Growth Periods

July 28, 2019

by Steve Stofka

Did you know that housing costs double every twenty years? The predictability surprised me. Both rents and home prices double. Based on the last forty years of data the average annual increase is about 3-1/2% (Note #1).

House prices can only get ahead of earnings for so long before a correction occurs. Take a look at the chart below. Yes, low interest rates reduce mortgage payments so people can afford more home. That’s what we said in the 2000s. This trend does not look sustainable to me.

I was doing some work on potential GDP and wondered which president since World War 2 has enjoyed the longest and strongest run of real (inflation-adjusted) GDP above potential. Potential GDP is estimated as a nation’s output at full employment.

I won’t start with the #1 award because that would be no fun. Nixon came in fourth place with a run of strong economic growth from 1971 – 1973. The oil embargo that followed the Arab-Israeli War of 1973 sent this country into a hard tailspin that ended that growth spurt.

Ronald Reagan comes in third with a cumulative total of 24.5% growth above potential GDP. The expansion began in the third quarter of 1983 and ran through the second quarter of 1986. These strong growth periods seem to last two to three years.

Second place goes to President Truman with a short (less than two years), sharp 25.2% gain that ended with the beginning of the Korean War.

And the award goes to…the envelope please…Jimmy Carter. Wha!!? Yep, Jimmy Carter. The growth streak began in 1976, the year Carter was elected, and ended in 1979 when Iran overthrew their Shah, oil production sank, and oil prices doubled. At its end, the expansion had totaled 25.5% above potential GDP. In less than two years, the nation soured on Carter and put Reagan in office.

What about other Presidential administrations? We might remember the late 1990s as a heady time of skyrocketing stock prices during the second Clinton administration. The output above potential was only 11.5% but is the longest period of strong growth, lasting almost four years, from the first quarter of 1996 through the last quarter of 1999.

George Bush’s growth streak was only slightly higher at 12.8% but is the second longest growth period, beginning in the third quarter of 2003 and ending in the last quarter of 2006. A year later began the Great Recession that lasted more than 1-1/2 years.

Barack Obama’s presidency began with the nation deep in a financial crisis. By the time he took office fourteen months after the recession began, the economy had shed 5 million jobs, 3.6% of the employed. Employment was more than 6 million jobs below trend. The economy did not start growing above potential until the first quarter of 2010. The growth period ended in the third quarter of 2012, but employment did not regain its 2007 pre-recession level until May of 2014, 6-1/2 years after the recession began. It is the weakest strong growth period of the post-WW2 economy.

President Trump’s streak of strong growth began in the last few months of Obama’s term and is still ongoing with a cumulative gain of 7.5%. Unlike other growth periods, this one is marked by steadily accelerating growth above potential.

I’ve charted the cumulative growth above potential and the period length for each president.

As the economy shifted away from manufacturing in the 1980s, the days of 20-plus percent growth ended. Manufacturing is more cyclic than the whole economy. The manufacturing sector contributes to strong growth in recovery and pronounced weakness at the end of the business cycle each decade. In the 1980s, economists and policy makers in both government and the Federal Reserve welcomed this shift away from manufacturing. They dubbed it the Great Moderation and it ended twenty years later with the Great Recession.

President Trump is on a mission to begin another “Great” period – the resurgence of manufacturing in America. It is a monumental task because manufacturing depends on a supply chain that is presently located in Asia. In 2013, Apple tried to manufacture and assemble its high-end computer, the Mac Pro, in Texas. Production faltered on the availability of a tiny screw (Note #2). Six years later, the Trump administration is levying 25% tariffs on Apple products to encourage them to manufacture computers again in Texas.

The widespread use of tariffs usually leads to fewer imports. As other countries retaliate, exports decrease. Slowing global growth poses additional challenges to repatriating manufacturing to this country. If Trump can realize his passion, we may again return to those days of heady growth and more severe business cycle corrections.



  1. The Case-Shiller home price index (HPI) for home prices. The Consumer Price Index’s rent of a primary residence.
  2. A NY Times account of Apple’s last attempt to manufacture in the U.S.A.

Grandma’s Kids

May 27, 2018

by Steve Stofka

The birth rate has touched a 30-year low, repeating a cycle of generational boom and bust since World War 2. The first boom was the Boomer generation born in the years 1946-1964 (approx). They were followed by the baby bust Generation X, born 1964-1982. The Millennials, sometimes called Generation Y and born 1982 – 2001, surpassed even the Boomers in numbers. Based on the latest census data, Generation Z, born 2002- 2020, will be another low birth rate cohort.

