Taxes – the Necessary Good

Taxes shall be levied according to ability to pay. – Franklin D. Roosevelt

August 19, 2018

by Steve Stofka

In the aggregate taxes are necessary and beneficial to everyone. Because Federal taxes act as a drain from the economic engine, they are different from state and local taxes. How those taxes are levied is a matter of policy debate, but they are necessary for the survival of a nation’s government and its economy. Revenue from natural resource production that is owned by a national government acts as a tax. Failing to understand that concept weakens and cracks governments around the world.

The inability to create money constrains state and local governments (Note #1). Taxes paid act as income for goods and services received from those governments. The Federal government has no such constraints. It does not need tax income as such. Rather, it must drain taxes to offset the amount of spending that it pumps into an economy. Inflation, the chief measure of extra money in an economy, rises when the Federal government doesn’t drain enough in taxes. As inflation rises, people turn to goods and service exchange that is not recorded and not taxed. The underground economy tries to offset the hidden tax of inflation.

As Venezuelans flee the runaway inflation in their country, they are running from too much spending and not enough taxation. Yes, it is counterintuitive. Venezuela owns the world’s largest reserve of oil. The net revenue from that oil competes with the taxes that a private oil company would pay to the government. The national government “owes” itself the tax revenues that it would have collected from a private company. Oil production has declined from 2.4 million barrels per day in 2008 to 1.2 million barrels in 2018 (see Note #2). Corruption and incompetence are the chief causes of the decline. Net oil revenue has declined by 95% from the bull market levels of the mid-2000s. Because the national government has not been paying their taxes, inflation has exploded the economy.

Because national politicians begin their careers in local politics, they regard a nationalized resource (NR) as a source of income, not an economic drain. That drain must be kept open through spending in oil infrastructure, training and transportation. In Venezuela, 2016 gross oil revenues were 20% of GDP and a net of less than 5% (see Note #3). Inflation taxes 100% of an economy. Because NR revenue acts as a pressure relief on inflation, that 20% portion of GDP affects 100% of the economy. A lack of understanding of the nature of a NR led to the crisis and decline of Great Britain in the 1970s, China in the 1960s and 1970s, and Zimbabwe in 2008.

How should a national government levy taxes on the taxpayers within the economy? FDR suggested “ability to pay.” For the past one hundred years we have measured ability to pay by income. Is that a good measure? French economist Thomas Piketty suggests that assets are a better measure. Local governments use this method to collect property taxes. Consider a retiree with $500K in liquid assets, who is taxed on $10K in interest and dividends earned each year. Clearly, the retiree’s assets are a better indication of his ability to pay. Should Congress abolish the income tax and tax people and corporations a multiple of what they pay in property taxes on their primary residence or business locations? Those living in high tax suburban and ex-urban areas might move toward lower-taxed urban areas. Would suburban areas actively recruit businesses to widen their tax base and lower property taxes? An intriguing thought.

Tax levies are the subject of endless debate because people cannot agree on what constitutes a fair tax. In the aggregate, the pressure reducing function of taxes benefits everyone, but is especially beneficial to those with less income. Should a national government impose a head tax on everyone? It could. That would amount to $15,000 per person this year, more than some families make. How does a national government extract tax money from its poor? It doesn’t. From 1958 – 1962, China forced taxes out of poor farmers in Mao’s Great Leap Forward (Note #4). Millions starved as a result.

Everyone should contribute equally to shared benefits, but practicality triumphs over principle. The survival of the national government becomes paramount. Some form of redistributive taxation must ensue. How to shape that redistribution? A government could take all the wealth of the ten richest people in America and still be short $3.8 trillion (Note #5). All the debate falls between total equality and total unfairness, and neither accomplishes the task of draining enough taxes out of the engine. A government could spend nothing: no defense, no research, no border or shore protection, no pension, medical or education spending. That’s a government in name only, and not for long. Other governments will want to capture control of that country’s resources.

The vast middle of the debate is an endless variety of proposals of “fairness” in both taxing and spending, a debate that has changed little since Cicero argued for his proposals in the Roman Senate in the first century B.C.E. What is not debatable is that a nation’s taxes must be roughly guided by its spending. A nation like Venezuela, which taxes half of what it spends, was headed for an economic tsunami of high inflation and inevitable collapse.

The debate is important. Just as it did in Rome two thousand years ago, consolidated party power corrupts. Because the current Presidency and House are held by the same party, we can expect a strong growth rate of net input, spending less taxes, and the data confirms the prediction. Net Federal input in the first full year of the Trump administration, April 2017 – March 2018, grew at a record-breaking annual pace of 19.6%, far above the sixty-year average of 8%. However – because Federal input has been so low this decade, the Federal government must continue this torrid pace of input in 2018 and 2019 just to reach the 8% average.

Republicans have held the House for the majority of the past three decades. Neither party agrees with the other party’s priorities, so the Republican strategy has been simple. They talk fiscal discipline and curtail Federal spending during Democratic administrations so that Republicans can spend big on their priorities when they have the Presidency. The Democrats did this for forty years when they held the House from 1954-1994 and will do so again when they have their next Congressional “run.”

To sum up: taxes are good, in general, but bad in the particular. No nation’s leader has stood on the world stage and said, “To tax or not to tax, that is the question.” For a nation and its economy, “to tax” is synonymous wtih “to be.”



1. Before the Civil War, each state controlled banking within its border (National Bank Act). For a deeper dive into state financing, try this Brookings Institute article.

2. A background paper on Venezuela oil (PDF). Crude oil production in the first quarter 2018 fell to 2.19 million barrels, a thirty-year low (Reuters). The Venezuela government spends more than 40% of GDP but collects only 20% in taxes (Statistica). During the 1997-2006 oil bull market, net revenues to the Venezuelan government averaged $20B per year (background paper above). Last year it was less than $1B. On August 20th, Venezuelans will lose their gasoline subsidies and pay a competitive price for gasoline (PDVSA article).

