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.

The Market and Growth

March 2nd, 2014

Some pundits have made the case that the stock market is due to fall this year because of the almost 30% rise in prices in 2013.  On the face of it, it seems logical.  If the average rise in the SP500 over the past fifty years is about 8-1/2% and there is a 30% rise in one year, then the market has essentially “used up” more than three years of the average – all in one year.  But the stock market is the net result of billions of buy and sell decisions by human beings.  My experience has taught me that the connection between sense and the behavior of human beings is tenuous, at best.  The Red Carpet walk at the Oscars Award Ceremony is a demonstration of the nonsensical choices that human beings make.  I mean, can you believe the dress that actress is wearing?  And who told that actor he could grow a beard?  PUH-LEEZ!

So I looked at past history and wondered: what is the average yearly return of the SP500 index over the three years following a 20% rise in the market?  As an example, if the market rises 20% in Year #1, what is the 3 year average of yearly returns in Year #4?  The results surprised me – 9.5%.

But wait! you say.  The late nineties were an aberration of irrational exuberance that skews the average.  Removing those two outliers from the data set gives a yearly average of 6.2%.  Add in 2% dividends and the total comes to 8.2%, a respectable return.

But wait!, you say again.  What about the year after the 20% rise?  Surely, the index must compensate for the above average rise the previous year.  In the year after a 20% rise in the market, the average gain was 13.5%.  Again, there were those crazy years of the late nineties so I’ll take them out, leaving an average gain of 3.7%.  Add in the 2% dividend and it easily outpaces the current return on long term bonds.

This year the pundits could be right and the stock market falls.  However, a successful long term investor must learn to play the averages.


GDP and Savings

GDP is a measure of the economic output of a nation but what the heck is it?  A recent presentation by Gary Evans, an economics professor at Harvey Mudd College in California, has a number of wonderfully illustrated graphs that may help the casual reader understand the components of GDP and recent trends in the economy.

On January 30th, the Bureau of Economic Analysis (BEA) released their advance estimate of real GDP growth of 3.1% in the 4th quarter.  As more information of December’s slowdown became available in late January and early February, the market began anticipating that the BEA would revise their advance estimate down.  Slower growth might mean further declines in stock prices, right? Instead, the market anticipated that a slowing of growth in the fourth quarter would calm the hand of the Fed in tapering their bond purchases. As a result, the market  rebounded in February, more than making up for January’s decline.  On Friday, the BEA revised their second estimate of fourth quarter growth downward to 2.4%, almost exactly what the market consensus had anticipated and the market finished out a strong month with a small gain.  The BEA attributed the slower growth in the fourth quarter to reductions in federal, state and local government spending and a slowdown in residential housing.

As the BEA revises their methodology, they also revise previously published GDP data.  In the 2013 revision the BEA adjusted their data going back to 1929.  In the past few years, revisions have added about 1/2 trillion dollars to GDP.  Adjustments to the personal savings rate were substantially higher but savings in the past decade have been at historically low levels.  Personal savings are the amount of disposable income, or income after taxes, that families save.  The rate or PSR is the the percentage of their disposable income that they don’t spend.

When people charge purchases that decreases the savings rate.  Conversely, when families pay down their credit purchases that increases the savings rate.  Despite the explosive growth of household debt in the past thirty years,

the savings rate has remained positive, meaning that the people who do save are more than offsetting those who don’t or can’t save.

Let’s take an example of three families:  the Jones family makes $60K in disposable, or after tax income, saves nothing, but increases their debt $8,000 by buying a new car.  Their personal savings rate is $-8K/$60K, or -13.3%.  The Smith Family also has $60K in disposable income, but is frugal and pays down a few loans and saves some money for a total savings of $2K, or 3.3%.   The Williams family has a disposable income of $120K and has net savings of $20K, or 16.7%. Families with higher incomes tend to save proportionately more of that income.  Total disposable income for the three families is $240K.  Total savings is $14K, or 5.8% of disposable income, but that hides the fact that it is the Williams family that is making most of the contribution to that savings rate.

There is another subtle element contributing to this disparity in savings: inflation.  The Consumer Price Index charts the increasing prices of goods and services – spending.  A higher income family that spends less of its income is less affected by changes in the CPI than a lower income family and this helps a higher income family save proportionately more than the lower income family.  The difference is slight but the compounded effect over thirty years is significant.

During the past thirty years, the personal savings rate has steadily declined.

This doesn’t mean that families are saving less as a percentage of their income but that the number of families with net savings are becoming fewer while the number of families with little net savings or negative net savings are becoming more numerous.  The period from 1930 to 1980 was one of relatively more income equality than the period 1980 to the present.  Let’s look again at the chart above.  In the late 1970s, as income equality begins a decades long decline, so too does the personal savings rate.  The ratio of high income families with a relatively high savings rate to lower income families with a low savings rate also declines.

Savings drives investment in the future.  The low savings rate means that future U.S. economic growth must rely ever more on the savings from those in other countries.  Typically savings rates increase as a recession progresses and then the economy recovers.

Notice that the savings rate has stayed relatively steady in the past three years, indicating neither an increasing confidence or caution.  As shown in the table, only the three year period from 1988 – 1990 period showed the same lack of direction.  GDP growth in that period was stronger than it is today but the savings and loan crisis and the stock market crash of October 1987 had diluted the confidence of many.


New Home Sales
Here’s a head scratcher.  New home sales rebounded almost 10% in January, after falling 13% in December.  Even the figures for December were revised a bit higher.  As I noted last week, the rather flat growth in incomes has become an obstacle to the affordability of homes. December’s Case Shiller 20 city home price index reported a 13.4% annual increase in home prices. January’s rise in home sales was partially aided by sellers willing to make price concessions, resulting in a 2.2% decrease in the median sales price.


Durable Goods
Orders for durable goods, excluding transportation, were up about 1% this past month. A durable good is something which has a life of 3 years or more.  Cars and furniture are common examples. The year over year gain, a bit over 1% as well, indicates rather slow growth over the past year after adjusting for inflation.  However, several current regional reports of industrial activity indicate a quickening growth at the start of this year.  Reports from Chicago, Philadelphia and Kansas City hold promise that next week’s ISM assessment of manufacturing activity nationally will show a rebound.

As I have noted in blogs of the past few months, the pattern of the CWI index that I have been compiling since last summer indicated a rebound in overall activity in the early spring of this year.  This gauge of manufacturing and non-manufacturing activity is based on the Purchasing Managers Index released each month by ISM.  I suppose a better name for the CWI index would be “Composite PMI.”  Readers are welcome to make some suggestions.


New unemployment claims rose, approaching the 350K mark, but the 4 week average of new claims is holding steady at 338K.  In past winters the 4 week average has been around 360K.  If new claims remain relatively low during this particularly harsh winter in half of the country, it will indicate an underlying resiliency in the labor market.

