Place Your Bets

January 6, 2019

by Steve Stofka

This will be my tenth year writing on the financial markets. As I’ve written in earlier posts, we’ve been sailing in choppy waters this past quarter. In 2018, a portfolio composed of 60% stocks, 30% bonds and 10% cash lost 3%. In 2008, that asset allocation had a negative return of 20% (Note #1). We can expect continued rough weather.

If China’s economy continues to slow, the trade war between the U.S. and China will stall because a slowing global economy will give neither nation enough leverage. Will the Fed stop raising interest rates in response? If there is further confirmation of an economic slowdown, could the Fed start lowering interest rates by mid-2019? Ladies and gentlemen, place your bets.

Thanks to good weather and a strong shopping season, December’s employment reports from both ADP and the BLS were far above expectations (Note #2). Wages grew by more than 3%. Will stronger wage gains cut into corporate profits? Will the Fed continue to raise rates in response to the strong employment numbers and wage gains? Ladies and gentlemen, place your bets.

The global economy has been slowing for some time. After a 37% gain in 2017, a basket of emerging market stocks lost 15% last year. Although China’s service sector is still growing, it’s manufacturing production edged into the contraction zone this past month (Note #3). Home and auto sales have slowed in the U.S. What is the prospect that the U.S. could enter a recession in the next year? Ladies and gentlemen, place your bets.

The partial government showdown continues. The IRS is not processing refunds or answering phones. If it lasts one more week, it will break the record set during the Clinton administration. Trump has said it could go on for a year and he does like to be the best in everything, the best of all time. Could the House Democrats vote for impeachment, then persuade 21 Republican Senators (Note #4) to vote for a conviction and a Mike Pence Presidency? Ladies and gentlemen, place your bets.

When the winds alternate directions, the weather vane gets erratic. This week, the stock market whipsawed down 3% one day and up 3% the next as traders digested the day’s news and changed their bets. Interest rates (the yield) on a 10-year Treasury bond have fallen by a half percent since November 9th. When yields fell by a similar amount in January 2015 and January 2016, stock prices corrected 8% or so before moving higher. Since early December, the stock market has corrected by a similar percentage. Will this time be different? Ladies and gentlemen, place your bets.

Staying 100% in cash as a long-term investment (more than five years) is not betting at all. From a stock market peak in 2007 till now, an all cash “strategy” earned less than 1% annually. A balanced portfolio like the one at the beginning of this article earned a bit less than 6% annually. Older investors may remember the 1990s, when a person could safely earn 6% on a CD. Wave goodbye to those days for now and place your bets.

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Notes:

  1. Portfolio Visualizer results of a portfolio of 60% VTSMX, 30% VBMFX and 10% Cash
  2. Automatic Data Processing (ADP) showed 271,000 private job gains. The Bureau of Labor Standards (BLS) tallied over 300,000 job gains.
  3. China’s manufacturing output in slight contraction
  4. The Constitution requires two-thirds majority in Senate to convict an impeached President. Currently, there are 46 Democratic Senators and Independents who caucus with Democrats. They would need to convince 21 Republican Senators to vote for conviction to get a 67 Senator super-majority. 22 Republican Senators are up for re-election in 2020 and might be sensitive to public sentiment in their states.

Changing Dance Partners

October 14, 2018

by Steve Stofka

This week’s stock market activity helps us remember some simple rules of investing. Many of us confuse mass and weight. Mass is the resistance of an object to a change in speed or direction. Weight is the force of gravity on that object. Using this model, let’s compare the masses of stocks and bonds. On Wednesday, when stocks fell over 3%, the price of a broad bond composite barely moved.

Bonds act like a big cruise ship, more resistant to changes in wind and wave than a sailboat. The cruise ship’s progress is ponderous but predictable. Stocks behave like a sailboat which moves in a zig-zag fashion, changing directions to cope with wind and wave. Sometimes, the sailboat makes a lot of progress in calm waves with a favorable wind. November 2016 through January 2018 was one such period when stocks made steady progress.

On the previous Wednesday, October 3rd, a “rout” – a half-percent drop – in the bond market indicated a global unease. A half-percent move in the stock market occurs weekly. The last half-percent drop in the bond market was on March 1st 2017, eighteen months ago. Let’s look at that incident to help us understand the pattern.

BondStockMoves201703

Post-election, the stock market rose for three months, then plateaued for two weeks following that bond rout. Bonds drifted slightly lower and then, on March 15, 2017, charged higher by .6%. Within a few days, stocks lost 2-1/2%. On May 17th, bonds again surged, and stocks fell 2%.

The gigantic size of the bond market dwarfs the stock market. An infrequent daily shift in the pricing of the bond market signals a long-term recalculation of future risks and profits in both the bond and stock markets. When large shifts in the bond market happen frequently, stock investors should pay attention. Between Thanksgiving 2007 and the end of that year, the bond market experienced ten days of greater than 1/2% price swings! It signaled confusion and was a warning to stock investors that rough times were coming.

