Category: stocks

New Directions

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December 28th, 2014

Emergency Plan

Let’s say you have $60 invested in the stock market.  You have $30 invested in bonds and $10 sitting in your savings account, for a total of $100.  This is essentially a 60/40 stock/bond mix. You do not rely on your investments for current income.

Some crisis unfolds, sending shock waves through global markets.  Within a month, the stock market loses 30%.  Bonds have gone up 10% as investors flee to safety.  Financial soothsayers are predicting further stock losses, perhaps as much as 50%.  Others are saying that the market has bottomed.

Your stock portfolio has lost $18 (30% of the $60).  Your bond portfolio has gained 10% or $3.  Your portfolio is now valued at $42 stocks, $33 bonds, $10 savings, a 50/50 mix of stocks/bonds.

Now, let’s add some historical context. From 1968 to 1982, a period of fourteen years, there was no change in the SP500.  From 1982 to 2000, the SP500 rose 1400%.  Then from 2000 to early 2013, almost thirteen years, there was no change in the SP500.  Yes, it’s only been a year and a half since the market regained those levels of 2000.

So, what would you do?  Do you:

A)  Invest the $10 in savings to bring you back closer to your original allocation mix of 60/40 stocks/bonds.

B) Stick to allocation goals.  Keep the $10 tucked away in savings for emergencies, sell some bonds and buy stocks to get closer to your allocation goals.

C) Change your allocation mix.  Cut your losses by selling the stocks you own and buying the better performing bonds.

D) Shrug and make no changes.  Turn on the game and order a pizza. The stock market will rebound in due time and automatically rebalance your portfolio on its own.

E)  Freeze, not knowing what to do.  Yes, not knowing what you would do is a game plan, a choice.  Perhaps its not the best plan but it is often one chosen as the default.

Now, run that same scenario, changing only one thing. You rely on your investments and savings for half of your current income.  Now what do you do?

Was the past year and a half the beginning of an eighteen year run up in prices similar to the 1982 – 2000 period?  Could the SP500 index, currently trading near 2100, be valued at 21000 (1500 * 1400%) in 2032?  Maybe.  Could 2014 be the last year in the previous flat cycle so that the market drops 25% to the 1500 level of 2000 and 2007?  Maybe.

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GDP
The third estimate of 3rd quarter GDP growth was a strong 5% on an annualized basis, more than offsetting the weak 1st quarter of this year. On a more sobering note, it is only in the past six months that per person GDP has firmly surpassed 2007 levels.
GDP is a measure of tradeable goods and services in an economy.  There is much important human activity that is not measured in GDP so it is far from perfect.  If you want perfect, go to the universe next door. Per person GDP growth below 1% causes concern among traders, money managers, economists and policy makers.  This year per capita growth is a healthy 2% – not robust but respectable.  
Contributing to GDP growth in the third quarter was a 4% yearly increase in federal government spending, more than double the rate of inflation.
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Oil 
Monday’s meeting of the OPEC members left little doubt that Saudi Arabia is content to let the price of oil fall as low as natural supply and demand might take it.  They said they would not consider production cuts until oil went as low as $20 a barrel, about a third of what oil is currently trading at, and a fifth of its price in 2013.  This rhetoric was aimed directly at two non-OPEC members, the U.S. and Russia, warning both countries that the Saudis intend to keep their leadership position in the international oil market.
Missouri was the first state to report an average price per gallon of gas that was lower than $3.  Others are sure to follow.  A few weeks ago an EIA administrator testified before Congress, revealing a number of dramatic shifts in U.S. oil production, consumption and import.  Once the largest importer of petroleum products, the U.S. is now the world’s largest exporter.  Despite falling oil prices, the EIA expects production to increase 10% in 2015.  

The Talk

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November 23, 2014

A strong wind from the southwest blew into town, chasing the cold weather out onto the great plains east of Denver.  Most of the trees had given up their leaves as the days grew shorter but the elm trees had stubbornly held onto their leaves, still green far into November.  The turning of color began during the cold snap of the previous week and now the great gnarly giants began to release their leaves to the winds.  Busy at work for many years, George had hired out the autumn cleanup.  Now that he was retired, he was becoming more attuned to the daily and seasonal rhythms of the plants and animals in the neighborhood.

