Category: housing starts

The Role of a Rule

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December 31, 2023

by Stephen Stofka

This week’s letter is about the role of a monetary rule and the guiding points that help the Fed steer its policymaking. Since the 2008-9 financial crisis, the Fed has purchased a lot of assets, increasing its balance sheet from less than one trillion dollars at the end of 2007 to almost $8 trillion this month. It has kept the federal funds rate that anchors all other interest rates near zero for ten of the last 15 years. The members on its board of governors serve 14 year terms, affording them an autonomy resistant to political influence. From those board members the President and Senate choose and confirm the Chair and Vice-Chair of the board. The governance structure allows them to set and follow a plan of steady guidance but their actions have resembled those of sailors steering against unpredictable winds. What are the guiding lights?

In the late 1950s, economists and policymakers enthusiastically endorsed the concept of the Phillips Curve. Picture an ellipse, a circle that has been stretched along one axis so that it appears like an egg.

Think of unemployment along the x-axis and inflation along the y-axis. More unemployment stretched the circle, shrinking inflation. More inflation stretched the circle in the y-direction, lessening unemployment. Policymakers could tweak monetary policy to keep these two opposing forces in check. In the 1970s, both inflation and unemployment grew, shattering economic models. Nevertheless, Congress passed legislation in 1978 that essentially handed the economic egg to the Fed. While the central banks of other countries can choose a single policy goal or priority – usually inflation – Congress gave the Fed a twin mandate. It was to conduct monetary policy that kept inflation steady and unemployment low – to squeeze the egg but not break it.

Mindful of its twin mission, the Fed later recognized – rather than adopted – a monetary policy rule, often called a Taylor rule after John B. Taylor (1993), an economist who proposed the interest setting rule as an alternative to discretion. The Fed would use several economic indicators as anchors in policymaking. The Atlanta Fed provides a utility that charts the actual federal funds rate against several alternate versions of a Taylor rule. I’ve included a simple alternative below and the actual funds rate set by the Fed. When the rule calls for a negative interest rate, the Fed is limited by the zero lower bound. Since the onset of the pandemic in March 2020, the Fed’s monetary policy has varied greatly from the rule. Only in the past few months has the actual rate approached the rule.

In a recent Jackson Hole speech, Chairman Powell said, “as is often the case, we are navigating by the stars under cloudy skies.” What are these guiding points that should anchor the Fed’s monetary policy? I’ll start with r-star, represented symbolically as r*, which serves as the foundation, or intercept, of the rule. Tim Sablick at the Richmond Fed defined it as “the natural rate of interest, or the real interest rate that would prevail when the economy is operating at its potential and is in some form of an equilibrium.” Note that this is the real interest rate after subtracting the inflation rate. The market, including the biggest banks, consider it approximately 2% (see note at end). This is also the Fed’s target rate of inflation, or pi-star, represented as π*. The market knows that the Fed is going to conduct monetary policy to meet its target inflation rate of 2%.

Why does the Fed set a target inflation rate of 2% instead of 0%? The Fed officially set that target rate in 1996. The 2% is a margin of error that was supposed to give the Fed some maneuvering room in setting policy. There was also some evidence that inflation measures did not capture the utility enhancements of product innovation. Thirdly, if the public expects a small amount of inflation, it adjusts its behavior so that the cost is so small that the benefit is greater than the cost (Walsh 2010, 276). Today, most central banks set their target rate at 2%.

The definition of r-star above is anchored on an economy “in some form of equilibrium.” How does the Fed gauge that? One measure is the unemployment rate and here we have another star, U-star, often represented as un, meaning the natural rate of employment. In 1986 Ellen Rissman at the Chicago Fed described it (links to PDF) as “the rate of unemployment that is compatible with a steady inflation rate.” So now we have both unemployment and the interest rate anchored by the inflation rate.

