Category: CWPI

Circumstance

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May 21, 2017

Last week I mentioned the 20 year CAPE ratio, a modification of economist Robert Shiller’s 10 year CAPE ratio used to evaluate the stock market. This week I’ll again look at equity valuation from a different perspective.  The results surprised me.

The date of our birth is circumstance.  When we retire is guided by our own actions and the circumstance of an era. We have no control over market behavior during the twenty year savings accumulation phase before we retire or the distribution of that savings during our retirement.   Let’s hope that we live long enough to spend twenty years in some degree of retirement.

The state of the market at the beginning of the distribution phase of retirement can have a material effect on our retirement funds, as many newly retired folks found out in 2008 and 2009.  Some based their retirement plans on the twenty year returns  prior to retirement.

I’ll use the SP500 total return index ($SPXTR at stockcharts.com or ^SP500TR at Yahoo Finance) to calculate the total gain including dividends. The twenty year period from 1988 through 2007 began just after the stock market meltdown in October 1987 and ended just as the 2007-2009 recession was beginning in December 2007. The total gain was 742%, or 11.3% annualized. Sweetness! Sign me up for that program.  Those high returns led many older Americans to believe that they didn’t need to accumulate more savings before retirement.  Then came the double shock of zero interest rates and a 50% meltdown in stock market valuation.

Now let’s move that time block one year forward and look at the period 1989 through 2008. Still good but what a difference one year makes. The total gain was 404%, or 8.4% annualized. That’s a drop of 3% per year! Investors missed the 16% bounce back in 1988 after the October 1987 crash, and the time block now included the 35% meltdown of 2008. There was even more pain to come in the first half of 2009 but I’ll come back to that.

1995 through 2014 was a good period with total gains of 550%, or 9.8% annualized. Shift that time block by two years to the period 1997 through 2016 and the gains fall off significantly. The total gain was 340%, or 7.7% annualized.

We can make a rough approximation of total returns during the late 1970s and into the 1980s, an ugly period for equities. In 1980, someone quipped “Equities are dead.” Twenty year periods ending during this time did not fare so well but still notched gains of more than 6%. Bonds, CDs and Treasuries were paying far more than that at the time. In today’s low interest environment, 6% seems a lot better than it did during the double digit inflation of 1980.

In past weeks I have written about the overvaluation of today’s stock market based on trailing P/E ratio and the smoothed 10 year CAPE ratio. Let’s look at the current valuation from the perspective of this twenty year return. It would come as no surprise that the total twenty year gain hit a low at the end of February 2009 when the market was about a 1/4 of its current valuation. That 20 year annualized gain was 5.7%. What surprised me was that the current valuation shows the same 20 year gain! Using this metric as an evaluation guide, the market sits at a relatively low level just like it was in 1988 and 1989.

The historical evidence shows that stock returns may be erratic but consistently make over 5% over a twenty year retirement period. Those who are newly retired or about to retire might understandably desire more safety. The safest approach is not to suddenly shift one’s portfolio entirely to safe assets.

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Income Inequality

Much has been written about the growth of income inequality. The GINI coefficient is the most popular but there are other measures (for those who want to get into the weeds of inequality measures). The Social Security Administration offers a simple indicator of the trend. They track the average and median incomes of millions of earners every year.

When the median and average are fairly close to each other, that indicates that the numbers in the data set are uniformly distributed. As the ratio percentage of the median to the average falls, that indicates that a few big numbers are raising the average but do not raise the median.

Here’s a simple example of an evenly distributed set. Consider a set of numbers 1, 2, 3, 4, 5, 6. The average is 3.5. The median is also 3.5 because there are three numbers in the set below 3.5 and three numbers above 3.5.  The percentage of the median to the average is 100%.

Let’s consider an unevenly distributed set: 1, 2, 3, 4, 5, 12. The median is still the same value as the earlier example: 3.5. But the average is now 4.5. The ratio of the median to the average is 3.5 / 4.5 = about 78%.

The ratio of the median to the average income has fallen from 71% in 1990 to 64% in 2015. This indicates that there is a growing number of large incomes in our data set.

SSAIncomeAvgMedian
Here’s the data in a graph form

SSAIncomeAvgMedianGraph
Median wages have doubled, or grown by 100%, while average wages have grown by more than 150% in the last quarter century.

Next week I will look at a hypothetical income tax proposal based on income. It might just blow your mind.

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Dividend Payout Ratio

FactSet Analytics grouped dividend paying stocks in quintiles (20% bands) by the dividend payout ratio (Chart). This is the percentage of profits that are paid to shareholders in the form of dividends. Over the last 20 years of rolling one month returns the stocks that had the highest and lowest payout ratios had the lowest total return. Think about that. Both the highest and lowest quintiles did the worst. What performed the best? Those stocks that were in the middle quintile, the companies who balanced their profit distributions between investors (dividends) and investment (future sales and profits).

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CWPI

Each month I compute a Constant Weighted Purchasing Index built on a combination of the two Purchasing Manager’s surveys (PMI) each month. For the six month in a row, this composite has shown strong growth and the three year average first crossed the threshold of strong growth in January 2015.

A sub-index composite that I build from the new orders and employment components of the services survey (NMI) shows moderate growth. Its three year average has shown moderate growth since early 2014.

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Caution: Strong Growth Ahead

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This week, the Congressional Budget Office (CBO) released their estimate of the fiscal impact of the AHCA, the draft version of the Republican health care reform plan. I’ll take a look at the CBO methodology later in this post. For those who may be tiring of the almost constant focus on the AHCA, let’s turn our attention to some economic indicators.