“Leave me a small bag of leaves, dear,” Mabel asked.  She would dry them out, then arrange them into an autumn harvest theme.  George knew he needed to bring up the renewal of the CD with Mabel before her attention became entirely focused on the holidays.  She would set up the card table in the dining room and the season’s decorating would begin.

George had spent a lifetime assessing risk for the insurance of commercial buildings, which are dependent on the municipal services available to them – the fire, police, utilities, transportation, communications, and medical facilities that reduce either the risk or cost of damage.  George had given too many presentations at city council meetings or at the city planning board, outlining the cost benefits of municipal improvements.  Unlike the federal government with its seemingly limitless ability to borrow money, state and local governments had to live with real budget constraints.

George categorized himself as a prudent judge of risk.  However, he knew that most people he had met in his line of work thought they were prudent.  If asked, “Do you think you are more or less prudent than average?” most would answer that they are above average.  It was the Lake Wobegon effect, where everyone’s child was above average.  We couldn’t all be above average.

Mabel’s experience as a school principal had given her a firm grounding in budgets and accounting, but she was reluctant to take much risk with their personal savings, preferring CDs and savings accounts. She was not alone. In a recent Wall St. Journal blog was a study showing that 1/3 of IRA accounts had no stock exposure.

Fifty-six percent of IRA owners had either all their IRA money in stocks or absolutely none of that money in stocks in both 2010 and 2012, according to a study by the Employee Benefit Research Institute of data on 25.3 million accounts. (It was 33.2% at the no-equity end of the spectrum and 22.5% at the all-equity end.)

 In today’s low interest environment these accounts paid little interest but their value was secure.  If the 2008 financial crisis had happened when he and Mabel were in their thirties and had little in savings and several decades of paychecks to come,  the emotional effect probably would have lessened with time.  Coming as it did right before their retirement, the crisis had shaken their faith in anything whose principal was not guaranteed.  Their losses during the crisis had been lessened simply because Mabel had been so insistent on selling what stocks and bonds they had in September of 2008.

She had blamed the crisis on Bush, whom she thought to be one of the worst presidents in U.S. history.  George, who followed the markets and financial news more closely, made several attempts to give Mabel a more balanced assessment but she was adamant.  “No rules!  No regulations!  This dummy for a president is finding out what happens when there are no rules or regulations!  It’s like high school with no one in charge!”  As stock prices continued to sink over that winter, George was thankful that they had avoided any additional losses.  On the other hand, they had avoided most of the subsequent gains in the past seven years.

He mentally rehearsed his presentation.  The $50,000 CD was coming up next week.  It had paid a paltry 1.1%.  He checked one year CD rates.  Chase was offering 1/100th of 1%, Wells Fargo 5/100ths.  Had George read that right?  He checked the decimal points.  Sure enough, .01% and .05%.  In short, “We don’t want your money!”  A savings deposit or CD was essentially a loan to the bank, so why would any bank want money from Ma and Pa Liscomb when they could get it for almost free from the U.S. government?  So, he would start off telling  Mabel about the low interest rates.

The next part of his presentation would be a cautionary tone of risk and reward.  He would tell Mabel that the stock market was like a wagon train.  Well, maybe that was too poetic.  She might give him her “gimme a break” look.  He would hold up his hand and ask for some patience.  Different wagon trains take different paths across the country. The bond wagon train takes the southern route.  The terrain is flatter but the distance is longer.  The stock wagon train takes the more direct route across the mountains and valleys.  He’d show her the chart of the SP500 as it went up and down the hills and valleys.

“Yeh,” she would say, “what I don’t like are the steep valleys.”  That’s when he would show her his zig-zag chart.  Do you see how bonds zig when stocks zag? he would say.  This way, bonds counterbalance some of the risks in the stock market.

“So what happened in 2008?” she would say with a healthy dose of skepticism in her voice.  “Well, that was unusual,” he would say.  “Everything fell.  Even it did happen again, it is unlikely to stay that way for more than a few months or at most a few years.  If a crisis like that happened again and stayed that way for several years, we’d be more worried about getting food and gas, not about paying for it,” he’d say.  Ok, maybe that would be an overstatement, but maybe not.