These numbers matter. They form the population tide that keeps the entitlement system afloat. Social Security and Medicare are “pay as you go” systems. Older generations who receive the benefits depend on taxes from younger generations for those benefits. As the population surge of Boomers draws benefits, the surge of Millennials is entering their peak earning years.

To maintain a steady population level, each woman needs to average 2.1 births. During the Great Recession, the birth rate for native-born Hispanic and Black women fell below that replacement level. White and Asian women fell below that level during the recession following the dot-com boom in the early 2000s. Foreign born Hispanic and Black women are averaging a bit more than 2-1/2 births. The average of foreign born White and Asian women is just about replacement rate.

Around the world, birth rates are falling. Social welfare programs depend on inter-generational transfers of income. When a smaller and younger generation must pay for a larger and older cohort, there is an inevitable stress.

I will distinguish between social welfare programs and socialist welfare programs with one rule: the former require that a person pay into the program before being entitled to the benefits from the program. In this regard, they are like insurance programs except that private insurance policies are funded by asset reserves held by an insurance company. Government “insurance” programs are “pay as you go” systems. Current taxes pay for current benefits. The Social Security “reserve” is an accounting fiction that the Federal government uses to track how much it has borrowed from itself.

Examples of social welfare programs that require the previous payment of dues are: Social Security, Medicare, Unemployment and Workmen’s Compensation Insurance. Although the latter two are paid directly by employers, they are effectively taken out of an employee’s pay by reducing the wage or salary that the employer pays the employee. Employers who fail to understand this go out of business early in the life of the business. I have known some.

Examples of socialist welfare programs that are based on income, or need: Medicaid, TANF (Welfare), WIC, Food Stamps, Housing and Education Subsidies. There is no requirement that a person pays “dues” into a specific program before receiving benefits.

Health care in America is primarily a social welfare program with socialist elements. The Federal government does subsidize all employer provided health insurance and most private insurance through the tax system or the Affordable Care Act. However, most beneficiaries must pay some kind of insurance to access benefits. Under the 1986 EMTALA act, emergency rooms are notable exceptions to this policy. They are required to treat, or medically stabilize, all patients insured or not.

As Grandma begins to draw benefits from Social Security and Medicare, she relies on the earnings of her kids who form the core work force aged 25 – 54. Grandma has paid a lifetime of dues into the social welfare programs and wants her benefits. Grandma votes.

Her grandkids want government subsidies for educational needs and job training. They depend on socialist welfare programs with no dues. The grandkids don’t vote.

The kids are caught in a generational squeeze.  Their taxes are paying for both their parent’s benefits and their kid’s benefits.


Housing Trends

In the spring of 2008, there was an eleven month supply of existing homes on the market.
2010 – 8-1/2 months
2012 – 6-1/2 months
2014 – 5-1/2 months
2016 – 4-1/2 months
2018 – 4 months

In some cities, a median priced home stays on the market less than 24 hours.

Here is another generational shift.  Grandma and Grandpa now own 40% percent of home equity, up from 24% in 2006. Their kids, the age cohort 45 – 60, own 45%. Those under 45 have only 14% of home equity, down from 24% in 2006.


Brave New World

E-Commerce is now 9.5% of all retail sales, almost triple the percentage ten years ago. (Fed Reserve series ECOMPCTSA). In 2000, the percentage was less than 1%.

Optical Illusions

May 12, 2018

by Steve Stofka

I have long enjoyed optical illusions. Is that a picture of a rabbit or a duck? Which way is the cube facing, right or left? (Some examples) Is that two people facing each other, or a vase? (Image page) These can be even more fun when shared with a friend or sibling. Can’t you see the rabbit? No, it’s a duck!!!

Moving images present a selective attention deception. When asked to count the number of basketball passes, we may not see the gorilla that walks across our field of view. (Video)

These examples excite our curiosity and fascination as children and carry important lessons for us as adults. We sometimes misinterpret the data our senses receive. Those with a strong ideological bent may focus narrowly on only that data that supports their view of the world, or that makes them feel comfortable.

Let’s look at an example. Real (inflation-adjusted) median (middle of the pack) household income peaked in 1999 at $58,665. In 2016, income climbed to $59,039. However, personal income did not peak till 2007, at $30,821. Like household income, personal income finally rose above that peak in 2016.


In the household series, the past twenty years have been especially tough. In the personal series, only the past ten years have been that difficult. What accounts for the difference in the two series? Households have grown faster than the population. Population Income / Households will be lower when households increase.

But what is income? Household income is money income received and does not include employer-provided benefits and retirement contributions (Census Bureau Defs). The BLS does track total compensation costs which do include these benefits, and those costs are 67% higher today than they were in 2001.