3. Gross oil revenue in 2016 was $48B, 20% of GDP of $236B (Reuters article). Exxon Mobil had a net profit of 6.5% in 2011. Venezuela would greatly benefit if the oil production was owned privately and paid 25-30% in income and other taxes.

4. Frank Dikotter was one of several historians afforded access to People’s Party records of the Great Leap Forward. He wrote an exhaustive account of human folly in Mao’s Great Famine .

5. Richest people in America  – Wikipedia 


Gold is down more than 10% in the past few months. BAR is a gold ETF launched in the past year. As an alternative to GDL and IAU, it has the lowest expense ratio at .2%. Here is a June 2018 article on the ETF.

Growing Government Debt

March 6, 2016

Earlier this year and again last week I suggested that a broad index of energy companies would probably be a good investment for the long term investor.  This week’s inventory report from the U.S. Energy Information Administration (EIA) showed that crude oil inventories continued to climb but that demand for gasoline is up a strong 7% over last year.

The latest Baker Hughes rig count showed an 11th week of declines in North America.  Oil rigs are now at levels last seen in early 2008 and gas rigs are at a 70 year low.

In response to demand growth and a steadily declining supply, crude oil prices climbed almost 10% and energy ETFs like XLE and VDE climbed almost 8% this past week.


Constant Weighted Purchasing Index (CWPI)

At the beginning of each month I update an index that is based on the Purchasing Managers Index (PMI) using a methodology initially developed by financial economist Roland Pelaez in 2003 as a possible forcasting indicator for recessions.  I modified that to include the dominant non-manufacturing part of the economy, and called this combined index the CWPI, which I have included in my blog for three years.

The PMI is a monthly survey of Purchasing Managers throughout the country that gauges expansion or contraction in several aspects of their business.  The two most important components in the model are employment and new orders.

For the first time since last October, the manufacturing component of the index rose but is still contracting slightly.  Export manufacturers have had to overcome a strong dollar in the past 1-1/2 years, which makes American made products more expensive overseas.  The services sector is still expanding and the composite reading is still strong, indicating that there is little risk of recession in the near term.

Although Friday’s employment report showed strong job gains of 240,000, growth in the employment component of the services sectors is slowing.

Mr. Pelaez has recently published  a peer reviewed recession forecasting tool that I have not reviewed yet but I do look forward to reading his insights. Recessions come infrequently, about once a decade, but a long term investor who can switch out of stocks and into Treasuries to avoid these recessions could theoretically triple their wealth.

A word of caution.  There are several inherent problems with trading models based on infrequent economic events like recessions: 1) backtesting can help one develop a model or trading rule that does little more than fit the historical data;  2) backtesting uses revised economic and financial data.  Unfortunately, we don’t get to make decisions with historically revised data.

A great example of this:  at the June 2008 meeting of the Fed, three months before the financial crisis imploded, the majority of economists at the meeting felt that the economy had skirted a recession.  As more data for the first and second quarters of 2008 showed a definite decline in GDP, the NBER actually marked the start of the recession six months before that meeting, in December 2007.  You want perfect?  Next universe that-a-way.


Debt Doubts

In December 2009, I mentioned  a comment by Raymond Baer, the chairman of Swiss private bank Julius Baer, who warned: “The world is creating the final big bubble. In five years’ time, we will pay the true price of this crisis.”

That time has come and gone but these things don’t run on a calendar.  As the book “The Big Short” noted, a person has to be right and timely.  Some who bet on the implosion of the housing bubble ran out of money before the bubble burst.

Taking advantage of extremely low interest rates, companies continue to borrow.  Levels of corporate debt are nearly a third of GDP.

Instead of bringing some of its cash profits back into the U.S. and triggering a tax expense, Apple has borrowed money to fund operations and investment.  Banks and investors would rather loan money to Apple than some medium sized business.  How good is that for the long term health of the economy?

To understand the makings of a debt bubble, let’s compare rates of return on investment and debt. Let’s say that a 50/50 balanced portfolio can earn 5.5% per year; 7.5% for stocks, 3.5% for bonds.  If a mortgage can be had for 4%, then it makes sense to NOT pay down the mortgage.  A car lease or loan at a 2% interest rate?  Keep rolling the loan or lease.  A company like Johnson and Johnson can borrow money for 25 years at the same 4%.  Why would they pay down debt?

Debt continues to grow because there is no financial incentive to pay it down.  Some families may pay down debt out of conservative prudence but there is no economic sense in doing so as long as money can be borrowed at a rate that is below what one can earn with the money.

As an example, let’s say that a family is considering paying off the remaining $100K on their mortgage.  They can get a new mortgage for 3.5% – 4%.  If they can earn 5% on that money, why bother paying off the mortgage?  Persistently low interest rates cause families and businesses to make short term decisions that make sense – until they don’t.  Some families will pay off debt as a matter of prudence but the low interest rate environment encourages families and businesses to NOT pay off debt.

In 2009, Raymond Baer was referring to the amount of corporate debt that was being rolled over at the time in order to avoid taking a loss on the loan.  Central banks have helped subsidize that rising corporate debt with low interest rates.  Banks reciprocate by buying government debt.

Global government debt has DOUBLED from $28 trillion in 2007 to almost $56 trillion in 2015 (Global debt clock).  China’s government debt-to-GDP ratio has more than doubled from 21% in 2007 to an estimated 54% in 2008 (S. China Post)

In the U.S. and Europe, government banking agencies reciprocate by requiring banks to hold little if any reserve collateral for the Federal or central government debt the banks purchase.  It’s a great financial buddy system – until it’s not.  We have never lived in a world where central banks can create so much money with an entry in a ledger.  As long as no one runs for the exits, everything is OK.