Another part of that r-star definition is an economy “operating at potential.” Included in the Fed’s interest rate decisions is an estimate of the output gap that is produced by economists at the Congressional Budget Office (CBO). The estimate includes many factors: “the natural rate of unemployment …, various measures of the labor supply, capital services, and productivity.” The CBO builds a baseline projection (links to PDF) of the economy in order to forecast the federal budget outlook and the long term financial health of programs like Social Security. Each of these factors does contribute to price movement but the analysis is complex. A more transparent gauge of an output gap could help steer public expectations of the Fed’s policy responses.

In a paper presented at the Fed’s annual Jackson Hole conference in Wyoming, Ed Leamer (2007, 3) suggested that the Fed substitute “housing starts and the change in housing starts” for the output gap in constructing a monetary policy rule. At that time in August 2007, housing starts had declined 40% from their high in January 2006. Being interest rate sensitive, homebuilders had responded strongly to a 4% increase in the Fed’s key federal funds rate. Despite that reaction, the Fed kept interest rates at a 5% plateau until September 2007. By the time, the Fed “got the message” and began lowering rates, the damage had been done. Six months after Leamer delivered this paper, the investment firm Bear Sterns went bankrupt. The Fed engineered a rescue by absorbing the firm’s toxic mortgage assets and selling the rest to JP Morgan Chase. Six months later, Lehman Brothers collapsed and the domino effect of their derivative positions sparked the global financial crisis.

I have suggested using the All-Transactions House Price Index as a substitute for the output gap. A long-term average of annual changes in this index is about 4.5%. The index is a summation of economic expectations by mortgage companies who base their loan amounts on home appraisals, banks who underwrite HELOC loans to homeowners and loans to homebuilders. The index indirectly captures employment trends among homeowners and their expectations of their own finances. Any change that is more than a chosen long-term average would indicate the need for a tightening monetary policy. Anything less would call for a more accommodative policy. Either of these housing indicators would be a transparent gauge that would help guide the public’s expectations of monetary policy.

Although the Fed considers the Taylor rule in setting its key interest rate, the rate setting committee uses discretion. Why have a rule only to abandon it in times of political or economic stress? The rule may not operate well under severe conditions like the pandemic. A rule may be impractical to implement. A Taylor rule variation called for a federal funds rate of 8% in 2021. This would have required a severe tightening that forced the interest rate up 7% in less than a year. The Fed did that in 1979-80 and again in 1980-81. Both times it caused a recession. The second recession was the worst since the 1930s Depression. An economy as large as the U.S. cannot adjust to such a rapid rate increase.

How strictly should a rule be followed? Some of us want rule making to be as rigid as lawmaking. A rule should apply in all circumstances regardless of consequences. Many Republican lawmakers felt that way when they voted against a bailout package in September 2008. Some of us regard a rule as an advisory, not a straitjacket constraint of policy options. Each of us has a slightly different preference for adherence to rules.

See you all in the New Year!

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Photo by Mark Duffel on Unsplash

Keywords: housing starts, house price index, stars, output gap, unemployment, interest rate, inflation

All-Transactions House Price Index is FRED Series USSTHPI. The annual change is near the long-term average of 4.5%, down from a high of 20% in 2022.

Housing starts are FRED Series HOUST. The output gap is a combination of two series, real GDP GDPC1, and real potential GDP, GDPPOT.

A gauge of long-term inflation expectations is the 10-year breakeven rate, FRED Series T10YIE. The 20-year average is 2.08%. The series code is T=Treasury, 10Y = 10 year, IE = Inflation Expectations. The T5YIE is a 5-year breakeven rate.

Leamer, E. (2007). Housing Is the Business Cycle. https://doi.org/10.3386/w13428

Taylor, J. B. (1993). Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy, 39, 195–214. https://doi.org/10.1016/0167-2231(93)90009-l

Walsh, C. E. (2010). Monetary theory and policy. MIT press.

Trends

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April 14, 2019

by Steve Stofka

In the current housing market, there are .4 new homes started for every 100 people, near century long lows. The Millennials (1981-1996) are now the largest generation in history but home builders are not responding to the population boom (Note #1). In the 1970s, home builders started triple that number of homes in response to the swelling number of Boomers coming of age.

