Author: sgstofka

The Great Moderation

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June 30th, 2013

Economists cite a number of factors to account for the growth during the 1980s and 1990s, a period some call the “Great Moderation” because it is marked by more moderate policies by politicians and central bankers.  Causes or trends include less regulation, lower taxes, lower inflation than the 1970s, the rise of emerging economies,  and a more consistent rules based monetary policy by the Federal Reserve.  Often underappreciated, but significant, was the huge increase in consumer credit. Household spending accounts for 2/3rds of the economy.  A new generation, the boomers, emerging fully into adulthood in the early ’80s, welcomed the broader availability of credit.  Like their parents, the boomers took on the burden and responsibility of owning a home, the largest portion of a household’s debt load, but unlike the previous generation, the boomers sucked up as much credit as they could get for cars, clothes, vacations, home furnishings and the growing array of electronic devices.

When we look at the non-mortgage portion of household debt, the rate of growth is more restrained – a mere 80% increase in per capita real dollars.

The parents of the boomer generation, dubbed by newscaster Tom Brokaw as the “Greatest Generation”,  had been habitual savers.  By 1980, the personal savings rate was about 10% of disposable income.  By the middle of that decade, the Greatest Generation began retiring and withdrawing some of that savings.  Their children, the boomers, did not have a similar sense of frugality.

Rapid advances in technology led to the introduction of new electronic toys for adults.  Credit cards, once reserved for the well to do, became ubiquitous.  Consumers parted with their money more painlessly when charging purchases.  Financing terms for automobiles became more generous,  allowing more people to purchase new cars, which became increasingly expensive as regulators mandated more safety controls.

After thirty years of gorging on credit, households threw up.  The past six years could be called the “Great Diet” or the “Great Purge” to get over the three decade credit binge.

We can expect rather lackluster growth for several more years as households continue to shed those ungainly pounds debts.  Not only are households shedding debt but also certain kinds of assets. In 2009, the Federal Reserve reported that households and non-profit corporations owned $400 billion in mortgage securities like Fannie Mae and Freddie Mac.  In the first quarter of 2013, the total was $10 billion.  (Table of household assets and liabilities)

Households continue to keep ever higher balances in low yielding savings accounts and money market funds, indicating the high degree of caution. The big jump in deposits was probably due to higher dividends and bonuses paid in the last quarter of 2012 to avoid higher taxes in 2013.

For the past two weeks, global markets shuddered at the prospect of the Federal Reserve easing up on their quantitative easing program of buying government bonds.  Some have proclaimed that it is the end of the thirty year bull market in bonds, causing many retail investors to pull money out of bonds.  In several speeches this past week, Reserve Board members have reassured the public that quantitative easing will be here for several years.

As we have seen, households still shoulder a lot of debt weight, making it unlikely that either this economy or interest rates will experience a surge upward in the next several years.  An aging and more cautious population together with a declining participation rate in the work force indicates that another “Great Moderation” is upon us.  The previous moderation was one of political policy.  This moderation is led by consumers.  We can expect – yes, moderate, or lackluster – growth over the coming years.  The positive tradeoff for this subdued growth is the probability that the underlying business cycle of growth surges and corrective declines in economic activity will be subdued as well.

Summer Sale

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June 23rd, 2013

It would be a mistake for the casual investor to think that the decline in the market this week was due entirely to Fed chairman Ben Bernanke’s comments regarding future Fed policy.  There was little that was not anticipated.  The Fed will continue to follow a rules based approach to its quantitative easing program, scaling back its purchases of government securities if employment improves or inflation increases above the Fed’s target of 2%.  Bernanke also reiterated that the Fed would increase its purchases if employment does not improve and inflation remains subdued.  So why the drop?

Shortly after the conclusion of each Fed meeting, Bernanke holds a press conference, where he issues a ten minute or so summary of the meeting and issues discussed.  He then takes about twenty questions.  At the start of this past Wednesday’s press conference at 2:30 PM EDT, the market was neutral as it had been all morning.  The Fed chairman was more specific about the anticipated timeline of the wind down of quantitative easing if the economy continued to improve.   Although he was essentially repeating himself, the voicing of a specific and concrete timeline evidently jolted some sleeping bulls who surmised that the party was over; in the final hour of trading the SP500 fell a bit more than 1% in the final hour.  For many traders, it was time to take profits from the eight month run up in prices.  “Quadruple witching”, a quarterly phenomenon that occurs when stock and commodity options and futures expire, was approaching.  The few days before this event usually see a spike in volume as traders resolve their options and futures bets.

With much of the Eurozone in a mild recession and slow growth in emerging markets, the rest of the world perked up their ears as the central banker of the largest economy envisioned an easing of monetary stimulus sometime in 2014.

Overnight (Wednesday/Thursday) came the news that the Shanghai interbank rate had shot up from about 4% to 13%, a rate so high that it threatened to seize up the flow of money between Chinese banks.  This bit of bad news from the second largest economy added additional downward pressure on world markets.  For some time, analysts covering China have been warning about the amount of poorly performing loans at China’s biggest banks.  The spike in interbank rates, prompted by the Chinese government, was an official warning to Chinese banks to be more cautious in their lending practices.