Under the Dodd-Frank rules, the Federal Reserve does not rate state and municipal debt with the same safety it accords U.S. Treasury debt.  This forces banks to hold more collateral against the debt, making it less attractive.  The Dodd-Frank test is whether banks can survive for thirty days during a financial crisis.  Since municipal and state bonds don’t trade very frequently, their lack of liquidity makes them more susceptible to downward price pressures in a crisis.  The Fed wants banks to offset that risk.  Cities and states complain that this forces them to pay higher interest rates on their debt and gives them less access to the bond market.  What do governments do when they don’t like the judgment of finance professionals?  Get their legislators to pass laws to override that prudence.  Several bills in both the Senate and House have been proposed.  This is how the world goes to hell.  One step at a time. (WSJ article on municipal debt)


Bonds Bust ZLB

Howz dat for a headline?!  ZLB means “Zero Lower Bound”, or 0%. Last Monday, the central bank of Japan sold almost $20 billion of 10-year government bonds that paid a negative interest rate.  Buyers are paying the Japanese government a fee to loan the government money.  Bizarro world!  While I don’t know the details, the buyers are probably Japanese banks who “take one for the team” – lose money – to implement a plan that the central bank hopes will combat the threat of deflation.

Re-pricing the Market

January 31, 2016

In the closing moments of one of the “big ape” films, the very large gorilla Mighty Joe Young saves the girl, placing her on a boat as an island in the Pacific, broken by a volcano, falls back into the sea.  The bandaged hand of the big ape reaching out of the roiling waters is the last we see of the movie’s star.

On Friday morning, the Bank of Japan (BOJ) surprised the world by cutting it’s funds rate to a negative .1% from a positive .1%, vowing to fight the deflation and lack of growth that has plagued the Japanese economy for two decades.  As the island’s economy collapses under the weight of its aging population and lack of immigration, the bank thrust its arm above the Pacific waters to save – well, the entire Japanese population.  Could be the script of another big ape movie or a Godzilla sequel.

The first estimate of fourth quarter GDP was released Friday morning and the news was not good, which meant that the news was good, get it?!  GDP growth for the last quarter was positive, not negative, but less than 1%, so traders figured that the Fed will not raise interest rates again in March.

#3 in the combination was positive earnings surprises from Microsoft and Facebook, among others. Thursday was the busiest day of the earnings season.  #4 The price of oil continued to climb above the near rock-bottom benchmark of $30.  All of these factors were the impetus for a stock market surge of 2-1/2% on Friday and helped soften a really bad start to the year.  For the month, the index fell 5%.  During the month, revisions to earnings estimates for 2016 fell about the same amount – 4.7% (Fact Set).  In short, the stock market re-priced itself.



As the primary season approaches and millions of Americans receive their W-2 earnings record in the mail, Americans turn their attention to the cheery subjects of incomes and income taxes.  Here’s a Heritage Foundation chart of the effective payroll tax rates and income tax rates for the five quintiles of Americans based on income.

Those in the lowest quintile making less than $25K pay a combined rate of 2.1%.  Those in the next quintile making less than about $47K pay a combined rate of 6.6%.  Those in the next higher quintile making less than $80K pay 12.2%.  The top two quintiles pay 14.7% and 21% respectively.  It is easy to understand why many in the upper quintiles feel that they are already paying their fair share of taxes.

The fault in these calculations is that they neglect the employer’s portion of the payroll tax which is paid indirectly by the employee in the form of a lower wage.  Including that portion would add another 7.5% to 8% to the lower quintiles, a bit less to the top two quintiles.  Here’s a chart showing the total payroll tax burden since the Social Security Act was passed in the 1930s.

Should the rich pay more in taxes?  Yes, says Democratic Presidential contender Bernie Sanders.  Many Americans do not realize that we are in the top 10% of global incomes, the world’s fat cats.  Should Americans pay a global fairness tax of 10% or so?  This money would then be redistributed to poorer people around the world.  That is the world that Mr. Sanders is aiming toward.


Consumer Problem Survey

Over the past several thousand years people have developed numerous tools to predict the future.  Reading chicken bones, tea leaves and other forms of augery have given way to mathematical and statistical modeling.  The folks at Georgetown have developed a predictive tool to estimate consumer spending. Using a survey methodology researchers ask consumers what problems they have and which ones they are planning to solve in the coming months. These can be the payment of taxes, needing a new computer, iPad, or cell phone, the purchase of new home, etc.  Based on these responses, the researchers compile a Problem Driven Conumption Index (PDCI).  In the spring and early winter of 2014, the predictive index badly under-estimated retail sales.

However, the approach brings an essential understanding of the challenges American families face.  In a 2013 survey, respondents reported having many problems for which they see no solutions.  We learn that men and women have a few problems in common but confirm the axiom that each sex really does see the world differently.  The researchers are able to chart the shifting patterns of problems as we age.  This problems based approach is another statistical tool in the field of behavioral finance.

The China Syndrome

August 23, 2015

Some of you may have spent the summer vacation on a small island in the Pacific where there was no access to the news.  So a quickie catch up.  The new Mission Impossible movie Rogue Nation is edge of the seat great fun and its still on the big screen.  And, yeh, almost two weeks ago the central bank of China devalued the Yuan a bit over 3%. Yes, that was a bit unusual.  An unexpected 8% drop in July’s exports spooked economists in the Chinese government.

That brought some additional pressure on oil stocks but the larger market eked out a .7% gain at the close of the week on August 14th.  But – cue up the going down the dark stairs into the basement music – the 50 day average of the Dow Jones crossed below the 200 day average during that week.