Have you heard that there won’t be enough workers to support Social Security and Medicare payments for the retiring Boomer generation? Here’s the ratio of seniors to the core work force aged 25-54. Yes, it has gone up since the Financial Crisis.

Here’s the ratio of seniors to all workers. Each worker’s social security taxes are “funding” benefits for three seniors. The Social Security fund was never a separate fund, only an accounting gimmick that politicians enacted eighty years ago. As former Fed chairman Alan Greenspan explained, the federal government can continue to make payments to seniors (Note #2).

Have you heard that the interest on the debt is going to grow so large that it will crowd out all other spending? As a percentage of total expenses, it is at a low level.  Each year the federal government runs a deficit of about 2.4% (Note #3). Can it continue to do that indefinitely? Yes.

Each day we hear a lot of half-truths and outright lies. As the 2020 Presidential election gets nearer, half-baked versions of reality will grow like mold on bread. The Constitution was structured to encourage debate as an alternative to war among ourselves. The 1st Amendment guarantees everyone a right to spout half-truths and lies. Two dominant political parties compete for our belief in their version of the truth. This is the land of argument.

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Notes:

  1. Pew Research has redefined the Millennial generation as those born 1981-1996.
  2. YouTube video of Alan Greenspan explaining to Representative Paul Ryan that the Federal Gov’s checks are good
  3. The 80-year average of deficits is 2.4%. Not including debt for wars, it is 2.2%, per Steve Keen, author of Debunking Economics.

Wild Ride

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October 19, 2014

On Monday, Mabel met for lunch with several friends, both active and retired teachers, to celebrate a new inductee into the Million Mistake Club.  Mabel had once explained it to George, “It started a few decades ago when Mr. Densmore – he taught trigonometry at the school – commented one day in the break room that he had passed the two million mark.  He was probably in his late fifties, early sixties at that time. I had only a few years of teaching under my belt at that time and was still trying to get comfortable in the job.  Mr. Densmore – funny, I don’t think I ever called him by his first name and I can’t remember what it is right now – anyhow, he just seemed to flow so easily into the job.  It was like he wore the job as easily as he wore those old suit jackets he had.  Students that I had discipline problems with in my class behaved well in his class.  I was still trying to figure out the quiet command thing that can make or break a teacher.  He just seemed to make it all look so easy.  I asked him what the two million mark was.  He said it was the number of mistakes he had made in his lifetime.  It didn’t seem possible because it just seemed to me, being fairly new to the job, that he didn’t make any mistakes.  Well, except for his taste in clothes.  He would sometimes wear brown pants with a gray jacket which seemed to emphasize his age.  Mr. Densmore calculated that he made at least a hundred mistakes a day.  Joan – she taught sociology – said that no adult could survive if they made that many mistakes in a day.  Gary, the biology teacher, said that at the cellular level, our bodies probably made at least that many mistakes a day but we correct most of them before the mistakes turn into cancer or we get sick.”

Mabel had paused then, a catch in her throat. “Anyway, on my 28th birthday, several of the teachers, including Mr. Densmore, chipped in for a catered lunch.  Roast beef, some wonderful Italian pastries, potato salad, ice cream.” Mabel paused on her trip down memory lane.  “Security in the schools today.  Probably couldn’t have caterers come in without some planning weeks in advance.”  She went on with her story.  “Instead of wishing me a happy birthday, they inducted me into the million mistake club.  For the first time in my short career at the point, I felt like I was going to make it.  It changed how I taught.  I was no longer trying so hard to get everything just right.  I would discuss the wrong answers on tests with the students.  Why was it wrong?  No, Lee was not the general of the union army that won the battle at Gettysburg.  But what if Lee had been the general of the union army?  How did each army differ and so on.  The A students who were good at memorization stretched their imaginations, their analytical skills.  The C students started taking more interest in the class, participated more in discussion.  The stigma of wrong answers was less.  It became more about learning from our wrong answers.  I would occasionally take time to review episodes in the history of wrong answers, like phlogiston.”