If an employer gave an employee $500 a month for health care expenses and the employee sent the money to the health insurance company, that would be counted as income in the data. But because the employer sends the money directly to the insurance company, that income is not counted. Because of World War 2 wage and price controls, and to avoid being taxed under the income tax system, most employee benefits never touch the employee’s pocket, and are not counted as income. This becomes important when something not counted, benefits, grows much quicker than the income that is counted, or money received.

Since 1970, real hourly wages have grown only 3%. Bernie Sanders and other Democrats use a similar figure to press for more social welfare programs. Total hourly compensation has grown 60% (Fed Reserve blog) and most of that is not included in household income.


Is it a rabbit or a duck?


Do Millennials have it worse than Boomers did at this age?

I’ll call them the Mills and the Booms, so I don’t wear out my fingers. The Mills were born about 1982-2001 so they are 17 – 36 years old today.  A decade after the worst recession since the Great Depression, home and apartment prices are rising fast in many urban areas.  Mills are now the largest generation alive and are at an age when a majority of  them are independent and increasing the demand for housing.

Some Mills are trying to provide shelter for their families when the competition for housing puts constant upward pressure on prices. Some Mills are paying off student loans, while paying $800 to $1000, or more in California, to share a 3 bedroom house with  two other people. It is stressful.

The Booms were born approximately 1946 – 1964. The youngest are 54; the oldest are 72. When the Booms were 17-36, the year was 1982, and oh, what a year it was. The Booms had just endured a decade of double-digit inflation rates (it is now less than 2%), four recessions, mortgage rates that were considered a “bargain” at 9% (4% today), and high housing and apartment prices because there was so much demand for living space from this post war baby boom.

Oh, and tax increases. Tax rates were not indexed for inflation till 1985, so higher wages each year to keep up with that double-digit inflation meant that many workers were kicked up into a higher tax bracket each year. One of Ronald Reagan’s campaign promises was to stop the sneaky practice of dipping deeper into worker’s pockets every year. He got elected President, beating President Jimmy Carter who had told workers to turn the heat down and put a sweater on.

How do today’s monthly debt payments compare? Household Debt Service Payments as a percent of disposable personal income are 5.8% today compared to 5.6% in 1982. The 37-year average is 5.7% (Federal Reserve).

What are those average debt service payments buying? Better cars, more education, more square footage of housing space per person, and computers and electronics that didn’t exist in the 1980s. People are paying more for housing but are enjoying 30% more square footage per person (Bloomberg). In 1982, 17% of the population 25 years and older had a college degree. Today, it is double that percentage (Census Bureau table A-1), an achievement that the Mills can be proud of.

The Mills do have it better than the Booms, who had it better than the generations before them. That “good old days” talk that we heard from Bernie Sanders on the campaign trail are based on some foggy memories. The reality was way tougher than Sanders remembers or talks about because his perception is clouded by his ideology. He only sees the data that tells him it’s a rabbit. He doesn’t see the duck.

Home Sweet Asset

April 3, 2016

Normally we do not include the value of our home in our portfolio.  A few weeks ago I suggested an alternative: including a home value based on it’s imputed cash flows.  Let’s look again at the implied income and expense flows from owning a home as a way of building a budget.  The Bureau of Labor Statistics and the Census Bureau take that flow approach, called Owner Equivalent Rent (OER), when constructing the CPI, and homeowners are well advised to adopt this perspective.  Why?

1) By regarding the house as an asset generating flows, it may provide some emotional detachment from the house, a sometimes difficult chore when a couple has lived in the home a long time, perhaps raised a family, etc.

2) It focuses a homeowner on the monthly income and rent expense connected with their home ownership.  It asks a homeowner to visualize themselves separately as asset owner and home renter. It is easy for homeowners to think of a mortgage free home as an almost free place to live. It’s not.

3) Provides realistic budgeting for older people on fixed incomes.  Some financial planners recommend spending no more than 25% of income on housing in order to leave room for rising medical expenses.  Some use a 33% figure if most of the income is net and not taxed.  For this article, I’ll compromise and use 30% as a recommended housing share of the budget.

A fully paid for home that would rent for $2000 is an investment that generates an implied $1400 in income per month, using a 70% net multiplier as I did in my previous post. Our net expense of $600 a month includes home insurance, property taxes, maintenance and minor repairs, as well as an allowance for periodic repairs like a new roof, and capital improvements.

Using the 30% rule, some people might think that their housing expense was within prudent budget guidelines as long as their income was more than $2000 a month.  $600 / $2000 is 30%.