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CWPI (Constant Weighted Purchasing Index)

February’s survey of purchasing managers (PMI) indicated a broad base of confidence among purchasing managers in most industries. New orders in manufacturing are surging, an expansion more typical in the early stages of recovery after recession. Regardless of how one feels about Trump, there is a sense of renewal in the business community. Consumer Confidence is at record highs. Confident of finding another job, the number of employees who are quitting their jobs is at a 16 year high.

The CWPI is a composite of both the manufacturing and non-manufacturing PMI surveys and is weighted toward the two strongest indicators of future growth, employment and new orders. Since October, the composite has been rising from mild to strong growth.

CWPI201702

For most of 2016, new orders and employment were below their five year average.  Since October, they have been above that average.

EmpNewOrders201702

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Housing

The Housing Market Index released by the National Assn of Homebuilders just set a multi-year record. Housing starts are strong and single family homes under construction are the best in ten years. A popular ETF of homebuilders, XHB, is nearing a recovery high set in August 2015. 58,000 construction employees found work during a particularly warm February. Now the big picture. As a percent of the working age population, housing starts are still at multi-decade lows.

HouseStartsPctWorkPop201702

There has been an upshift toward multi-family units in some cities but, in a broad historical context, these are also near all time lows as a percent of the working age population.

MultiFamPctWorkPop201702

A primary driver of new housing construction, both single and multi-family, is the growth in new households, which is still soft. In 2016, households grew by 1%, below the 30 year average of 1.2%, and far below the 70 year average of 1.7%.

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Consumer Credit

Here’s an interesting data series from the FRED database at the Federal Reserve: the percent of people with subprime credit in each county. Click on the link and zoom in to see the data for a particular county. In New York City, Manhattan has a 16% subprime rate, less than half the 35% rate of the nearby Bronx. Give the link a few seconds to load the data and display the map.

Subprime

On July 1st, the credit rating agencies will remove tax liens and judgments from their records if liens do not include the full name, address, SSN or date of birth of the debtor. This will raise the credit scores of hundreds of thousands of subprime consumers.

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Real Estate Pricing Tool

Trulia has a heat map, by zip code, of the median home price per square foot. I will include this handy tool on the tool page.

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IRS Data

Of the 145 million returns filed, 46 million itemized deductions. Under the Republican draft of tax reform (PDF), almost all deductions would be eliminated in favor of a standard deduction that is almost twice as large as current law, $12,000 vs. $6300. (Deductions, Child Credits ). Half of capital gains, interest and dividends would not be taxed. For most filers, the dreaded 1040 tax form is only 14 lines. Publishers of tax software like Intuit are sure to lobby against such simplicity.

BetterWayTaxForm.png
Health insurance reform is the prerequisite to tax reform.  If House Speaker Paul Ryan encounters strong resistance in his own party to health insurance reform, his tax reform plan will be stymied as well.

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AHCA

This past Monday, the Congressional Budget Office released their “score” (summary report and full PDF report) of the American Health Care Act, or AHCA. Score is a euphemism for the 10 year cost estimate that the CBO customarily gives on proposed legislation.

The CBO was careful to stress the uncertainty of their estimate. A critical component is the human response to changing incentives and the tentativeness of future state legislation. With most major legislation, the CBO estimates the macroeconomic effects. They did not include such an analysis in this report and note that fact. In short, the CBO is saying “take this estimate with a grain of salt.”

The headline number was the amount of people estimated to lose their health insurance over the next ten years – a whopping 24 million. Democrats used this ballpark estimate as a defining fact as they bludgeoned the plan. How did the CBO come up with their numbers?

Medicaid is the health insurance program for low income families and individuals.  When the program was introduced in 1965, enrollment was 1/4 million.  Today, 74 million are on the program.  The federal government and states share the costs of the program; the federal share averages 57%. Under the ACA’s Medicaid expansion, low income individuals younger than 65 without children could enroll.  An increase in the income threshold enabled more people to qualify for the program.  The federal share was guaranteed to not fall below 90% of those individuals enrolled under the expansion guidelines.

Medicaid (CMS) reports that 16.3 million people were added to Medicaid under the ACA expansion program and represent almost 75% of all enrollment under ACA. California has 12% of the U.S. population, but accounts for more than 25% of additional enrollees under Medicaid expansion. (State-by-state Medicaid enrollment ) Only 31 states adopted Medicaid expansion. The CBO estimates that those 16.3 million are 50% of the total pool of individuals that would be eligible if all states adopted the expansion program. So the CBO estimate of the total pool is almost 33 million.

Undere current law, the CBO estimates that additional states will adopt expansion so that 80% of the estimated total pool, or 26.4 million, will be enrolled under Medicaid expansion by 2026.  Under the AHCA, the CBO estimates that only 30% of that eligible population of 33 million, about 10 million, will be enrolled as of 2026. 26.4 million (under ACA) – 10 million (under AHCA) equals 16 million whom the CBO estimates will lose coverage under Medicaid. Note that this is a lot of blue sky math.

To summarize the ten year loss estimate under the rollback of Medicaid expansion: 6 million current enrollees and 10 million anticipated enrollees.