“But stocks have already gone up for the past few years,” she might say.  “Some people are saying that it’s a bubble.”  Then he’d mention all the good economic signs.  Manufacturing and services were both strong.  Industrial Production continued to rise and has been above 2007 levels for more than a year.

Sure, there were signs of weak consumer demand. The Consumer Price Index had risen only 1.7% over the past year.  Falling gas prices had helped keep a lid on raises in the CPI and was putting extra money in consumers’ pockets.  It was not only lifting airline profits but contributing to lower costs for a lot of companies.  The Homebuilders association was reporting strong confidence among their members and existing home sales were at a stable level.

George wouldn’t tell her one thing that concerned him.  It was a long term phenomenon, a growing caution that George attributed to the aging of the population.  People put money in safe money accounts like savings, CDs, money markets, and checking when they were less confident about the future or anticipated a short term need for  cash.  On the second point, it was true that as people got older, they prudently put more money in safe accounts.  Retired people in particular were encouraged to keep five years of anticipated withdrawals in a safe place, not the stock market.  The Federal Reserve tracked the amount of these safe money accounts, known as the M2 money supply.  Occasionally, George would look at this amount as a percent of GDP.  Over the past decade the percentage of M2 to GDP had been growing.

This could be a natural trend of an aging population but there was another metric that concerned George.  Over the past thirty years, people were keeping twice the amount of money in safe accounts.  In the early 1980s, it had been about $8000.  After accounting for inflation over the past thirty years, the per capita average was $15000.

George guessed that this cautious move to safety would contribute to slowing economic growth for years to come.  But he wouldn’t tell Mabel that.  He was also keeping a wary eye on small cap stocks.

If the index continued to break down below the neckline, George expected further weakness, perhaps another 10% drop as investors lost confidence in small cap stocks.  Falling oil prices and low gas prices helped small caps but the strong dollar and continued weakness in the European countries and Japan would curtail export growth.

Armed with a mental outline of his presentation, George sat down next to Mabel in the living room.  “Whatcha reading?” he asked.  If she was in the middle of a whodunit, this wouldn’t be a good time.  “It’s a series of papers, mostly statistical studies on student scores,” she said.  “Teaching models, and correlations with their socioeconomic backgrounds, their race.  Lorraine lent me her copy.  It’s very interesting but reminds me that I need to brush up on some terms.”

This was good, George thought.  Her brain was in analytical mode already.  “Hey, hon, I wanted to talk to you about that CD coming up next week,” he started.  “Oh, yeh,” Mabel responded.  “I was at the bank the other day and couldn’t believe how low the rates are now.  Why do they insult their customers by posting the rates?” she mused.

“I was thinking about that,” George stepped in.  God, she was making this easy, he thought.  “What do you think,” she continued, “maybe move that money into one of those bond index funds?” she asked.  “Uh, yeh,” George said, a bit befuddled. She was making it too easy after all the time he’d spent planning his presentation, her objections, and his persuasive responses.  “You had said you wanted to keep everything totally safe, so I thought…,” George’s voice trailed off.  “Well, I do, but this is ridiculous,” Mabel said.  “Obviously, we are going to have to take some risk.”  “And I’ve got the time to watch it,” George reassured her.  “I’ve noticed that,” she said. “I don’t have the interest to watch it.  I guess I always thought that investing was a ‘set it and forget it’ proposition.  Maybe it was never that way.  But, after 2008, I’m…” and she gave a rock-the-boat gesture with her hand.  “Ok,” George said and stood up. “I’ll have the bank close out the CD, then transfer the money.”

Diminished Expectations

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February 3rd, 2014

The SP500 has been hovering over a support trendline in the 1760-1775 range, with buyers coming in at 1775.  At 1750, the market would have corrected 5%, a fairly normal occurrence.  Market watchers have been concerned that the market has not experienced one of these small “shaking of the tree” corrections since May/June of 2012.  Disappointing earnings and revenue reports from bellweather companies, together with selling pressure on some emerging market currencies, have made traders nervous.

The market is composed of buyers and sellers responding within varying time frames.  In a short to mid term time horizon, one person might pay more attention to turbulence in emerging markets or the latest corporate reports.  A mid to long term investor might pay more attention to rising industrial production, healthy GDP numbers, consumer spending and income, and declining unemployment.

