Category: CWPI

Income Distributions

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February 7th, 2016

Updates on January’s employment report and CWPI are at the end of this post.  Get out your snowboards ’cause we’re going to carve the political half-pipe! (*v*)
(X-Game enthusiasts can click here)

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To Be Rich or Not To Be Rich

Every year the IRS takes a statistical snapshot of the almost 150,000,000 (150M) personal tax returns it receives.  There are some interesting tidbits contained in these tables that will put the lie to many a politician’s claim in this election season.  The IRS lists the number of returns for each of some twenty income brackets.  They also list the exemptions claimed for each of these income brackets and let’s turn to that for some interesting insights.

From Table 1.4 we learn that there were 290M exemptions claimed in the 147M tax returns filed in 2013, or almost two exemptions per return.  In 1995 (Table 1, same link as above) the number of exemptions claimed was 237M for 118M returns, exactly two exemptions per return. Exemptions are people that need to be fed, clothed, and housed.

Census Bureau surveys (CPS) over the past few decades show that households are shrinking.  Conservatives assert that median household income has stagnated simply because there are fewer people and workers in households today compared to the past.  If this were true, IRS data would show a greater decrease in exemptions over an 18 year period. We can’t say that one or the other data source is “true,” but that averaging data from the two sources probably gives a more accurate composite of income trends in the data.  Census data probably overcounts households while the IRS undercounts them.  Conservatives who advocate less government support will ignore IRS data that conflicts with their beliefs.

30% of the exemptions were claimed by tax returns with adjusted gross incomes (AGI) of less than $25,000, or less than half the median household income. (AGI is earned income and does not include much of the income received from government social programs.)  Only 2M exemptions, or 2/3 of 1%, were claimed by tax returns with an AGI of $1M or more.  Out of 315 million people in the U.S., there are only two million “fat cats” with incomes above $1,000,000.

Presidential contender Bernie Sanders tells his supporters that he is going to tax the rich to help pay for his programs.  IRS data shows just how few there are to tax to generate money for ambitious social programs. Mr. Sanders says he will get money from the big corporations.  Corporations with lots of well paid lawyers are not going to give up their money peacefully.

Instead, Mr. Sanders’ plans will rely on taxing individuals who can not erect the legal or accounting barricades employed by big corporations.  11% of exemptions were claimed by those making more than $200,000, a larger pool of potential tax money. Doctors, lawyers and other professionals will “Feel the Bern.”  It is not unusual for a middle class married couple in a high cost of living city like New York or Los Angeles to make $200K.  Mr. Sanders has his sights on you.  You are now reclassified as rich.

Here is a well-sourced analysis of the net cost to families.  Most will save money.  Unfortunately, Mr. Sanders made the political mistake of admitting that he would raise taxes, but…  No one paid attention to the “but.”  Should he win the Democratic nomination, Mr. Sanders will “feel the Bern” as Republicans use the phrase against him.  He might have used a phrase like “my plan will lower mandatory payments” to describe the combined effect of higher income taxes and no healthcare insurance payments.

The author calculates that the top 4% will spend a net $21K in extra taxes less savings on health care premiums.  The author probably overstates the effect on those at the top because he uses an average instead of a median, but we could conservatively estimate an additional $10K for those with AGIs in the $200K-$300K range.

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Earned Income Tax Credit

The Earned Income Tax Credit (EITC) is  a reverse income tax for low income workers, who get a check from the federal goverment.  For the 2014 tax year, over 27 million returns received about $67 billion from the government for an average of $2400 per receipient (IRS).  In inflation adjusted dollars, this is up 50% from the 2000 average of $1600.  The number of receipients has expanded 50% as well, growing from 18 million to 27 million.  Although Democrats often tout their support for the poor, it is Republican congresses that are largely responsible for expanding this support for low income families.  Republicans may talk tough but are more than willing to reach out a helping hand to those who are giving it their best effort.  There is a practical political consideration as well.  An analysis of IRS data by the Brookings Institute found that, in the past fourteen years, the poor have shifted from urban areas largely controlled by Democrats to the outlying suburbs of metropolitan areas, where Republicans have more support. In short, Republicans are taking care of their voter base.

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Constant Weighted Purchasing Index (CWPI)

The manufacturing sector, about 15% of the economy, continues to contract slightly, according to the latest Purchasing Manager’s Survey from ISM.  The strong dollar and a slowdown in China have dragged exports down.   Extremely low oil prices have impacted the pricing component of the manufacturing survey, which has reached levels normally seen during a recession.

 

For some industries, like chemical products, the low oil prices have boosted their profit margins.  Most industries are reporting strong growth or at least staying busy.  Wood, food, beverage and tobacco manufacturers and producers report a sluggish start to the year, as reported to ISM.

The services sectors have weakened somewhat in the latest survey of Purchasing Managers, but are still growing, with a PMI index reading of 53.5.  Above 50 is growing; below 50 is contracting.  The weighted composite of the entire economy, the CWPI, is still growing strongly but the familiar up and down cycle of the recovery is changing.  Both exports and imports are contracting

The composite of employment and new orders in the non-manufacturing sectors has broken  below the 5 year trend.  It may turn back up again as it did in the winter of 2014, but it bears watching.

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Employment

Each month theBureau of Labor Statistics  (BLS) surveys thousands of businesses and government agencies to compute the number of private and public jobs gained or lost during the month.  The payroll processing firm ADP also tallies a change in private jobs based on paychecks generated from thousands of its client businesses.  If we subtract government jobs from the BLS total, we should get a total number of jobs that is close to what ADP tallies.  As we see in the graph below, that is the case.