Medicaid expansion accounts for 16 million fewer enrollees. Where are the remaining 8 million missing? In the non-group private market. Currently, there are 11.5 – 12 million enrolled in these individual plans, an increase of about 5 million over the 6.6 million enrollees in 2007 (Health and Human Services brief) . The CBO estimates that, in 2018 and 2019, 2 million additional enrollees would take advantage of the ACA subsidies to buy policies. That results in a potential pool of about 14 million. Under the AHCA, the CBO estimates that the non-group private insurance market will return to its former level of 6 – 7 million, a loss of about 8 million.

Voila! 16 million under Medicaid expansion + 8 million in non-group private insurance = 24 million loss.

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Side Note

How do people get their health insurance?
74 million people, about 25% of the population, are enrolled in Medicaid. Half of Medicaid enrollees are children.
55 million, about 16% of the population, are on Medicare.
Over 150 million, or 50% of the population, are enrolled in an employer group plan (Kaiser Family Foundation).
Approximately 27 million, or 9% of the population, are uninsured.

Before the ACA, almost 50 million, or 16% of the population, were classified as uninsured. About 6 million of these uninsured had high deductible insurance plans called catastrophic plans. Offered by large insurance companies, they contained exclusions for pre-existing conditions, did not cover pregnancy, or mental disease, but were adequate for many self-employed tradespeople, contractors, consultants and farmers. (Info) In late 2013, the ACA redefined catastrophic plans by specifying the minimum benefits that a catastrophic plan must offer and, in 2014, began offering these plans through the state health care exchanges.

Optimism Reigns

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Dec. 11, 2016

For the second week since the election the SP500 index rose more than 3%, reversing a slight loss the previous week.  The SP500 has added 160 points, or 7.6%, in total since the election.  Barring some surprise, the market looks like it will end the year with a 10+% annual gain, all of it in the 6 – 7 weeks after the election. Small cap stocks have risen 17% in the past five weeks.  Buoyed by hopes of looser domestic regulations, and that international capital requirements will be relaxed, financial stocks are up a whopping 20% in the same time.

Having held their Senate majority, Republicans now control both branches of Congress and the Presidency but lack a filibuster proof dominance in the Senate.  They are expected to pass many measures in the Senate using a budget reconciliation process that requires only a simple majority. The promise of tax cuts and fewer regulations has led investment giants Goldman Sachs and Morgan Stanley to increase their estimate of next year’s earnings by $8 – $10.  Multiply that increase in profits by 16x and voila!  – the 160 points that the SP500 has risen since the election.  The forward Price Earnings ratio is now 16-17x.

Speculation is about what will happen.   History is about what has happened. The Shiller CAPE10 PE ratio is calculated by pricing the past ten years of earnings in current year’s dollars, then dividing the average of those inflation adjusted earnings into today’s SP500 index.  The current ratio is 26x, a historically optimistic value.  The Federal Reserve is expected to raise interest rates at their December meeting this coming week.

As buyers have rotated from defensive stocks and bonds to growth equities, prices have declined.  A broad bond index ETF, BND, has lost 3% of its value since the election.  A composite of long term Treasury bonds, TLT, has lost 10% in 5 weeks.  For several years advisors have recommended that investors lighten up on longer dated bonds in anticipation of rising interest rates which cause the price of bond funds to decline.  For 6 years fiscal policy remedies have been thwarted by a lack of cooperation between a Democratic President and a Republican House that must answer to a Tea Party coalition that makes up about a third of Republican House members.  The Federal Reserve has had to carry the load with monetary policy alone.  Both former Chairman Bernanke and curent Chairwoman Yellen have expressed their frustration to Congress.  If Congress can enact some policy changes that stimulate the economy, the Federal Reserve will have room to raise interest rates to a more normal range.

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Purchasing Manager’s Index

The latest Purchasing Manager’s Index (PMI) was very upbeat, particularly the service sectors, where employment expanded by 5 points, or 10%, in November.  There hasn’t been a large jump like this since July and February of 2015.  For several months, the combined index of the manufacturing and service sector surveys has languished, still growing but at a lackluster level.  For the first time this year, the Constant Weighted Purchasing Index of both surveys has broken above 60, indicating strong expansion.

The surge upward is welcome, especially after October’s survey of small businesses showed a historically high level of uncertainty among business owners.  This coming Tuesday the National Federation of Independent Businesses (NFIB) will release the results of November’s survey.  How much uncertainty was attributable to the coming (at the time of the October survey) election?  Small businesses account for the majority of new hiring in the U.S. so analysts will be watching the November survey for clues to small business owner sentiment.  Unless there is some improvement in small business sentiment in the coming months, employment gains will be under pressure.

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Productivity

Occasionally productivity growth, or the output per worker, falters and falls negative for a quarter.  Once every ten or twenty years, growth turns negative for two consecutive quarters as it has this year. Let’s look at the causes.  Productivity may fall briefly if businesses hire additional workers in anticipation of future growth.   Or employers may think that weak sales growth is a temporary situtation and keep employees on the payroll.  In either case, there is a mismatch between output and the number of workers.

During the Great Recession productivity growth did NOT turn negative for two quarters because employers quickly shed workers in response to falling sales.  The last time this double negative occurred was in 1994, when employment struggled to recover from a rather weak recession a few years earlier.  For most of 1994, the market remained flat.  In Congressional elections in November of that year, Republicans took control of the House after 40 years of Democratic majorities.  The market began to rise on the hopes of a Congress more friendly to business.  Previous occurrences were in the midst of the two severe recessions of 1974 and 1982.   As I said, these double negatives are infrequent.



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The Next Crisis?