Janet Yellen, the new chairwoman of the Federal Reserve, appeared before the Senate Finance Committee this week.  In her response to questions about the dual mandate of the Fed – inflation and employment – she noted that the Fed looks at much more than just the unemployment rate in gauging the health of the labor market.  One of the employment indicators they use is new unemployment claims.

When asked what unemployment rate the Fed considers “full employment,” Ms. Yellen stated that it was in the 5 – 6% range.  One of the Republican Senators asked about the “real” unemployment rate, without specifying what he meant by the word “real.”  Without hesitation and in a neutral tone, Ms. Yellen responded that if the Senator meant the “widest” measure of unemployment, the U-6 rate, that it was about 13%.  The U-6 rate includes discouraged workers and part time workers who want but can not find full time work.

When George Bush was President, “real” meant the narrowest measure of unemployment to a Republican because it was the smallest number.  With a Democrat in the White House, the word “real” now means the widest measure of unemployment to a Republican because it is the largest number.  Democrats employed the same strategy when George Bush was President, preferring the higher U-6 unemployment rate as the “real” rate because it was higher.  I thought that it would be a good response for anyone when confronted by a colleague at work about the “real unemployment rate” that we steer the conversation to more precise and politically neutral words like “widest” and “narrowest.”

A reader sent me a link to a Washington Post article on the pension and budget woes of San Jose, a large city in California.  I am afraid that we will see more of these in the coming decade.  Beginning in the 1990s politicians in state and local governments found an easy solution to wage demands from public workers: make promises.  Wages come out of this year’s budget; pension promises and retiree health care benefits come out of some budget in the distant future.  For an increasing number of governments, the distant future has arrived.

In Colorado, a reporter at the Denver Post noted that the Democratic Governor and the Republican Treasurer are hoping that the state’s Supreme Court will force the public employee’s pension fund, PERA, to open its books. It might surprise some that a public institution like PERA is less transparent than a publicly traded company.  Actuarial analysis estimates are that PERA’s asset base is underfunded by $23 billion, or about $46,000 for each retiree. It was only last year that the trustees of the fund reluctantly lowered its expected returns to 7.5% from 8%.  Assumptions on expected returns, what is called the discount rate, is a major component in analyzing the health of any retirement fund and the money that must be set aside today to pay for tomorrow’s promised benefits.  Many analysts contend that even 7.5% is a rather lofty assumption in this low interest rate environment.

Readers who Google their own state or city and the subject of pensions will likely find similar tales of past political promises and lofty assumptions running headlong against the realities of these past several years.

Housing and Stocks

February 23rd, 2014

The extreme cold in half of the country had a profound effect on housing starts which fell 16% in January.  Less affected by the weather are permits for new housing which slid 5%.

The Bible prescribes that every 50th year should be a Jubilee year, in which all debts are forgiven.  While this policy of redistribution of property might be a practical solution in a smaller tribal society, it is much less practical, even dangerous, in a complex economy.  By targeting a 2% inflation rate, central banks in the developed world engage in a type of gradual debt forgiveness.  Inflation incrementally shifts the real value of a debt from the debtor to the creditor.  At a 2% inflation rate, a debt is worth half as much in 35 years.

Let’s say Sam borrows $1000 from Jane at 0% interest and doesn’t pay her anything for 35 years, then pays off the debt.  The $1000 that Sam pays back in 35 years is only worth $500 in purchasing power.  Half of Sam’s debt has effectively been forgiven.  So why would Jane loan Sam any money?  She wouldn’t – not at 0% interest.  At that interest rate the loan is actually a gift.  Jane would need Sam to pay her an interest rate that 1) offsets the erosion of the purchasing power of the loan amount, the principal, and 2) compensates Jane for the use of her money over the 35 years.

Janes all over the world loan Sam the money and don’t want much interest.  The Sam in this case is Uncle Sam, the U.S. Government.  The loan is called a 30 year Treasury bond.  (Treasury FAQs )

If your name is just plain old Sam though, few people want to loan you money for thirty years, even if it is to buy a hard physical asset like a house.  That is why U.S. government agencies back most of the mortgages in the U.S., essentially funneling the money from around the world to ordinary Sams and Janes to buy housing.  Heck of a system, isn’t it?

The affordability of housing… 

In the metro Denver area, median household income was $59,230 in 2011, compared to the national median income of $50,054. (Source)  According to Zillow, the median home value in Denver is $253,700, or 4.3 times income.   Although Denver is a large city, it is not a megalopolis like New York City or Los Angeles. In Los Angeles, median home values are $491,000.  Median incomes in 2011 were $46,148, so that home values are more than ten times incomes.  Like other megaregions, Los Angeles has a huge disparity in housing and incomes, resulting in a median income that is skewed downward because of the large number of poor people that inhabit any large metropolitan area.  The L.A. Times ranks incomes by neighborhoods.  This ranking shows a median income in middle class areas at about $85K.  Using this metric, housing is still more than six times income.  Using a conventional bank ratio of .28 of mortgage payment to income, a household income of $85K will qualify for a monthly mortgage payment of almost $2K, which will get a 30 year, 4.5% fixed interest mortgage payment, including property taxes, of about $320K.  A 20% down payment of $80K brings the price of an affordable house to $400K, below the median value of $461K, meaning that many middle class Los Angelenos can not afford to live in a middle class neighborhood.

… acts as a constraint on home sales.

This week the National Assoc of Realtors reported a year over year 5% drop in existing home sales.  After rising more than 10% over the past year, prices have outrun increases in income.  While we don’t have median household income figures for 2013, disposable personal income actually declined in 2013 so we can guesstimate that household income was relatively flat as well.

As this year progresses, we may see other effects from the drop in disposable income.  Economists and market watchers will be focusing on auto and retail sales in the coming months.  January’s Consumer Price Index showed a yearly percent gain of 1.6%, indicating little inflationary headwinds.  An obstacle to growth is the difference between inflation and the weak growth in household income.


Minimum Wage

On Tuesday, the Congressional Budget Office released their estimate of the net effect of raising the minimum wage to either $9 or $10.10 from the current Federal level of $7.25 an hour.  Their analysis ranged from a minimal loss of jobs to almost a million jobs lost.  The average of this range, 500,000 jobs lost, became the headline number.  The CBO also noted that over 16 million low income workers would see an increase in income, enabling some to rely less on government aid programs.  Their projection was a slight increase in revenues to government.  A half million jobs is relatively small in a workforce of 150 million.  Some economists would concur that there is no clear evidence that raising the minimum wage has any effect on the number of jobs.  The science of economics is the study of complex human behavior in response to changes in our environment and resources.  Many times the data is not as conclusive as one might like, leading researchers to statistically filter or interpret the data according to their professional biases.