Economists, policy makers and the media look at the monthly change in that total number of jobs.  This change is miniscule compared to the 121 million private jobs in the U.S.  A historical chart of that monthly change shows that BLS survey numbers are more volatile than ADP.

I find an averaging method reduces the monthly volatility.  I take the change in jobs as reported by the BLS, subtract the  change in government employment, average that result with the ADP report of jobs gained or lost, then add back in the BLS estimate of the change in government employment.  This method produces a resulting monthly change that proves more accurate in time, after the data is subsequently revised by the BLS.  Based on that methodology, jobs gains were close to 175K in January, not the 151K reported by the BLS or the 205K reported by ADP.

There was a lot to like in January’s survey.  The unemployment rate fell below 5%.  Average hourly earnings increased by 1/2%.  Manufacturing jobs added 29,000 jobs, the most since the summer of 2013.  This helped offset the far below average job gains in professional and business services.  Year-over-year growth in the core work force aged 25-54 increased further above 1%.

The bad, or not so good, news: job gains in the retail trade sector accounted for 1/3 of total job gains and were more than twice the past year’s average of retail jobs gained.  Considering that job growth in retail was near zero in December, this may turn out to be a survey glootch.  Food services were another big gainer this past month.  Neither of these sectors pays particularly well.  The jump in manufacturing jobs probably contributed the most to lift the average hourly wage.

The Labor Market Conditions Index (LMCI) is a cluster of twenty or so employment indicators compiled by the Federal Reserve.  December’s change in the monthly index was almost 3%.  In the forty year history of this index, there has NEVER been a recession when this index was positive.

We are innately poor at judging risk.  We derive indicators and other statistical tools to help us balance that innate human weakness with the strength of mathematical logic.  Still, people do not make money by NOT talking about recession.  NOT talking does not pay commissions, does not generate the buying of put options, expensive annuities, and other financial products designed to make money on the natural gut fears of investors.  Next week I’ll look at the price stability of our portfolios.

A Change Is Gonna Come

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December 6, 2015

A horrible week for many families.  When we count the dead and injured in mass shootings, we often neglect to include the family and friends of each of these victims.  If we conservatively estimate 20 – 30 people affected for each victim, we can better appreciate the emotional and economic impact of these events. Shooting Tracker lists the daily mass shootings (involving four or more victims) in the U.S. in 2015.  What surprised me is that, in most cases, the shooter/assailant is unknown.

A strong November jobs report sent equities, gold and bonds soaring higher on Friday.  Markets reacted negatively on Thursday following a lackluster response from the European Central Bank(ECB) and comments by Fed chair Janet Yellen indicating that a small rate increase was in the cards at the mid-December Fed meeting.  The SP500 closed Thurday evening below November’s close.  Not just the close of November 2015, but also the monthly close of November 2014!

Overnight (early Friday morning in the U.S.), the ECB said that they would do whatever it took to support the European economy. Shortly after the cock crowed in Des Moines, the Bureau of Labor Statistics released November’s labor report, confirming an earlier ADP report of private job gains.  By the end of trading on Friday, the SP500 had jumped up 2%.  However, it  is important to step back and gain a longer term perspective.  The index is still slightly below February 2015’s close – and May’s close – and July’s close.

Extended periods of price stability – let’s call them EPPS – are infrequent.  Markets struggle constantly to find a balance of asset valuation. Optimists (bulls) pull on one end of the valuation rope.  Pessimists (bears) pull on the other end.  Every once or twice in a decade, neither bears nor bulls have a commanding influence and prices stabilize. Markets can go up or down after these leveling periods: 1976 (down), 1983 (up),  1994 (up), 2000 (down), 2007 (down), 2015 (?)

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Year End Planning

Mutual funds must pass on their capital gains and losses to investors.  Investors who have mutual funds that are not in a tax-sheltered retirement account should take the time in early December to check on pending capital gains distributions either with their tax advisor or do it themselves.  Most mutual fund companies distribute gains in mid to late December.  Your mutual fund will have a list of pending December distributions on their web site.  For those retail investors in a rush, you might just scan through the list and look for those funds that have a distribution that is 5% or more of the value of the fund, then look and see if it is one of your funds.

An EPPS tends to produce relatively small capital gains but this year some mid-cap growth funds and international funds may be declaring gains of 7 – 10% of the value of the fund.  An investor who had $50,000 in some mid-cap growth fund might see a capital gain distribution of $4,000 on their December statement.  When an investor receives the statement in January 2016, it is too late to offset this gain with a loss.  Depending on the taxpayer’s marginal tax rate, they could be on the hook to the tax man for $700 – $1200.

Let’s say an investor is anticipating a $4000 capital gain distribution in a taxable mutual fund in late December.  Most mutual fund companies list the cost basis of each fund in an investor’s account. An investor who had a cost basis that was higher than the current value of the fund could sell some shares in that fund to offset some or all of the capital gain distribution in the other fund.  This is called tax loss harvesting.  Again, remind or ask your tax advisor if you are unclear on this.

Here is an IRS FAQ sheet on capital gains and losses.  Here is an article on the various combinations of short term and long term gains and losses.

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CWPI

The latest ISM Survey of Purchasing Managers (PMI) showed that the manufacturing sector of the economy contracted in November.  October’s reading was neutral at 50.1.  November’s reading was 48.6.

The services sector, which is most of the economy, is still growing strongly.  Both new orders and employment are showing robust growth.   

However, manufacturing inventories have contracted for five months in a row.  For now, this decline is more than offset by inventory growth in the service industries.  However, the drag from the manufacturing sector is affecting the services sector.  The trough and peak pattern of growth in employment and new orders since the recession recovery in 2009 has begun to get a bit erratic.  Nothing to get too concerned about but something to watch.