The economies of the United States and China are so large that each country naturally exports its problems to the rest of the world.  The causes of the 2008 Financial Crisis were many but one cause was the extremely high capital leverage used by U.S. Banks.  A prudent ratio of reserves to loans is 1-8 or about 12% reserves for the amount of outstanding loans.  Large banks that ran into trouble in 2008 had reserve ratios of 1-30, or about 3%.

Now it is China’s turn.  Many Chinese banks have reported far less loans outstanding to avoid capital reserve requirements.  How did they do this?  By calling loans “investment receivables.”  It sounds absurd, doesn’t it?  Like something that kids would do, as though calling something by another name changes the substance of the thing.  70 years ago George Orwell warned us of this “doublespeak,” as he called it.  Reluctant to toughen up banking standards for fear of creating an economic crisis, the Chinese central bank is planning a gradual move to more prudent standards that will take several years.  However, it is a crisis waiting for a spark.  Here’s a Wall St. Journal article on the topic for those who have access.

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Third Quarter Rebound

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October 9, 2016

Last month I reviewed the background and history of the CWPI index based on the monthly survey of purchasing managers.  I was a bit concerned that this index might continue to decline.  Instead it showed a big upsurge in new orders and employment in the service sectors, sending an index of these two components above its five year average. This may be a sign of a third quarter rebound after a lackluster first half of the year.

September’s stronger manufacturing survey lifted its index from the contractionary reading of the previous month. The CWPI composite of the manufacturing and non-manufacturing surveys is a smoothed average to dampen any month-to-month erraticness and give a truer picture of trend. Although the CWPI indicates strong growth, this is the longest period of time since 2011 that the CWPI has registered below 60, a mark of fairly robust expansion.

The height of this last wave was over a year ago, in August 2015.  The downward trend is stil in place but this month’s survey gives some hope of a turnaround.

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Households

A Pew analysis of Census Bureau data shows that 18-34 year olds are living with their parents in even greater numbers – 32% – than during the Great Recession. This bests the previous record set in 1940, between the Great Depression and World War 2. In the EU, almost half of 18-34 year olds are living with their parents. In a consumer driven economy, growth depends on children moving out of their parents’ home to form new households, to buy furniture and home furnishings, to consume electricity and water, to pay property taxes and all the many expenses involved in running a household.  Here is a recent paper published by the Federal Reserve.

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Infrastructure
There is not much that Hillary Clinton and Donald Trump agree on.  However, both candidates are calling for a big infrastructure spending program to repair roads, bridges, airports, dams, water pipes, schools, etc.  The American Society of Civil Engineers has given a D+ grade to this country’s  infrastructure and has estimated that $3.6 trillion of repairs are needed by 2020.  $3.6 trillion is the entire Federal budget, or about $12,000 per person.

A Liberal Idea Adopted by A Republican Candidate

It is unlikely that either candidate can get a bill through a Republican Congress.  In 2011, Robert Frank, Paul Krugman and several liberal economists called for a $2 trillion infrastructure spending bill.  The goverment could borrow at rock bottom interest rates, the repairs were needed and the spending would have been good for employees and businesses at a time when unemployment was 9% and real GDP had finally reached the same pre-recession level four years earlier.  Citing large budget deficits and a Federal debt that had increased 50% in three years, Republicans squelched any infrastructure bill.

The Current Distribution of Highway Trust Fund Dollars

Included in the price of each gallon of gas is a Federal excise tax that is paid into the Highway Trust Fund (HTF) to pay for repairs to the interstate highway system. The allocation of tax revenue is currently based on the amount of gallons of gasoline that each state sells but that presents another set of complications.  Exclusions to the allocation computation are jet fuel, fuel used by tribal lands and a host of other exceptions that are peculiar to each state.  This results in a spider’s web of adjustments to the gallons reported by each state. As you can imagine, the instructions for the adjustments are complicated.

Alternative Distribution Models

 An easy formula for distributing the tax revenues to the states could be a simple one: allocate the money based on the number of miles of interstate highway in each state.  But that would treat a low traffic route like U.S. 90 through Montana the same as the heavily traveled U.S. 495 running through part of New York City.  One suggestion has been to count only the interstate highways that pass through more than one state, and to exclude secondary highway routes designated by a three digit number.  For instance, US 495 is a route from US95 through New York City.  US 635 is a highway that goes around Dallas, Texas and connects with the primary north-south highway US 35.

An allocation scheme based on actual mileage driven has been proposed but would require the reporting of one’s travels to a government agency via a transponder, a step too far for many.  While newer cars and many trucks already have a GPS locator in the vehicle, the logistics and cost  of upgrading older commercial and passenger vehicles are daunting.

Twenty Years Without An Increase in the Highway Tax

The last increase in the Federal exice tax occurred in 1993 and efforts to rate the rate have met fierce resistance from Republicans, most of whom have taken an oath not to raise taxes of any sort.  Even though gas prices have come down in recent years, there seems to be little enthusiasm for bringing this subject back from the dead. (More info on the gas tax)

Every four years we have a Presidential election, a contest to choose the next Peter Pan who will magically overcome an entrenched bureaucracy, a recalcitrant Congress and a horde of fat cat lobbyists feasting on the power and money flowing into Washington.

The Supply Chain Sags

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September 11, 2016

Fifteen years ago almost three thousand people lost their lives when the twin towers crumpled from the kamikaze attack of two hijacked airplanes.  Over the fields of rural Pennsylvania that morning, the passengers of a another hijacked plane sacrificed their own lives to rush the hijackers and prevent an attack on Washington.  We honor them and the families who endured the loss of their loved ones.