A 2013 analysis of minimum wage workers by the Economic Policy Institute indicated that the average age of minimum wage workers was about 35 years old.  Yet, 2012 data from the Bureau of Labor Statistics, the primary aggregator of labor force characteristics, does not support EPI’s conclusions – unless one includes workers who are exempt from minimum wage laws – like waiters – who are paid below the minimum wage law.  The BLS data shows that 55% of minimum wage workers are below 25 years old.

Too frequently, financial reporters who could summarize the caveats of a particular study either don’t bother or their work is left on the editor’s floor.  Many readers digest the headline summary without question and a difficult guesstimate by a government agency like the CBO is re-quoted as though it were gospel truth.


Manufacturing Rebound?
On the bright side, an early indicator of manufacturing activity in February showed a rebound from January’s decline.


Stock Market Dividends
As the market continues to rise, the voices of caution, if not doom, get louder.  Some analysts are permanent prophets of catastrophe.  Eventually they are right, the market sinks, they proclaim their skills of prognostication and sell more subscriptions to their newsletters.  Subscribers to these newsletters don’t seem to mind that the authors are wrong most of the time.

Last August, I wrote about the dividend yield – or it’s inverse ratio, the price dividend ratio – of the SP500 index using data that economist Robert Shiller compiles from a variety of sources.  The dividend yield of the SP500 index is currently 1.9%, meaning that for every $100 a person invested in the SP500 index, they could expect $1.90 in dividends.  The price dividend ratio is just the inverse of that, or $100 / $1.90 = 52.6. The current dividend yield is at the 20 year average.  I will focus on the dividend yield, or the interest rate that the SP500 index pays an investor.

It might surprise some investors that dividend information is available on a more timely basis than earnings.  In the aggregate,  dividends are more reliable and predictable.  Most companies have several versions of earnings and they massage their earnings to present the company in the best light.  On the other hand, most companies announce their dividend payouts near the end of each quarter so that the aggregate information is available to an investor more quickly than aggregate earnings.

Most portfolios contain a mixture of stocks and bonds so it is instructive to compare the dividend yield of the relatively risky SP500 with the yield on what is considered a perfectly safe bond – the 10 year Treasury.  Many investors think of these two asset classes as complementary – they are – but they are also in competition with each other. If the real dividend yield on stocks is the same as ten year Treasuries, it means investors in stocks want to be compensated for risking their principle on stocks.  If the interest rate on 10 year Treasuries is 4% and the  dividend yield of the SP500 is 2%, then the dividend ratio of stocks to Treasuries is 2% / 4%, or .5.  As investors perceive less risk in the stock market, this “demand for yield” from stocks will fall and the ratio will decline.   In the past, this ratio has reached a low of .19 in July 2000 as the stock market reached its apex of exuberance and investors became convinced that the rise of the internet and just in time inventory control had ushered in a new era in business.  Bill Gates, then CEO, Chairman  and founder of Microsoft, scoffed at dividends as a waste of money that could be better put to use by a company in growing the business. At the other extreme, this demand for yield ratio rose as high as 1.28 in March 2009 as stocks reached their lows of the recession.

More importantly is the movement of this ratio from peaks and troughs, indicating a change in sentiment among investors.  Note that the early 2003 market lows after the tech bubble burst were about the 50 year average of this ratio.  Compare that relative calm to the spikes of fear in this ratio since late 2007 to early 2008.  For the past 18 months, this demand for yield has declined but is still above the 50 year average.  There is still enough skepticism toward the stock market that it continues to curb exuberance.

Housing, Unemployment and CPI

January 19th, 2014

A strong retail report for December and an improvement in sentiment among small business owners buoyed the market at the start of the week.  Both reports continue a trend that indicates a healthy economy:  results are at at the upper bound or above expectations.

The latest report of  jobless claims at 325,000 pulled the 4 week average further down away from the psychological mark of 350,000.  This is sure to reassure short to mid term traders.  The weak BLS employment report released a week ago may have just been an anomaly.  Other employment indicators, as well as retail sales and business production simply do not confirm the headline numbers from the BLS.

The Consumer Price Index for December showed a mild 1.5% year over year increase and will reassure the Fed that its stimulus program poses little danger of igniting inflation.

The National Assn of Homebuilders reported continued strong growth in their Housing Market Index.

Featured on one of the blogs that I link to is a chart of the annual returns of the SP500.  Double digit gains in the index, like the one we had last year, are rather common, occurring about 40% of the time.  A reassuring takeaway for the longer term investor is that the market goes up in 75% of the years for the past eighty years.

The number of unfilled job openings in November was the highest since March of 2008, indicating continuing strengthening in the labor market.  Job openings have been above the ten year average for over a year now.

The number of people who voluntarily quit their jobs continues to climb over the past year.  Employees quit when they feel more confident about job prospects. While this metric has been improving, it is only at the lowest levels of the past decade.

Housing starts declined slightly in December to a million but is still growing from the lows of the bust.

Let’s get a bit of perspective. There is a decided shift downward from the post war building boom.  Below is a graph of  housing starts adjusted for population growth.

Adjusted for population growth, the multi-family component of housing starts has reached the normal levels of the past two decades.  This is the more stable component of housing starts.

Starts of single family homes have not yet reached the lows of past recessions.  The words “improvement” and “recovery” should be viewed in the context of these abysmal lows.

The Consumer Price Index (CPI) for December showed a year over year increase of 1.5%.  I believe this understates current inflationary pressures on consumers but it is the official rate, one that the Federal Reserve will use to guide policy.  The low rate will help allay fears that continuing stimulus will spur inflation in the near term.

Stock prices will be driven largely by earnings reports at this time.  About 10% of SP500 companies have reported this past week, too few to get a solid feel yet for the past quarter.  62% of companies have beat expectations, a bit less than the more normal 70%.  The market is largely trading sideways as it digests both the past quarter’s results and the forward guidance that companies give when they report.  IBM, Johnson and Johnson, and Verizon kick off this holiday shortened week when they report earnings on Tuesday. McDonald’s, Microsoft, Proctor and Gamble, and Netflix are due to report this week as well.  There don’t appear to be any significant market moving economic reports coming up this week.  Existing Home Sales on Thursday might have some minor impact and traders will be watching the continuing trend in new unemployment claims.

Year In Review

January 5, 2013  2014

The start of any year presents an opportunity for reflection on the past year as well as the upcoming one.  At the start of the year, few, if any, analysts called for such a strong market in 2013.  The S&P500 closed the year at 1850, a 30% gain. After a correction in May – June of this year, the index rose steadily in response to better employment data, industrial production, GDP increases, and the willingness of the Federal Reserve to continue  buying bonds and keep interest rates low.