“What’s that?” George asked.  “For a long time people speculated that it was the substance that caused things to burn,” Mabel responded.  “Wow,” George nodded.  “They didn’t know about oxygen yet.  You know, that’s the heart of risk assessment.  Learn from our mistakes.  The insurance business is just one long rocky path through mistakes in figuring out where the risk is, the degree of risk and how to reduce the risk.”

Monday was the Columbus Day holiday and there wasn’t much good economic news to stem the deepening pessimism in the market. Fears over the spread of Ebola just added to the darkening mood.  Mabel would be furious with him if they lost any more money so George sold the two remaining ETFs he hadn’t sold a week or so before.  If he had anticipated this pessimism, why hadn’t he bought an ETF that shorted the market?  The really good employment report in the beginning of October had made him less sure about his earlier forecast of lower prices.  Then he considered – again – buying the 20 Year Treasury ETF but everyone else had been doing that for the past ten days or so and the price was near $121 a share, up about 6% – 7% in the past few week.  Geez, George thought. The buying demand for safety has gotta slow down pretty soon.

Tuesday dawned brighter than Monday’s close but then came the release of a report  from the International Energy Agency forecasting that oil demand in 2014 would be 22% less than previously forecast.  Industrial production in the Eurozone was tepid.  George was surprised that the market finished near Monday’s close.  Maybe this was the end of the downturn in prices.  Like so many retail investors, George had probably sold at the bottom on the previous day.  Of little note to the world that day was the fact that George finally cleaned up the wasp nests above the door to the shed.  There were only two wasps buzzing around so George didn’t feel like a mass murderer.  Where did wasps go for the winter?

On Wednesday morning, George forgot to check the market or economic news before going out to clean up the rock garden.  With all of their money now in cash, George had turned his attention to his seasonal chores.  The climbing vine had shed most of it’s leaves.  The ash tree nearby had shed half of its leaves as well.  As George picked leaves out of the ground cover and other perennials in the garden, he wondered whether he should cut down the climbing vines.  He had planted them years ago to prevent the neighbor’s dog from jumping the fence during lightning storms in the summer.  The dog had died and the vines had spread.  Before lunch, Mabel came out onto the back deck. “George, honey.  The market is going crazy.”  “It’s OK,” George replied, assuring her, “we’re out of the market.”  “Oh,” the worry in her voice evaporated. “Well, just thought you’d want to know.”  Yeh, just wanted to let me know, George thought wryly. He wondered how many money managers had been fielding calls from clients who were worried about a meltdown like the fall of 2008. “Mrs. Jones, the SP500 is only down about 5 or 6 percent from its September peak,” they might tell their clients.  “But I heard that the Dow had dropped 200 points yesterday,” the client might say.  To older clients, anything more than 100 points was big. “Yes, but 200 points is just a bit more than 1%.  And remember, the Dow is only a part of the stock market.”  Yes, the firm is taking prudent care of your money, Mrs. Jones.   Put phone down.  Next phone call from another worried client.

Employment and retail sales are the top two economic reports that consistently set the tone of the market.  When the mood is pessimistic, it doesn’t take much negative news to send things into a tailspin. Wednesday’s retail sales report wasn’t bad but it wasn’t good.  Strong auto sales in August had led to expectations that total retail sales would decline in September.  The decline was just a teeny tiny more than expected, contributing to the wave of selling.  The core retail market without auto sales showed 3% year on year growth.

Part of the decline was because gas prices had been falling, producing less revenue.  What the market wanted to see was that the American consumer was taking that money saved on gas and spending it on back-to-school items, or a fall wardrobe.