On Thursday morning came the news that jobless claims had increased, adding more downward pressure.  The SP500 opened up another 1% lower that morning and dropped a further 1.5% during the trading day. This classic “one-two” punch knocked the market down about 4%.  European markets fell about 5%, while emerging markets endured a 7.5% drop in two days.

In the past four weeks, there has been a decided shift in market sentiment.  When the market is bullish, it tends to shrug off minor bad news.  As it turns toward a bearish stance, the market reacts negatively to news that just a few months ago it largely ignored.

Over the past two months, long term bonds have declined 10% and more.  Here is a popular Vanguard long term bond ETF that has declined 12% since early May.

For the long term investor, periods of negative sentiment can be an opportunity to put some cash to work.

Business Cycles

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June 16th, 2013

The manufacturing sector accounts for less than 20% of the economy but is probably the major cause of business cycles in the economy.  In the 1990s, the growing development of technology and business services in the U.S., together with what was called “just in time” inventory management, led some economists to declare an end to the business cycle. Cue the loud guffaws.

May’s monthly report on industrial production released Friday showed no monthly gain, after a decline of .4% in April.  The year over year change in the index was just under 2%.  In a separate report from the Institute for Supply Management (ISM) released a week ago, the Manufacturing Purchasing Managers Index (PMI) index for May fell into contraction, its lowest reading since June 2009, when the recession was ending.


New Orders and Production components of this index saw sizeable decreases.  Computer and electronic businesses reported a slowdown that they attributed to the sequester spending cuts enacted a few months ago.

The latest data for non-defense capital goods excluding aircraft from the U.S. Dept of Commerce showed an uptick after a period of decline in the latter half of 2012; however, there is a month lag in this data set.



The sentiment among small businesses improved somewhat, as shown by the monthly National Federation of Independent Businesses (NFIB) survey.  The overall index of 94 indicates rather tepid expectations of growth by small business owners.  Plans for capital spending to expand business are still at recession levels.

A business builds inventory in anticipation of sales growth.  Since the beginning of this year the net number of small businesses expanding inventory has finally turned positive.

  In a 2003 paper, economist Rolando Pelaez tested an alternative model of the Purchasing Managers Index that would better predict business cycles, specifically the swings in GDP growth.  Assigning varying constant weights to several key components of the overall PMI index, his Constant Weighted Index (CWI) model is more responsive to changes in business conditions and expectations.  In early 2008, the PMI showed mild contraction but Pelaez’ CWI model began a nose dive. It would be many months before the National Bureau of Economic Research (NBER) would mark the start of a recession in December 2007 but the CWI had already given the indication.  In May of 2009, the CWI reversed course, crossing above the PMI to indicate the end of the contractionary phase of the recession.  It would be much later that the BEA would mark the recession’s end as June 2009.


The CWI index is rather erratic.  We lose a bit of its ability to lead the PMI when we smooth it with a three month moving average but the trend and turning points are more apparent in a graph.

Before the 2001 recession the CWI index led the PMI index down.

OK, great, you say but what does this have to do with my portfolio?  Smoothing introduces a small lag in the CWI but it is a leading, or sometimes co-incident indicator of where the stock market is headed over the next few months.

Let’s look at the last six years.  In December 2007, the smoothed CWI crossed below the PMI, which was at a neutral reading of about 50.  The stock market had faltered for a few months but as 2008 began, the CWI indicated just how weak the underlying economy was.  The NBER would eventually call the start of the recession in December 2007.  In June 2009, the CWI crossed back above the PMI.  Coincidentally, the NBER would later call this the end of the recession.

The period 2000 – 2004 was a seesaw of broken expectations, making it a difficult one to predict because it was, well, unpredictable.  I did not show this example first because this period is a difficult one for many indicators.  Before 9-11, we were already in a weak recession.  Although the official end was declared in November 2001, the effects were long lasting, a preview of what this last recession would be. In 2002, we seemed to be pulling out of the doldrums but the prospect of an Iraq invasion and a general climate of caution, if not fear, prompted concerns of a double dip recession.

An investor who bought and sold when the smoothed CWI crossed above or below 50 would have had some whipsaws but would have come out about even instead of losing 15% over the five year period.

The present day reading of both the CWI and PMI are at the neutral reading of 50.  Given the rather lackluster growth of the manufacturing sector, the robust rise of the stock market since last November indicates just how much the market is riding on expectations and predications of the future decisions of the Federal Reserve regarding future bond purchases and interest rates. Over the past thirteen years, when the year over year percent change in the stock market hits about 22%, the percentage of growth in the index declines.

So what is a normal run of the mill investor to do?  The CWI, a predictor of business cycles, is not published anywhere that I could find. This and many other indicators are used by the whiz kids at investment firms, pension funds, by financial advisors and traders, to anticipate business conditions as well as the movements of the markets.  But look again at the SP500 chart above and remember that it is the composite of millions of geniuses and not so geniuses trying to anticipate the market.  As I have mentioned in previous blogs, when that percentage change drops below zero, it is time for the prudent investor to consider some portfolio adjustments.  Since 1980, the average year over year percent change in the SP500 is 9.7%, using a monthly average of the SP500 index. Despite the recent 20% gains, the average year over year percent gain during the past ten years is only 4.9%.  If we look back to the beginning of the year 2000, the average is only 3.1%.  Those rather meager gains look robust when compared to the NASDAQ index, which is still 25% below its January 2000 high.  Think of that – thirteen years and still 25% down. The Japanese market index, the Nikkei 225, is at the same level as it was in early 1985, almost thirty years ago.  Both of these examples remind us that we need to pay some  attention or pay someone to do it for us.