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Purchasing Managers Index

Each month a private company ISM surveys the purchasing managers at companies around the country to assess the supply chain of the economy. Are new orders growing or shrinking since last month?  Is the company hiring or firing?  Are inventories growing or shrinking?  How timely are the company’s suppliers?  Are prices rising or falling? ISM publishes their results each month as a  Purchasing Managers Index (PMI), and it is probably the most influential private survey.

ISM’s August survey was disappointing, especially the manufacturing data.  Two key components of the survey, new orders and employment, contracted in August. Both manufacturing and service industries indicated a slight contraction.

For readers unfamiliar with this survey, I’ll review some of the details The PMI is a type of index called a diffusion index. A value of 50 is like a zero line.  Values above 50 indicate expansion from the previous reading; below 50 shows contraction. ISM compiles an index for the two types of suppliers, goods and services, manufacturing and non-manufacturing.

The CWPI variation

Each month I construct an index I call the Constant Weighted Purchasing Index (CWPI) that blends the manufacturing and non-manufacturing surveys into a composite. The CWPI gives extra weight to two components, new orders and employment, based on a methodology presented in a 2003 paper by economist Rolando Pelaez.  Over the past two decades, this index has been less volatile than the PMI and a more reliable warning system of recession and recovery, signaling a few months earlier than the PMI.

Weakness in manufacturing is a concern but it is only about 15% of the overall economy.  In the calculation of the CWPI, however, manufacturing is given a 30% weight.  Manufacturing involves a supply chain that produces a ripple effect in so many service industries that benefit from healthy employment in manufacturing. Because there may be some seasonal or other type of volatility in the survey, I smooth the index with a three month moving average.  Sometimes there is a brief dip in both the manufacturing and non-manufacturing sides of the data. If the downturn continues, the smoothed data will confirm the contraction in the next month.  This is the key to the start of a recession – a continuing contraction.

History of the CWPI

The contraction in the survey results was slight but the effect is more pronounced in the CWPI calculation. One month’s data does not make a trend but does wave a flag of caution. Let’s take a look at some past data.  In 2006 there was a brief one month downturn. In January 2008, the smoothed and unsmoothed CWPI data showed a contraction in the supply chain, and more important continued to contract. The beginning of the recession was later set by the NBER at December 2007. ( Remember that these recession dates are determined long after the actual date when enough data has been gathered that the NBER feels confident in its determination.)  The PMI index did not indicate contraction on both sides of the economy until October 2008, seven months after the signal from the CWPI.  During that time, from January to October 2008, the SP500 index lost 30% of its value.

The CWPI unsmoothed index showed expansion in June 2009 and the smoothed index confirmed that the following month. The PMI did not show a consistent expansion till August 2009.  The NBER later called the end of the recession in June 2009.

The Current Trend

Despite the weak numbers, the smoothed CWPI continues to show expansion but we can see that there is a definite shift from the wave like pattern that has persisted since the recovery began.

With a longer view we can see that an up and down wave is more typical during recoveries.  A flattening or slow steady decline (red arrows) usually precedes an economic downturn.  The red arrows in the graph below occurred a year before a recession.  The left arrow is the first half of 2000, a year before the start of the 2001 recession.  The two arrows in the middle of the graph point to a flattening in 2006, followed by a near contraction.  A rise in the first part of 2007 faltered and fell before the recession started in December 2007.  The current flattening (right arrow) is about six months long.

New Orders and Employment

Focusing on service sector employment and new orders, we can see the weakness in this year’s data.

With a long view, a smoothed version of this-sub indicator signals weakness before a recession starts and doesn’t shut off till late after a recession’s end.  The smoothed version has been below the 5 year average for seven months in a row.  If history is any guide, a recession in the next year is pretty certain.

The 2007-2009 Recession

 In August 2006 this indicator began consistently signaling key weakness in the service sectors of the economy (big middle rectangle in the graph below). Stock market highs were reached in June 2007 and the recession did not officially begin till December 2007, a full sixteen months after the signal started.  That signal didn’t shut off till the spring of 2010, about eight months after the official end of the recession.

The 2001 Recession, Dot-Com Bust and Iraq War

The recession in 2001 lasted only six months but the downturn in the market lasted three years as equities repriced after the over-investment of the dot-com boom.  The smoothed version of this indicator first turned on in January 2001, two months before the start of the recession in March of that year.   Although, the recession officially ended in November 2001, the signal did not shut off till June 2003 (left rectangle in the graph above).  Note that the market (SP500) hit bottom in September 2002, then nosedived again in the winter.  Weak 4th quarter GDP growth that year fueled doubts about the recovery.  Concerns about the Iraq war added uncertainty to the mix and drove equity prices near that September 2002 bottom.  In April 2003, two months before the signal shut off, the market began an upward trajectory that would last over four years.

No one indicator can serve as a crystal ball into the future, but this is a reliable cautionary tool to add to an investor’s tool box.

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Stocks, Interest Rates and Employment

There are 24 branches of the Federal Reserve. This week, presidents of two of those banches indicated that they favored an interest rate hike when the Fed meets later this month (Investor’s Business Daily article).  On Friday, the stock market dropped more than 2% in response.  One of those presidents, Rosengren, is a voting member on the committee (FOMC) that sets interest rates.  I have been in favor of higher interest rates for quite some time so I agree with Rosengren that gradual rate increases are needed. However, Chairwoman Janet Yellen relies on the Labor Market Conditions Index (LMCI) to gauge the health of the labor market.