The Constant Weighted Purchasing Index combines the manufacturing and service surveys and weights the various components, giving more weight to New Orders and Employment.  Both components anticipate future conditions a bit better than the equal weight methodology used by ISM, which conducts the surveys.  In addition, there is a smoothing calculation for the CWPI.

During this six year recovery, the CWPI has shown a wave-like pattern of growth.  Since the summer of 2014, growth has remained strong but there has been a leveling in the pattern as the manufacturing sector no longer contributes to the peaks of growth.

Despite the underlying growth fundamentals, there are some troubling signs.  In response to activist investors, to boost earnings numbers and maintain dividend levels, companies have bought back shares in their own company at an unprecedented level.  In some cases, companies are taking advantage of low interest rates to borrow money to make the share buybacks. (U.S. Now Spend More on Buybacks Than Factories, WSJ 5/27/15)

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Labor Report

46,000 jobs gained in construction was a highlight of November’s labor report and was about a fifth of all job gains.  Rarely do gains in construction outweigh gains in professional services or health care. This is more than twice the 21,000 average gains of the past year. The steady but slow growth in construction jobs is heartening but a long term perspective shows just how weak this sector is.

Involuntary part-timers, however, increased by more than 300,000 this past month, wiping out a quarter of the improvement over the past year.  These employees, who are working part time because they can not find full time work, have decreased by almost 800,000 over the past year.

The core work force, those aged 25-54, remains strong with annual growth above 1%.

Other notable negatives in this report are the lack of wage growth and hours worked.  Wage growth for all employees is a respectable 2.3% annual rate, but only 1.7% for production and non-supervisory employees.  This is below the core rate of inflation so that the income of ordinary workers is not keeping up with the increase in prices of the goods they buy.

Hours worked per week has declined one tenth of an hour in the past year, not heartening news at this point in what is supposed to be a recovery.  Overtime hours in the manufacturing sector has dropped 10% in the past year.

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Inflation

The core CPI is a measure of inflation that excludes the more volatile price changes of food  and energy.  While the headline CPI gets the attention, this alternative measure is one that the Federal Reserve looks at to get a sense of the underlying inflationary forces in the economy.  The target annual rate that the Fed uses is 2%.

October’s annual rate was 1.9%.  November’s rate won’t be released till mid-December. However, Ms. Yellen made it pretty clear that the Fed will raise interest rates this month, the first time since the financial crisis. I suspect that prelimary reports to the Fed on November’s reading showed no decline in this core rate.  With employment gains and inflation stable, the FOMC probably felt comfortable with a small uptick in the bench mark rate.

Oh My Gawd!

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November 8, 2015

There is the famous Tarzan yell by Carol Burnett and the iconic “Oh my Gawd” exclamation of Janice Lipman in the long running TV series “Friends.”  That’s what Janice would have said when October’s employment report was released this past Friday.

Highlights:

271,000 jobs gained – maybe. That was almost twice the number of job gains in September (137,000).  Really??!! ADP reported private job gains of 182,000.  Huge difference.  Job gains in government were only 3,000 so let’s use my favorite methodology, average the two and we get 228,000 jobs gained, awfully close to the average of the past twelve months.  Better than average gains in professional business services and construction.  Both of these categories pay well.  Good stuff.

At 34.5 hours, average hours worked per week has declined by 1/10th of an hour in the past year.  The average hourly rate rose 2.5%, faster than headline inflation and giving some hope that workers are finally gaining some pricing power in this recovery.

For some historical perspective, here is a chart of monthly hours worked from 1921 to 1942.  Most of those workers – our parents and grandparents – have passed away.  At the lows of the Great Depression people still worked more hours than we do today.  They were used to hard work.  There were few community resources and social insurance programs to rely on.

The headline unemployment rate fell slightly to 5%.  The widest unemployment rate, or U-6 rate, finally fell below 10% to 9.8%, a rate last seen in May 2008, more than seven years ago.  This rate includes people who are working part time because they can’t find a full time job (involuntary part-timers), and those people who have not actively looked for a job in the past month but do want a job (discouraged job seekers).  Macrotrends has an interactive chart showing the three common unemployment rates on the same chart.

The lack of wage growth during this recovery, coupled with rising home prices, may have made owning a home much less likely for first time buyers.  The historical average of new home buyers is 40%.  The National Assn of Realtors reported that the percentage is now 32%, almost at a 30 year low.

2.5% wage growth looks a bit more promising but the composite LMCI (Labor Market Conditions Index) compiled by the Federal Reserve stood at a perfect neutral reading of 0.0 in September.  The Fed will probably update the LMCI sometime next week.  This index uses more than twenty indicators to give the Fed an in-depth reading of the labor market.

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Bonds and Gold

The strong employment report increased the likelihood that the Fed will raise interest rates at their December meeting and this sent bond prices lower.  A key metric for a bond fund is its duration, which is the ratio of price change in response to a change in interest rates.  Shorter term bond funds have a smaller duration than longer term funds. A short term corporate bond index like Vanguard’s ETF BSV has a duration of 2.7, meaning that the price of the fund will decrease approximately 2.7% in response to a 1% increase in interest rates.  Vanguard’s long term bond ETF BLV has a duration of 14.8, meaning that it will lose about 15% in response to a 1% increase in rates.  In short, BLV is more sensitive than BSV to changes in interest rates. How much more sensitive?  The ratio of the durations – 14.7 / 2.7 = 5.4 meaning that the long term ETF is more than 5 times as sensitive as the short term ETF.