However, let’s separate the roles involved in home ownership.  The renter pays $2000 a month, implying that this renter needs $6700 a month in income to stay within the recommended 30% share of the budget for housing expense.  The owner receives $1400 in net income a month, leaving a balance of $5300 in income needed to stay within the 30% budget recommendation. $6700 – $1400 = $5300.  Some readers may be scratching their heads.  Using the first method – actual expenses – a homeowner would need only $2000 per month income to stay within recommended guidelines.  Using the second method of separating the owner and renter roles, a homeowner would need $5300 a month income. A huge difference!

Let’s say that a couple is getting $5000 a month from Social Security, pension and other investment income.  Using the second method, this couple is $300 below the prudent budget recommendation of 30% for housing expense.  That couple may make no changes but now they understand that they have chosen to spend a bit more on their housing needs each month.  If – or when – rising medical expenses prompt them to revisit their budget choices, they can do so in the full understanding that their housing expenses have been over the recommended budget share.

This second method may prompt us to look anew at our choices.  Depending on our needs and changing circumstances, do we want to spend $2000 a month for a house to live in?  Perhaps we no longer need as much space.  Perhaps we could get a suitable apartment or townhome for $1400?  Should we move?  Perhaps yes, perhaps no.  Separating the dual roles of owner and renter involved in owning a home, we can make ourselves more aware of the implied cost of our decision to stay in the house.  A house may be a treasure house of memories but it is also an asset.  Assets must generate cash flows which cover living expenses that grow with the passage of time.


The Thrivers and Strugglers

“Bravo to MacKenzie. When she was born, she chose married, white, well-educated parents who live in an affluent, mostly white neighborhood with great public schools.”

In a recent report published by the Federal Reserve Bank at St. Louis, the authors found that four demographic characteristics were the chief factors for financial wealth and security:  1) age; 2) birth year; 3) education; 4) race/ethnicity.

While it is no surpise that our wealth grows as we age, readers might be puzzled to learn that the year of our birth has an important influence on our accumulation of wealth.  Those who came of age during the depression had a harder time building wealth than those who reached adulthood in the 1980s.

Ingenuity, dedication, persistence and effort are determinants of wealth but we should not forget that the leading causes of wealth accumulation in a large population are mostly accidental.  It is a humbling realization that should make all of us hate statistics!  We want to believe that success is all due to our hard work, genius and determination.



March’s job gains of 215K met expectations, while the unemployment rate ticked up a notch, an encouraging sign.  Those on the margins are feeling more confident about finding a job and have started actively searching for work.  The number of discouraged workers has declined 20% in the past 12 months.

Employers continue to add construction jobs, but as a percent of the workforce there is more healing still to be done.

The y-o-y growth in the core workforce, aged 25-54, continues to edge up toward 1.5%, a healthly level it last cleared in  the spring of last year.

The Labor Market Conditions Index (LMCI) maintained by the Federal Reserve is a composite of about 20 employment indicators that the Fed uses to gauge the overall strength and direction of the labor market.  The March reading won’t be available for a couple of weeks, but the February reading was -2.4%.

Inflation is below the Fed’s 2% target, wage gains have been minimal, and although employment gains remain relatively strong, there is little evidence to compel Chairwoman Yellen and the rate setting committee (FOMC) to maintain a hard line on raising interest rates in the coming months.  I’m sure Ms. Yellen would like to get Fed Funds rate to at least a .5% (.62% actual) level so that the Fed has some ability to lower them again if the economy shows signs of weakening.  Earlier this year the goal was to have at least a 1% rate by the end of 2016 but the data has lessened the urgency in reaching that goal.

ISM will release the rest of their Purchasing Manager’s Index next week and I will update the CWPI in my next blog.  I will be looking for an uptick in new orders and employment.  Manufacturing lost almost 30,000 jobs this past month – most of that loss in durable goods.  Let’s see if the services sector can offset that weakness.


Company Earnings

Quarterly earnings season is soon upon us and Fact Set reports that earnings for the first quarter are estimated to be down almost 10% from this quarter a year ago.  The ten year chart of forward earnings estimates and the price of the SP500 indicates that prices overestimated earnings growth and has traded in a range for the past year.  March’s closing price was still below the close of February 2015.  Falling oil prices have taken a shark bite out of earnings for the big oil giants like Exxon and Chevron and this has dragged down earnings growth for the entire SP500 index.