Despite an unemployment rate below 5%, this index of about 20 indicators has been lackluster or negative this year.  There are a record number of job openings but employees are not switching jobs as the rate they do in a healthy labor market.  This is the way that the majority of employees increase their earnings so why are employees not pursuing these opportunities?

The Federal Reserve has a twin mandate from Congress: “maximum employment, stable prices, and moderate long-term interest rates.” (Source) There is a good case to be made that there are too many weaknesses in the employment data, and that caution is the more prudent stance.  The FOMC meets again in early November, just six weeks after the upcoming September meeting. Although the Labor Report will not be released till three days after the FOMC meeting, the members will have preliminary access to the data, giving them two more months of employment data. Yellen can make a good case that a short six week pause is well worth the wait.

Stuck in the Mud

In 18 months, the SP500 is little changed.  A broad index of bonds (BND) is about the same price it was in January 2015.  The lack of price movement is a bit worrying.  There are several alternative investments which investors may include in their portfolio allocation.  Since January 2015, commodities (DBC)  have lost 15%, gold (GLD) has gained a meager 1%, emerging markets (VWO) are down 5%, and real estate (VNQ) is literally unchanged.  A bright note: international bonds (BNDX) have gained almost 6% in that time and pay about 1.5%.  1994 was the last time several non-correlated assets hit the pause button.  The following six years were good for both stocks and bonds.  What will happen this time?  Stay tuned.

Small Hope Amid Tragedy

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July 10, 2016

The horrific news from Dallas on Thursday night and Friday morning understandably drowned out this month’s extraordinary employment report. No one anticipated job gains of 287,000 that were far above the consensus average estimate of 170,000.  Like last month, the BLS numbers are way off from those from the private payroll processor ADP, which reported gains of 172,000.

The strike at Verizon that started in May and ended in June involved 38,000 workers and skewed the BLS numbers down in May, then reversed back up again in June.  BLS methodology does not adjust for a strike involving so many workers, leading some to criticize such a widely followed methodology.  Because these estimates are prone to error, I think we get a more reliable picture by averaging the two estimates from the BLS and ADP.  As we can see in the graph below, economic growth during the past five years has been strong enough to stay ahead of the 150,000 monthly gains needed to keep up with population growth.

Those working part time because they couldn’t find full time work have dropped by 1.4 million in the past year – a positive sign. Although the supposed recovery is seven years old, it is only since the spring of 2014 that the ranks of involuntary part timers have consistently decreased.  Today’s level is almost 7 million less than it was two years ago but is still 2/3rds more than pre-Crisis levels.

This month’s 1/10th uptick in the participation rate was a welcome sign that more people are coming back into the workforce.  Although the unemployment rate ticked up two notches to 4.9% this was probably due to more people actively looking for work. An important component of the economy is the core work force aged 25 – 54, which continued to show annual growth in excess of 1%, a healthy sign.

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CWPI (Constant Weighted Purchasing Index)

Earlier in the week, the monthly survey of Purchasing Managers (PMI) foreshadowed a positive employment report. A surge in new orders in the services sector and some healthy growth in employment helped lift up the non-manufacturing PMI to strong growth.  The Manufacturing index grew as well.  The CWPI composite of both surveys has a reading of almost 58, indicating strong growth.  The familiar peak and trough pattern that has continued during the recovery has changed to a steadier level.  New Export Orders in both manufacturing and services reversed direction this month.  The strong dollar makes American made products more expensive to buyers in other countries and presents a significant obstacle to companies who rely on exports.

Last month’s survey of purchasing managers in the services sector indicated some worrying weakness in employment.  This month’s reading suggests that a surge in new orders has reversed the decline in employment, a trend confirmed by the BLS report later released at the end of the week.

A few months ago I was concerned that the familiar trough that had developed in the spring might continue to weaken.  This month’s survey put those fears to rest.

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Housing Bubble?

Soaring home prices in some cities has led to speculation that, ten years after the last peak in the housing market, we are again approaching unaffordable price levels.  Heavy migration into the Denver metro area has made it the third hottest housing market in the U.S., just behind San Francisco and Vallejo (northeast of SF) in California (Source). Despite bubble indications in these hot markets, the Case Shiller composite of the twenty largest metropolitan areas does not indicate that we are at excessive levels.

In the period 2000 through mid-2006 when housing prices peaked, annual growth was more than 10%.  Ten years have passed since then.  In the 16.5 years since the start of 2000, annual growth has averaged 4%.  While this is almost twice the 2% rate of inflation, it is approximately the same as the rate of growth during the past century.

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In the past two weeks following the Brexit vote in the U.K. the S&P500 has rebounded 6%, recovering all the ground lost and then some. It is near all time highs BUT so are Treasuries.  When both “risk on” (stocks) and “risk off” (Treasuries) both rise to new highs, it creates a tension that usually resolves in a rather ugly fashion as the market chooses one or the other.

Caution: Under Construction

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June 12, 2016

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

CWPI

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

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

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

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

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

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LMCI

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

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

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

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

Pickup and Letdown

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May 8, 2016

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

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

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

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

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Employment

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

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

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

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

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

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

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

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Hungry

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

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

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

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

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

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

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Earnings

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

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

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

The Weathervane of Growth

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April 10, 2016

CWPI (Constant Weighted Purchasing Index)

March’s survey of Purchasing Managers showed a big upsurge in new orders for the manufacturing (MFR) sector. Export orders were up 5.5% in both the manufacturing and services (SVC) sectors and overall output increased 2% or more.  After contracting for several months, MFR employment may have found a bottom.  The total of new orders and employment is still growing but below five year averages.