Goldilocks Jobs

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June 9th, 2013

In the long running comedy series “Frasier,” Frasier or Niles would often order a latte  in their local neighborhood bar, being careful to note exactly how they wanted the drink made.  Friday’s employment report was made to order – not too strong so as to hasten the end of the Fed’s latest bond buying program and not so weak as to confirm fears of another summer swoon.

Slowly and inexorably the number of employed trudges up the recovery hill.  The unemployment rate ticked up a scosh to 7.6% as more people tried to find work.  The year over year percent change is still in good territory.

On the not so good side, the percent of the total population that is working is still below the 30 year average of almost 44%.

The unemployment rate of those with a college degree is far below that of the general labor force but is still 50% above the average of the early 2000s.

Student aid loans have passed a trillion dollars (source).  To put that figure in perspective,  student loan debt is about 10% of the $11 trillion in outstanding debt of residential mortgages (source)

Changes in the bankruptcy laws in 2005 exempted student loan debt from bankruptcy.  Over the next decade or so, will the investment in education pay off?  Let’s hope so.  100 years, an 8th grade education became a standard used by employers to winnow job applicants in a tough job environment.  70 years ago, the new standard became a high school education.  For the past 30 years, we have moved to a 4 year degree as the new standard.
We now spend more on defense and more on Medicare that the $500 billion total amount spent by the state and the federal government on K-12 education. (source) Community college educators are painfully aware that many students are simply not prepared to take college courses.  Local communities used to fund 70% of K-12 education.  Thirty years ago, homeowners protested ever rising property taxes to fund K-12 education and, since that time, local funding has dropped below 50%.

If we expect our children to develop the skills for a college education, we are going to have to find an alternative model of funding.  The states have relied on an ever increasing share of Federal funding for K-12 education.  Although the percentage of Federal spending on K-12 is small, less than 10%, the aging Boomer generation will command ever more spending of general tax dollars in addition to the Medicare taxes collected.

The core work force aged 25 – 54 struggled upwards

but the participation rate, the percentage of the population in the labor force, is still weak.

The “total” unemployment rate, which includes those working part time for economic reasons, continues to drift down but is still high.

Understand that this represents over 20 million people, a bit more than the entire population of New York State.  Turn on C-Span sometime and tell me how many committee hearings on jobs there are.  Immigration, federal surveillance and the targeting of conservative groups by the IRS are important matters, yes, but why aren’t politicians in Washington talking about jobs?  There are several reasons: no one has a clue; no clear political advantage to be gained; constituents are not writing letters to their representatives and senators about jobs.

Welcome to the “New Abnormal.”

Stocks vs Bonds

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June 2nd, 2013

As the market makes new highs this past month, I am reading articles and seeing charts on asset allocation that reminded me of those I saw in 2000.  Here is a chart that appeared in the WSJ this weekend.

Mutual Funds typically report their performance over several time periods, usually 1, 3, 5, and 10 year periods.  This spring, as the SP500 index continue to peak, a ten year lookback window begins near a trough in the index in the spring of 2003.

Why did the WSJ writer pick 25 year and 35 year time periods as a comparison?  We can only guess but it just so happens that the starting points of these two lookback periods were also troughs in stock prices.  Why not pick 20 and 30 year time periods? Let’s look at the 25 year period which starts in April 1988.

What if the writer had used a 20 year lookback?  They would have started in April 1993, when the stock market was 72% higher.  I don’t want to take the time to calculate the difference in returns, including dividends, between the different strategies shown in the chart, but the reader can imagine that the difference would be significant.

Why use a 35 year lookback?  Why not a 30 year lookback?  In 1978, the SP500 index was again pulling out of a trough in prices after a slow slide in values during 1977.

Had the WSJ writer picked a 30 year window starting in April 1983, the stock market index was – again – 72% higher than in April 1978.  Again, we can imagine that the comparison of strategies would be significantly different.

Being aware of these peaks and troughs can help us evaluate past performance of various investment allocations.  Consider an example of a 10 year comparison of the SP500 vs a bond index fund like Vanguard’s VBMFX

The SP500 index shows the better return but, if we know that spring of 2003 was a trough in this index, we can view such a comparison with some skepticism.  A five year comparison tells a different story.

Now we are comparing performance starting with a downslide in the index, when the SP500 had fallen about 11% from its peak.  It is also close to the 3 year moving average of the SP500 index.

Based on a five year window and the fact that our starting point was a 3 year average in the SP500, we might conclude that our portfolio should contain mostly bonds.  Who needs the aggravation of the volatility in the stock index when we can make the same return with a boring bond index?

In a 3 year time frame, stocks have clearly outperformed bonds.

Our starting point of this 3 year window also happens to be the 3 year average of the SP500 index.  Not only that, it is just  a bit above the midpoint between the 2007 index peak and the trough in the spring of 2009.  We couldn’t ask for a more reliable starting point to make our comparison.