What do we get for this sensitivity, this higher risk exposure?  A higher reward in the form of higher interest rates, or yield.  After a 2.5% drop in the price of long term bond funds this week, BLV pays a yield close to 4% while BSV pays 1.1%.  The reward ratio of 4 / 1.1 = 3.6, less than the risk ratio.   On September 3rd, the reward ratio was much lower, approximately 3.27 / 1.3 = 2.5, or half the risk ratio.

Professional bond fund managers monitor these changing risk-reward ratios on a daily basis.  Retail investors who simply pull the ring for higher interest payments should be aware that not even lollipops at the dentist’s office are free.  Higher interest carries higher risk and duration is that measure of risk.

The prospect of higher interest rates has put gold on a downward trajectory with no parachute since mid-October.  A popular etf  GLD has lost 9% and this week broke below July’s weekly close to reach a yearly low.  Investors in gold last saw this price level in October 2009.  Back then  gold was continuing a multi-year climb that would take its price to nosebleed levels in August 2011, 70% above its current price level.

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CWPI (Constant Weighted Purchasing Index)

Manufacturing is hovering at the neutral 50 mark in the ISM Purchasing Manager’s Index but the rest of the economy is experiencing even greater growth after a two month lull.  No doubt some of this growth is the normal pre-Christmas hiring and stocking of inventories in anticipation of the season.

The CWPI composite of manufacturing and service sector activity has drifted downward but is within a range indicating robust growth.

Employment and New Orders in the non-manufacturing sectors – most of the economy – rose up again to the second best of the recovery.

Economists have struggled to build a mathematical model that portrays and predicts the rather lackluster wage growth of this recovery in a labor market that has been growing pretty strongly for the past few years.

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Social Security

The Bipartisan Budget Act of 2015, passed and signed into law this past week, curtails or eliminates a Social Security claiming strategy that has become popular.  (Yahoo Finance – can pause the video and read the text below the video).  These were used by married couples who were both at full retirement age.  One partner collected spousal benefits while the “file and suspend” partner allowed their Social Security benefits to grow until the maximum at age 70.  On the right hand side of this blog is a link to a $40 per year “calculator” that helps people maximize their SS benefit.

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Tax Cuts Anyone?

Former Senator, Presidential contender and actor Fred Thompson died this past week.  The WSJ ran a 2007 editorial by Thompson arguing that the “Bush tax cuts” that the Republican Congress passed in 2001 and 2003, when he was a Senator, had spurred the economy, causing tax revenues to increase, not decrease, as opponents of the tax cuts claimed.  Like others in the tax cut camp, Thompson looked at a rather small slice of time to support his claim: 2003 -2007.

Had tax cut advocates looked at an earlier slice of time – also small – in the late 1990s they would have seen the opposite effect.  Higher tax rates in the 1990s caused greater economic growth and higher tax revenues to the government, thereby shrinking the deficit entirely and producing a surplus.

Tax cuts decrease revenues.  Tax increases increase revenues.  That tax cuts or increases as enacted have a material effect on the economy has been debated by leading economists around the world for forty years.  At the extremes – a 100% tax rate or a 0% tax rate – these will certainly have an effect on people’s behavior.  What is not so clear is that relatively small changes in tax rates have a discernible impact on revenues.  A hallmark of belief systems is that believers cling to their conclusions and find data to support those conclusions in the hopes that they can use that to help spread their beliefs to others.

The evidence shows that economic growth usually precedes tax revenue changes; that tax policy advocates in either camp have the cart before the horse.  A downturn in GDP growth is followed shortly by a decline in tax revenues.

Thompson’s editorial notes a favorite theme of tax cut advocates – that the “Kennedy” tax cuts, initiated into law in memory of President Kennedy several months after his assassination in November 1963, spurred the economy and increased tax revenues. Revenues did increase in 1964 but the passage of the tax act occurred during that year so there is little likelihood that the tax cuts had that immediate an effect.  Revenues in 1965 did increase but fell in subsequent years.  A small one year data point is all the support needed for the claims of a believer.

The question we might ask ourselves is why do tax policy and religion share some of the same characteristics?

October Surprise

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October 11, 2015

A good week for stocks (SPY), up over 3%.  Emerging markets (VWO) were up over 5%, but are still down 18% from spring highs and are on sale, so to speak, at February 2014 prices.

On news that domestic crude oil production had fallen 120,000 barrels per day, about 15%, in September, an oil commodity ETF (USO) rose up 8% this week.  On fears, and confirmations of fears, of an economic slowdown in much of the world, commodities have taken a beating in the past year, falling 50% or more.  A broad basket of commodities (DBC) was up 4% this week but are still at ten year lows.  An August 2010 Market Watch commentary recounted the evils of commodity ETFs as a place where the pros take the suckers’ money.  Not for the casual investor.

The Telegraph carried a brief summary of the latest IMF assessment of credit conditions around the world.  There is an informative graphic of the four stages of the macro credit cycle and which countries are at what stage in the cycle.

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Social welfare

Some people say they dislike redistribution schemes on moral grounds.  The government takes money from some people based on their ability and gives it to other people based on their need, a central tenet of Communism.

In a 2014 paper IMF researchers have found that redistribution is a hallmark of developed economies.  Why?  Because advanced economies have the most income inequality.  Why?  Developed economies have greater income opportunity and opportunity breeds inequality.  A sense of human decency prompts the voters in these developed countries to even the playing field a bit.

In countries with greater equality, living standards and median income are lower.  There is less income to redistribute.  In the real world where the choices are higher income and redistribution vs an equality of poverty, I’ll take the more advanced economies.