The broader CWPI is still expanding but at a slightly slower pace for the past seven months.  The cyclic pattern of declining growth followed by a renewal of activity has changed. While there is no cause to make any strategic changes to allocation, it does bear watching in the months ahead.

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IRA Standard of Care

Financial agents – investment advisors, stock brokers and insurance agents – have had different standards of care when they deal with their clients.  The first and highest standard is fiduciary: the agent should operate with the best interests of the client in mind.  Registered Investment Advisors (RIA) are registered with the SEC and follow this strict standard. The second and more lax standard is suitability: the agent should not sell the client anything that is not suitable for the client based on what the client has told them about their circumstances.  Here’s a short paper on the difference between the two standards.

This week the Obama administration issued new guidelines for agents servicing IRA account holders, requiring agents to maintain the higher fiduciary standard starting in 2017.  This requirement was left out of the Dodd-Frank finance reform bill because many in the investment industry lobbied against it.  Here is the first rule proposal in February.

Opponents will criticize the Obama administration for this “new” set of regulations but this policy has been recommended by some in the industry, on both sides of the political aisle, for at least 25 years.  During the 1980s Congress made several changes that made IRA accounts available to a wide swath of savers, most of whom were unfamiliar with the marketplace of financial products now available to them.

Some in the insurance and investment industries fought against the imposition of a stricter fudiciary standard because it would require more training and would likely reduce the sales commissions of agents.  The growing volume of tax deferred employee retirement plans has generated a steady stream of fees for those in the financial industry.

Keep in mind that the new policy only applies to retirement accounts.

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Debt

Banks are in the business of loaning money, meaning that they must loan money to stay in business.  Most of the time some part of the economy wants to borrow money.  Borrowers come in three types:  Household, Corporate and Government.  If households cut back on their borrowing, corporations may increase theirs.

A historical look at total debt as a percent of GDP shows several trends.  Keep in mind the leveling of debt since the financial crisis.  We’ll come back to that later.

In the thirty years following World War 2, debt levels remained fairly consistent with the pace of economic activity.  The three types of borrowers offset each other.  Households and corporations increased their borrowing while government, particularly the Federal government, paid down the high debt incurred to fight WW2.

In 1980 the Reagan administration and a Democratic House began running big deficits, contributing to a spike in the the total level of debt.  By 1993, when President Clinton took office, Federal and State Debt as a percent of GDP was about the same as it was at the end of WW2.

A combination of higher tax rates and cost cutting by a Republican House elected in 1994 led to a reduction in government spending as household and corporations increased their spending.  Total debt levels flattened during the late 1990s.

Following the 9/11 tragedy and a recession, government debt levels increased but now there was no offset in household borrowing as mortgage debt climbed.  Helping to curb the pronounced rise in total debt levels, a Democratic House at odds with a Republican president dampened the growth of government borrowing in the two years before the financial crisis.

Arguably the most severe crisis in eighty years, the financial crisis caused both households and corporations to cut back on their borrowing.  Offsetting this negative borrowing, the Federal government assumed an often overlooked role – the Borrower of Last Resort.  We are accustomed to the role of the Federal Reserve Bank as the Lender of Last Resort, but we might not be aware that some part of the economy has to be the Borrower.  That role can only be filled by the Federal government because the states and local governments are prohibited from running budget deficits.

Look again at the second chart showing the huge spike in government borrowing following the financial crisis.  Now remember the leveling off of total debt shown in the first graph.  The Federal government has increased its debt level by more than $10 trillion.  Almost $4 trillion of that has come from the lender of last resort, the Fed, but the rest of that borrowing has offset a significant deleveraging by corporations and households.  Had the Federal government not borrowed as much as it did, many banks would have experienced significant declines in profits to the point of going out of business.

There is a potential bombshell waiting in the $2 trillion in corporate profits that businesses have parked overseas to delay taxes on the income.  If Congress and the President were to lower tax rates so that corporations could “repratriate” these dollars, two things would happen: 1) corporations could lower their debt levels, using the cash to pay back the rolling short term loans they use to fund daily operations; and 2) the Federal government would lower its debt levels as the corporations paid taxes on those repatriated profits.

Great.  Lower debt is good, right?  Unless households were to step up their borrowing, total debt could fall significantly, causing another banking crisis.  Although politicians on both sides like to talk about bringing profits home, such a move will have to be done slowly so that the economy and the banking system can adjust in slow increments.

Partisans cheer when candidates express strong sentiments in rousing words, but cold caution must quench hot spirits. We can only trust that candidates for public office will temper their campaign rhetoric with prudence if entrusted with the office.

Growing Government Debt

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March 6, 2016

Earlier this year and again last week I suggested that a broad index of energy companies would probably be a good investment for the long term investor.  This week’s inventory report from the U.S. Energy Information Administration (EIA) showed that crude oil inventories continued to climb but that demand for gasoline is up a strong 7% over last year.

The latest Baker Hughes rig count showed an 11th week of declines in North America.  Oil rigs are now at levels last seen in early 2008 and gas rigs are at a 70 year low.

In response to demand growth and a steadily declining supply, crude oil prices climbed almost 10% and energy ETFs like XLE and VDE climbed almost 8% this past week.