The bond market’s YTD price loss of 4% marks the probable end of a multi-decade bull market in bonds. The bond market is so stable that a small loss of 4% can mark the largest loss in decades.

We are seeing a change in dance partners. As an example, the stocks of high growth companies rose 20% from February lows. That was almost twice the gains of the SP500 broader market. Many of these are small and medium size companies whose growth is hampered by the greater cost of borrowing money in an environment of rising interest rates. The owners of growth stocks wanted to take some profits this past week but could not find buyers at those high prices. In the past week, prices of those stocks fell 8%. Cushioning the fall of some stocks is the large stockpile of cash – $350 billion – that U.S. companies have stockpiled for buybacks of their own stock. Some of that money was put to work in Friday’s recovery.

The U.S. stock market has been the one of the few bright spots in a global marketplace that has turned down this year. This week begins the reporting for the 3rd quarter earnings season so we may see more price swings in the days to come.

The Hunt, Part 2

July 22, 2018

by Steve Stofka

Last week, I showed the inputs to the credit constrained economy as a percent of GDP. I’ll put that up again here.

CreditGrowthFedSpendPctGDP

This week I’ll add in the drains but first let me review one of the inputs, bank loans. Focus your attention on that period just after 9/11, the left gray recession bar,  and the end of 2006, just to the left of the red box outlining the Great Recession on the right.  For those five years after 9/11, the banks doubled their loans to state and local governments, a surge of $1.4 trillion. The banks increased their household and mortgage lending by $5.3 trillion, or 67%. Why did banks act so foolishly? Former Fed chairman Alan Greenspan couldn’t answer that. We have a partial clue.

For 4-1/2 years after 9/11 and the dot-com bust, there was no growth in credit to businesses, a phenomenon unseen before in the data history since WW2. The banks reached out to households, as well as state and local governments because they needed the $1 trillion in loan business missing on the corporate side (#1 below).

There are four drains in the economic engine – Federal taxes, payments on loans, bad debts and the change in bank capital. State and local government taxes are not a drain because those government entities can not create credit. The change in bank capital reflects the changes in the banks’ loan leverage and their confidence in the economy. During the 1990s and 2010s the sum of the inputs and the drains remained within a tight range of about 1/7th of GDP.

InputLessDrains

The results of bad policy during the 2000s are shown clearly in the graph. In addition to the surge in bank loans, the Federal government went on a spending spree after 9/11. There was too much input and not enough drain. The reduction in taxes in 2001 and 2003 exacerbated the problem. There was less being drained out. Asset prices absorb policy mistakes until they don’t – a life lesson for all investors.

Let’s add in a second line to the graph – inflation. The rise and fall of inflation approximates the flows of this economic engine model with a lag time of several months. I’ve shown the peaks and troughs in each series.

InputLessDrainsVsPCE

Look at that critical period from 2006 through 2007. The Fed kept raising rates in response to rising inflation (the red line), driven primarily by increases in the price of oil.  The Fed Funds rate peaked out at 5-1/4% in the summer of 2006 and stayed at that level for a year. The Fed misread the longer term inflation trend and contributed to the onset of the recession in late 2007. The net flows in the engine model (blue line) indicated that the long term trend of inflation was down, not up.

Where will inflation go next? Using last week’s theme, follow the hounds! Who are the hounds? The banks. The inflow of credit from the banks is the primary driver of inflation. Why has inflation in the past decade been low? Because credit growth has been low. Where will inflation go next? A gentle increase – see the slight incline of the blue line at the right of the graph. Contributing to that increase were last year’s tax cuts. Less money is being drained out of the engine.

Too much flow into the economic engine or an improper setting of interest rates – these mistakes are absorbed by assets, which are the reservoirs of the engine. Stocks, bonds and homes are the most commonly held assets and most likely to be mispriced. During the early to mid 2000s, the mistakes in input were so drastic that the financial crisis seems inevitable when we look in the rear view mirror. During the past eight years, the inputs and drains have remained steady, but interest rates have been set at an inappropriate level. Again, we can anticipate that asset prices have been absorbing the mistakes in policy.

 

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1. In the last quarter of 2001, loans to non-financial corporate business totaled $2.9 trillion and had averaged 6%+ growth for the past decade. Anticipating that same growth would have implied a credit balance of $3.9 trillion by the end of 2006. The actual balance was $3.1 trillion.

Hunt For Inflation

July 15, 2018

by Steve Stofka

Saddle up your horses, readers, because we are going on the Hunt for Inflation. I promise you’ll be home for afternoon tea. During this recovery, Inflation has been a wily fox, a real dodger. It has not behaved according to a model of fox behavior. Has Inflation evolved a consciousness?