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CWPI

Since the beginning of this year the manufacturing component of the Purchasing Managers’ Index has continued to expand.  The strong dollar has made U.S. products more expensive around the world and this has hurt domestic manufacturers.  Growth has slowed from the strong expansion of the last half of 2013 and all of 2014.  September’s survey of manufacturers is right at the edge between expansion and contraction.  The CWPI weights the new orders and employment portions of each index more heavily.  Using this methodology, the manufacturing side of the equation looks stronger than the headline index indicates.

The services sector, most of the economy, is still enjoying robust growth and this strength elevates the combined CWPI.

How much will the substandard growth in the rest of the world affect the U.S. economy?  Industrial production in Germany declined last month.  China’s growth is slowing.  GDP growth in the Eurozone is barely positive.  Emerging markets are struggling with capital outflows.  Developed economies that are dependent on natural resources – Canada and Australia – are struggling.  The GDP growth rate of both countries is very slightly negative. The U.S. is probably the one economic ray of hope.  September’s lackluster labor report and the Fed’s decision to delay a rate increase has attracted capital back into the stock market. This past Monday, volatility in the market (VIX – 17) dropped down below its long term historical average of 20 but is a tiny bit above its 200 day average.  I’d like to see another calm week before I was convinced that the underlying nervousness in the market has abated.  Third quarter earnings season is here and estimates by Fact Set  are for a 5% decline in earnings, the second consecutive quarter of declines since 2009.

Crossroad

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September 13, 2015

The SP500 index is very close to crossing below its 25 month average this month, four years after a similar downward crossing in September 2011.  Worries over the economy and political battles over the budget had created a mood of caution during that summer of 2011.  The market immediately rebounded with a 10% gain in October 2011 and has remained above the 25 month average in the four years since.   Previous crossings, however – in November 2000 and January 2008 – have marked the beginnings of multi-year downturns.

These long term crossings are coincident with extended periods of re-assessment of both value and risk.  Sometimes the price recovery after a crossing below the 25 month average is just a few months as in August 1990, and October 1987, or the quick rebound in 2011.  More often the price of the index takes a year or more to recover, as in 1977, 1981, 2000 and 2008.

The downward crossings of 2000 and 2008 preceded extended periods of price weakness.  Recovery after the popping of the dot-com bubble lasted till the fall of 2006.  In January 2008, just over a year after the end of the last recovery, another downward crossing below the 25 month average occurred.  Later on that year, it got really ugly.

As the saying goes, we can’t time the market.  However, we can listen to the market.  For the fourth year in a row the bond market continues to set records.  The issuance of investment grade and higher risk “junk” corporate bonds has totaled $1.2 trillion so far this year.  Ahead of a possible rate hike by the Federal Reserve this month, Wednesday’s single day bond issuance set an all time record. The reason for the high bond issuance is understandable – companies want to take advantage of historically low interest rates.  The demand for this low interest debt is a gauge of the long term expectations of low inflation.

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CWPI

The Purchasing Manager’s Index presents a somewhat contradictory note to the recent volatility in the stock market.  The CWPI, a composite of the manufacturing and services surveys, shows strong growth.  The manufacturing sector has weakened somewhat.  The strong dollar has made U.S. exports more expensive.

On the other hand…the ratio of inventory to sales remains elevated at 1.37, meaning that merchants have 37% more product on hand than sales.  The particularly harsh winter was unexpected and hurt sales, helping to boost inventories.  Five months after the winter ended, there should have been a notable decline in this ratio.

Has some of the strong economic growth gone to inventory build-up?

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Annuity

In  the blog links to the right was an article written by Wade Pfau on the mechanics of income annuities.  Even if you are not considering annuities, this is a good chance to expose yourself to some basic concepts about these financial products.

Which Way Sideways?

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August 9, 2015

As we all sat around the Thanksgiving table last November, the SP500 was about the same level as it closed this week.  Investors have pulled off the road and are checking their maps to the future.  After forming a base of good growth in the past few months, July’s CWPI reading surged upwards.

Despite years of purchasing managers (PMI) surveys showing expanding economic activity, GDP growth remains lackluster.  Every summer, in response to more complete information or changes to statistical methodologies, the Bureau of Economic Analysis (BEA) revises GDP figures for the most recent years.  A week ago the BEA revised real annual GDP growth rates for the years 2011 – 2014 from 2.3% to 2.0%.  “From 2011 to 2014, real GDP increased at an average annual rate of 2.0 percent; in the  previously published estimates, real GDP had increased at an average annual rate of 2.3 percent.”

A composite of new orders and rising employment in the service sectors showed its strongest reading since the series began in 1997.  The ISM reading bested the strong survey sentiments of last summer. We can assume that the PMI survey is not capturing some of the weakness in the economy.

This level of robust growth should put upward pressure on prices but inflation is below the Federal Reserve’s benchmark of 2%.  Energy and food prices can be volatile so the Fed uses what is called the “core” rate to get a feel for the underlying inflationary pressures in the economy.

The stronger U.S. dollar helps keep inflation in check.  There is less demand from other countries for our goods and the goods that we import from other countries are less expensive to Americans. .  Because the U.S. imports so much more than it exports, the lower cost of imported goods dampens inflation.  In effect, we “export” our inflation to the rest of the world.

When the economy is really, really good or very, very bad we set certain thresholds and compare the current period to those benchmarks.  When the financial crisis exploded in late 2008, the world fled to the perceived safety of the dollar in the absence of a exchange commodity of value like gold.  Because oil is traded in U.S. dollars and the U.S. is a stable and productive economy and trading partner, the U.S. dollar has become the world’s reserve currency.  The conventional way of measuring the strength of a currency like the dollar has been to compile an index of exchange rates with the currencies of our major trading partners.  This index, known as a trade weighted index, does not show a historically strong U.S. dollar.  In fact, since 2005, the dollar has been extremely weak using this methodology and only recently has the dollar risen up from these particularly weak levels.