Yep, the death cross of doom.  Of course, the Dow Jones is only 30 stocks, weighed down by the plunging fortunes of oil giants like Chevron and Exxon.  The 50 day average of the broader SP500 index was still above the 200 day average so there was cause for concern, but not panic.

For the first two days of this past week, the market was essentially flat.  USO, a commodity ETF that tracks West Texas Intermediate crude oil (WTI) rose more than 1% on Tuesday.  Then came the news that crude oil inventories were continuing their relentless advance upwards. On the good side, lower oil prices are leading to higher demand but sometimes investors focus on the bad news.  WTI oil dropped 4.4% on Wednesday.  Whispers of disappointing manufacturing production out of China added fuel to the fire. On Thursday, the broader market fell 2%, joining the continuing downturn in energy stocks and emerging markets.  A PMI (Purchasing Managers Index) survey of Chinese manufacturers confirmed a slight contraction in the Chinese economic machine. That spooked investors, leading to a 3% drop in the broader market on Friday.

By the time the smoke cleared at the end of the week’s battle, the broader index had lost 5.6% for the week.  Energy and emerging market indexes were down 8%.  Weekly volume in the popular SP500 ETF SPY was the highest this year, an indication that this concern may be more than a temporary blip.

The 50 day average of the SP500 is still above the 200 day average.  No feared death cross yet.

After four years without a 10% correction, the SP500 crossed below that mark this week, falling 10% from the recent high in late May.  Time to sell? Did you get out of the market last October when the broader market fell more than 6% in a month?  Remember that one? The market was going to fall by 50%, according to some market gurus.  Friday’s close is 5% above that October low.

Some long term traders use a 50 week average as a guideline.  As long as it is rising, why worry?  Until this week, the 50 week average had been substantially rising since September 2009.  Why do I use the word “substantially?”  There were a few weeks in late 2011 and early 2012 when the average dipped a few cents.  This week’s decline was like those little dips – a mere 5  cents in SPY, the popular ETF that tracks the SP500.

The world’s economy has come to depend on the growth of two stalwarts – the U.S. and China. For the past eight years, the Eurozone has fumbled and floundered through a cobweb of of political and economic problems. When the U.S. economy cratered in 2008 – 2009, the economic burden shifted to China, whose expansionist growth truly saved the world from a Great Depression.  Although the U.S. economy is showing strong growth, can it offset the economic weakness in China?  The stock market is holding an election, a vote of confidence on that very question.

China, Oil, Treasuries and Stuff

August 2, 2015

An exciting and unnerving ride this past week as the Chinese market fell 8% on Monday and finished out the week about 10% down (Guardian here  and analysis here).  If trading had not been halted in a number of companies, the damage could have been much worse.  In the past year the Shanghai Composite has shot up 150% as individual investors piled into the market with both their own savings and borrowed money. Despite the loss of 14% for the entire month of July, investors in the Shanghai index are still up 13% for the year.

Let’s turn to the U.S. where the SP500 index has gained 6% since the downturn in October 2014.  Below is a chart of SPY, an ETF that tracks the SP500 index.  MACD is a common technical indicator that follows market trends.  The most common setting is to compare 12-day and 26-day price averages (the MA in MACD) and measure the convergence and divergence (the C and D in MACD)  Comparisons of longer time periods can clarify overall trends in sideways markets like we have experienced this year.  The chart below compares the 30-day and 72-day averages (blue line). The red line is a signal line, a 15-day average of the blue line.  The market seems to be at the end of a mildly positive cycle  that has been in place for nine months.

We may see a renewed move upwards but the near zero reading of the past few weeks indicates the uncertainty in the market.  Earlier this year, the price of long term bonds went down (yields went up) in anticipation of rate increases from the Federal Reserve. Counteracting that trend in the past month, long-term bond yields have gone down (U.S. Treasury) as investors bid up treasuries in the hopes that the Fed will delay raising rates till after September.

On July 22, the price of of a barrel of West Texas Intermediate (WTI) oil broke below $50 (NYMEX). Two previous times this year the price has come close to the psychologically important $50 mark only to rise back up.  Now traders are concerned that the U.S. Energy Information Administration’s (EIA) short term estimates of oil reserves and rig counts may not be accurate.  “When in doubt, get out” has been a recent refrain.

Let’s  go up in our time balloon to see why the breaking of this price point has some traders worried.  The last time WTI broke $50 was in the 2008 meltdown.

China’s growth is slowing.  Europe is idling in neutral.  Forecasts for global economic growth are subdued = low demand and this is why commodity prices are at ten year lows. Positive economic growth in the U.S.  may be the only bright spot in this global forecast.

Easter Egg

April 5, 2015

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

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

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

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

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

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



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



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

Steady As She Goes

March 22, 2015

Monetary Policy

The FOMC is a committee of Federal Reserve members who meet every six weeks to determine the course of monetary policy.  A statement issued at the end of each two day meeting is carefully parsed by traders in an orgy of exegesis.  And thus it was so this past week.  Recent statements by the Fed included the word “patient” as in low inflation and some lingering weaknesses in the labor market allow us to take a patient approach with monetary policy.  If the Fed removed the word patient, then it was a good bet that they would start raising rates at their mid June meeting.  By the end of the year, the thinking was, the benchmark Fed funds rate could be 1%-1.25%.

So here’s what happened while you were at work, or at lunch or picking up the kids on Wednesday afternoon when the Fed meeting concluded. The initial reaction was negative, or at least that’s how the HFT (high frequency) algorithms parsed the Fed’s statement.  “Patient” was gone.  Sell, sell, sell. Then some human traders noticed that the Fed was also saying that they did not have to be impatient either – the perfect neutral stance.  Buy, buy, buy.  The SP500 jumped 1.5% in a few minutes.  The neutral stance of  the Fed caused many to revise their estimates of the Fed rate at the end of the year to .75% or less.  The broad market index ended the week at the same level as it was when the month began.  Volatility as measured by the VIX is rather low but there has been a lot of  positioning since Christmas and a net gain of only 1% in those three months.