Inflation often behaves quite predictably. The central bank lowers interest rates and pumps money into the economy. Too much money and credit chasing too few goods and Inflation begins running amuck. Tally-ho! Unleash the bloodhounds! The central bank raises interest rates which curbs the lending enthusiasm of its member banks through monetary policy. Inflation is caught, or tamed; the bloodhounds get bored and take a nap.

Not this time. Every time we think we see the tail of Inflation wagging, it turns out to be an illusion. Knowing that Inflation must be out there, the central bank has cautiously bumped up interest rates in the past two years. Every few months another bump, as though unleashing one more bloodhound ready to pounce as soon as Inflation shows itself.

Yes, Inflation has evolved a consciousness – the composite actions of the players in the Hunt. These players come in three varieties. One variety is the private sector – you and me and the business down the street. The second variety is the federal government and its authorized money agent, the Federal Reserve, the country’s central bank. Finally, there is a player who is a hybrid of the two – banks. They are private but have super powers conferred on them by the federal government. The private sector is the economic engine. The federal government and banks have inputs, drains and reservoirs that control the running of the economy.

The three money inputs into the constrained (see end) economy are 1) Federal spending, 2) Credit growth, and 3) net exports. In the graph below, the blue line includes 1, 2, and 3. The red line includes only 1. The graph shows the dramatic collapse of credit growth in this country. Federal spending accounted for all the new money flows into the economy.

CreditNXFedSpendvsFedSpend

Before the financial crisis, money flows into the economy were just over 30% of GDP. In less than a year, those inputs collapsed by almost 25%.

CreditGrowthFedSpendPctGDP

When inflation is lower than target, as it has been for the past decade, too much money flow is being drained out for the amount that is flowing in. In the case of too high or out of control inflation, as in the case of Venezuela, the opposite is true. Too much is being pumped in and not enough is being drained out. That’s the short story that gets you back to the lodge in time for a cup-pa or a pint. Next week – the inputs, drains and reservoirs of the economy.

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  1. Constrained – the private economy, state and local governments who cannot create new credit.
  2. Net exports are the sum of imports (minus) and exports (plus).

Lots of Changes

March 25, 2018

by Steve Stofka

What a week it was. A glance at the headlines would lead someone to believe that it was all about tariffs and an impending trade war between the U.S. and China. On Thursday and Friday, the Dow Jones Industrial Average lost more than 1000 points, or almost 5%. Was that all about tariffs? Hardly.

As expected, the Federal Reserve raised interest rates ¼% on Wednesday.  This put the Fed rate at 1.5% – 1.75%. Half of the members of the interest setting committee (FOMC) indicated that it might be necessary to raise interest rates four times this year. The market has been pricing in three interest rate increases for 2018. Until Thursday, a fourth increase had not been fully priced in.

Further, the Fed is projecting an unemployment rate below 4% by late 2018 and early 2019. The current rate is 4.1%. Many industries are already struggling to find qualified workers. Rarely does the unemployment rate dip below 4%, and each time, inflation has risen and the stock market has fallen – sometimes substantially.

CPIUnemploy

The downturn following the Korean War was short and shallow, but the other two periods of low unemployment were followed by steep corrections in the market.

On Thursday night, the White House tweety bird announced another change in the roster. Out with the old National Security Adviser, General H. R. McMaster. In with the new adviser, John Bolton, an old school war hawk who avoided military service in Vietnam by joining the National Guard. Bolton’s first instinct is war and regime change as a solution to global disputes. In choosing Mike Pompeo as his new Secretary of State and John Bolton as his new National Security Advisor, Trump has assembled a war cabinet. The market has still not priced in the heightened chances of conflict with North Korea or Iran. Nor has it recognized a greater likelihood of armed conflict with China in the South China Sea. That might come in the next few weeks.

On Thursday, Trump enacted tariffs on imported steel and aluminum from China as promised. Stronger action against China’s trade policies are overdue, as it has long violated the spirit, if not the letter, of the WTO global agreements. Car manufacturers wanting to set up a plant in China must have a Chinese business partner with a 25% stake and – surprise – access to industrial trade secrets. The national government heavily subsidizes key industries so that they can support their own industries and workers. They avoid labor and environmental regulations, and when caught, pledge to do better. They issue a national change in regulation, but the change is only published and enforced in a few local areas.

The theft of intellectual property is a hallmark of most developing nations like China. In the 18th and 19th century, the U.S. was notorious for copying products made by companies in England and France. Article 1, Section 8 of the Constitution added some promise of patent and copyright protection, but the laws instituted protected only U.S. citizens. A half century later, Charles Dickens was “one of the chief victims of American literary piracy” (Source). A foreign inventor had to establish citizenship or residency in the U.S. for two years to gain any patent protection. In 1887, the U.S. joined a 19th century version of the WTO called the Paris Convention. As China does today, the U.S. skirted international agreements for at least a decade (Patent history).