The Census Bureau released manufacturing and trade sales data for August that showed a 4.5% year-over-year increase in sales but a 5.7% increase in inventories.  People were not buying as much as distributors were anticipating.  This only seemed to confirm fears that growth in consumer spending might be slowing down.  As though being routed by an opposing army, traders ran for the rear lines.  The SP500 dropped 4% by midday.  As George checked quotes on the SP500 ETF, SPY, he saw that it had climbed up from a bottom near 182.  He was tempted to put a buy order in, taking advantage of an afternoon rally.  Transportation stocks were bouncing up as well.  IYT, the iShares ETF, was bouncing off a midday bottom, indicating that money managers were buying in after the 14% decline from the mid-September highs.  Then George remembered that he had already tried his hand at these really short term trades.  From genius to dunce in a day, he had found that it was not good for him temperamentally.  Plus it took an hourly vigilance that he wasn’t willing to give.  One more report of Ebola in the U.S. could send this market into a dive within a few minutes. He closed the lid of his laptop.  By the end of the day, the Dow Jones had swung more than 600 points. After dropping about 4% during the day, the SP500 closed down only .7% from its previous day close.  Fresh troops in the rear had rallied at the end of the day.

Thursday’s release of October’s Housing Market Index from the National Assn. of Homebuilders showed a reversal of six months of rising sentiment.  More data from the Eurozone indicated that the entire region might be headed back into recession.  Sound the retreat alarm!  The market opened up about 1.5% lower.  Once again the troops in the rear pressed forward to the battle line as attention turned to several positive reports.

New claims for unemployment were near historic lows, prompting a discussion that had been missing for several years: when would unemployment get low enough to generate some wage growth?  George remembered Mabel’s Million Mistake Club earlier in the week.  Decades ago, unemployment levels below 5 or 5-1/2% were thought to be inflationary. This target level was called NAIRU, the Non-Accelerating Inflation Rate of Unemployment. At low levels of unemployment, workers could bargain for higher wages which pushed up the cost of products which pushed up prices which led workers to demand more wages, ad infinitum.  Like the “law” of gravity, this theory of unemployment and inflation had been regarded as solid by both investors and policy makers.  Theories are tested in the passage of time.  During the 1990s, unemployment dropped and did not spark inflation.  Economists scrambled to explain the phenomenon with global trade adjustments to their models. In the 2000s, unemployment fell below 5% and inflation remained tame by historic standards.  More adjustments to the models, more explanations of how the theory was still true. It is still a controversial topic.  (1998 article on NAIRU by Nouriel Roubini )

In addition to the positive employment news, Industrial Production grew in September, notching a 1% monthly gain, and rising back into the sustainable growth zone of 4 – 5%, year-over-year.

“Fix Bayonets, men!” came the call as the greenies beat back the morning onslaught from the reds. Greenies were days when the market closed higher than it opened, red the opposite.  George wondered if some set or prop designer for CNBC would come up with a Civil War soldier set for the talking heads to play with on camera when the market clash over valuation was particularly intense. As a kid, he’d been so disappointed that all the great battles like the Alamo had already been fought.  Santayana’s Mexican legions had rushed forward on the plains of Texas as the small band of brave Texans like Davey Crockett and Jim Bowie prepared for the onslaught.  The good ole days when life was exciting – and much shorter.

Friday was the last day of October option trading. The release of new Housing Starts for September, and strong earnings from G.E. and Morgan Stanley prompted a flood of buy orders at the opening bell on Friday.  The previous months housing starts had been volatile, rising up strongly in July, then falling a lot in August, and now up more than 6% in September.  On a year-over-year basis, September’s starts were up almost 18%.

George was not as awed by the housing data.  The declining peaks of year-over-year percent gains in new housing starts would probably continue.  Friday’s upswing continued shortly after the open when the latest consumer confidence numbers revealed a rising sentiment based on  improvements in employment and lower gas prices.  The price had crossed above both the open and closing prices for the past two days.  Could be a fake out but George hit the buy button. The earnings season would be in full swing next week.  

Housing and Bond Trends

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August 24, 2014

Housing

The week began with a bang as July’s Housing Market index notched its second consecutive reading of +50, growing a few points more than the 53 index of last month.  Readings above 50 indicate expansion in the market.  The index, compiled by the National Assn of Homebuilders, is a composite of sales, buyer traffic and prospective sales of both new and existing homes.  The index first sank below 50 in January and stayed in that contractionary zone for a few months before rising again in June and July.

Housing Starts rose back above the 1 million mark but the big gains were in multi-family dwellings.  Secondly, this number needs to be put in a long term perspective. We simply are not forming new households at the same pace as we did for the past half century.