Earnings Recession

The analytics firm FactSet projects a year-over-year decline in the earnings of the SP500 companies for this first quarter of 2015.  Here is a good review of the historical response of the stock market to earnings recessions, defined as two quarters of year-over-year declines in the composite earnings of the SP500.



Oil is an international commodity that trades on world markets in U.S. dollars.  A prudent strategy for countries which are net importers of oil is to stock up on dollars to pay for its short term oil needs.   As the demand for dollars climbs so does its price in other currencies, a self-reinforcing mechanism.  Half of the drop in the price of oil is due merely to the appreciation of the dollar, which has spiked some 25% since the beginning of the year.

For decades, many in academia and government have advocated the adoption of an international currency called the SDR, already in use by the International Money Fund.   Here is an article from last May, before the price of oil started its slide.  The dollar is the latest in a series of reserve currencies over the past 500 years and has been the dominant currency for almost 100 years (History here). The reliance on one country’s currency works – until it begins to cause more problems than it solves.  The  largest producer and consumer of oil, Saudi Arabia and the U.S., have formed a decades long agreement to price oil in U.S. dollars, binding the rest of the world to the movements in the U.S. dollar.The recent volatility in the dollar in threatening the economic stability of many nations, who are increasing their calls for a change in international monetary policy.


Sticky CPI

In a survey of newspaper articles, inflation was mentioned more than unemployment or productivity.  In the U.S., inflation is often measured by the Consumer Price Index (CPI).  A subset of that measure is called the core CPI and excludes more volatile food and energy items to arrive at a fundamental trend in inflation.  (IMF primer on inflation ) Critics of the core CPI point out that food and energy items are the most frequent purchases that consumers make and have a fundamental effect on the economic well being of U.S. households.  Responding to some of the inherent weaknesses in the methodology of the CPI, the Atlanta branch of the Federal Reserve began development of an alternative measure of inflation – a “sticky” CPI. (History)  This metric gives a statistical weight to the components of the CPI by how much prices change for each component.  The Atlanta Fed has an interactive graph that charts both the sticky measure and a more volatile, or flexible CPI that is similar to the conventional CPI.  The sticky CPI tends to measure expectations of future changes in inflation and moves rather slowly.

Over a half century, the clearest trend is the closing of the gap between the regular CPI and the sticky CPI.

When we compare all three measures, core, sticky and regular CPI, we see that the sticky CPI is usually above the core CPI.  January’s readings are 2.06% for the sticky index, 1.64% for the core index and -.19% for the headline CPI index.

A private project called Price Stats goes through the internet comparing prices on billions of items.(WSJ blog article here)  This data is more timely and shows an uptick in core inflation that is approaching 2%, the Federal Reserve’s target rate.  When asked why the Fed uses 2%, chair Janet Yellen answered that inflation indexes do not capture improvements in products, only prices, so they tend to overstate inflation as a matter of design and practical data gathering.  Secondly, the 2% mark gives the Fed a statistical cushion so that they are able to take appropriate monetary steps to avoid deflation.

Why is deflation a bad thing?  In answering this question, we discover the true benefit of the core CPI.  Food and energy are regularly consumed.  Demand for these goods is relatively “sticky”.  A family may change what types of foods it buys in response to price changes but it is going to buy food. Deflation in these core purchases can be a good thing as it takes less of a bite out of the average household’s wallet.

On the other hand, deflation in less frequently purchased goods, which the core CPI tracks, is not good because it leads to a self-perpetuating cycle in which consumers delay making purchases in the expectation that tomorrow’s price will be lower than today’s price.  If I expect that the price of an iPhone will be lower next week, how likely am I to buy one this week?  As consumers delay purchases, suppliers lower prices even more to move their goods.  Seeing the price competition among vendors, consumers are even more likely to delay purchases, waiting for prices to come down even further.  As sales drop, vendors and manufacturers begin to layoff employees.  Lower prices no longer entice consumers who become concerned about keeping their jobs and purchase only what they need.


The Conference Board, a business association, released their monthly index of Leading Indicators this week but it has a spotty history of forecasting trends. Doug Short puts together a nice snapshot of the Big Four indicators, Employment, Real (inflation-adjusted) Sales, Industrial Production, and Real Income.

Dance Partners

January 18, 2015

When investors are grumpy, good news is not good enough or it is too good.  Confidence among small businesses climbed to levels not seen since late 2006 and the positive sentiment was broadly based, including new hiring and plans for expansion.

On the other hand…December’s 9/10% decline in retail sales was a surprise after a strong November.  However, a closer look at the retail figures shows some real positives.  The year-over-year gain was 2.6%, above the 1.7% core inflation rate, indicative of modestly  growing demand.

Excluding retail gas sales, retail sales gained 4.8% over last year.

Now, let’s put gas sales in some historical perspective.  In January 2007, the price of a gallon of gasoline was $2.10, about the same as it is now.  On average, we are driving more fuel efficient vehicles than in 2007, yet total retail gas sales are 25% higher now.

Every six weeks, the Federal Reserve releases their Beige Book survey of economic conditions around the country.  They also reported moderate growth in employment and sales.  They noted that flat wage growth and low inflation reduces any urgency in raising rates.  Friday’s release of the CPI confirmed the low inflation rate.  Including gas and food, the yearly increase was only .7%.  Core inflation, which excludes gas and food prices, rose 1.7%.  Consumer sentiment is nearing the levels of the early to mid-1980s, the beginning of a period of strong growth.