As I mentioned earlier, a strong dollar helps mitigate inflation pressures; i.e. they are negatively correlated. When the dollar moves up, inflation moves down.  To show the loose relationship between the dollar index and a common measure of inflation, the CPI, I have plotted the yearly percent change in the dollar (divided by 4) and the CPI, then reversed the value of the dollar index.  As we can see in the graph below, the strengthening dollar is countering inflation.

What does this mean for investors?  The relatively strong economy allows the Fed to abandon the zero interest rate policy (ZIRP) of the past seven years and move rates upward.  A zero interest rate takes away a powerful tool that the Fed can employ during economic weakness: to stimulate the economy by lowering interest rates.

The strong dollar, however, makes Fed policy makers cautious. Higher interest rates will make the dollar more appealing to foreign investors which will further strengthen the dollar and continue to put deflationary pressures on the economy.  The Fed is more likely to take a slow and measured approach.  Earlier this year, estimates of the Effective Federal Funds Rate at the end of 2015 were about 1%.  Now they are 1/2% – 3/4%.  In anticipation of higher interest rates, the price of long term Treasury bonds (TLT) had fallen about 12% in the spring.  They have regained about 7% since mid-July.

DBC is a large commodity ETF that tracks a variety of commodities but has about half of its holdings in petroleum products.  It has lost about 15% since May and 40% in a year.  It is currently trading way below its low price point during the financial crisis in early 2009.  A few commodity hedge funds have recently closed and given what money they have left back to investors.  Perhaps this is the final capitulation?  As I wrote last week, there is a change in the air.

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Labor Report

Strong job gains again this month but labor participation remains low.  A key indicator of the health of the work force are the job gains in the core work force, those aged 25 – 54.

While showing some decline, there are too many people who are working part time because they can’t find a full time job.  Six years after the official end of the recession in the summer of 2009, this segment of the work force is at about the same level.

In some parts of the country job gains in Construction have been strong.  Overall, not so much.  As a percent of the work force, construction jobs are relatively low.  In the chart below I have shown three distinct phases in this sector since the end of World War 2.  Extremes are most disruptive to an economy whether they be up or down.    Note the relatively narrow bands in the post war building boom and the two decades from 1975 through 1994.  Compare that to the wider “data box” of the past two decades.

For several months the headline job gains have averaged about 225,000 each month.  The employment component in the ISM Purchasing Managers’ Index (on which the CWPI above is based) is particularly robust.  New unemployment claims are low and the number of people confident enough to quit their jobs is healthy.  The Federal Reserve compiles an index of many factors that affect the labor market called the Labor Market Conditions Index (LMCI).  They have not updated the data for July yet but it is curiously low and gives more evidence that the Fed will be cautious in raising rates.

Keynes, Income, Spending

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July 12, 2015

In the past few weeks, I have looked at savings and investment as forms of spending shifted in time.  Now let’s examine the idea of income.  We earn money, spend most of it, and hopefully save a little of it.

In the 1930s John Maynard Keynes proposed an income expenditure model to explain business cycles. (More here) Although Keynes’ model was mathematically simple by today’s standards, it showed an interlocking relationship between employment, interest rates and money.  Keynes popularized his ideas in lectures, debates and magazine articles.  Although he died shortly after World War 2, financial institutions and economic policies still bear his mark.  It was he who first proposed and then co-developed the framework for the International Monetary Fund (IMF) and World Bank.

One of Keynes many seminal insights was that one person’s income is another person’s spending.  If I decide to save $5 by not buying a latte at the neighborhood coffee shop, I am in effect putting my $5 in a savings account at my local bank.  But the coffee shop owner has $5 less in income.  $5 less in income is $5 less profit, keeping all else the same.  The owner of the coffee shop must go to the local bank and take $5 out of their savings account to make up for the lost income.  There is no net savings when a person decides to not spend money and we see the relationship between savings and profit; namely, savings = profit.

We are now ready to develop that insight of Keynes, that income = spending.  As we discussed in previous weeks, the amount that we don’t spend on current consumption is savings.  Savings = spending, either yesterday’s spending, i.e. an investment in someone’s debt, or tomorrow’s spending, i.e. an investment in someone’s future profits, or savings.  When we spend for tomorrow, we are effectively moving our savings into the future.  Likewise, when we spend for yesterday, we move our savings into the past to replace the savings that someone else did not have at the time they borrowed the money.

All of these categories – income, spending, saving, investment – are all forms of spending shifted in time.  Next week we’ll look at the GDP accounting identity and the government component of that equation.

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CWPI

The manufacturing sector stumbled during the harsh winter and strengthening dollar.  The service sectors fell somewhat but remained strong.  In June, the manufacturing sector regained strength, helping offset a slight slackening in the service economy.  The composite index remains strong in a several month growth trough.

Some are of the opinion that the stock market can be overvalued or undervalued.  In my opinion, liquid markets are usually fairly valued.  Expectations of buyers and sellers change, causing a recalculation of future growth and a change in valuations.  Comparing an index like the SP500 to a valuation model can help identify periods of investor optimism and pessimism.

I built a model based on a 930 average price of the SP500 in the 3rd quarter of 1997.  At the end of 2014, the 10 year total return of the SP500 was 7.67% (Source) which I used as a base growth rate modified by the change in growth shown by the CWPI index.  The CWPI measures a number of factors of economic growth but measures profits indirectly as a function of that economic growth.  Profit growth may outpace or lag behind economic growth and investors try to anticipate those varying growth rates when they value a company’s stock.