I was one of many who were mildly bullish at the beginning of the year but got increasingly cautious as the index pushed past 1600.  Yet, month after month came not only positive or mildly positive reports but a notable lack of really negative reports.  Leading economies in the Euozone, teetering on recession, did not slip into recession.  Fraying monetary tensions in the Eurozone did not explode into a debt crisis.  China’s growth slowed then appeared to stabilize.  Although the attention has been on the Eurozone the past few years, the sleeping dragon is the Chinese economy, its overbuilt infrastructure, the high vacancy rate in commercial buildings in some areas of the country and the high housing valuations relative to the incomes of Chinese workers.

A year end review is an exercise in humility for most investors.  Some fears were unfounded or events unformed which confirmed those fears.  People are story tellers – stories of the past, imaginings of the future.  An investor who keeps all their money in CDs or savings accounts is predicting an unsafe investing environment for their savings.

Perhaps the best strategy is the one that John Bogle, the founder of Vanguard, advocates.  He doesn’t try to predict the future or be the best investor.  He aims for that allocation of stocks, bonds and other investments that, on average, forms a suitable mix of risk and reward for his goals, his age and the financial situation of his family.  He looks at his portfolio once a year.  I do think that a good number of individual investors had adopted the same outlook as Mr. Bogle advocates – until the 2008 financial crisis.

Since the financial crisis, too many investors have adopted a paralyzed strategy, a “deer in the headlight” reaction to the financial crisis that has been hugely unrewarding. Part of this year’s rise in the stock mark can be attributed to individual investors moving cash back into the stock market but I would guess that many of those investors are ready to pull it back out at the first sign of any trouble.  This shows less a confidence in the market but a frustrating lack of alternatives.

Long term bond prices took a significant hit in the middle of the year on fears of an impending rise in interest rates.  Bond prices had simply become too high, driving down the yield, or return, on the investment. Lower bond yields and meager CD and savings rates provided little return for investors, leaving many investors with little choice but to venture back into the stock market.

The Coincident Index of Economic Indicators remains level and strong.  A decline in this index below the 1% average growth rate of the population indicates the start of or an impending recession.

Note the index in 2002 – 2003 as it fell back, never rising above the 1% level.  I have written about this economic faltering before.  Much of the headlines were focused on the lead up to and start of the Iraq war.  The recovery from the recession of 2001 and 9-11 was very sluggish.  Fears that the country was entering a double dip recession similar to that of the early 1980s prompted Congress to pass the Bush tax cuts in 2003.  It was only the increased defense spending of 2003 that offset what would have been a decline in GDP and another recession.

A worrisome rise in new unemployment claims has puzzled some analysts.  Typically, new claims for unemployment decline at the end of the year, particularly in a year such as this one when reports of strong economic growth have been consistent.  Since 2000, rises in claims at the end of the year have been a cautionary note of things to come.  Mid-term investors and traders will be paying attention to this in the weeks to come.

However, the decline this year may be more of a leveling process that has been forming for most of the year.  On a year over year basis, the long term trend is down – which is up, or good.

In March 2013, I wrote “when unemployment claims go up, the stock market goes down … On a quarterly basis, this negative correlation has proved to be a reliable trading signal for the longer term investor.  When the y-o-y percentage change in new unemployment claims crosses above the SP500 change, sell.  When the claims change crosses below the SP500 change, it’s safe to buy. ”  The percent change in SP500 is still floating above the change in unemployment claims.

Sales of motor vehicles in November were above even the most optimistic expectations.  The ISM manufacturing index showed a slight decline but is still in strong growth mode and the already robust growth of new orders continues to accelerate.  The manufacturing component of the composite index I have been following since last June is at the same vigorous levels of late 1983 and 2003 when the economy finally breaks free of a previous recession.  I’ll update the chart when the non-manufacturing report is released this coming Monday.

In a healthy economy, the difference between real GDP and Final Sales Less the Growth in Household Debt (Active GDP) stays above 1%, which incidentally is the annual rate of population growth.  As the chart below shows, this difference dropped below 1% in late 2007.  Finally, six long years later, the difference has risen above 1%, indicating a healthy, growing economy.

And now a brief look at the year in review.

At the end of 2012, the price of long term bonds had declined slightly from the nose bleed levels of the fall but there was more to come.  I wrote “As this three decade long upward trend in bond prices begins to turn, bond prices can fall sharply as investors turn from bonds to stocks and other investments. We are approaching the lows of interest yields on corporate bonds not seen since WW2. Investors are loaning companies money at record low rates and companies are sucking up all that they can while they can. Sounds a lot like home buying in the middle of the last decade, doesn’t it?”

During the past year, long term bonds declined another 10%.  They seem to have formed a base over the past several months.  Intermediate term bonds are less sensitive to interest rate changes so they are the safer bet.  They lost about 6% in price over the past year.  Short term corporate bonds are a good alternative to savings accounts.  They pay about 1% above the average savings account and they usually vary very little in price so that the principal remains stable.

At the end of 2012, I wrote “the underlying fundamentals of the economy give reason for cautious optimism.” A month later, “As the saying goes, ‘The trend is your friend.’ When the current month of the SP500 index is above the ten month average, it’s a good idea to stay in the market.”  In January 2012, the monthly close broke above the 10 month average. This is a variation of the Golden Cross that I wrote about in January and February 2012.

Let’s look at this crossing above and below the 10 month average.    When this month’s close of the SP500 index crosses above the 10 month average of the index, it indicates a clear change in market sentiment.  I have overlayed the percent difference between each month’s close and the ten month average.

As you can see, the close near the end of December is near 10% above the 10 month average.  If the above chart is a bit too much information for you, here is a graph of the percent difference only.

Is the market overheated?  As you can see the market has sustained a robust (or some might call it exuberant) 10% for 6 – 9 months in 2003, 2009, and 2010-2011.  From 1994 to 1999, the market spent a lot of time in the 10% percent range. Some pundits are talking about this market as a bubble but we can see that this market has not penetrated the 10% mark.  At the end of January 2013, the market closed at more than 7% above it’s 10 month average, over the 4 year positive average of 5.6% (the average when the difference is positive).  The market is 20% up since then.

In March I introduced the “Craigslist Indicator,” the number of work trucks and vans for sale in a local area, as a gauge of the health of the construction industry.  It was a funny little indicator that indicated a growing strength in the construction industry at the beginning of the year.  Now for the amended version of the Craigslist Indicator: when there are a lot of older work trucks and vans advertised for sale on Craigslist, that indicates a robust construction market.


On March 24th, 2013 I wrote ” For the past year, the Eurozone has been in or near recession, yet some are hopeful that increased demand in this country and some emerging markets are helping to balance the contractionary influence of decreased demand in the Eurozone. Let’s hope that this surge in the first part of the year does not fade as it did in 2012.”  Instead, emerging markets began to contract and the Eurozone expanded slightly. Investors who bought emerging markets in March 2013 witnessed a more than 10% decline during the summer but the index ended the year at about the same level as nine months ago.