Older Chinese citizens may have watched patrolling U.S. naval ships from the shores of the Yangtze River. The nation remembers the century of U.S. gunboat diplomacy (Wikipedia article). Despite American free market rhetoric, Chinese leaders understand that mercantilism still retains a strong political influence in the trading policies of many developed countries, including the U.S.

When NAFTA was signed in the early 1990s, subsidies of American corn farmers enabled them to sell cheap corn to Mexico. Unable to compete, many farmers in northern Mexico went out of business. As farming jobs decreased in Mexico, many laborers journeyed north to the U.S. to pick crops so that they could support their families. The U.S. is partially responsible for creating the very environment that led to so much illegal immigration from Mexico.

Around the world, developed countries cry foul when another country subsidizes goods that are exported at a lower cost into their countries. Since 1963, the U.S. has imposed a protectionist tariff of 25% on imported light duty trucks, the so called “chicken tax”. Protected for over fifty years by this tariff, domestic truck manufacturers like Ford and Chevy had made few substantial changes to their work vans in the past few decades. In 2015, Ford finally made a substantial change to its F-150 pickup. Notice those Mercedes tall work vans on the road? They are built in Germany, disassembled to avoid the tariff, shipped to the U.S. and reassembled by U.S. workers. Ford uses the same process with its Transit Connect van.

Boeing imports parts from all over the world to build its Dreamliners. Chinese companies use southeast Asia as a manufacturing supply, then assemble and ship thousands of products to the U.S. and around the world. In the truly global manufacturing economy, a trade war is a threat to the profits of many large businesses. They have tuned their operations to the contradictory rules of international trade.

Business leaders understand the political strut of free trade. Each business wants free trade when it wants to compete in someone else’s market. Each business lobbies for more regulations, tariffs and barriers to protect its competitive position within its own market. Yes, it’s all lies, so it’s important that the rules underlying this game not change too much. Trade wars change the rules and that’s bad for business.

Debt and Housing

March 18, 2018

by Steve Stofka

Republicans used to care about yearly budget deficits when Obama was President. Since Obama left office, the budget deficit is up 20%. As a percentage of GDP, 2017’s deficit was above the forty-year average of deficits (Treasury Dept press release).  At the end of the Obama term, the gross federal debt was 77% of GDP. In ten years, the Congressional Budget Office estimates that percentage will be over 90%. (Spreadsheet ) That estimate does not include the lower revenues from the tax cuts passed in December.

During the two Bush terms, Republican deficit hawks, genuinely concerned about budget deficits, were overruled by a majority of Republicans who paid only political lip service to common sense budgeting.

The Federal Government’s fiscal year runs from October to September. At the end of February, the fiscal year was five months old. According to the Treasury’s monthly budget statement, this fiscal year’s deficit has gone up 10%. Because of the tax cut passed in December, payroll tax collections are down. Because of higher interest rates, the government paid an extra $40 billion on the federal debt in the first five months of this fiscal year, which began October 2017. $40 billion is half of the food stamp program. Debt matters. The government is going into more debt to pay the interest on the existing debt.

The government paid $550 billion in interest last year and is estimated to pay over $600 billion this year. That is just a $100 billion less than the defense budget. Because interest rates are historically low, the interest as a percent of GDP is low. We cannot expect that they will remain low.

InterestPctGDP

Interest rates were low in the 1950s. By 1970, they were over 7% and had climbed to 14% by 1980. Since the financial crisis ten years ago, central banks in China, Europe and the U.S. have been buying government debt. Central banks don’t demand higher interest. As their role diminishes, price-sensitive buyers like pension funds and households will demand higher interest rates (Bloomberg article). Recent Treasury debt auctions have been lightly subscribed, and the Fed is having to step in as a buyer to artificially make a market. Remember, the Fed is just another pants pocket of the Federal Government. In essence, the Federal Government is buying its own debt.   What can’t continue forever, won’t.

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Housing

Have you gotten the impression that the housing market is going gangbusters? As a percent of GDP, housing investment is double what it was at the lows of the recession. The bad news is that current levels are near the historic lows of the post WW2 economy.

ResInvest

On the other hand, housing affordability has hit all time lows. A prudent rule of thumb is that a person or family should not spend more than 25% of their income on housing. A corollary of that rule is that a household should not buy a home that is more than 4 times their annual income. At 5.2, the current ratio is far above a prudent rule of thumb.