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Apple forecast lower than expected revenues for the coming quarter in the China market.  The announcement prompted an 8% decline in the company’s stock.  Facebook reported blow out revenue growth of 63% in the past quarter, causing the stock to rise about 16%.  FB’s active user base has more than doubled in two years.  Despite the robust growth, the sky high valuation of the company reminds me of some internet stocks in the late 1990s.  The stock has a Price to Sales – not Price to Earnings – ratio of about 15 to 1.  Google has a track record of strong revenue and earnings growth and sports a richly valued price to sales ratio of 6.4.  Does Facebook’s short track record deserve a valuation that is more than twice Google’s?  In 2000, Microsoft had a price-sales ratio of 23 to 1. Fourteen years later, Microsoft’s stock sells for 30% less than it did in 2000.  In 2000, Cisco had a price to sales ratio of 30 to 1.  Cisco’s revenues were growing 50% a year.  “The stock is cheap,” some said.  Fourteen years later, Cisco sells for less than a third of what it did in the heady days of rapid growth.  A word of caution to long term investors.

Amazon reported “only” a 20% increase in quarterly revenue during the busy 4th quarter Christmas season. This is five times the sales growth of the overall retail industry so a casual observer might think that the stock enjoyed a healthy bump up in price, right?  Wrong. After rising 50% over the past year, the company’s stock was priced to perfection. The disappointing growth particularly in overseas markets prompted a lot of selling and an 8% decline in price on Friday.

As I noted last week, many retailers will report quarterly earnings in February.  Many companies get a sense of the bottom line that they will report before the official release of quarterly data.  If there are material differences between consensus expectations and forecast results, a company will issue a revised forward guidance.  Wal-Mart did so this past week, revising its revenue and earnings forecast down for the fourth quarter and lowering earnings projections for the coming year.  The company cited a much greater than forecast impact from November’s reduction of the food stamp program.  The severe storms in December also had a material impact on sales.

In the past two months, Wal-Mart’ stock has declined 8%.  Let’s think about that for a moment.  The market value of Apple and Amazon declined 8% in one day.  It takes two months for Wal-Mart’s stock to decline by the same percentage.  Individuals who invest in companies like Apple and Amazon have to be able to take abrupt market gyrations in stride.  Companies are essentially stories.  Some like Apple and Amazon are stories of growth.  There comes a time when the story changes, as it did for Microsoft and Cisco more than a decade ago.  Apple’s story has been “under construction” in the past 18 months. Since the beginning of 2008, Wal-Mart’s stock has risen 56%, Apple’s is up 150%, and Amazon’s market price has soared more than 6 times.  Growth companies offer rich rewards for the investor who has the time to  follow the story, but it can be difficult to know when the story is changing.

During the past 3 weeks, Home Depot has lost about 6% after gaining 35% since the beginning of 2013.  This giant has one foot in the home construction and remodeling sectors, one foot in the retail sector.  The decline reflects lowered near term expectations for both construction and retail.  Consumer spending has risen steadily but incomes are flat.

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December’s report of new homes sold was disappointing.  After rising above an annual level of 450,000 in the fall, sales have fallen closer to the 400,000 mark.

 Some blame the particularly harsh December in the east, some blame the weak labor report released in early January, others blame the low supply, still others blame rising mortgage rates. The Case Shiller home price index shows a year over year gain of almost 14% in metro area homes, indicating relatively healthy demand.  However, the latest Consumer Confidence survey reports a decline in the number of people planning to buy a home.  On an ominous note, pending home sales in December declined more than 8%, the worst monthly decline in almost four years.  Without a doubt, the severe winter weather in the eastern U.S. was a big factor but it is difficult to assess how much of a change.  This is the second report – employment was the first – that was far below even the lowest of estimates.

The link between employment and new home sales is counterintuitive; changes in new home sales anticipate changes in employment.

In a 2007 paper presented at a Federal Reserve conference, economist Ed Leamer demonstrated that changes in residential investment, a relatively small component of the economy, indicate coming recessions and recoveries.  The National Assn of Homebuilders estimates that each new home generates a bit more than three full time jobs.

Residential investment includes new homes, remodels, furniture and appliances.  Eventually residential investment reaches a point where it is contributing too much to the economy. As that percentage begins to correct to more normal levels, the contraction tugs on the total of economic growth.