I thought that home prices in the early spring has reached a peak and wrote on March 31st, “The upturn in home prices is still above the trend line growth of disposable income and until personal income can resume or surpass a 3% growth rate, any rise in home prices will be constrained.” The Purchase Only House Price Index (HPIPONM226S) rose steadily throughout the year.
In late summer, I noted the falloff in single family home sales that began in the spring.  But prospective buyers were incentivized to make the deal as interest rates began to climb from their historically low levels.  Home sales surged upward; a lack of inventory in many cities also formed a support base that propped up prices.

A sobering note in September, “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.”

After a decline in the stock market in June, I wrote “For the long term investor, periods of negative sentiment can be an opportunity to put some cash to work.”  Although I took my own advice, I wished I had acted with more conviction.  Of course, if the market had declined 10%, I would have been patting myself on the back for my cautious stance.  Smiley Face!!

In July I noted the rather dramatic decrease in the value of securities held at the nation’s largest banks “Recently rising bond yields have contributed to banks’  operating profit margins but the corresponding value of banks’ bond portfolios has fallen quite dramatically.  This decline in asset value affects bank capital ratios, which makes them less likely to increase their lending … [and] will be an impediment to economic growth.”  The rising stock market and a respite in the decline of bond prices helped stabilize those portfolios in the second half of the year.

In September, I noted “Despite all the daily and weekly responses to political as well as economic news, the SP500 stock market index essentially rides the horse of corporate profits.”  Profits have more than tripled in the past ten years.  We should stay mindful of that stock price to profit correlation as we look out on the investment horizon.

From time to time I comment on the venality of our elected representatives.  Although they might appear to be idle rants to some readers, they are a caution.  Politicians make promises to get votes.  People become more dependent on those promises.  Inevitably, the day comes when the promises can not be met – as promised.  Those nearing or in retirement become increasingly dependent on political promises and should leave themselves a cushion – some wiggle room – if possible, when they make income and expense projections.  This Washington Post article on proposed budget cuts to military pensions is a case in point.  As long as “they” come for the other guy, we don’t pay too much attention – until they come for us.  Over the next ten to twenty years, we can expect many small cuts to promised benefits.  The cuts have to be small or target a small sector of the population so that they don’t anger voters too much.  In several blogs, I have shown how a simple recalculation of the Consumer Price Index eats away at the incomes of workers and retirees.  Expect more of these “recalculations” in the future as politicians follow a long standing tradition of making promises to win votes and bargain patronage to gather financial support for their campaigns.

We have the midterm elections to look forward to this year!  OK, calm down. Republicans will be hoping to take the Senate and make President Obama’s life miserable for the following two years.  I am guessing that the political campaigns for some Senate seats will vacuum in more money than the GDP of a lot of small and poor countries.

Employment Growth

December 29th, 2013

In several past blogs here and here, I have noted a “rule of thumb” guide to recessions based on the unemployment rate.  When the year over year percentage change in the unemployment rate goes above 0, recession smoke alarms go off.  Sorry, no phone app for this alarm. This metric sometimes indicates a recession that doesn’t quite materialize in the economic data, a false positive, although the market may react to the possibility of a recession.  Employment is but one factor in a complex economy and no one indicator can stand as a fail safe predictor of a serious enough decline in the economy that it gets labelled “recession” by the NBER.

Another related measure is the total employment level.  This employee count comes from the Establishment Survey conducted by the BLS and is the source for the monthly headline job gains or losses. To show the correlation between payroll and economic activity, I took a measure of GDP – I’ll call it active GDP – that excludes changes in business inventories and net exports.  From this I subtracted the change in real household debt in each quarter.  This measure of economic activity reflects what consumers can actually pay for.  Below is a chart of the yearly change in this adjusted measure of GDP and the number of people working.  There is a remarkable correlation.

As I will show below, the employment market has not fallen into an unsafe zone but the decline in growth of domestic demand indicates a fragility that should not be overlooked.  Comparing the number of people working to the 12 month average reveals trends and weaknesses in the economy.  Historically, when the number of workers falls below its 12 month average we are almost certainly in a recession.  As of now employment is maintaining a healthy but not robust growth rate.

When the difference between the monthly count of people working and its 12 month average (I’ll call it DIFF) falls below 1% (I’l call it WEAK), it shows a pre-recession weakness in the economy. In past decades, this DIFF might fall to .75% before recovering, a temporary weakness.  Since June 2000, employment growth has been in a WEAK state, never recovering above 1%.  Following the dot com bust in 2000, 2001 included an 8 month recession, the admittance of  China to the World Trade Organization and the sucking up of low skilled manufacturing jobs, and the horrific events of 9-11.  For two years the country endured a painfully slow and fitful recovery, prompting a Republican Congress to pass  what are called the Bush tax cuts.  Neither tax cuts or the overheated housing market of the mid 2000s could kick the DIFF above 1% although it got very close for a number of months in late 2005 and early 2006 as the housing market peaked.

When the DIFF falls below 500, we can mark fairly closely the beginnings and ends of recessions as they are called by the NBER many months later.

It is important to note that historical data is already revised data.  We must make investment decisions with the data available at the time. (See an earlier blog for some examples of revisions to payroll data.)

This week’s reports were generally better than expected.  These included durable goods orders, sales of new homes, personal income and spending.  Housing prices, as shown by the FHFA purchase only index, are maintaining an 8% year over year change.  Over the past quarter century, housing prices have followed a 3.2% annualized growth rate.

In previous blogs, I have examined the PCE inflation measure that routinely produces the lowest rate of inflation.  This is not the headline CPI index but is used to produce what is called a chain type price index.  Inflation estimates based on this indicator showed 0% inflation in November and less than 1% for an entire year.  Isn’t that great?  Rents, food, utility bills, insurances have barely increased over the past year.  Yes, I know you are ROFL until you realize that the joke is on you, on all of us.


Let’s get in the wayback machine and go back to early 2007 when the Bush administration released their estimate of GDP for the years 2007 – 2013.  Every Presidential budget indulges in the folly of predicting the future economic growth of the largest economy in the world.  When we dig into the figures, the process is rather simple.  These estimates simply take actual figures from 2006 and calculate 5% annual growth in nominal GDP.  Any of us could do this with an Excel spreadsheet.   An unemployment rate below 5% is rather infrequent and unlikely to continue for very long but the Bush Administration projected that this sub-5%level would continue for another six years.  If your 12 year old came to you with these calculations, you would probably praise them for their effort and smile inwardly at the innocence of the projections.  You wouldn’t tell your twelve year old that things don’t stay rosy indefinitely because they will find that out in due time.  This kind of middle school mentality is what passes for wisdom in Washington.