HousingIncomeRuleOf4

Government debt levels make the government, and us, vulnerable to any loss of confidence.  Low housing investment makes the economy less resilient.  High housing costs make it more difficult for families to save.  In a downturn, more families must turn to government for benefits.  Saddled with high debt levels and interest payments, government is less able and willing to extend benefits. The cycle turns vicious.

 

The Puff

February 25, 2018

by Steve Stofka

Each week I’m hunting scat, the data droppings that a society of human beings leaves behind. This week I’m looking for a ghost ship called the Phillips Curve, a relationship between employment an inflation that has had some influence on the Federal Reserve’s monetary policy. The ideas and policies of others, some long dead, have a daily impact on our lives. I’ll finish up with a disturbing chart that may be the result of that policy.

A word on the word “cause” before I continue. As school kids we learned a simplistic version of cause and effect. Gravity caused my ball to fall to the ground. As kids, we like simple. As adults, we long for simple. As we grow up, we learn that cause-effect is a very complex machine indeed. The complexity of cause-effect relationships in our lives are the chief source of our disagreements.

So, “cause” is nothing more than shorthand for “has an important influence on.” The dose-response mechanism is a key component of a causal model in biology. If A causes B, I should be able to give more of A, the dose, and get more of B, the response, or a more frequent response.

Let’s turn to the Phillips Curve, an idea that has influenced the Federal Reserve’s monetary policy since it was proposed sixty years ago by economist A.W. Phillips. Simply stated, the lower the unemployment rate, the higher the inflation rate. There is an inverse relationship between unemployment and inflation.

Inverse relationships are everywhere in our lives. Here’s one. The lower the air temperature, the more clothes I wear. I don’t say that air temperature is the only cause for how many clothes I wear. There is wind, humidity, sex, age and fitness, my activity level, social protocols, etc. While there is a complex mechanism at work, I can say that air temperature has an important effect on how many clothes I wear. If I measure the varying air temperatures throughout the year and weigh the amount of clothes that people have on, I will get a strong correlation. High temps, low clothes.

Now what if the temperature got colder and people still wore the same amount of clothes? I would need to come up with an explanation for this discrepancy. Perhaps there never was much of a relationship between air temperature and clothes? That seems unlikely. Perhaps clothes fabrics have been improved? I would need to look at all the other factors that I mentioned above. If I could find no difference, then I would have to conclude that air temperature had little to do with clothes wearing. Headlines would herald this new discovery. Important areas of our economy would be upended. Retail stores would stop stocking coats or bathing suits a few months in advance of the season. Businesses around the country who depend on warm weather clothing would go out of business.

Unlike air temperature and clothes, the relationship between inflation and employment is two-way. The change in one presumably has some influence on the other. During the 1970s, inflation and unemployment both rose. The hypothesis behind the Phillips curve posits that one should go up when the other goes down. Some economists threw the Phillips curve in the trashcan of ideas. Milton Friedman, an economist popular for his lectures and his work on monetary policy, proposed a concept we now call NAIRU. This is a “natural” level of unemployment. If unemployment goes below this level, then inflation rises.

Some economists complained that NAIRU was a statistical figment designed to fit the Phillips curve to existing data. Economic predictions based on the Phillips curve have been consistently wrong. Still, the Congress has mandated that the Federal Reserve maintain “maximum employment, stable prices, and moderate long-term interest rates” (Federal Reserve FAQs). Economists at the Fed must consider both employment and inflation when setting interest rates. The models may not accurately describe the relationship, but many will instinctively feel that the relationship, in some form or another, is valid.

For the past several years, the economy has been at or near maximum employment. In January 2018, the unemployment reading was 4.1%. Whenever that rate has been this low, the country has either been at war or within a year of being in recession. The puzzlement: only lately have there been signs of an awakening inflation.

Because inflation was below the Fed’s 2% benchmark while unemployment declined, the Fed kept its key interest rate near zero for seven years. For its 105 year history, the Fed has never kept interest rates this low for as long as it did. Low interest rates fuel asset bubbles. Such low rates cause people and institutions who depend on income to take inappropriate risks to earn more income. The financial industry develops and markets new products that hide risk and provide that extra measure of income. We can guess that these products are out in the marketplace, waiting to blow up the financial system if a set of circumstances occurs. What set of circumstances? We will only know that in the rear view mirror.

Here’s a chart that tracks price movement of the SP500 ETF SPY for the past twenty years. I’ve shown the tripling in price that has occurred during the past five years.  Notice the long stalk of rising prices. That growth has been nurtured by the Fed’s policy.  Well, maybe this time is different.  Maybe not.

SPYPF20180223

Long-Term Trends

January 7th, 2018

by Steve Stofka

This week I’ll look at a few long-term trends in the marketplace for goods and labor.  Millennials born between approximately 1982 – 2002 are now the largest generation alive. Their tastes will dominate the marketplace for the next twenty years at least.  In the first eighteen years of the new century, change has been a dominant theme.