Until mid-2013, the SP500 lagged behind the model, indicating a degree of pessimism.  In 2013, the SP500 gained 30% and it is in that year that we see the crossover of investor sentiment from pessimism to optimism.  In the first six months of this year, the SP500 has changed little and we see the index drifting back toward the model, which was only 4% less than the closing price of the SP500 index at the end of June.

In hindsight, we can identify periods when investors were too exuberant and miscalculated future growth.  But we can only do so because in that future, profits and growth were not as hoped for.  That is the problem with futures.  We never know which one we are going to get.

Spring is springing

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May 10, 2015

CWPI

The dollar’s appreciation against the euro and other currencies in the first quarter of this year caused a natural slowdown in exports, which has hurt manufacturing businesses in this country.  U.S. products are simply more expensive to customers in other countries because dollars are more expensive in other currencies. The PMI manufacturing survey showed a decline in employment for the month.  The non-manufacturing sector, which is most of the economy, rallied in April.  As I noted last month, the CWPI should have bottomed out in March-April, reaching the trough in a wave-like series that has been characteristic of this composite index during the past six years of recovery.  Any change to this pattern – a continuing decline rather than just a trough – would be cause for concern.

April’s resurgence in the non-manufacturing sector more than offset the weakness in manufacturing. In fact, there was a slight gain in the CWPI from March’s reading.

Employment and new orders in the non-manufacturing sector are two key components of the composite index and leading indicators of movement in the index.  They have been on the rise since the beginning of the year.  While the decline in the overall index lasted 5 – 6 months, this leading indicator declined for only 3 months, signalling a probable rebound in the spring. Now we get some confirmation of the rebound.

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Employment

Released at the end of the week a few days after the PMI surveys, the monthly employment report from the BLS confirmed a renewal in job growth after rather poor job gains in March.  April’s estimated job gains were over 200K, spurring a relief rally in the stock market on Friday.  Gains were strong enough to signal that the economy was on a growth track but not so strong that the Fed would be in any rush to raise interest rates before September.

March’s job gains were revised even lower to below 100K, but the story was that the severe winter weather was responsible for most of that dip.  As the chart below shows, there was no dip in year over year growth because the winter of 2014 was bad as well.  Growth has been above 2% since September of last year.

During the 2000s, the economy generated plus 2% employment growth for a short three month stretch in early 2006, just before the peak of the housing boom.  The past eight months of plus 2% growth hearkens back to the strong growth of the good ole ’90s.  Like the 90s, Fed chair Janet Yellen warned this week that asset prices are high, recalling former Fed chair Alan Greenspan’s 1996 comment about “irrational exuberance.” Prices rose for another four years in the late 90s after Greenspan’s warning so clairvoyance and timing are not to be assumed simply because the chair of the Federal Reserve expresses an opinion.  However, history is a teacher of sorts.  When Greenspan made that comment in December 1996, the SP500 was just under 600.  Six years later, in late 2002, after the bursting of the dot-com bubble, a mild recession, the horror of 9-11 and the lead up to the Iraq war, the SP500 almost touched those 1996 levels.  An investor who had pulled all their money out of the stock market in early 1997 and put it in a bond index fund would have earned a handsome return.  Of course, our clairvoyance and timing are perfect when we look backward in time.

For 18 months, growth in the core work force, those aged 25 – 54, has been positive.  This age group is critical to the structural health of an economy because they spend a larger percentage of their employment income than older people do.

Construction employment could be better.  Another 400,000 jobs would bring employment in this sector to the recession levels of the early 2000s before the housing sector got overheated.

In the graph below, we can see that construction jobs as a percent of the total work force are at historically low levels.

Every year more workers drop out of the labor force due to retirement, or other reasons.  The population grows by about 3 million; 2 million drop out of the labor force.

The civilian labor force (CLF) consists of those who are employed or unemployed (and actively looking for work).  The particpation rate is that labor force divided by the number of people who can legally work, those who are 16 and over who are not in some institution that prevents them from working.  (BLS FAQ)  That participation rate remains historically low, dropping from 65% five years ago to under 63% for the past year.

That lowered rate partially reflects an aging population, and fewer women in the work force relative to the surge of women entering the work force during the boomer “swell.”  A simpler way of looking at things shows relatively stable numbers for the past five years:  those who can work but don’t, as a percentage of those who are working.  The population changes much more than the number of employed, and the percentage of those who are not working is rock steady at about 66%.  This percentage is important for money flows, the vitality of economic growth and policy decisions.  Those who are not working must get an income flow from their own resources or the resources of those who are working, or a combination of the two.

The late 90s was more than just a dot-com boom.  It was a working boom where the number of people not working was at historically low levels compared to the number of people working.  The end of the dot-com era and the decline in manufacturing jobs that began in the early 2000s, when China was admitted to the WTO, marked the end of this unusual period in U.S. history.  Former Secretary of Labor Robert Reich (Clinton administration) sometimes uses this unusual period as a benchmark to measure today’s environment.

Not only was this non-working/working ratio low, but GDP growth was rather high in the 1990s, in the range of 3 – 5%.

Let’s look at GDP growth from a slightly different perspective.  Real GDP is the country’s output adjusted for inflation.  Real GDP per capita is real GDP divided by the total population in the country.  Real GDP per employee is output per person working.  As GDP falls during a recession, so too do the number of employees, evening out the data in this series.  A 65 year chart reveals some long term growth trends.  In the chart below, I have identified those periods called secular bear markets when the stock market declines significantly from a previous period of growth.  I have used Doug Short’s graph  to identify these broader market trends.  Ideally, one would like to accumulate savings during secular bear markets when asset prices are falling and tap those savings toward the end of a secular bull market, when asset prices are at their height.