So we have a second reliable starting point but the conclusion we draw is significantly different from the conclusion we drew in the 5 year comparison.  Let’s look closer at this stronger performance of the SP500 vs a bond index.

Half of the better 3 year performance of stocks has come in just the last 6 months after the Federal Reserve announced their open QE program of buying government bonds until the unemployment index reaches a target of 6.5%.  The recent upsurge in stocks has “goosed” the comparison numbers upwards in favor of stocks.

Our conclusion is that historical performance numbers presented by mutual funds or an investment advisor cannot be taken at face value.  It is important to understand the starting point of the historical comparison, which can have a significant effect on the numbers.

Grandpa’s Index

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May 26th, 2013

Last week I wrote about the various benefits, particularly Social Security, that are based on the Consumer Price Index and the discussions about alternative measures of increases in the cost of living.  The term “CPI” is a general term for a specific index, the CPI-U, a widely used index of prices for urban (hence, the “U”) consumers that the Bureau of Labor Statistics compiles.

Today I’ll look at an alternative measure, the CPI-E, or Elderly index, which weights the expenditures of elderly consumers differently.  Since the sample size of this population is relatively small, the BLS warns that it is more prone to sampling error, i.e. that the sample may not accurately reflect the characteristics of the entire elderly population.  For the past decade or so, seniors have argued for cost of living increases in Social Security payments to be based on such an alternative measure.  Using the latest BLS survey comparison data, I constructed a chart to show the differences in weighting of the larger components of the CPI-U, the commonly used index, and the CPI-E, the Elderly index.

Housing and medical expenses are weighted significantly higher in the Elderly index.  A survey by the Employee Benefit Research Institute (EBRI) found that over 80% of 65 year olds own their own home.  The mortgage component of total housing costs stays relatively steady for the younger group of elderly, yet the CPI-E that the BLS compiles shows a 4% increase in this component.  The EBRI survey found that homeownership declines rapidly after 75, and it is this older group of the Elderly for whom housing costs rise.  The question is whether the CPI-E can be properly sampled and compiled to show a more accurate picture of costs for the elderly.

The medical component of the elderly index is almost twice that of the general urban population.  Although seniors have access to the subsidized Medicare program, the premiums for Medicare and costs not covered by Medicare are now borne by the elderly, rather than being fully or partially supplied as part of an employee benefit package.  In addition, people access more medical care as they age.  The combination of these two factors make it feasible that medical costs would be significantly higher for seniors.

Inaccuracies in measuring the housing component of the elderly index will be brushed aside by seniors receiving SS benefits.  Whatever measure increases benefits – well, that’s the most accurate one, of course.

An interesting note is the change in recent years of housing costs as surveyed by the BLS.  In 2007-2008, housing was 42% of total expenses.  After the housing and financial crises, that component had dropped to about a third of total expenses. (Source)

But the December 2012 CPI-U index does not reflect the results of more recent findings of BLS personal expense surveys because they are using 2009 -2010 weightings. (Data)

The largest part of the discrepancy between the actual changes in cost of living expenses and the published index is probably the “Owners Equivalent Rent” portion of housing costs which don’t reflect actual costs at all.  Instead they are a calculation of what a home owner would have to pay herself to rent her own home from herself.  No doubt, BLS economists would defend this phantom calculation as accurate but this calculation was never designed to allow for the precipitous drop in housing prices that we have experienced in the past few years.

Based on BLS surveys of actual, not the adjusted, cost of housing changes, there is a good case to be made that the economy is experiencing a continuing mild deflation, not mild inflation. Deflation has become an ugly word. Social Security payments, labor contracts and a host of benefits are tied to the CPI and rely on the cost of living to increase, not decrease.  Lawmakers in Washington have, in fact, mandated that Social Security payments can not decline if the CPI turns negative.  Deflation is reviled almost as much as too much inflation.  The Federal Reserve has a target of 2% inflation, meaning that it should start pulling money out of the economy if inflation rises above 2%.  On the other hand, the Federal Reserve should be pumping money like there’s a five alarm fire if inflation has turned negative.  Has the Fed been pumping money?  Yes.  Ben Bernanke, Chairman of the Fed, prefers to look at Real Personal Consumption Expenditures.  Per capita expenditures have just now risen above 2007 levels.

While some inflation watchers are shouting “The sky is falling” as the Fed continues to pump money into the economy, Mr. Bernanke is looking at the big picture and its tepid.  Tepid means fragile.  Here’s the big pic of the last 15 years or so.

Growth has moderated.  Bernanke has to be worried that low interest rates and continued purchases of mortgage securities by the Fed is helping inflate a stock bubble but he is equally concerned at the slower growth of the economy.  Despite the headline CPI numbers of below 2% inflation, the reality is that it may be closer to 0% than the headline index indicates.

What’s behind that slower growth of spending?  Look no further than something I write about each month, the lack of growth in the core work force, those aged 25 – 54.  These are the people who buy stuff and if a smaller percentage of them are working, then they buy less stuff.  Less stuff buying reduces inflationary pressures.