After monthly declines in May and June, new home sales popped up almost 16% in July.  Existing home sales rose in July but have now shown 9 consecutive months of year-over-year decreases.

The number of existing home sales is at the same level as 1999-2000.  On a per capita basis, we are about 11-12% below the rather stable level of those years, before the housing bubble really erupted in the 2000s.

During the 1960s and 1970s, households grew annually by 2.1% (Census Bureau data).  That growth slowed to 1.4% in the 1980s and 1990s and has declined in the past decade to 1% per year.  During the 1960s and 1970s, the number of households with children headed by women exploded by over 3% per year, leading to a growing economic disparity among households.  During the 1980s, growth slowed but still hit 2.5%.  In the past two decades, this growth has stabilized at 1.2 to 1.3% per year, just a bit above the total rate of growth of all households.

The trend of slower growth in household formation shows no signs of changing in the near term.  We can expect that this will curtail any historically strong growth in the housing industry.  The price of an ETF of homebuilders, XHB, has plateaued since the spring of 2013.  The price has tripled from the dark days of 2009 but is unlikely to reach the formerly lofty heights of the mid-$40s anytime soon.

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Interest Rates

As the long days of summer wane and children return to school, central bankers gather in the majestic mountains of  Jackson Hole, Wyoming. Let’s crank up the wayback machine and return to those yester-years when fear and despondency continued to grip the hearts of many around the world.  In August 2010, the Chairman of the Federal Reserve, Ben Bernanke, announced that the Fed would continue to buy Treasuries and other bond instruments to maintain a balance sheet of about $2 trillion dollars, which was already far above normal levels. Bernanke hinted that the Fed would be ready to further expand the program should the economic recovery show signs of faltering. This speech would later be viewed as a pre-announcement of what would be dubbed QE2, or Quantitative Easing Part II, which the Fed announced in November 2010.  The promise of Fed support helped fuel a 30% rise in the market from August 2010 to the spring of 2011.

Like the announcement of a new pope, investors look toward the mountain and try to read the smoke signals rising up from this annual confab.  Financial gurus practiced at linear regressions and Bayesian probabilities struggle to  parse the words of Fed Chairwoman Janet Yellen. Did she use the word “likely” or “probably” in her speech? What coefficient of probability should we assign to the two words?  Did she use the present perfect progressive or the past perfect progressive verb tense?

Here’s the gist of Ms. Yellen’s speech – essentially the same gist that she has given in several testimonies before Congress:

monetary policy ultimately must be conducted in a pragmatic manner that relies not on any particular indicator or model, but instead reflects an ongoing assessment of a wide range of information in the context of our ever-evolving understanding of the economy.

Investors like simple forecasting tools – thresholds like the unemployment rate or the rate of inflation.  In 2012 and 2013, former chairman Ben Bernanke reminded investors that thresholds are benchmarks that may guide but do not rule the Fed’s decision making.  Ms. Yellen reiterated several points:

Estimates of slack necessitate difficult judgments about the magnitudes of the cyclical and structural influences affecting labor market variables, including labor force participation, the extent of part-time employment for economic reasons, and labor market flows, such as the pace of hires and quits….the aging of the workforce and other demographic trends, possible changes in the underlying degree of dynamism in the labor market, and the phenomenon of “polarization”–that is, the reduction in the relative number of middle-skill jobs.

 Each month I have encouraged readers to go beyond the employment report headlines, to look at these various  components of the labor market.  The Fed uses a complex model of 19 components:

This broadly based metric supports the conclusion that the labor market has improved significantly over the past year, but it also suggests that the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions.

Long term bond prices are at all time highs, leading some to question the reward to risk ratio at these price levels.  Prices took a 10% – 12% hit in mid-2013 in anticipation of a rate hike in 2014, indicating that investors are that jumpy. Since the beginning of this year, prices have risen from those lows of late last year.  Will 2015 be the year when the Fed finally begins to raise interest rates? Investors have been asking that question for four years.