In the course of our lives, how many times do we come to a carefully calculated answer only to step back and say “Well, that can’t be.  Something’s wrong.”  It seems that there are few in Washington who doubt themselves.  The polarization in Washington means that everyone in any position of responsibility has many critics on the other side of an issue.  Each one then surrounds themselves with others who support their position, their values, their calculations.  There is no stepping back and saying, “Wait, is that right?” The revolving door in Washington ensures that many politicians have little to lose even if they lose their seats.  Many soon find an even more lucrative position in the private lobbying industry.  What they do lose is the ability to wake up in the morning, look in the mirror and say, “I’m important.”  Lose a bit of arrogance, gain a bit of humility.  Not such a bad tradeoff.

The investor who puts his own money at risk, who has skin in the game, as the economist Nassim Taleb calls it, can not afford to NOT step back and take a second look at their investment strategies and allocations.  As we complete another lap, this is a good time to recheck and rebalance.  The 25+% gains in the stock market have probably skewed the allocations of many an individual’s portfolio.  Here’s hoping everyone has a good year!

Investment Allocation and Housing

December 1st, 2013

While cleaning up some old files, I found a 1999 “Getting Going” column by Jonathan Clemens in the Wall St. Journal.  That year was rather turbulent, rocked by Y2K fears that the year 2000 might play havoc with older computers still using a two digit date,  and a intensifying debate about the valuation of stocks.  Looking away from the hot internet IPOs of that year,  Clemens interviewed several professors about the comparatively mundane subject of home ownership.

 “A house is not a conservative investment,” says Chris Mayer, a real-estate professor at the University of Pennsylvania’sWharton School. “Any market where prices can fall 40% in three years is not a safe investment.” 

Remember, this is 1999.  At that time, what 40% decline is he talking about?  It would not be till 2009 or 2010 that house prices tumbled down the hill.  In the past, declines of this magnitude were confined to particular areas of the country where a fundamental shift  in the economy occurred.  The Pittsburgh area of Pennsylvania, the Pueblo area of Colorado and the Detroit area of Michigan come to mind. In the first two examples the collapse of the steel industry had a profound effect on home prices as people moved to other areas to find work.  In case a homeowner thinks “it can’t happen here,” I’m sure many homeowners in Detroit felt the same way during the 1960s when the car industry was at its peak.

“William Reichenstein, an investments professor at Baylor University in Waco, Texas, suggests treating your mortgage as a negative position in bonds.”  

What does this mean?  Let’s say a person has $100K in stock mutual funds, $100K in bond mutual funds, owns a house valued at $200K with $100K still left on the mortgage.  Subtract the remaining balance of the mortgage from the amount in bonds and that leaves $0 invested in bonds.  Why do this?  When we buy a bond we are buying the debt of a company, or some government entity.  A mortgage is a debt we owe.  So, if a person were to pay off the mortgage, trading one debt for another, they would sell their bonds to pay off the mortgage.

Should the house be included in the investment mix?  There is some disagreement on this.  An investment portfolio should include only those assets which a person could access for some cash flow if there was a loss of income or some other need for cash.  An older couple with a 5 BR house who intend to downsize in five years might include a portion of the house in the portfolio mix.

For this example, let’s leave the house out of the investment portfolio to keep it simple. Using this analysis, this hypothetical person has 100% of their assets in stocks, not a 50/50 mix of stocks and bonds.

Now, let’s fast forward ten years from 1999 to 2009.  An index mutual fund of stocks has lost a bit more than 20%.

A long term bond fund has gained about 100%.

[The text below has been revised to reflect the above bond fund chart.  The original text presented numbers for a different bond fund.]

Let’s say the mortgage principal has been paid down $60K over those ten years.  Assuming that no new investments have been made in the ten year period, what is this person’s investment mix now?  The stock portion is worth $80K, the bonds $200K less $40K still owed on the mortgage for a total of $240K, with a net exposure in bonds of $160K.  The person now has 33% (80K / 240K) in stocks and 67% in bonds, a conservative mix.  If we didn’t account for the mortgage as a negative bond, the mix would appear to be 29% (80K / 280K) for stocks and 71% for bonds.  What is the net effect of treating a mortgage balance as a negative bond?  It reduces the appearance of safety in an investment portfolio.

Now let’s imagine that this person is going to retire and collect a monthly Social Security check of $1500.  To get a 15 year annuity paying that monthly amount with a 3% growth rate, a person would have to give an insurance company about $220K (Calculator)   There are a lot of annuity variations and riders but I’ll just keep this simple.  Throughout our working lives our Social Security taxes are essentially buying Treasury bonds that we start cashing out during retirement.

If we were to add $220K to our hypothetical investment mix,  we would have a total of $460K: $80K in stock mutual funds, $200K in bond funds, -$40K still owed on the mortgage, $220K effectively in Treasury bonds that we will withdraw as Social Security payments.  The $80K in stock mutual funds now represents only 17% of our investment portfolio, an extremely conservative risk stance.  If we have a private pension plan, the mix can get even more conservative.

The point of this article was that many people in their 50s and 60s may have too little exposure to stocks if they don’t account for mortgages, pensions and Social Security payments into their allocation calculations.


In October 2005, the incoming Chairman of the Federal Reserve, Ben Bernanke, indicated to Congress that he did not think there was a bubble developing in the housing market. (Washington Post Source)

In September 2005 – a month before – the Federal Reserve Bank of New York published a report on the rapid housing price increases of the past decade:

Between 1975 and 1995, real [that is, inflation adjusted] single-family house prices in the United States increased an average of 0.5 percent per year, or 10 percent over the course of two decades. By contrast, from 1995 to 2004, national real house prices grew 3.6 percent per year, a more than seven-fold increase in the annual rate of real appreciation, and totaling nearly 40 percent in one decade. In some individual cities, such as San Francisco and Boston, real home prices grew about 75 percent from 1995 to 2004, almost double the national average. 

Remember, these are real, or inflation adjusted prices.  Now it is easy, in hindsight, to go “ah-ha!” but it should be a lesson to us all that we can not possibly hope to consume all the information needed to mitigate risk.  There is just too much information.  A professional risk manager, Riccardo Rebonato, discusses common flaws in risk assessment in his book “Plight of the Fortune Tellers” (Amazon). Written before the financial crisis, the book is surprisingly prescient.  The ideas are accessible and there is little if any math.

On Monday, the National Assn of Realtors released their pending home sales index. These are signed contracts on single family homes, condos, and townhomes. The index has declined for five months but is still slightly above normal (100) at 102.1.  At the height of the housing bubble, this index reached almost 130.  At the trough in 2010, the index was below 80.

This chart was clipped from a video by an economist at NAR (Click on the video link on the right side of the page).  The clear and simple explanation of trends in housing and interest rates is well worth five minutes of your time.  Sales of existing homes have surpassed 2007 levels and are growing.

Demographia surveys housing in m ajor markets around the world and rates their affordability.  Their 2012 report found that major markets in the U.S. are just at the upper range of affordable.  As Canada’s housing valuations have climbed, their affordability has declined and are now less affordable than the U.S.  Britain’s housing is in the severely unaffordable range.