In the chart above note the periods (circled in green) of slower growth during the 1968-82 secular bear market and the last few years of the 2000-2009 secular bear market.  After a brief upsurge at the end of this past recession, we have continued the trend of slower economic growth that started in 2004.  A rising tide raises all boats and the tide in this case is the easy monetary policy of the Federal Reserve which buoys stock prices.  In the long run, however, stock prices rise and fall with the expectations of future profits.  Contrary to previous bull markets, this market is not supported by structural growth in the economy, and that lack of support increases the probability of a secular bear market in the next several years, just at the time when the boomer generation will be selling stocks to generate income in their retirement.

Earthquakes in some regions of the world are inevitable.  In the aftermath of the tragedy in Nepal, we were reminded that risky building practices and regulatory corruption can go on for decades.  There is no doubt that there will be  horrific damage and loss of life when the inevitable happens yet the risky practices continue.  The fault lines in our economy are slower per employee GDP growth and a greater burden on those employees to pay for programs for those who are not working. The worth of each program, who has paid what and who deserves what is immaterial to this particular discussion.  Growth and income flow do matter. Asset prices are rising on shaky growth foundations that will crack when the fault lines slip.  Well, maybe the inevitable won’t happen.

Easter Egg

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April 5, 2015

On this Easter Sunday, Christians celebrate the Resurrection of Jesus, Jews observe Passover, basketball fans await the final contest of the Final Four and baseball fans look forward to the start of the new season.  After Friday’s disappointing report of job gains in March, investors might be wondering what will happen Monday when markets in the U.S. reopen following Good Friday.  In overseas markets, yields on the 10 year Treasury bond fell on the employment news.  Job gains that were about half of expectations helped allay fears of a June rate increase.  We may see a positive response from both the bond and equity markets on Monday as the time table for rate increases might start in September.  On the other hand, the weekend might allow more rational judgment to prevail. One month’s disappointment does not a trend make.  Year over year gains in employment are especially strong.

April is usually a good month in the stock   market.  Since breaking the 2000 mark in August, the index has neither gained or lost much ground.  Gains in the technology companies that are included in the SP500 (Apple, for example) have been offset by losses in the oil sector of the SP500 (Exxon, Chevron, for example).  Long term Treasuries (TLT) have risen 10% in the past six months, despite the prospect of rising interest rates in 2015.

ICI reports that domestic long term equity mutual funds had an outflow of about $8 billion in March. Investors have not abandoned equity funds by any means but have changed focus. During this past month, $14 billion flowed into world equity funds.   Bond funds continue to post strong inflows – $10 billion in March.

The boomer generation amassed a lot of pension promises through their working years.  Pension funds must balance both equity and bond risk in their investment portfolios  and yet try to meet their assumed growth rates of 7% – 8%.  Caught on the horns of this dilemma, pension funds straddle both the equity and bond markets.  During the past ten years, many have become underfunded because they have not been able to match their projected growth rates.   This delicate balance of risk and reward sets the stage for a catastrophic decline in response to even a relatively small monetary shock because pension funds can not afford to wait out another three or four year decline.  Too many boomers will start cashing in those promises accumulated during the past decades.

The relatively low number of new jobs created in March was probably due to the severe winter in the eastern part of the country.  The BLS revised downward their previous estimates of employment gains in January and February.  Even with the downward revisions and this past month’s relatively anemic 126,000 gains, the average for the quarter is still about 200,000 per month, a particularly strong figure when one considers the impact that plummeting oil prices have had. In the first 3 months of this year, companies in oil and gas exploration have shed 3/4 of the jobs added during all of last year.  The strong dollar makes U.S. exports more expensive and hurts manufacturing.  The employment diffusion index in manufacturing industries dropped below 50, a sign that there is some contraction in the 83 industries included in this index.  However, March’s Manufacturing Purchasing Managers Index showed some slight expansion still and employment in manufacturing is still strong.  Across all private industries, the diffusion index remains strong at 61.4.

Fed chair Janet Yellen has repeatedly said that interest rate decisions will be based on data.  If the data of subsequent months show a resumption of strong growth, an interest rate increase at the FOMC meeting in late July could still be in the cards.  The CWPI composite built on the PMI anticipated a declining trend in growth this winter and spring before resuming an upward climb.  When the non-manufacturing  PMI is released this coming Monday, I’ll update that and show the results in next week’s blog.  Based on the numbers already released, I do anticipate a further decline in March then an evening out in April.  The particularly strong dollar  has cast some doubt on growth predictions, particularly in manufacturing. Both oil and the dollar have made sharp moves in the previous months and it is the rate of change which can be disruptive in an economy.

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Unemployment

New claims for unemployment were the lowest since the spring of 2000, just as the bubble of the dot-com boom began to deflate.  As a percent of those working, this is the third time since WW2 that new claims have reached these very low levels.  The last two times did not turn out well for the economy or the stock market.

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Oil

Going back through some old notes.  Here’s an October 2009 article where Deutsche Bank estimates the price of oil at $175 in 2016.  2009 was just about the time that newer techniques in horizontal drilling were being developed.  The fracking boom was just about to get underway.  Whether you are an investor or a second baseman, the future is tough to figure out so stay balanced, stay prepared and keep your knees bent.

Winter Wanders

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March 8, 2015

Labor Market

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

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

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

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

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

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

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

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

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

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

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

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

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Purchasing Managers Index

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

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

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