Some businesses drowned in the rush of change. A former member of the Dow Jones Industrial Average, the film giant Eastman Kodak is a shadow of its former self after it emerged from bankruptcy in 2013.

Some in the music business complain that the younger generations don’t want to pay for music. Much of YouTube music is pirated material and yes, Google, the site’s owner, does remove content in response to complaints. There’s just so much of it. Album sales revenue in the U.S., both digital and physical, fell 40% in the five years from 2011 to 2016. Globally, the entire music business has lost 40% in revenues since the millennium and is just now starting to grow again (More).

Some in the porn industry make the same complaint as those in the music business. As online demand for porn grew, the industry helped pioneer digital payment security. Now there is too much free porn on the internet. Producers and distributors pirate each other’s content. Who wants to invest in good production values only to see their work ripped off? (Atlantic article/interview on the porn industry) Will the lack of quality reduce demand? ROFL!

An ever-diminishing number of city newspapers struggle to survive. Some complain that people don’t want to pay for local news. Local reporters have long been the bloodhounds who sniff out the corruption in city halls and state capitols around the country. There are fewer of them now.  Think that corruption has been reduced?  ROFL!

Surviving bookstores glance over their shoulders at Amazon’s growing physical presence in the marketplace. This year Amazon became the 4th largest chain of physical bookstores. The large book publishing houses try to preserve their hegemony as readers turn to a greater variety of alternatively published books.

As online sales grow, brick and mortar stores struggle to produce enough revenue growth to sustain the costs of a physical store.  During the past three years, an ETF basket of retail sector stocks (XRT) is down almost 10%.

Hip-hop music was a fad of the ‘80s and ’90 until It wasn’t. Rock ‘n Roll was a fad that has lasted sixty years. In the early 60s, the Beatles were told to make it rich while they could, and they worked hard to capitalize on their success before it fizzled. Never happened.

How are we going to predict the future if it is so unpredictable? Some standards fade while some fads become standards. We face the past, not the future, as the future sneaks up on us from behind.

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Employment

A few notes on what was the weakest employment report of the past year. Job gains were only 150K as reported to government surveyors but the percentage of businesses responding to the survey was particularly low. Expect the BLS to revise those job gains higher next month when more of the survey forms come in. I have long used an average of the BLS numbers and ADP’s estimate of private job gains. That average was 200K – a healthy number indicative of a growing economy.

The long-term trend remains positive. The annual growth of total employment should be at 1.5% or above. We are currently holding that threshold despite the loss of jobs to automation and the growing number of Boomers retiring.  Growth in construction jobs  remains at or above the growth in total employment – another healthy sign.

ConVsPayemsGrowth

The employment market faces a long-term challenge as the largest generation of workers in history is retiring. In January 2000, 69 million adults were out of the labor force. That figure now stands at 95 million. As a ratio, there were 53 adults not in the labor force for every 100 adults with a job. Now there are 65 adults for each 100 workers.

NotInLabForceVsPayems

Although growth in hourly wages is at 2.5%, weekly paychecks have grown 3% as part-time workers get more hours or find full-time jobs. Look for inflation to approach that growth in paychecks.

WeeklyEarnVsInflation

When inflation rises above paycheck growth, workers struggle more than usual to balance their income with spending.  I’ll use that same chart to highlight some stress points during the past decade.

WeeklyEarnStressPoints

As the economy continues to improve, the Fed is expected to continue increasing interest rates either two or three times in the coming year.  After a decade of zero interest rates (ZIRP), those with savings accounts may have noticed that their bank is paying 1% or more in interest.  It is still a far cry from the 4% to 5% rates paid on CDs in the ’90s and 2000s.  This past decade has been particularly worrisome for older folks trying to live off their savings.

Intervention

August 27, 2017

Pew Research surveyed four generations of Americans, from the oldest Americans who are part of the Silent Generation, those who grew up during the Great Depression, to the Millennials, those born between the years 1983 – 2002. Pew asked the respondents to list ten events (not their own) or trends that happened during their lifetime that had the most influence on the country. 9-11 was at the top of the list for all four generations. Obama’s election, the tech revolution and the Iraq/Afghanistan war were the other events common on each list. Some differences among the generations were understandable. Some were a surprise to me. The Great Recession/Financial Crisis of 2008 was only on the Millennials list. Many in this generation were in the early stages of their careers when the recession began. Here is a link to the survey results. Perhaps you would like to make your own list. Keep in mind that the events must have happened during your lifetime.

I don’t think that the Boomer generation understands the long-term impact of the Great Recession. In another decade, many will discover how vulnerable the financial crisis left all of us, not just the Millennials. As we’ll see below, the crisis may be over but the response to the crisis is ongoing.