Next Friday comes the release of the monthly employment report.  I’ll also cover a few long term trends in manufacturing and construction employment that may surprise you.

Retail, Housing, The Fed And More

Last week I pointed to several contradictory outlooks for sales in the upcoming holiday season.  Bill McBride at Calculated Risk has several charts on the import and export volume at the port of Los Angeles.  The import data indicates that businesses were buying goods in late summer and the fall in anticipation of a good holiday season.  Both Home Depot and Best Buy reported better than expected earnings on Tuesday but Best Buy’s sales were less than expected.  The company cited increasing pressure from online retailers.  E-Commerce continues to take an ever increasing share of the retail sales market.

Amazon is now making more money selling other vendors’ products than it does its own.  Vendors typically turn over much of the sales, shipping and billing process to Amazon.  Businesses, including mine, are increasingly turning to Amazon for parts or supplies.  Why?  Amazon has become an easy to search portal for so many vendors and the prices are competitive.  Why spend time searching the web for long discontinued parts when Amazon has already done that?  What is even more surprising is the enormous volume of third party items that Amazon now stocks and, surprisingly, the items are received from Amazon, not the vendor.

On Wednesday, the monthly report of retail sales showed a .4% month on month gain, causing analysts at Morgan Stanley to reverse their earlier dour opinion of the coming holiday season.  The year over year gain is at 4% but retailers that target lower income consumers are experiencing some difficulties.  J.C. Penney reported sales and earnings that were disappointing.  After an earlier upbeat report from the home improvement chain Home Depot, Lowe’s reported strong sales and earnings, confirming the continuing strength in this sector.  Later in the week, Target issued a disappointing earnings report.  Will the ongoing decline in gas prices leave working class families with enough extra cash in their wallets this Christmas season?  Wal-Mart, Target and J. C. Penney hope so.

[Revised to clarify the two separate housing indexes below]

 October’s housing market index reading of 54 from the National Assoc of Homebuilders indicated continuing strength in the new home market.  This index is a composite of factors, including sales, inventory, builder expectations and traffic.  The series, like the industrial reports, is indexed so that 50 is the neutral mark, indicating no net growth.  Although the overall index has declined from the summer peak, both sales and expectations are in the strong to robust growth.

The Federal Housing Finance Agency tracks an index of home prices (only).  Major markets on both the east and west coasts are still below the bubble peaks of 2005 – 2006.

From 1983 to 1999, the average house cost 13 to 15 years worth of rent.  This baseline is a good rule of thumb when pricing out houses.  In 2006, at the height of the housing bubble, houses were selling for 25 years worth of the average monthly rental.  Los Angeles experienced a much greater price inflation during the 2000s than either SF or NYC.  Although the nationwide economy is growing steadily but slowly, Los Angeles has responded to the strong growth in manufacturing throughout the country. Asking rents for industrial properties in L.A. are rocketing upward this year, accelerating from the strong three year growth and exceeding the price levels of 2007.

http://www.loopnet.com/xNet/MainSite/Tools/WidgetHTML.aspx?WidgetType=50&CountryCode=US&StateCode=CA&State=California&CityName=Los+Angeles&SiteID=1&TrendTypeID=2&PropertyTypeID=40&ListingType=LEASE&PropertyType=Industrial&TrendType=Asking%20Rent Available Office and Industrial property in the LA area is at multi-year lows.


Los Angeles, CA Market Trends


The Consumer Price Index released Wednesday showed a tiny decrease in inflation for the month.  The year over year change was 1.7%, indicating that demand at many levels is positive but weak so that there is little pressure on prices.  On Thursday, the Producer Price Index (PPI) confirmed that the supply chain is experiencing very low upward pressure.


The PMI Flash Index, a preview of the upcoming report on the manufacturing sector, confirmed the continuing growth in the manufacturing sector.


The Job Openings and Labor Turnover Survey (JOLTS) by the BLS was released on Friday.  Unlike the timeliness of the monthly Employment report, this one lags by a month but does provide a more comprehensive analysis of the growth or decline in the labor market.  The BLS surveys employers at the end of the month, September in this case, for job openings and layoffs.  A job opening can be full time, part time, seasonal or temporary so the data can be skewed by seasonality factors.  The longer term trend, though, is apparent.

It may be several more years before job openings reach the level attained during the tech boom of the late ’90s.  Like the gold fever of the mid-19th century, investors poured money into a lot of ventures with little more than a napkin sized business plan.  This pattern of bubble and bust is fairly typical when game changing technologies emerge.  The spread of the telegraph and railroads led to horrific recessions in the late 19th century, culminating in the depression of 1893-94.  The rise of radio in the 1920s prompted speculative fever that contributed mightily to the crash of 1929, setting the stage for the bad monetary policy and haphazaard fiscal policies that fed the depression of the 1930s.  In the 1960s, a rush of investment in airlines and war funding helped fuel a frenzy of speculation that crashed in 1970.


In Washington this week, the Senate voted to change the rules for Senate confirmation of most executive and judicial appointments, the so called “nuclear option” that requires only a majority vote for confirmation.  This modification of the filibuster rule should have been done ten years ago when then Democratic Senate Minority Leader Tom Daschle led filibusters to block many of George Bush’s appointments.  Since then, the Senate has grown ever more dysfunctional, incapable of even ordering pizza.  Under the elitist filibuster rules, each Senator could act like a despot or one of the “Knights who say ‘Nee’!” in the comic movie “Monty Python and the Holy Grail.”  A Senator representing 300,000 people in Wyoming could nix or delay an executive appointment – this in a country of over 300 million. Sounds a bit like England in the 1770s. A lot of people died in the Revolutionary War so that America would not be a country ruled by a despot, be it a king or a Senator.


The rule change makes the confirmation of Janet Yellen as the next chair of the Federal Reserve a near certainty. In a speech at the Cato Institute’s Annual Monetary Conference, Charles Plosser, President of the Philadelphia branch of the Federal Reserve, made a good case for some restraint by the Federal Reserve – not in the amount of debt the Fed purchases but the type of debt:

“[The Federal Reserve’s] purchase [of] specific (non-Treasury) assets amounted to a form of credit allocation, which targets specific industries, sectors, or firms. These credit policies cross the boundary from monetary policy and venture into the realm of fiscal policy.”

Mr. Plosser would rather see politicians, not central bankers, decide which industries to favor through bailouts or loan purchases.  In a democratic republic like ours, if the politicians in Washington want to bailout banks or the housing sector, they can do so by issuing general debt obligations, Treasuries, which the Federal Reserve can buy.  Gridlock in Washington has prevented them from reaching any consensus about these policies, leaving it up to the Federal Reserve to act in their place, to make political decisions which compromises the neutral stance that a central bank should have.