Investment Flows

October 18, 2015

When economists tally up the output or Gross Domestic Product (GDP) of a country, they use an agreed upon accounting identity: GDP = C + I + G + NX where C = Consumption Spending, I = Investment or Savings, G = net government spending, and NX is Net Exports, which is sometimes shown as X-M for eXports less iMports. {Lecture on calculating output}

In past blogs I have looked at the private domestic spending part of the equation – the C.  Let’s look at the G, government spending, in the equation.  Let’s construct a simple model based more on money flows into and out of the private sector.  Let’s regard “the government” as a foreign country to see what we can learn.  In this sense, the federal, state and local governments are foreign, or outside, the private sector.

The private sector exchanges goods and services with the government sector in the form of money, either as taxes (out) or money (in).  Taxes paid to a government are a cost for goods and services received from the government. Services can be ethereal, as in a sense of justice and order, a right to a trial, or a promise of a Social Security pension.  Transfer payments and taxes are not included in the calculation of GDP but we will include them here.  These include Social Security, Medicare, Medicaid, food stamps and other social programs.  If the private sector receives more from the government than the government takes in the form of taxes, that’s a good thing in this simplified money flow model. There are two types of spending in this model: inside (private sector) and outside (all else) spending.

Let’s turn to investment, the “I” in the GDP equation.  In the simplified money flow model, an investment in a new business is treated the same as a consumption purchase like buying  a new car.  Investment and larger ticket purchase decisions like an automobile depend heavily on a person’s confidence in the future.  If I think the stock market is way overpriced or I am worried about the economy, I am less likely to invest in an index fund.  If I am worried about my job, I am much less likely to buy a new car.  In its simplicity this model may capture the “animal spirits” that Depression era economist John Maynard Keynes wrote about.

We like to think that an investment is a well informed gamble on the future.  Well informed it can not be because we don’t know what the future brings.  We can only extrapolate from the present and much of what is happening in the present is not available to us, or is fuzzy.  While an investment decision may not be as “chanciful” as the roll of a dice an investment decision is truly a gamble.

Remember, in the GDP equation GDP = C + I + G + NX, investment (the I in the equation) is a component of GDP and includes investments in residential housing. In the first decade of this century, people invested way too much in residential housing.

In the recession following the dot-com bust and the slow recovery that followed the 9-11 tragedy, private investment was a higher percentage of GDP than it is today, six years after the last recession’s end.  Much of this swell was due to the inflow of capital into residental housing.

The inflation-adjusted swell of dollars is clearly visible in the chart below.  It is only in the second quarter of this year that we have surpassed the peak of investment in 2006, when housing prices were at their peak.

Investment spending is like a game of whack-a-mole.  Investment dollars flow in trends, bubbling up in one area, or hole, before popping or receding, then emerging in another area.  Where have investment dollars gone since the housing bust?  An investment in a stock or bond index is not counted as investment, the “I” in the equation, when calculating GDP.  The price of a stock or bond index can give us an indirect reading of the investment flow into these financial products.  An investment in the stock market index SP500 has tripled since the low in the spring of 2009 {Portfolio Visualizer includes reinvestment of dividends}

Now, just suppose that some banks and pension funds were to move more of those stock and bond investments back into residential housing or into another area?

A Lack of Giddyup

May 3, 2015

The first estimate of GDP growth in the January to March quarter was almost flat.  Not a big surprise given the severe winter in the eastern part of the U.S. but an annual rate of just .2% growth was lower than most estimates.  It would be a mistake to attribute all of the slow down to the weather.  Lower gas prices have delayed new drilling projects and idled more costly operations.  Some economists have not fully appreciated the positive influence that shale oil drilling has had on a tepid economic recovery.

Growth has not only slowed. It has shifted lower.  The Shiller P/E ratio, or CAPE, uses a 10 year period as a base.  A common measure of inflation expectations is the 10 year Treasury bond.  Let’s look at the change in real per capita GDP over rolling ten year periods starting in 1970.  Below I’ve graphed the logarithm, or log, of current GDP using the GDP 10 years ago as a base.  We can see a fairly consistent trend over forty years until 2008.

Some economists build models – partial derivatives – in which quantity of output fluctuates as a function of price, or F(p).  The thinking goes that price changes are part of a self-reinforcing mechanism. The problem is that price is a reaction to events, not a cause of them.  Prices distribute the effects of changes in supply, demand, and expectations in an economy or market.

The Fed believes that the economy has too much inventory – of savings, of caution.  Just as any store merchant would do, the Fed has lowered the price of savings, the interest rate, in the hopes that  customers will come in and borrow some of that savings.  Blue light special in Housing, Aisle 3!  The sale has been going on for almost seven years but demand in some sectors, particularly housing, is still very low.   The total of outstanding mortgage debt remains subdued no matter how much the price, or interest rate, is lowered.