As you can see in the chart above, a sustainable “sweet spot” is in the 4 to 4-1/2% of GDP range but residential investment is still less than 3% of GDP.  In past recessions, residential investment has helped recovery.  This time is different.  Housing’s less than normal contribution to the nation’s GDP has dampened overall growth.

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The first estimate of GDP growth for the fourth quarter was a rather remarkable 3.1%.  Although this was in line with estimates, I was concerned that the severe winter weather in the east might have more of a negative impact.  A version of GDP that reflects domestic consumption, Final Sales of Domestic Product, showed a modest 2.1% growth in the 4th quarter, reflecting the impact of the weather, I think. The third quarter growth rate was revised to 4.1%, up substantially from the initial estimate of 2.8%.  The hope is that this is now a 4% growth economy and the first quarter of this year may hold some welcome surprises as delayed economic activity in the 4th quarter is rolled into this year’s first quarter.  As I noted a few weeks ago, the wave like trend of the CWI composite index of manufacturing and non-manufacturing indicated a slight lull in these winter months before another peak in early to mid-spring.

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Consumer Confidence rose to 80, the lower bound of what I consider healthy.  This index fell below 80 in the early part of 2008 and did not get above that mark till this past summer, then fell back in the fall.  A separate Consumer Sentiment survey from the U. of Michigan showed a similar reading at slightly above 81.

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January’s monthly employment numbers will be released next Friday.  I ran a chart of those not in the labor force as a percent of those working.  Thirty years ago, the economy was coming out of the most severe employment recession since the Depression.  It is rather disturbing that this ratio continues to climb to the nose bleed levels of that recession thirty years ago.

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The harsh winter weather may be affecting consumers more than businesses.  Chicago and the upper Midwest region got creamed with cold snap after cold snap in December yet industrial production figures for the month are still robust, declining somewhat from the incredibly strong readings of the past few months.

Investment Allocation and Housing

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December 1st, 2013

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

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

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

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

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

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

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

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

A long term bond fund has gained about 100%.

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

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

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

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

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

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

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

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

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

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

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

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

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

Labor and Money Flows

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September 1st, 2013

On this Labor Day weekend, I’ll review some things that caught my attention this past week.

The employment picture has shown steady but slow improvement.  The weekly survey of new unemployment claims continues to show downward movement.  In a survey that is about 13 years old, called the JOLTS, the BLS gathers data on Job Openings, Layoffs and Turnovers.  A component of this survey includes the number of employees who have quit their jobs, referred to as the “JOLTS quit rate.” In the aggregate, it indicates a hive intelligence, the estimation of millions of people about the prospects of getting another job.  Decades ago, researchers asked a number of people to estimate the number of jelly beans in a jar.  Each estimate has very small chances of getting close to the actual number, but the average of all estimates was found to be almost exactly the number of jelly beans in the jar.  I don’t know whether this experiment has been replicated but it is interesting.

After recent months of surging new orders for durable goods, July’s report, released Monday, showed signs of caution and a “return to the mean” of a positive upswing this year.

Although this past month’s data was negative, industrial production shows a clear uptrend.

In an analysis released a few months ago, the Federal Reserve examined data from the 2010 triennial (every 3 years) survey of households and estimated that inflation adjusted net worth per household (green line in the graph) has just climbed back to the level it was almost ten years ago.

 

On the positive side, average net worth is not less than it was ten years ago.  On the negative side for those nearing retirement, it is not more that it was ten years ago.

On Friday, the Personal Consumption and Expenditures (PCE) report showed a 1.4% year over year percent gain, indicating the tepid growth in household spending.  Below I’ve charted the percent gain in PCE vs the percent gain in GDP for the past thirty years.

We are still below the low points of the 1980s, 1990s and early 2000s.  The Federal Reserve is projecting GDP growth of 3 – 3.5% in 2014 but this may be another in a string of rosy forecasts by the Fed, who have repeatedly revised earlier rosy forecasts.  If the Fed were a contractor, it would be out of business due to poor estimating.  A $16 trillion economy is not a kitchen remodel by any means, but it does illustrate how difficult it is for the best minds to make even short term predictions of the economy from the vast amounts of sometimes conflicting data.  Consider then the folly of the Government Accountability Office (GAO), the economic watchdog created by Congress and mandated by Congress to come up with ten year estimates of economic growth and the consequences of existing and proposed legislation.  Those in Congress continue to trot out these fantasy numbers to support or criticize policy and legislation.