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Constant Weighted Purchasing Index (CWPI)

At the beginning of each month I update an index that is based on the Purchasing Managers Index (PMI) using a methodology initially developed by financial economist Roland Pelaez in 2003 as a possible forcasting indicator for recessions.  I modified that to include the dominant non-manufacturing part of the economy, and called this combined index the CWPI, which I have included in my blog for three years.

The PMI is a monthly survey of Purchasing Managers throughout the country that gauges expansion or contraction in several aspects of their business.  The two most important components in the model are employment and new orders.

For the first time since last October, the manufacturing component of the index rose but is still contracting slightly.  Export manufacturers have had to overcome a strong dollar in the past 1-1/2 years, which makes American made products more expensive overseas.  The services sector is still expanding and the composite reading is still strong, indicating that there is little risk of recession in the near term.

Although Friday’s employment report showed strong job gains of 240,000, growth in the employment component of the services sectors is slowing.

Mr. Pelaez has recently published  a peer reviewed recession forecasting tool that I have not reviewed yet but I do look forward to reading his insights. Recessions come infrequently, about once a decade, but a long term investor who can switch out of stocks and into Treasuries to avoid these recessions could theoretically triple their wealth.

A word of caution.  There are several inherent problems with trading models based on infrequent economic events like recessions: 1) backtesting can help one develop a model or trading rule that does little more than fit the historical data;  2) backtesting uses revised economic and financial data.  Unfortunately, we don’t get to make decisions with historically revised data.

A great example of this:  at the June 2008 meeting of the Fed, three months before the financial crisis imploded, the majority of economists at the meeting felt that the economy had skirted a recession.  As more data for the first and second quarters of 2008 showed a definite decline in GDP, the NBER actually marked the start of the recession six months before that meeting, in December 2007.  You want perfect?  Next universe that-a-way.

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Debt Doubts

In December 2009, I mentioned  a comment by Raymond Baer, the chairman of Swiss private bank Julius Baer, who warned: “The world is creating the final big bubble. In five years’ time, we will pay the true price of this crisis.”

That time has come and gone but these things don’t run on a calendar.  As the book “The Big Short” noted, a person has to be right and timely.  Some who bet on the implosion of the housing bubble ran out of money before the bubble burst.

Taking advantage of extremely low interest rates, companies continue to borrow.  Levels of corporate debt are nearly a third of GDP.

Instead of bringing some of its cash profits back into the U.S. and triggering a tax expense, Apple has borrowed money to fund operations and investment.  Banks and investors would rather loan money to Apple than some medium sized business.  How good is that for the long term health of the economy?

To understand the makings of a debt bubble, let’s compare rates of return on investment and debt. Let’s say that a 50/50 balanced portfolio can earn 5.5% per year; 7.5% for stocks, 3.5% for bonds.  If a mortgage can be had for 4%, then it makes sense to NOT pay down the mortgage.  A car lease or loan at a 2% interest rate?  Keep rolling the loan or lease.  A company like Johnson and Johnson can borrow money for 25 years at the same 4%.  Why would they pay down debt?

Debt continues to grow because there is no financial incentive to pay it down.  Some families may pay down debt out of conservative prudence but there is no economic sense in doing so as long as money can be borrowed at a rate that is below what one can earn with the money.

As an example, let’s say that a family is considering paying off the remaining $100K on their mortgage.  They can get a new mortgage for 3.5% – 4%.  If they can earn 5% on that money, why bother paying off the mortgage?  Persistently low interest rates cause families and businesses to make short term decisions that make sense – until they don’t.  Some families will pay off debt as a matter of prudence but the low interest rate environment encourages families and businesses to NOT pay off debt.

In 2009, Raymond Baer was referring to the amount of corporate debt that was being rolled over at the time in order to avoid taking a loss on the loan.  Central banks have helped subsidize that rising corporate debt with low interest rates.  Banks reciprocate by buying government debt.

Global government debt has DOUBLED from $28 trillion in 2007 to almost $56 trillion in 2015 (Global debt clock).  China’s government debt-to-GDP ratio has more than doubled from 21% in 2007 to an estimated 54% in 2008 (S. China Post)

In the U.S. and Europe, government banking agencies reciprocate by requiring banks to hold little if any reserve collateral for the Federal or central government debt the banks purchase.  It’s a great financial buddy system – until it’s not.  We have never lived in a world where central banks can create so much money with an entry in a ledger.  As long as no one runs for the exits, everything is OK.

Under the Dodd-Frank rules, the Federal Reserve does not rate state and municipal debt with the same safety it accords U.S. Treasury debt.  This forces banks to hold more collateral against the debt, making it less attractive.  The Dodd-Frank test is whether banks can survive for thirty days during a financial crisis.  Since municipal and state bonds don’t trade very frequently, their lack of liquidity makes them more susceptible to downward price pressures in a crisis.  The Fed wants banks to offset that risk.  Cities and states complain that this forces them to pay higher interest rates on their debt and gives them less access to the bond market.  What do governments do when they don’t like the judgment of finance professionals?  Get their legislators to pass laws to override that prudence.  Several bills in both the Senate and House have been proposed.  This is how the world goes to hell.  One step at a time. (WSJ article on municipal debt)

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Bonds Bust ZLB

Howz dat for a headline?!  ZLB means “Zero Lower Bound”, or 0%. Last Monday, the central bank of Japan sold almost $20 billion of 10-year government bonds that paid a negative interest rate.  Buyers are paying the Japanese government a fee to loan the government money.  Bizarro world!  While I don’t know the details, the buyers are probably Japanese banks who “take one for the team” – lose money – to implement a plan that the central bank hopes will combat the threat of deflation.