Bennies From Heaven

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May 19th, 2013

During the past several years, a demographic and economic shift crossed below the zero line.  For decades, Social Security taxes collected exceeded Social Security benefits paid.  The Federal Government “borrowed” this excess and used it for other programs.  Since 2010, there has been nothing to borrow.  The Social Security Administration (SSA) has several sources of revenue, but the bulk of its revenues is what we commonly call the Social Security tax, or FICA.  However, this tax has several components.  The largest portion of the tax – the Old Age and Survivors Insurance tax (OASI) – is to pay out social security benefits and it is this component I wanted to look at.  SSA gives a pie chart of its revenue and benefits paid.

I have shown the latest revisions to the pie chart but it gives you a sense of the revenue and expense components.  A table of SSA income and outgo shows only the total receipts and expenditures.  When we look at the OASI component, we can get a sense of the upcoming political debates and financial pressures.  SS benefits paid are already exceeding OASI tax receipts.  Below is a chart of SSA data showing the surplus and deficit for the past ten years.

On January 1st, the Congress let lapse the 2% reduction in payroll taxes.  In the first quarter of 2013, that has meant an additional $245 billion in revenue to the Treasury. (Source).  Since the money all goes into the same Federal pot, the additional revenue has forestalled the debt limit debate till this fall.

The SSA records other income, including income taxes on the SS benefits paid out.  This is a “pencil” income entry: the IRS keeps track of taxes paid on SS benefits and “transfers” them to the SSA.  For decades, this pencil entry has increased the SS surplus and Congress borrowed it.  The SSA charges interest income to the Federal government and records this pencil income as more money that the Federal government owes the SS trust funds.

The bottom line is that SS is a “pay go” system.  Current taxes pay for current benefits.  When benefits exceed the taxes devoted to pay for those benefits, the money has to come from somewhere.  That “somewhere” is the Federal government, but it can only get those funds from you and I and the companies who pay corporate taxes.  More troubling is the ever increasing percentage of federal tax receipts devoted to paying social benefits of one form or another.  These include, SS, Disability, SSI, TANF, SNAP and a host of other programs.

As people become increasingly dependent on the government for their welfare, they will put increasing pressure on politicians to maintain or increase these benefits.  This political pressure only heats up the political debate over how to pay for these benefits.  At the federal level, benefits have increased by $800 billion over the last ten years.

Including the states and local governments, the increase is over $1 trillion.

Any cuts in calculating benefits are met with a firestorm of protest from those who are, or will, collect those benefits.  Few care about the accuracy of calculating cost of living adjustments to these benefits.  Whatever calculation provides the best benefit becomes the most “accurate” calculation.  The current debate is whether to use the CPI or what is called a Chained CPI.  Over several decades, the CPI gives the most increase in benefits.

40% of the calculation of the CPI is housing cost and the calculation of that cost, called Owner’s Equivalent Rent, has almost tripled in the past thirty years, boosting the CPI.

Census data shows that 2/3rds of the 132 million households in this country own their homes.  Before the housing boom, a primary reason for owning a home was to lock in a monthly payment, avoiding rent increases.  Taxes, upkeep, and energy costs do go up, but the majority of a house expense, the mortage payment, is a fixed cost for many homeowners.  However, the Bureau of Labor Statistics, which compiles the CPI, calculates the housing component of the CPI as though a homeowner was renting from herself.

“according to the National Association of Realtors, between 1983 and 2007 the monthly principal and interest payment required to purchase a median-priced existing home in the United States rose by 79 percent, much less than the rental equivalence increase of 140 percent over that same period.” (BLS Source)

We will continue to have a lively debate over the calculation of the CPI because it influences millions of Social Security checks each month.  We can anticipate that this debate will be at the forefront of the upcoming 2014 elections.  Why?  Because the debate stirs passions on both sides and that is what politicians need – passion.  Passion provokes people to vote.  Passion promotes donations.  Passion ignites political volunteer efforts.

The trend of worsening deficits between SS contributions and the benefits paid will only worsen as we get into the latter half of the decade.  Before the 2010 elections, we were treated to the spectacle of angry old people – without makeup – yelling at politicians to keep their stinkin’ government hands off their Medicare, itself a government program.  In the upcoming years, the debates over Social Security will make those earlier demonstrations seem rather mild.  Old people vote.  Angry old people vote a lot.

Out Of the Tent and Into the Forest

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May 12, 2013
We can take some steps to reduce our susceptibility to adverse events but if our primary aim is to reduce uncertainty as much as possible, our lives suffer in quality and our wallets suffer in quantity.  In our financial lives, we must try to find a balance between risk and reward.  There is a high demand for low risk, high reward investments.  Unfortunately, there is little supply of such investments and the few that are offered are usually scams.

There is a good supply of low risk, low return products. In the past ten years, conservative savers have taken a beating.  There have been only two periods where the interest on one year CDs has exceeded the percentage increase in inflation.

Challenged by low interest rates on CDs, savers have fled the market.

Older people who rely on their savings to generate income continue to search for yield, or the income generated by an investment.  The iShares High Yield Corporate Bond ETF, HYG, and the iShares Dividend Select Index ETF, DVY, have posted strong gains.  As more investors chase yield and drive up prices, the yields correspondingly become lower.   In December 2007, DVY paid out an annualized 4.7% yield on a price of about $53.  In March 2013, the yield was 3.4% on a price of $65 (Source)

Despite the fact that the Federal Reserve has held interest rates at historic lows, the amount of household savings continues to climb.  Some of this is due to an aging population which has more in savings and tends to be more conservative.