For now, stocks and oil prices are dance partners.  In a week of negative sentiment, traders were watching the 1975 level on the SP500.  This was mid-December’s bottom, a short-term key level of support.  After Thursday’s close near 1990, stocks rallied on the strong consumer sentiment and a report from the International Energy Agency that lower prices are causing some oil production cuts. Fourth quarter earnings season has just begun but if volatility in oil prices remains strong, this may drive market sentiment at least as much as earnings reports.


Job Openings (JOLTS)

November’s job openings showed a slight increase, getting ever closer to the 5 million mark and nearing an all time high set in the beginning of 2001 as the dot-com boom was ending.  This summer open positions surpassed the mark set in June 2007 at the end of the housing boom.

The  economy grows stronger on many fronts – labor, retail, housing and industrial production – and is near multi-year high marks without the help of a widespread boom in any one sector of the economy.  The surge in oil  shale production is confined to a few states.


Portfolio Allocation

As the market remains somewhat volatile, it’s time to revisit a familiar theme – allocation.  Let’s look at a selection of portfolios with moderate allocation. How much difference has there been between a portfolio with 60% stocks and 40% bonds (60/40), and one with 40% stocks, 60% bonds (40/60)?

Earlier in the year, I mentioned a site  that can backtest a pretend portfolio.  In the free version, the re-balancing rules are fairly simple but it does allow us to make some comparisons of long term trends.

All of the following tests include the years 2000 – 2014, a period which covers two downturns.  The first, from 2000 to 2003, was a protracted decline after the dot com bubble.  The second, from late 2007 to 2009, was severe.

The test includes an annual re-balancing to get to the target percentages, and assumes a modest investment of $100 each year into a $10,000+ portfolio.  Because of the two downturns, it’s no surprise that the portfolio weighted toward bonds did better than the portfolio weighted toward stocks.

The difference between the 60/40 and 40/60 was about 7/10% in annual return.  If we were to use intermediate term bonds as a proxy for the bond component of the portfolio, the difference would be even less.  In the middle range of allocation models, the differences in returns over a long period of time are probably smaller than what we worry about.

The importance of moderate allocation is illustrated by the following two examples.  Let’s consider the period from 1995 – 2014, which includes three market rises and two downturns.  Note the ratio: three up to two down.  If we compare a portfolio of all stocks to a balanced portfolio of 50% stocks and 50% long term bonds, we see that it is only in the past five years that the all stock portfolio finally meets the return of the balanced portfolio.

Long term bonds are especially sensitive to changes in interest rates so let’s look at a balanced portfolio of stocks and intermediate term bonds.

In this case, it is only in the past two years that the total return of the all stock portfolio has outperformed the balanced portfolio.  One of the those years included an unusual 30% gain in one year.  In short, it is hard to argue against a balanced portfolio over a long period of time.

Lastly, the example below shows a slight advantage to re-balancing a portfolio.  However, the additional .2% gain each year should not cause us to lose sleep if we forgot to do this for a few months.


Oil Prices

Oil suppliers are pumping down their inventories as global demand for oil weakens.  More product, less demand = lower prices. In a standard economic model, customers want more of a good at a lower price.  Suppliers are less willing to supply a good at a lower price.  Eventually, suppliers and customers reach an equilibrium at a certain price.

What happens in a price war does not follow this simplified textbook model.  Suppliers with deep reserves try to drive out other suppliers by flooding, or at least over supplying, the market, thus driving the price down.  More units are bought but at lower prices, so the value of gross sales may be lower even though the units sold is higher than before.  The profit on each unit sold, or marginal profit, gets lower and may get negative for a time till the more vulnerable suppliers leave the market.

The governments of Venezuela, Russia and Nigeria depend on oil revenues for much of their income.  Should oil prices stay below $50 for half a year or more, these countries will be pressed to curtail social benefit programs and infrastructure projects.  The interest rates on their bonds will increase as investors price in a greater risk of default.

Sudden changes produce fractures.  Fractures produce frictions. Frictions dissipate in a cascade of minor adjustments or suddenly in a violent upheaval.

Merry Christmas

December 21, 2014

In preparation for today’s solstice, the market partied on in a week long saturnalia.  The week started off on a positive note.  Industrial production increased 1.3% in November, gaining more than 5% over November of 2013.

Capacity utilization of factories broke above 80%, a sign of strong production.  Production takes energy.  I’ll come to the energy part in a bit.

The Housing Market Index remained strong at 57, indicating that builders remain confident.  Tuesday’s report of Housing Starts was a bit of a head scratcher.  After a strong October, single family starts fell almost 6%.  Multi-family starts fell almost 10% in October, then rebounded almost 7% in November.  Combined housing starts fell 7% from November 2013.

The market continued to react to the change in oil prices.  For the big picture, let’s go back a few years and compare the SP500 (SPY) to an oil commodity index (USO).  For the past five years, USO has traded in a range of $30 to $40, a cyclical pattern typical of a commodity.  In October, the oil index broke below the lower point of that trading range.

On Tuesday, oil seemed to have found a bottom in the high $50 range.  USO found a floor at $21, about a third below its five year trading range.  Beaten down for the past three weeks, energy stocks began to show some life (see note below).

Encouraging economic news helped lift investor sentiment on Tuesday morning. Some bearish investors who had shorted the market went long to close out their short positions. Growth in China was slowing down, Japan was in recession, much of Europe was at stall speed if not recession and the continued strength of the U.S. dollar was making emerging markets more frail.  While the rest of the world was going to hell in a hand basket, the U.S. economy was getting stronger.  Thee Open Market Committee at the Federal Reserve, FOMC, began its two day meeting and traders began to worry that the committee might react to the strengthening U.S. economy with the hint at an interest rate increase in the spring of 2015.  This helped sent the market down about 2% by Tuesday’s close.