Now, we might say that the result is the same so what’s the big deal?  Knowing that Fed chairman Ben Bernanke would come to the rescue has allowed politicians to not make difficult compromises.  Why should they?   If Congress does less, the Fed does more.  Because it can be so difficult to enact their agenda through the political process, Presidents and political parties turn to the Fed as the fourth branch of government.

Plosser also questions the dual target of both inflation and unemployment that the Fed has assumed as its mandate.  The law states that the Fed should enact monetary policy that is “commensurate” with the “long run potential to increase production.”  Since the recession began in 2008, the Fed has adopted a series of “QE” short term measures designed to decrease unemployment and Plosser’s view is that these are not part of the job description.  Plosser will be a voting member in 2014.  His vote of restraint is unlikely to hold much sway with Janet Yellen, who is ready to keep the cornucopia money machine flowing.


In the Wall St. Journal’s Washwire Blog, Elizabeth Williamson writes that the White House is conducting a self-assessment in the wake of the health-law launch, “recognizing that administration officials missed warning signs and put too much trust in their management practices.”   What on earth has given this administration any reason to trust their management practices?  Was it their management of the attack on the U.S. consulate in Benghazi in September 2012?  Or perhaps the “red line” that President Obama drew with Syria, promising a military response if Syria used chemical weapons against its own people?  Or the terribly mismanaged mortgage relief program, HAMP, that former Treasury Secretary Tim Geithner put in place?

This is only a partial list of the persistently poor management practices that have marked this administration.  It began with the poor preparation in advance of the March 2009 meeting with the nation’s largest banks, leading Obama and Geithner to offer generous terms to the banks when the banks would have accepted any terms in order to stay alive.  The crafting of the stimulus bill was an example of indecisive leadership and management at one of those rare times in history when both houses of Congress were controlled by the President’s party.  Using a basketball analogy, the administration blew a layup.

Now comes the news that the Obama administration wants to exempt some union health care plans from a “reinsurance tax” – about $63 per person per year – that all plans under the ACA health care law pay.  How will they do this?  By a carefully worded exemption that applies only to self-administered health plans.  A little background.  Many big companies self-insure and hire an administrator like Blue Cross to take care of the details.  Under the Taft-Hartley act passed after World War 2, employers often in the same industry may collectively construct or join what is essentially a health insurance trust, offering their employees insurance through the trust.  These plans are called “Taft-Hartley Multi-employer Health and Welfare Plans” and are really a benefit in the construction trade because they enable smaller employers to offer employees – usually these are unionized employees – a health plan at more affordable rates, taking advantage of the larger pool of insured offered by the trust.  It also enables employees to move from one company to another and retain their health insurance.  The plans are defined as self-administered even though the trust may contract out the details of daily management to a third party.   So here is a plan that fills a need and offers a benefit to both employers and employees.  Labor unions, like everyone else, want special treatment, of course, so they have been lobbying for an exemption from this rather small tax.  In September the Huffington Post reported that the unions were having little success in lobbying for another exemption – the ability of these plans to qualify for subsidies as though they were individual health care plans.

With a history of spineless leadership from an Obama administration that can’t say no but can’t say yes either, unions will continue to press for special treatment.  Finally, even they may get disgusted with an administration that can’t take a stand.

Like the Durango-Silverton narrow gauge train, the stock market chugs up the hill.  Production, sales and employment reports are either strong or not too bad or neutral but not bad.  Short, mid and long term volatility measures are subdued.  Gold has been drifting steadily down, nearing the lows of July.  Of course, some say that the time to get worried is when no one is worried.

The biggest worry for many in the coming week may be a dry turkey, or a heated discussion about politics.  Do pass the sweet potatoes if asked even if that so-and-so relative of yours is dumber than the potato.  Happy Turkey Day!

Shoot Out At the OK Corral

October 20th, 2013

This coming Saturday is the 132nd anniversary of the gunfight at the OK corral.  We got our own OK corral in Washington and there was a whuppin’ this week – a Washington style whuppin’, which means that no one got whupped but everyone agreed on an appointment date for a  future whuppin’.

Congress passes a continuing budget resolution with the same frequency that many of us get our teeth and gums cleaned.  Many government reports were not released this past week but the National Assoc of Homebuilders (NAHB) released a very positive monthly report of the national housing market, showing a slight decline over the past few months last month but still a strong index reading of 55.  Two years ago this October, that index stood at 15.  In fact since the latter part of 2007, the index oscillated in the range of 15 – 20, so this has been a strong and sustained growth surge.

Over the past hundred years, house prices have risen at about the same rate as inflation, so that the real price of homes stays about the same.  Most homeowners finance their home purchase and it is this interest cost that determines the total capital cost of the home.  That capital cost and the interest cost is divided over the life of the mortgage into monthly payments.  PITI is a familiar acronym to many home owners and buyers; the initials represent the components of a monthly house payment. The ‘P’ stands for Principal – the monthly capital cost of the home.  The ‘I’ is interest on the amount of the loan.  The ‘T’ represents the local real estate taxes which are included in the monthly house payment sent to the mortgage servicer who forwards them on to the local taxing agency. The ‘I’ represents Insurance.  This can be both house insurance and, for those with an FHA loan, the amount of the loan insurance.  The interest rate on the home loan is a key component and although there has been an increase in mortgage rates since the spring, they are near all time lows.  A 30 year mortgage is a common benchmark.

Let’s index the CPI and the house price index to 1991 and look at the divergence.

Declining interest rates have enabled many more people to qualify for a home purchase, thus driving up home prices. In 1995, Congress made some major revisons to the 1977 Community Reinvestment Act, making home loans more available in distressed urban and rural districts.  This further exacerbated the rise in home prices, creating a large divergence between the CPI and the housing price index.

As every homeowner knows, the cost of a home includes maintenance, repairs, utilities, and improvements.  As I discussed last week , real median household incomes plateaued during the 2000s.  The rise in home values and changes in banking laws enabled homeowners to tap the equity in their homes to meet these additional obligations and to augment stagnant incomes.

In the past dozen years, many people discovered that housing is not a reliable source of income.  At the turn of the century, stock traders who quit their jobs to trade stocks during the tech bubble, discovered the same truth about the stock market, whose price returns are a few percent above inflation.  A nifty calculator at  DQYDJ illustrates the average returns of the SP500 over the past 100 years.


At the heart of the financial follies of past centuries is that a surge in price for some asset, be it tulip bulbs, Florida real estate or tech stocks leads people to conclude that they can hop on the gravy train.  What is the gravy train?  As an asset increases in value, more people invest in the asset bubble, the valuation continues to rise and – for a time – it is possible to convert a stock, a store of value, into a flow of income by either buying and selling the asset or borrowing money against the asset.  There is always some constraint – the rise of inflation, or the rise of personal incomes, or the growth rate of profits – that eventually brings an asset valuation down to earth.  Einstein famously quipped that the most powerful force in the universe was compound interest.  He might have mentioned  what may be the most powerful force – reversion to the mean.