Since the spring of 2009, 5-1/2 years ago, an index of long term corporate and government bonds (VBLTX as a proxy) has risen 65%.  From the spring of 2000 to the spring of 2009, a period of nine years, this index gained the same percentage.  Perhaps too much too fast?  Only time will tell.

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Takeaways

Housing growth will be constrained by the slower growth in household formation.  Further valuation increases in long term bonds seem unlikely.

How Much Is That Doggie In the Window?

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June 22, 2014

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

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GDP Growth Revised

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

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Fed Don’t Fail Me Now

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

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

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401K Retirement Plans

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

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Stock Market Valuation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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The P/E of Housing

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

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

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

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

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

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Takeaways

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

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

Home Sweet Home

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September 22nd, 2013

The monthly report of new housing starts was released Wednesday morning, the second day of a much anticipated meeting by Federal Reserve. On an annualized basis, builders started 891,000 homes, a 19% year over year increase. This figure includes both single family homes and apartment buildings. Starts were below expectations and may cause some Fed officials to postpone or soften their quantitative easing program.  (Note:  later that day, the Federal Reserve announced that they would not start tapering their bond buying program, a surprise that spurred a surge upward in the  stock market)

A 19% increase sounds great until we take a birds eye view of housing starts.

The 5 month average of housing starts has been declining since the spring. A decline in the volume of new homes sold is an early warning of recession.  Builders are motivated sellers and respond to changes in demand.  Because builders borrow money, called “bridge” loans, to manage their cash flow they are motivated sellers and respond more readily to changes in demand.

 

A common metric heard on the nightly news is the months supply of new homes for sale.  This is the inventory of new homes in a particular area.  More months is bad, less months is good but too little inventory puts upward pressure on prices.  New home inventory is low.

The months supply is a ratio of home sales to starts and can be misleading. The components of housing starts and sales tell another story.  Starts indicate confidence of builders in future home sales in their region. A thirty year graph of new one family homes started less one family homes sold shows a deep underlying caution among builders.  They got burned in this last downturn and are not sticking their necks out.

As the population grows, people need to live somewhere.  Below is the number of new privately owned housing starts per 1000 increase in the population.

This graph tells a different story than the usual “too many houses built” narrative.  The height of the 2000s boom was less than the heights of the 1970s and 1980s.  There were not too many houses being built but too many houses being bought by people who could not afford them.  Mortgage companies sold adjustable financing products designed to earn fees when homeowners refinanced every few years to avoid large interest rate increases.  Buyers were enticed by a hop-on-the-gravy-train mentality as housing prices rose dramatically, particularly in low income areas.

After the 2000 census, the Census Bureau summarized decades long shifts both in the type of housing and the characteristics of homeowners.   While there is a wealth of 2010 census data, I was unable to find a similar table that incorporated data from the recent census.  The Census Bureau notes that privately held housing starts do not include mobile homes, which grew to 7.6% of the housing stock in this country.   So the surge in housing per change in population of the 1970s and 1980s is understated.  This suggests that the new home market is not overbuilt but that people are less able or less willing to commit to owning a home than they were thirty and forty years ago.

Sales of existing homes, released Thursday, showed a recovery high of almost 5.5 million units on an annualized basis.  Realtors reported continuing strong demand in anticipation of rising mortgage rates.  The “churn” of existing homes is not a productive investment in and of itself since the home has already been built.  Sales in this category do generate fees for banks and realtors at the time of sale, and increased sales for Home Depot and remodelers as buyers remodel following the sales or sellers spruce up homes before they put them on the market.

The ratio of new spending per existing home is very small compared to the material and labor involved in building a new home.  The brisk pace of existing home sales does raise the valuation of existing homes, which leads people to feel that they are wealthier, which may induce them to loosen their purse strings.  Rising home values are good for those who own a home but increasing valuations make it that much more difficult for buyers trying to buy their first home.  People in their twenties and early thirties who are most likely to be first home buyers have been hit hard by the recession.

As the economy continues its muddling recovery and home prices rise, does this generation practice a stoic resignation as they look to the future?