The Federal Reserve is essentially kicking people out of the tent and into the forest where the wild animals live.  It’s risky out there in the forest.  How come the banks don’t want our money?  Some people do not realize that a CD or savings account is essentially a loan to the bank.  Through the FDIC, the U.S. government insures most of these loans.  Loan your brother in law money for a  year and you might not get it back.  Loan your bank the money and you are assured that you will get it back.

In the simplified models of banking we learned in grade school, the bank pays us interest for the money we loan it (deposits) and loans that money out to other people at a higher rate of interest.  The difference in the two interest rates is how banks pay their employees and other business costs and make a profit. The reality is much more complex.  A bank does not take a $10 deposit from Mary and loan it to Joe.  The bank takes the $10 deposit from Mary and loans $100 to Joe.  Where did the other $90 come from, you ask?  It is created out of thin air in a process called fractional reserve banking, which allows a bank to leverage the $10 deposit by ten times, in this example.  Because banks are leveraging money, there is a labyrinth of financial metrics of stability to insure that the banks are not taking too much risk.  Some of these metrics include the risk weighting of assets (deposits, loans and securities, for example) and capital asset ratios.

In a 1985 paper by Federal Reserve economists, they note that “There is remarkably little evidence, however, that links the level of capital or the ratio of capital to assets with bank failure rates.”  This paper was written before the S&L crisis of the 1980s.

The financial crisis in 2008 led to a surge of bank failures, peaking at more than 150 in 2010.  In this past year, failures have dropped to a level that can be counted with two hands.

 During the recession, the amount of commercial and industrial loans declined but have risen to nearly the same level as 2008.

From a thirty year perspective, we can see just how severe the decline was.

While loans and interest bearing accounts, or assets, at the largest banks are nearing 2007 levels, assets at small banks have declined.

The banking industry has been consolidating, larger banks eating up the smaller ones.

This past Friday, the Chairman of the Federal Reserve, Ben Bernanke, expressed concern that some of the larger banks are still prone to failure.  The ever increasing size of the big banks has enabled them to have an even greater voice in the halls of Washington.  Bernanke’s remarks hint that he is a proponent of further regulations which would reduce the amount of leverage that banks can use to increase their profits.  Banking industry lobbyists are making the case that if they are required to reduce their leverage, it will hurt the economy by reducing the amount of loans they can make.

The banks are feeling squeezed and they are sure to let lawmakers know.  Their net interest margin, or the spread between what they pay to depositors and what they charge to borrowers, has fallen to pre-recession levels, putting pressure on banks to take more risk to increase their bottom line.

I am reminded of a comment made by Raymond Baer, chairman of Swiss private bank Julius Baer, in 2009 who warned: “The world is creating the final big bubble. In five years’ time, we will pay the true price of this crisis.”  Let’s see: 2009 + 5 = 2014.  Hmmmm….

But we can’t live our lives waiting for the next catastrophe.  We must take some risk, be diversified and be vigilant.  As the stock market reaches new highs with each passing day, more investors will reassess their risk profile.  Some will curse their caution of the past few years and move money from safe but low yielding assets to the market, helping to fuel rising market prices.  The demand for yield creates a feedback loop that actually makes it harder to achieve yield.  If only we could live in a world where they didn’t have these darn feedback loops.

Job Trends

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This past Wednesday the payroll firm ADP released their monthly report of private employment with a rather tepid 119,000, prompting an equally tepid sell off in the market, which lost about .7% by the end of Wednesday.  Although the price move was under 1%, the volume of trading was high.  Was this the end of the 6+ month run up in stock prices?  Was the economy slowing down? 

Came Thursday and a very cheery weekly report of new claims for unemployment and moods brightened.  The market regained the ground lost Wednesday and then some, but on rather low volume.  Standing on the sidewalks of Wall Street, traders repeatedly opened up their umbrellas, then closed their umbrellas, put on their sunglasses, then took off their sunglasses. 

[And now a pause from our sponsor.  A trader tells his doctor he’s anxious and asks for a prescription.  The doctor gives him some advice: “stop looking at the market so much.”]

Back to our story. Friday morning dawned, the heavens opened and the sun shone.  The Bureau of Labor Statistics issued its monthly weather – er, labor – report and traders threw down their umbrellas and put on their shades.  Huzzahs rang throughout the canyons of lower Manhattan.  Some slacker dudes cooly tossed their stocking caps in the air, while men dressed in crisp suits wished that they too had hats.

The labor report is released an hour before the market opens at 9:30 AM.  The market opened up 1%, drifted higher but ended the day at about the same price as it opened.  So, huh? We’ll get to the huh part later.

The reported job gains of 165,000 for April were just slightly above the 150,000 jobs consensus estimate and the replacement rate needed to keep up with population growth.  Spurring the initial enthusiasm was relief that job gains were not as weak as some had feared (100,000 or so) and the revisions to previous months job gains, adding 114,000 to February and March’s job gains. But February’s revision from strong to very strong job growth provokes some head scratching.

What good things happened in February to inspire such strong job growth?  Hmmmm….here’s a table of the past 12 months data from the establishment survey. 