Wednesday’s report on the Consumer Price Index (CPI) was heartening.  Falling gas prices were responsible for a .3% fall in the index in November, lowering inflation pressures on the Fed’s decision making about the timing of interest rate hikes.  The core CPI, which excludes the more volatile energy and food prices, had risen 1.7% over the past year, slightly below the Fed’s 2% target inflation rate.  Traders piled back into the market on Wednesday ahead of the Fed announcement Wednesday afternoon.  Back and forth, up and down, is the typical behavior when investors are uncertain about the short term direction of both interest rates and economic growth.

The Fed’s announcement that they would almost certainly leave interest rates alone till mid-2015 gave a further 1% boost upwards on Wednesday afternoon.  Twelve hours later, the German market opened  up at 3 A.M. New York time.  Early Thursday morning, the price of SP500 futures began to climb, indicating that European investors were reacting to the Fed’s decision by putting their money in the U.S. stock market.  Those of you living in the mountain and pacific time zones of the U.S. might have caught the news on Bloomberg TV before going to bed.  Maybe you got your buy orders in before brushing your teeth and putting your nightgown on. Very difficult for an individual to compete in a global market on a 24 hour time frame.  On Thursday, the market rose up as high as 5% above Wednesday’s close, before falling back to a 2.5% gain.

Still, a word of caution.  Both long term Treasuries, TLT, and the SP500, SPY, have been rising since October 2013.

As long as inflation remains low and the Fed continues its zero interest rate policy (ZIRP), long term Treasuries and stocks will remain attractive.   Something has to break eventually.  ZIRP  helps recovery from the aftermath of the last crisis but helps create the next crisis.  Abnormally low interest rates over an extended period are bad for the long term stability of both the markets and the economy.

Sale – Energy Stocks – Limited Time Only

(Note: this was sent out to a reader this past Tuesday.  Energy stocks popped up 4 – 5% the following day, a bit more of rebound than I expected. The week’s gain was almost 9% and the ETF closed above its 200 week average.)

As oil continues its downward slide, the prices of energy stocks sink.  XLE, a widely traded ETF that tracks energy stocks,  has dropped below the 200 week (four years!) average.  (A Vanguard ETF equivalent is VDE).  Historically, this has been a good buying opportunity. In the market meltdown of October 2008, this ETF crashed through the 200 week average.  A year later, the stock was up 38% and paid an additional 2% dividend to boot.  Let’s go further back in time to highlight the uncertainty in any strategy. The 2000 – 2003 downturn in the market was particularly notable because it took almost three years for the market to hit bottom before rising up again.  The 2007 – 2009 decline was more severe but took only 18 months. In June 2002, XLE sank below its 200 week average.  A year later, the stock had neither gained nor lost value. While this is not a sure fire strategy – nothing is – an investor  is more likely to enjoy some gains by buying at these lows.


Emerging Markets Stocks

Also selling below the 200 week average are emerging market (EM) stocks.  These include the BRICs (Brazil, Russia, India, China) as well as other countries like Mexico, Vietnam, Turkey, Indonesia and the Philipines. When a basket of stocks is trading below its four year average, there are usually a number of good reasons. Several money managers note the negatives  for EM.   Also included are a few voices of cautious optimism.  Sometimes the best time to buy is when everyone is pretty sure that this is not the right time to buy.  Another blog author recounts two strategies for emerging markets: a long term ten year horizon and a short term watchful stance.  The long term investor would take advantage of the low price and the prospect for higher growth rates in emerging economies.  The short term investor should be cognizant of the fickleness of capital flows into and out of these countries and be ready to pull the sell trigger if those flows reverse in the coming months.



What are the characteristics of TANF families?  When the traditional welfare program was revised in the 1990s, lawmakers coined a new name, Temporary Assistance to Needy Families, to more accurately describe the program.  The old term carried a lot of negative connotations as well. Two years ago Health and Human Services (HHS) published their analysis of a sample of 300,000 recipients of TANF income in 2010.  Although the recession had officially ended in 2009, the unemployment rate in 2010 was still very high, above 9%.  It is less than 6% today.

There were 4.3 million recipients, three-quarters of them children, about 1.4% of the population. By household, the percentage was also the same 1.4% (1.8 million families out of 132 million households).  In 2013, the number of recipients had dropped to 4.0 million, the number of families to 1.7 million (Congressional Research Service)

In 2010, average non-TANF income was $720 per month, or about $170 a week.  To put this in perspective, this was about the average daily wage at that time The average monthly income from TANF averaged $392. Recipients were split evenly across race or ethnic background: 32% were white, 32% black, and 30% Hispanic. For adult recipients only, 37% were white, 33% black, and 24% Hispanic.

Rather surprising was how concentrated the recipients were. 31% of all TANF recipients in 2010 lived in California.  43.3% of all recipients lived in either New York, California or Ohio.  The three states have 22% of the U.S. population and almost 44% of TANF cases.

HHS data refutes the notion that welfare families are big.  50% of TANF families had only one child.  Less than 8% of TANF families had more than 3 children.  82% of TANF families also receive SNAP benefits averaging $378 per month.

In 2014, Federal and State spending on the TANF program was less than $30 billion, about 1/2% of the $6 trillion dollars in total government spending.  The Federal government spends a greater percentage on foreign aid (1%) than the TANF program. Yet people consistently overestimate the percentage of spending on both programs (Washington Post article).  The average estimate for foreign aid? A whopping 28%.  Cynical politicians take advantage of these public misperceptions.



Aiming to overhaul the health care insurance programs throughout the country, the Affordable Care Act (ACA) was a big bill.  No, it wasn’t 2700 pages as often quoted by those who didn’t like it.  The final, or Reconciled, version of the bill was “only” 900 pages.  The House and Senate versions were also about 900 pages each; hence, the 2700 pages.