Last week I showed a chart of new home sales per 1000 people.  I’ll overlay the thirty year mortgage rate over it.

Higher mortgage rates reduce the demand for new homes.  The exceptionally low rates of the past few years should accelerate the demand for new homes.  Let’s do a quick and dirty adjustment by multiplying new home sales by 1 + the interest rate.  This will have a greater effect on sales when interest rates are higher, helping offset the lowered demand.  The actual amounts are not relevant- it’s the comparison.  This chart shows the exceptionally low demand of the past several years.

The total of loans and leases has been growing about 2% annually on average since the end of 2008, from $7.2 trillion to $8.1 trillion, a total of a little over 12% during the period.  To put that in perspective, that total grew by 75% in the previous 6 year period 2003 through 2008, rocketing up from $4.1 trillion to $7.2 trillion.  Since 1995, our economy has shifted and has been running on borrowed money more than in past decades.  These loan totals don’t include the huge, no strike that, call it prodigious, government borrowing that has propped up GDP growth in the past dozen years.

The Fed finished its April meeting this week and decided to keep the fire sale going. “The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.” Fed statement 

Even if conditions do meet labor market and inflation targets, the Fed wants to make sure they can stay stable at those targets for a few months before taking action on interest rates.  The sale has been going on for so long now that the anxiety over the end of the sale has acted as a counter balancing force to the sale price.  Models of thinking as well as patterns of behavior are habit forming. One of the greatest scientists of all time, Isaac Newton, continued to believe in the principles of alchemy until he died.  Like other central banks, the Fed believes in the alchemy of interest rates, the price of money – that they can turn a leaden economy into gold.

New Home Sales Sink

April 26, 2015


A few months ago sales of new homes per 1000 people climbed above the low water mark set during the back to back recessions of the early 1980s.  In a more normal environment, new home sales would be closer to 800,000, not 500,000.

This past week came the news that new home sales fell more than 11% in March.  The good news is that they were up more than 10% over this month last year.  The supply of new homes is still fairly thin, less than half a year of sales, so builders are unlikely to slow the pace of construction.  As new home sales were climbing this winter, sales of existing homes – 90% of all home sales – languished.  The process flipped in March as existing home sales surged, up 10% year over year.


Long Term or Short Term

Somewhere I read that all investment or savings is a loan.  Loans are short or long term, principle assured or not.  When we deposit money in a checking or savings account, we are loaning the bank money, principle assured.  When we buy shares in an SP500 index mutual fund, we are loaning our hard earned money to “Mr. Market,” as it is sometimes called.  Principle not assured. We hope we get paid back with a decent rate of interest when we need to cash in our loan.  Most of us probably think that this type of investing is long term but, in this model, most stock and bond investments by individual investors are liquid, which is by definition short term.  Every month that a person leaves their money in a stock or bond fund, it is a decision to roll over the loan.  The value of our asset loan depends on the willingness of others to roll over their loans to that same asset market.  Occasionally many lenders to the stock and bond markets shift their concern from return on principal to return of principal and call in their loans.  When phrased this way, we come to understand the inherent fragility of our portfolios.

Because pension and sovereign wealth funds may carry a sizeable position in a market, the entirety of their position is not liquid.  Substantial changes in position will probably affect the price of the asset.  Even in a large position, however, there is a certain amount of liquidity because the fund can sell so many thousand shares of an asset without a material change in the price.  A family’s decision to leave their 401K money in a stock fund in any month, to roll over the loan, joins them at the hip with a sovereign wealth fund in Dubai or CALPERS, the California state employee pension fund.  They are all participants in the short term asset loan market.

In March 2000, at the height of the dot-com boom fifteen years ago, many investors were still loaning money to the NASDAQ market (QQQ).  This past month investors who had bought and held QQQ finally broke even on the nominal value of their loans.   The relatively small dividend payments over the years hardly compensated for the 27% loss of purchasing power during those fifteen years.  



Every facet of our culture seems to get a calendar month, so I guess April is tax month.  In that spirit, let’s look at some historical trends in income taxes.  In 2001, the Congressional Budget Office did an assessment of changes in Federal tax rates by income quintile for the years 1979 – 1997.   These are effective, not marginal, rates.  If someone makes $100K gross and pays $15K in Federal income tax, then their effective rate is 15%.

Effective corporate income tax rates went down for all quintiles while Social Security and Medicare taxes went up for those at all income levels.  The top 20% of incomes saw little change in their effective rates during this 19 year period, while everyone else enjoyed lower rates.  The reason why the top 20% saw little reduction was that their income grew faster than the incomes of those in the other quintiles.