There was a lot to like in this month’s report.  The unemployment rate dropped a tenth of a percent to 7.5%.  We just passed employment levels of February 2006 – yep, it’s been a slow recovery.

To get the big picture, let’s look at the last forty years.

From this perspective, we can see just how deep the job losses have been since 2008.  From this rather sobering point of view, let’s look at some of the positives from this month’s report.

Professional and Business services added a whopping 73,000 jobs this month, far above the 49,000 average of the past 12 months.  Restaurant and bar jobs were up 50% above their 12 month average, showing gains of 38,000. Temp help posted strong gains of 31,000, its highest of the past year.

Construction jobs showed little change, a surprise at this time of year.  Construction has been averaging gains of 27,000 a month for the past six months. This past week, I spoke to a woman at a Denver branch of a national temp agency.  This branch focuses on manual labor, mostly for the construction industry.  She confirmed that business has been brisk but most of the calls are for road repair and rebuilding and some commercial construction.  When I asked her about calls for helpers and job site clean up for residential construction, she said it had been sporadic.

Job gains in health care were somewhat below their 12 month average of 24,000 but any slack in health care was made up by strong growth in retail.  Government jobs continue to contract slightly each month.

Underlying the positive aspects of the job market are some anemic indicators.  The average of weekly hours dropped .2 hour to 34.4; the average has lost .1 hr in the past year.  The ranks of the long term unemployed dropped by 258,000 workers but the number of people working part time who would like a full time job jumped 278,000.  The ranks of the “involuntary” part timers – those who would like a full time job but can’t find one – is about 5 million.  Here’s a surprise. Today’s levels of involuntary part timers as a percent of total employment is only the third highest in the past fifty years; the late 1950s and the early 1980s were worse.  But this only means that the ranks of part timers have fallen mercifully from nose bleed levels.

The diffusion index is showing some weakness; this is the share of employers who are reporting job gains vs. job losses, with a value of 50 being neutral.  Manufacturing employers are already reporting more job losses than gains.  Overall, employers are slowly drifting toward neutral in their hiring for the past several months.

The core work force aged 25 – 54 is still limping along.

Even more disturbing is the participation rate of this core work force.

Shortly after the market opened on Friday came the report on factory orders and it muted some of the enthusiasm generated by the labor report.  New orders for durable goods, a barometer of business confidence, fell 5.8%, confirming the slowdown in manufacturing.  Employment in this sector has been flat the past two months.

While the monthly labor report makes headlines, it is not a leading indicator. Professional investors watch the squiggles of daily and weekly economic and news reports, trying to anticipate developing trends.  Many of us have neither the time or inclination.  For the long term “retail” investor, continuing job gains are positive, particularly if they are at or above the replacement level of 150,000. The long term investor is more concerned about significant losses in their retirement portfolio.

What if an investor lightened up on their stock holdings shortly after the BLS reported the first job losses?   I looked back at historical employment releases ; I wanted to use the original releases, not the revised figures of later months, to capture the sentiment at the time.  We must make decisions in the present.  We don’t have the luxury of going into the future, looking at data revisions, then coming back to the present and making our investing decisions.  That would be a good time machine, wouldn’t it?  Here’s an example of how employment data can be reported initially and later revised.  The graph shows the later revisions.

In early August 2000, the BLS reported job losses of 108,000 in July.  But this was due to the layoff of 290,000 temporary Census workers.  Do census workers really count in our strategy?  Let’s say not.  We wait till next month’s report, which shows a loss of 105,000. Should we use our strategy?  Again, those darn census workers.  Without them, there would have been a small gain in jobs.  So we don’t sell in September.  Then, in the beginning of October comes the news of strong job gains in September, followed by more job gains in October, November and December.  Good thing we didn’t sell at that first downturn, we tell ourselves.  Meanwhile the stock market has been slipping and sliding since that first negative job report.  Eventually, it will fall about 40%.

Wow, we should have taken that first signal and avoided all those losses!  But if our strategy is to then buy back in when there are positive job gains reported, then we could be in and out of the market like a yo-yo in years when the economy is struggling to find direction or strength. We were looking for a more even tempered strategy.

To emphasize how the revisions in employment can mean the difference between job gains and job losses,  take a look at the chart below.  These are the revised figures.  I have noted months where the initial monthly labor report showed positive job gains but were later revised to job losses.  Some of these revisions can happen months later.

From the first reported job losses in mid 2000, more than three years passed before job gains would exceed the “replacement” level of 150,000.  That is the number of jobs needed for the growth in the labor force. While many, myself included, have blamed the knucklehead politicans who enacted the Bush tax cuts in 2003, it is understandable that they were beginning to wonder if the labor market would ever turn around.  Three years of job losses is a long time.

Let’s move on to the last decline.  The market had already begun its decline before the first job losses were announced in early February 2008.

In this past recession, the job losses were severe but the first job increases were announced about two years after the first decrease, in early April 2010.  When reviewing the historical BLS releases, this really surprised me that the 2000 – 2003 labor downturn lasted longer than this last one, though it was much less severe.  By the time the first job increases had been announced in 2010, the market had already been on an upswing for a year. 