At 1600 pages in its final form, the recently passed Omnibus Spending bill makes the ACA look like a pamphlet.  As  specified in the Constitution, all spending bills originate in the House.  Past procedure has been to pass a series of 12 spending bills.  Majority leader John Boehner has found it difficult to get his fractious members to agree on anything in this Congress so all 12 bills were crammed into this behemoth bill just in time to avoid a government shutdown.  Just as with the ACA, most members of the House and Senate did not have adequate time to digest the details of the bill.  The bill is sure to hold many surprises for those who signed it and we, the people, who must live under the farcical law-making of this Congress.  Here is a primer on the budget and spending process.


Home Appraisals

They’re back!  A review of 200,000 mortgages between 2011 and 2014 showed that 14% of homes had “generous” appraisals, inflating the value of the home by 20% or more.  Loan officers and real estate agents are putting increasing pressure on appraisers to adjust values upwards.


Personal Income

You may have read that household income has been rather stagnant for the past ten years or more.  In the past fifty years household formation has increased 78%, far more than the 50% increase in population.  The nation’s total income is thus divided by more households, skewing the per household figure lower.  During the past thirty years, per person income has actually grown 1.7% above inflation each year.  Inflation adjusted income is now 66% higher than what it was in 1985.

In 2013, the Bureau of Economic Analysis released median income data for the past two decades. Median is the middle; half were higher; half were lower.  This is the actual dollars not adjusted for inflation.  Except for the recession around the time of 9-11 and the great recession of 2008 – 2009, incomes have risen steadily.

The 3.7% yearly growth in median incomes has outpaced inflation by almost 25%.

Why then does household income get more attention?  A superficial review of household data paints a negative picture of the American economy. Negative news in general tugs at our eyeballs, gets our attention.  The majority of the evening news is devoted to negative news for a reason. News providers sell advertising in some form or another.  They are in the business of capturing our attention, not providing a balanced summary of the news.  In addition, a story of stagnating incomes helps promote the agenda of some political groups.


Merry Christmas and Happy Chanukah!

Oil, oil, retail, and oil

December 14, 2014

The market seemed to wake up Monday morning on the wrong side of the bed.  The Federal Reserve updated their Labor Market Conditions Index, scoring the month of November with a tepid 2.9, a sobering counter punch to the previous Friday’s report of 321,000 job gains in November.  Too many part time workers, too many long term unemployed, a rate of unemployment that was too high among minorities, those in their twenties and those without a college education.

ISM’s monthly reports showed continued strength in both manufacturing and the services sector. The composite CWPI eased just a bit from the historic highs of the past two months.

The key components of the manufacturing index, new orders and employment, remained strong or robust.  The prices component showed a steep dive from expansion to contraction, 53.5 to 44.5.  George wondered if the falling price of oil had anything to do with this change.  New orders in the services sector grew even stronger while employment eased just a bit and was also continuing a strong expansion.

On his way to Home Depot on Tuesday morning, George filled up his SUV for just under $50.  When had that happened last he wondered.  2009, maybe?  George remembered the lead up to the 2012 elections. “Gas was $1.50 when Obama came into office,” he would hear on a conservative talk show, “and now it’s more than double that. Obama is hurting working families.”  As though Obama, or any President for that matter, had much to do with the price of gas.  Most talk show hosts counted on the fact that their audience was, well not stupid, as Jonathan Gruber had quipped when talking about Obamacare at a conference, but poorly informed.

The market had opened up that morning in a particularly foul mood after China tightened lending criteria so that Chinese investors could no longer use low-grade corporate debt as collateral for loans.  Overnight the Shanghai market lost more than 5% (WSJ ).

The EIA projected that U.S. oil production would rise in 2015 even as oil prices went lower.  Lower prices might curb new drilling but once the wells were drilled, the cost of production was fairly low.  The drop in gas prices put some extra money in most people’s pockets.  The EIA estimated that a gallon of gas would average about $2.60 in 2015, almost a $1 lower than the $3.51 average in 2013.

The continuing fall in oil prices contributed to another drop in the market on Wednesday, erasing the gains of the past month.  To sell or not to sell, that is the question, George thought as the volatility in the market continued to climb, rising more than 50% in the past week.  But he hemmed and hawed, then decided to replace the fence post in the back yard as the antidote to his indecision.

In an economy dominated by consumer spending, the monthly retail sales report and the employment report are probably the two most influential gauges of the strength of the economy.  Thursday’s report on retail sales was a huge positive, showing a rise of .7%.  On an annualized basis, that was an increase of more than 8%.  People were evidently spending the money they were saving at the pump.  The market opened higher and climbed up above Wednesday’s opening price.  Great stuff, George thought, then watched as the positive mood vanished and the market started sinking.  He must have made some sound because Mabel called out asking him if he was OK.  George realized that the early morning run up in prices was traders covering their short bets.  The underlying sentiment was still negative.  A strong employment report last Friday and now a strong retail sales report was having little effect on the mood of the market.  George decided to get out of the way of the darkening mood and sold the equity index he’d bought in mid-October.

The market continued to follow oil prices down on Friday.  George was pleased to find that the long term Treasuries that he had bought last week were up a few percent.  Glancing back at the beginning of the year, he saw that long term Treasuries (TLT) were up an unbelievable 20% so far this year.  Back in January many had projected higher interest rates toward the end of 2014, making long term Treasuries less attractive.  The equity market was up 10% for the year despite the recent change in mood.  Two types of investment that often moved opposite each other had moved in the same direction.  George smiled as he remembered something his  childhood baseball coach would say, “If it ain’t one thing, it’s the other, and sometimes it’s both.”  Which was just another way of saying not to put all your eggs in one basket.