped more than 40,000 to 265,000.  The week after the Martin Luther holiday is typically volatile each year with little consensus on the reasons.  The somewhat erratic weekly numbers are smoothed by using the four week average of new claims.  That average has been just below 300,000 since September.

Low numbers for the newly unemployed is good, right?!  As with GDP, too much of a good thing for a period of time may be a precursor to an offsetting period of not so good.  Such is the law of averages.  As a percent of the labor force, new claims are at the same low level as in mid-2000 and late 2006.

As the demand for labor increases, employers make compromising decisions out of necessity.  They hold onto low productivity workers. Workers who are let go can more readily find new jobs.  The number of new claims remains low.  Re-entrants into the job market help to reduce the pressure for wage increases but eventually wages begin to move upward.  Employers may cut margins to pay workers more than their productivity is worth.  Real wage growth climbs as the percentage of new unemployment claims remains low.

In the graph above I have highlighted two previous periods where new unemployment claims were low as real wage growth climbed.  The graph below illustrates the point a bit clearer.  It is based on the Employment Cost Index, a relatively new series about ten years old, that tracks the total employment cost, including benefits and required employment taxes and insurance.

Historical data suggests that a growing divergence between these two factors may play some part in generating an imbalanced economic environment – one that, unfortunately, soon rights itself.

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Market Timing

The link to Doug Short’s blog is on the right side of this page but in case you might miss it, here is Doug’s monthly update of moving averages and the simple allocation model of the Ivy Portfolio.    The 10 month simple moving average crossover is similar to the 50/200 day crossover system I have mentioned numerous times: i.e. the Golden Cross and Death Cross.  Either system will help a person avoid the worst of a protracted downturn as we saw in the early 2000s and 2008 – 2011, and capture the majority of a long term upswing.

For those of you who have not read it, the Ivy Portfolio is a keep-it-simple allocation and timing model of domestic and foreign stocks, real estate, commodities and bonds using low cost ETFs.

Then and Now

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January 25, 2015

Valuation

Blogger Urban Carmel has written a thorough article on current market valuation, focusing on Tobin’s Q as a metric.  This is the market price of equities divided by the replacement cost of the companies themselves.  During the past 65 years, the median ratio is .7, meaning that the market price of all equities is about 70% of the replacement cost.  At the end of December, the Tobin’s Q ratio was more than 1.1.

Are stocks overvalued?  Valuing the replacement cost of a company might have been more accurate when the assets were primarily land, factories and other durable equipment.  Today’s valuations consist of networks, processes, branding, and other less easily measured assets.  The valuation discussion is not new.  In 1996, before the U.S. shed much of its manufacturing capacity, economists and heads of investing firms argued about valuation, including Tobin’s Q.  You can punch the way back button here and read a NY Times article that could have been written today if a few facts were changed.

Currently, households have 20% of their financial assets in stocks, the same percentage as in 1996.  In December 1996, then Federal Reserve chairman made a comment about “irrational exuberance”  in market valuations.  Prices would continue to rise, then soar, before falling from their peaks in mid-2000.  At that peak, households held 30% of their financial assets in stocks.  At an earlier peak, 1968, households had the same high percentage of their assets in stocks.

On an inflation adjusted basis, the SP500 has only recently closed above the all time high set in 2000 (Chart here).  The Wilshire 5000 is a market capitalization index like the SP500 but is broader, including 3700 publicly traded companies in its composite. On an inflation adjusted basis this wider index is 40% above the peaks of 2000 and 2007.

Long term periods of optimistic market sentiment are called secular bull markets. Negative periods are called secular bear markets. (See this Fidelity newsletter on the characteristics of secular bull and bear markets).   These long-term periods are easier to identify in hindsight.  Some say that we are nearing the end of a long-term bear market, and that there willl be a big market drop to close out this bearish period.  There have been so few long term market moves in 150 years of market data, that it is possible to tease out any pattern one wants to find.  The aggregate of investor behavior is not a symphony, a piece of music with defined structure and passages.

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REIT

As Treasury yields decline, mortgage rates continue to fall.  The Mortgage Bankers Association reported  that their refinance application index had increased by 50% from the previous week.  The refinancing process involves the payoff of the previous higher interest mortgage.  Mortgage REITs make their money on the spread, or the difference, between the interest rate they pay for money and the interest on loaning that money on mortgages.  When a lot of homeowners prepay their higher interest mortgages, that lowers the profits of mortgage REITs like American Capital Agency (AGNC) and Annaly Capital Management (NLY).  Both of these companies have dividend yields above 10% and are trading below estimated book value.

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Housing

Back in ye olden days, around 1950, the world was a bit different.  The Bureau of Labor Statistics published a snapshot of incomes, housing, and other census data, including the data tidbit that people consumed fewer calories in 1950 than today, 3260 then vs. over 3700 today.

Housing and utilities averaged 27% of income in 1950 vs. 40% today.  Food costs were 33% then, 15% today.  The median house price of $9500 was about 3 times the median household income (MHI) of $3200.  For most of the 1990s, the prices of existing homes were slightly higher, about 3.4 times MHI.

The prices of existing homes rose 6% in 2014 – healthy but not bubbly.  However, the ratio of median price to median income is now at 3.8.  Historically low interest rates have enabled buyers to leverage their income to get more house for their bucks, but the lack of income growth will continue to rein in the housing market.

The ratio of median new home prices to MHI has now surpassed the peak of the housing bubble.

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Retirement Income

Wade Pfau is a CFA who has written many a paper on retirement strategies and occasionally blogs about retirement income.  Here is an excellent paper on the change in psychology, risk assessment and strategies of people before and after retirement.  Wade and his co-author summarize the critical issues, the two dominant withdrawal approaches, the development of the safe withdrawal rate, and the caveats of any long term planning.  The authors review the strategies of several authors, discuss variable spending rules, income buckets and income layering,  annuities, and bond ladders.  You’ll want to curl up in an armchair for this one.