In short, the headline monthly job gains don’t appear to offer a long term casual investor any particular insight or advantage.  In a work force of 143 million, a hundred thousand jobs can be a slip of the pencil.  But reported job gains of 150,000 or more do offer an investing hint – quit worrying about your retirement portfolio for at least another month.  Go fishin’, play with the kids, hang out with friends.

A labor indicator that seems to be more reliable is the year over year percent change in the unemployment rate, which I have discussed in earlier blogs.

Although the unemployment rate – or percentage – is derived from the count of total employment, the revisions are much smaller.  Secondly, we are using a percentage gain in that percentage, further reducing swings.

The stock market continues to post new highs in anticipation of good corporate profits in the latter part of the year.  What is a bit troublesome is the number of revenue shortfalls reported by companies in the first quarter.  Reducing expenses and boosting productivity can only get a company so far.  Profit growth becomes harder and harder to come by without revenue growth.

The Madness of Methodology

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April 28th, 2013

A fight between economists is not as exciting as a dinosaur smackdown (Jurassic Park), but the controversy can be as damaging.  Politicians and pundits love to trot out those economic studies and theories which justify their actions or political point of view.  In 2009, two economists Carmen Reinhart and Kenneth Rogoff (now affectionately known as RR), published a study which showed that a country’s GDP growth becomes slightly negative when its debt grows above 90% of its GDP.  The study was cited by many politicians and pundits in Europe and the US, including VP candidate Paul Ryan, as they proposed various forms of austerity to curb the explosive growth of national debt.

Here’s what the debt to GDP ratio looked like 1940 – 1960

In the years 1947 – 1959, we had an annualized growth rate of 3.6% but a strong component of this growth was our strategic advantage in exports, being the manufacturing capital of the world after much of the production capacity of the developed world was destroyed in WW2.

Here’s what it looks like now; the same spike of debt.

But we have lost the advantage of being the leading manufacturer.

Given the assignment of replicating an existing economic study, Thomas Herndon, a PhD candidate at UMass, discovered some glaring spreadsheet errors in the original data set compiled by RR.  You can read an Alternet article summarizing the details here.

Some quick background.  There are two categories of economic policies.  Fiscal policy encompasses taxing and spending measures by a government.  Monetary policy is conducted by a country’s central bank and are targeted at the supply of money and interest rates.  Economists argue over which policy is more effective in a given circumstance.  Each of us goes about our daily lives under the influence of both fiscal and monetary policy. 

During the 1930s depression, the economist John Maynard Keynes proposed that governments borrow and spend money during recessions to make up for the lack of aggregate demand in the economy.  After the economy recovered, governments would then raise taxes to pay back the borrowed money.  Another leading economist, James Buchanan, predicted that nations who followed Keynes’ ideas would have permanent deficits.  While Keynes’ economic model was elegant, Buchanan argued that there was no incentive for a politician to raise taxes.

In 1963, with the publication of A Monetary History of the U.S., economists Milton Friedman and Anna Schwartz argued that the Depression had been largely a result of failed monetary policy by central banks.  During the 1970s, when government fiscal policies of increasing intervention in the economy failed to ingnite growth or curb inflation, Keynes’ policies fell into disfavor. 

The age old debate about the effectiveness of fiscal and monetary policy never dies. The recession that began in 2008 revived Keynes’ ideas.  In the late 1990s and early 2000s, economist Paul Krugman and Federal Reserve chairman Ben Bernanke were proponents of monetary solutions for Japan’s moribund economy.  As the world economy imploded in 2008, both men changed course and became advocates for fiscal policy as the most effective solution for the country’s economic woes.

In a recently published paper UMass professors Michael Ash and Robert Pollin (Herndon’s advisors), explained their methodology and took RR to task for their lack of follow up on incomplete data analysis after several years.  What they had missed was a follow up paper by RR in February 2011 and another published in the summer of 2012.  In these papers, RR modified their initial findings, saying that GDP growth slowed but did not necessarily turn negative.

In a WSJ blog post , RR answered the critique from the UMass Professors.  They admitted their spreadsheet error but reaffirmed their other assumptions in the study and their amended conclusions.

Paul Krugman weighed in (or waded in?), voicing his disappointment with RR’s methodology and their conclusion.  Krugman does make a point oft repeated in the social studies: correlation is not causation.  Does high debt cause slow GDP growth?  Or, does slow GDP growth cause high debt?  Or can we say that there is some indication that they accompany each other?

At Econbrowser, U. Cal professor James Hamilton, reviewed RR’s methodology and Ash and Pollin’s critique. (Link)  To which, Professors Ash and Pollin responded with some good points.

Ash and Pollin have made the original data available.  Some have accused RR of purposefully leaving five countries out of their data, saying that these five countries would have weakened or invalidated their findings.  The Excel file shows that this was a simple – but dumb – mistake, not some nefarious plan by RR.  The countries left out are on the last five worksheets which are arranged in alphabetical order.  What surprises many is that two prominent economists could publish a paper based on work that had so little verification before publication. 

What I question is RR’s decision to include many of the smaller countries at all in their analysis.  Finland and Ireland each have less than 2% of the GDP of the U.S. 

What I do hope is that this controversy will spur more analysis of the relationship between a nation’s debt load and its economic growth.  What I am afraid of is that this will discourage researchers from sharing their working data.  Reinhart and Rogoff are to be highly commended for doing so.