The negative income tax rate for the lowest quintile was due to the adoption of the Earned Income Tax Credit and the increasing generosity of the credit given to low income families. (In 1979, a worker with three children received $1400 in 2012 dollars.  In 2012, they received $5,891, a 400% increase)


International Currencies

This graphic from the global financial nexus Swift com shows just how much the US dollar and the Euro dominate international trade.  For those of you interested in international currency wars, you might like this Bloomberg article.

Bank analyst Dick Bove thinks that it is unlikely that the Fed will raise interest rates this year.  The U.S. dollar has gained so much strength that a raise in interest rates has too many dangerous implications for other economies and would destabilize global trade.

A well written, informative and entertaining read is James Rickards’ Currency Wars (Amazon).  The author, a former CIA agent, weaves a coherent and interesting narrative that connects a lot of information and events of the past one hundred years.

Then and Now

January 25, 2015


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

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

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

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

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



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



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

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

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

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


Retirement Income

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

Employment, GDP and Construction

August 3, 2014


The employment report for July was moderately strong but below expectations.  Year-over-year growth in employment edged up to 1.9%, a level it first touched in March of 2012.

The unemployment rate ticked up a notch after ticking down two notches last month.  Notches can distract a long term investor from the underlying trend, which is positive.  Comparing the year-over-year percent change in the unemployment rate gives a good overall view of the economy and  the mid term prospects for the stock market.

There was some slight improvement in the Civilian Labor Force Participation Rate this month.  The decline in the participation rate has been worrisome.  When we view the unemployment rate as a percentage of the Civilian Labor Force Participation Rate, we do see a continuing decline in this ratio, which is positive.  From early 2002 to early 2003, the market continued its decline even after the end of a fairly mild recession.  Employment gains were meager, prompting concerns of a double dip recession. Should this ratio start to increase over several months, investors would be wise to start digging their foxholes.

Employment numbers can hide weaknesses in the labor market. After falling to a low of 7.2 million this February, people working part time because they can’t find full time work has climbed up 300,000 to 7.5 million.  The good news is that the ranks of involuntary part-timers has dropped by 700,000, or 8.5%, from July 2013 to this July.

Employment in service occupations makes up almost 20% of the work force and usually peaks in July of each year after a January trough.  The numbers come from the monthly survey of business payrolls so it affects the job gains number to some degree, depending on the seasonal adjustments.  I expected this month’s report to show the normal pattern, rising up at least 50,000 from June’s total of 26.54 million.  I was surprised to see that employment in this composite had dropped by 170,000 in July.

Unlike the majority of years, this year’s trough occurred in February, one month later than usual.  This may be weather related.  1998, 2003, 2005, 2011 were also years in which the trough occurred one month late. Over the past twenty years, the peak has always come in July – until this year.

Hourly wages have grown 2% in the past twelve months, meaning that there is no gain after inflation.  That’s the bad news.  The good news is that weekly earnings for production and non-salaried employees this July bested July 2013 earnings by 2.9%.


Auto Sales

July’s vehicle sales slipped 2.4% from June’s annualized pace of 16.9 million vehicles.  Robust vehicle sales are due in part to an increase in sub-prime loans, which have grown to 30% of new car loans.  A few weeks ago, the N.Y. Times published an article describing some auto loan application shenanigans.

The casual reader may not understand the significance of numbers in the millions so I created a chart showing numbers in the hundreds.  The manufacturing of cars is part of a broader category called durable goods.  If a 100 workers are employed making durable goods, we would like to see at least 11 of them making cars or parts for cars.  In a healthy economy, 5 people out of 100 buy a car or truck.  The chart below shows the relationship between the number of people buying cars and the percent of durable goods workers making cars.  The chart is a bit “busy” but I hope the reader can see that, despite talk of an auto bubble that could crash the market, the percent of the population buying cars is just barely above the minimum healthy level.

There may be a bubble in auto financing but not auto sales.  Secondly, a vehicle can be repossessed and resold much more easily than evicting a delinquent homeowner.



The first estimate of 2nd quarter GDP was 4% annualized growth, above the 3% consensus expectations.  Under the hood, we see that 1.7% of that 4% is a build up of inventories.  This mirrors the 1.7% negative change in inventories in the first quarter, as I noted in last month’s blog.  It is not a coincidence and should remind us that these are human beings making a first estimate of the entire economic activity of a country.