One of the trends common to each generation’s list was the tech revolution, which has reshaped much of the economy just as the last tech revolution did in the 1920s. The widespread use of electricity, radio and telephone in that decade transformed almost every sector of the economy and accelerated the mass migration of the labor force from the farm to the city.

Like today, a small number of people made great fortunes. Like today, the top 1% of incomes accounted for about 15% of all income (Saez, Piketty). The GINI index, a statistical measure of inequality of any data set, has risen significantly since 1967 (Federal Reserve). The GINI index ranges from 0, perfect equality, to 1, perfect inequality. Incomes in the U.S. are more equal than South Africa, Columbia and Haiti (Wikipedia) but we are last among developed countries.

For several decades, Thomas Piketty and Emmanuel Saez have collected the aggregate income and tax data of developed countries. Piketty is the author of Capital in the Twenty-First Century (Capital), which I reviewed here.  A recent NY Times article referenced a report from Piketty and Saez comparing the growth of after-tax, inflation-adjusted incomes from 1946-1980 (gray line labeled 1980) and 1980-2014 (red line labeled 2014). I’ve marked up their graph a bit.

IncomeGrowth1947-2014
The authors calculated net incomes after taxes and transfers to determine the effect of tax and social policies on income distribution. Transfers include social welfare programs like Social Security, TANF, and unemployment. Census Bureau surveys of household income include pre-tax income and it is these surveys which form the basis for the calculation of the GINI index and other statistical measures of inequality.

I am guessing that Piketty and Saez used their database of IRS post-tax income data then adjusted for transfer income based on Census Bureau surveys. The Census Bureau notes that people underreport their incomes on these surveys.  Is the IRS data more reliable?  Probably, but people do hide income from the IRS. Both Piketty and the Census Bureau note that the data does not capture non-cash benefits like food stamps, housing subsidies, etc.

From 1947 to the early 1960s, the very rich paid income tax rates of 90% so that would seem to explain the after-tax income data from Piketty and Saez. The federal government took a lot of money from the very rich, paid off war debts, built highways, flew to the moon and built a big defense network to fight the Cold War.  Those infrastructure projects employed the working class at a wage that lifted them into the middle class. So that should be the end of the story. High taxes on the rich led to more equality of after-tax income.

But that doesn’t explain the pre-tax income data from the Census Bureau. The very rich simply made less money or they learned how to hide it because of the extremely high tax rates.  In the Bahamas and Caymans, there grew a powerful financial industry devoted to hiding income and wealth from the taxman. In the first years of his administration, President Kennedy, a Democrat, understood that the extremely high tax rates were hurting investment, incentives and economic growth.  He proposed lowering both individual and corporate rates but could not get his proposal through the Congress before he died.  Johnson did push it through a few months after Kennedy’s death. The rate on the top incomes fell from 91% to 70%, still rather high by today’s standards.

An important component of income growth in the post war period from 1947-1970 was the lack of competition from other developed countries who had to rebuild their industries following World War 2. These two decades were the first when the government began collecting a lot of data, and this unusual period then became the base for many political arguments. Liberal politicians like Bernie Sanders and Elizabeth Warren advocate policies that they promise will return us to the trends of that period. It is unlikely that any policies, no matter how dramatic, could accomplish that because the rest of the world is no longer recovering from a World War.

We could enact a network of social support policies that resemble those in Europe but could we get used to a 10% unemployment rate that is customary in France? For thirty years beginning in the early 1980s, even Germany, the powerhouse of the Eurozone, had an unemployment rate that exceeded 8%. At that rate, many Americans think the economy is broken. Despite 17 quarters of growth, unemployment in the Eurozone is still 9.1%. Half of unemployed workers in the Eurozone have been unemployed for more than a year. In America, that rate of long term unemployed is only 13% (WSJ paywall).

The post-war period was marked by high tax rates and high federal spending, a period of robust government fiscal policy.  The federal government intervenes in the economy via a second channel – the monetary policy conducted by the central bank.  The Federal Reserve lowers and raises interest rates, and adjusts the effective money supply by the purchase or sale of Treasury debt.

The 1940s, 1970s and 2000s were periods of high intervention in both fiscal and monetary policy. The FDR, Truman, Eisenhower, Johnson and Nixon administrations exerted much pressure on the Fed to help finance war campaigns and the Cold War. In 1977, the Congress ensured more independence to the Federal Reserve by setting two, and only two, clear objectives that were to guide the Fed’s monetary policy in the future: healthy employment and stable inflation.

A rough guide to the level of central bank intervention is the interest rate set by the Fed. When rates are less than inflation, the Fed is probably doing too much in response to some acute or protracted crisis.