Let’s put this early estimate in perspective.  The year-over-year percent growth is 2.4%, above the 1.6% average y-o-y growth of the past ten years.  Let’s get out our magic wand and take away the recessionary four quarters in 2008 and two quarters in 2009.  Let’s add some good numbers in late 2003 and early 2004 as the economy recovered from the dot com boom period.  Presto chango!  Well, not so presto.  We see that the average over these 37 quarters, just a bit more than 9 years, is still only 2.3%.

From 1970 – 2007, the average is 3.1%, or almost double the 1.6% average of the past ten years.  The Federal Reserve and other central banks around the world have employed the tactics at their disposal to avert deflation and to spur lending.  While low interest rates and bond purchases have accomplished some of those goals, they have created some distortions in the markets, putting upward pressure on both equity and bond valuations.  Higher stock prices pressure companies to produce the profits – on paper, at least – that will justify the increased valuation.  In the past this has induced some companies to pursue a course of – an appropriate term might be “aggressive” accounting – to meet investor demands.

So this first estimate of GDP for the 2nd quarter is slightly above the magic wand average of the past decade and way above the real ten year average.  Not bad.  I’m guessing that the second estimate of 2nd quarter GDP, released near the  end of August, will be revised downward but even if it is, economic growth is better than average.


Construction Spending and Employment

Construction added 20,000 jobs in July, and are up 3.6% above July of 2013.  Total Construction spending includes residential and commercial buildings, public infrastructure and transportation. Spending in June declined almost 2% from a strong May but is up more than 5% from last year.  A casual glance at the spending numbers might lead one to observe that, after the housing boom and bust, the construction sector is on the mend.

The underlying reality is that further improvements in construction spending may be modest.  The chart below shows real, or inflation adjusted, per capita spending.  What was good enough in 1994 may be equally good in 2014 and beyond.

Residential construction has leveled off just slightly below what is probably a sustainable zone of $1200 to $1600 per person spending. At the height of the housing boom, per person spending was almost twice that of the midline $1400 per person.  Corrections to such severe imbalances are painful.

While many of us think that the boom was all in the residential sector, per person construction of public infrastructure had its own boom, growing almost 50% from the levels of the mid-90s.  Some economists and politicians continue to advocate more public construction as a Keynesian stimulus but we can see below that real per-capita public spending today is slightly more than the levels of the mid-1990s.

Spending on public infrastructure including highways helped buffer the downturn in residential construction.  As a percent of total construction spending, it is still contributing more than its share to the total.  If residential construction were just a bit stronger, this percentage would drop to a more normal range closer to 25%.

Workers in their thirties now came of age at a time when “normal” in the construction sector was far above normal. Policy makers grew to believe that this elevated level of spending was evidence of a strong economy.  They believed they were masters of the economy, ushering in a new normal of prudent fiscal policy that worked in tandem with assertive government policy to promote housing investment that would lift up those on the lower rungs of the economic ladder.

Today we don’t hear as much from those masters of economic and social engineering.  Their names include former Fed Chairman Alan Greenspan, former President George Bush, former Congressman Barney Frank, and current Congresswoman Maxine Waters.  Each of them might point to the mis-managers who helped pump up the housing balloon.  They include former Fannie Mae head Franklin Raines, and Kathleen Corbett, the former president of the ratings agency Standard and Poors which slapped a pristine AAA rating on the good and the bad. “Kathleen is an advocate of best practices, fiscal responsibility and effective management” reads Ms. Corbett’s page  at the New Canaan Town Council.

Then there are the crooks who knew what their companies were doing was dangerous, if not wrong. Topping that list is Angelo Mozilo, the head of Countrywide Financial, the largest originator of sub-prime loans.  “Crooks” is the term Mr. Mozilo once used to describe companies who wrote sub-prime mortgages.  If the suit fits, wear it.

A crook needs a fence to move the goods and there were two prominent ones in this side of the game: Dick Fuld, the former head of Lehman Bros, and Stan O’Neal, the former head of Merrill Lynch.  Both companies made a lot of sausage out of sub-prime mortgages.

Thank God that’s all behind us.  Hmmm, we said that after the savings and loan crisis of the late 1980s.  Well, thank God that’s all behind us till the mid-2020s, when we will repeat our mistakes.  A retiree should consider that during their retirement an episode of foolishness and downright dishonesty will likely have a serious impact on the value of their portfolio.



Continued strength in employment, with some weaknesses.  Estimate of 2nd quarter GDP growth probably a tad high.  Construction spending still just a bit below the historical per-capita channel of spending.

How Much Is That Doggie In the Window?

June 22, 2014

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


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.


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.


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.


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.


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.



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.