EffFundsRate-Infation

Let’s look at an odd – or not – coincidence. I’ll turn to the total return from stocks to understand the effects of central bank policies. There are two components to total return: 1) price appreciation, and 2) dividends. When price appreciation is more than 50% of total return, economic growth and company profits are doing well. Future profit growth looks good and more money comes into the market and drives up prices. When dividends account for more than half of total return, as it did in the 1940s and 1970s, both GDP and company profit growth are weak. Both decades were marked by heavy central bank and government intervention in the economy.

Here’s a link to an article showing the total return on stocks by decade. During the 2000s, the total return from stocks was below zero. An average annual return of 1.5% from dividends could not offset an annual loss of 2.4% in price appreciation. Hubris and political pressure following 9-11 led Fed Chairman Alan Greenspan to make several ill-advised interest-rate moves in the early 2000s that helped fuel the housing boom and the ensuing financial crisis. His successor, Ben Bernanke, continued the policy of heavy intervention. Following the financial crisis, the Fed kept interest rates near zero for nine years and has only recently begun a program of gradually increasing its key interest rate.

The price gains of the 2010s have lifted the average annual return of the past 18 years to 7.4%, and the portion from dividends is exactly half of that, at 3.72% per year.  It has taken extraordinary monetary policy to rescue investors, to achieve balanced returns  that are about average from our stock investments.  Some investors are betting that the Fed will always come to the rescue of asset prices.  That same gamble pushed the country to the financial crisis when the government did not rescue Lehman Brothers in September 2008.

The financial crisis should have been on each generation’s list.  Within ten years it will be.  It is still crouched in the tall grass.

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Debt

Happy days are here again.  Yes, girls and boys, it’s time to raise the debt ceiling!  By the end of September, the Treasury will run out of money to pay bills unless the debt ceiling is raised. This past week, President Trump hinted/threatened that he would not sign a debt increase bill unless it included money to build the wall between the U.S. and Mexico.

The Congress has not had a budget agreement in several years and is unlikely to enact one this year. People may sound tough on debt but a Pew Research study
showed that a majority do not want to cut government programs, including Medicaid.

Liberal economists insist that government debt levels don’t matter if the interest on the debt can be paid. This article from Pew Research shows the historically low rate on the federal debt. However, Moody’s reports that the U.S. government pays the highest interest as a percentage of revenue among developed countries. As a percent of GDP, we are 4th at 2.5%.

River Rafting

July 15, 2017

After a good year of snowfall in the Rockies, the rivers run strong. A popular spot for rafting is the Colorado River as it runs through the dramatic scenery of the Glenwood Canyon in western Colorado. Investing is a lot like rafting. We can’t control the amount of snowfall, the change in elevation, where the rocks are or the streams that feed into the river.

Our individual and group behavior on the river can help or hinder our progress. In a good year, rafting companies charge more for a rafting adventure. As more people come onto the river, we must pause in quiet water at the river’s side to give a safe distance between rafts. This crowding effect is made worse by stretches of river that require more caution to navigate. We can steer right or left to avoid some rocks but we are largely at the mercy of the river and each other.

Since the budget crisis in the late summer of 2011, the stock market has enjoyed a fairly strong run, more than doubling since that time. The financial crisis nine years ago was like a winter of extraordinarily deep snowfall. The Fed has kept interest rates abnormally low to thaw that snow, and equity investors have had a wonderful ride.

The Federal Reserve has committed to a series of gradual rate increases. Despite the low rates, people continue to pour their extra money into savings accounts and CDs. Wells Fargo is paying almost 1% below the Fed discount rate on their savings accounts. Why? As long as their customers are willing to accept savings rates of .3%, Wells Fargo has no incentive to raise rates. Discover, Goldman Sachs, American Express, Ally and Synchrony are paying about 1.15%, the Fed rate. (Bankrate) Savings account balances are near $9 trillion, more than double the balances in late 2007 before the recession began. The fear lingers.  Many people stand on the shore, too cautious to ride the river’s tumble and flow.

Until 2015, retail sector stocks (XRT) have been on a fast raft, quintupling from the market lows of March 2009. Over the past two years they have drifted into a side pool, losing about 20%. This year the stocks have been quite volatile as investors gamble on the future of the retail industry. Will Amazon continue to take sales from traditional brick and mortar stores?

June’s retail sales (RSXFS) were disappointing. Year over year growth was 3%, less than the 5 year average of 3.3%, and far below the near 5% growth of the 1st quarter. Excluding auto sales and auto parts (RSFSXMV), annual growth was only 2.4%, a 1/2% below the five year average and half of the 1st quarter rate.

The Trump administration and the Republican Congress have aimed for 3% real – inflation adjusted, that is – GDP growth. In an economy that depends so heavily on consumer sentiment, slowing retail sales will make that growth goal difficult to achieve.

For now, the sun is shining, the river is running strong and I am enjoying myself.  As long as I don’t look around the next bend in the river, everything looks fine!