Washington continues to vacuum in money and talent from the rest of the country.  Of the richest counties in per capita income in the U.S., the Washington metro area has two of the top three.  The other county in the top three is a stone’s throw from the metro area.  As Washington politicians convince the rest of us that they have the solutions, lobbyists and graduates flock to the concentration of power, jobs, money and influence.
 
Bond yields have increased more than 1% since the spring, meaning that the prices of the bonds themselves have fallen dramatically.  Most of this change has been a reaction to forecasts for stronger growth and a tapering of the Fed’s stimulus program called Quantitative Easing.  Washington is sure to get in the way of stronger growth for the economy as a whole.  Policy out of Washington is designed to promote strong economic growth for Washington.

The market research firm Trim Tabs regularly monitors money flows into and out of the stock and bond markets.  They  reported today that outflows from the stock market in August were half of the record inflows in July.

The blood spilled this year has been in the bond market.  Trim Tabs reports that outflows from bond funds and ETFs have totalled more than $123 billion in the past three months.  Flows into bond funds and ETFs were about $750 billion in 2012, almost a doubling from the $400 billion invested in 2011. (Fed Flow of Funds tables F.120, F.121)

While the prospect of higher rates may have been the trigger that caused a reversal of bond inflows, the underlying current is also an overdue correction of the surge of investment in bonds in 2012.

Households continue to shed debt in one form or another so that total liabilities continue to decline. However, every man, woman and child in this country is carrying, on an inflation adjusted basis, 2-1/2 times the amount of debt they carried thirty years ago.  This level of household liability will continue to put downward pressure on growth.

This next week will kick off with the ISM manufacturing report on Tuesday and finish the week with the monthly employment report.  Year over year percent gains in employment have been steady and guesstimates are for maybe 200,000 net job gains.  150,000 net jobs are needed to keep up with population growth.

The Fed meeting is coming up in mid-September so this employment report will be watched closely to guess the next steps the Fed will take. 

The Great Moderation

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June 30th, 2013

Economists cite a number of factors to account for the growth during the 1980s and 1990s, a period some call the “Great Moderation” because it is marked by more moderate policies by politicians and central bankers.  Causes or trends include less regulation, lower taxes, lower inflation than the 1970s, the rise of emerging economies,  and a more consistent rules based monetary policy by the Federal Reserve.  Often underappreciated, but significant, was the huge increase in consumer credit. Household spending accounts for 2/3rds of the economy.  A new generation, the boomers, emerging fully into adulthood in the early ’80s, welcomed the broader availability of credit.  Like their parents, the boomers took on the burden and responsibility of owning a home, the largest portion of a household’s debt load, but unlike the previous generation, the boomers sucked up as much credit as they could get for cars, clothes, vacations, home furnishings and the growing array of electronic devices.

When we look at the non-mortgage portion of household debt, the rate of growth is more restrained – a mere 80% increase in per capita real dollars.

The parents of the boomer generation, dubbed by newscaster Tom Brokaw as the “Greatest Generation”,  had been habitual savers.  By 1980, the personal savings rate was about 10% of disposable income.  By the middle of that decade, the Greatest Generation began retiring and withdrawing some of that savings.  Their children, the boomers, did not have a similar sense of frugality.

Rapid advances in technology led to the introduction of new electronic toys for adults.  Credit cards, once reserved for the well to do, became ubiquitous.  Consumers parted with their money more painlessly when charging purchases.  Financing terms for automobiles became more generous,  allowing more people to purchase new cars, which became increasingly expensive as regulators mandated more safety controls.

After thirty years of gorging on credit, households threw up.  The past six years could be called the “Great Diet” or the “Great Purge” to get over the three decade credit binge.

We can expect rather lackluster growth for several more years as households continue to shed those ungainly pounds debts.  Not only are households shedding debt but also certain kinds of assets. In 2009, the Federal Reserve reported that households and non-profit corporations owned $400 billion in mortgage securities like Fannie Mae and Freddie Mac.  In the first quarter of 2013, the total was $10 billion.  (Table of household assets and liabilities)

Households continue to keep ever higher balances in low yielding savings accounts and money market funds, indicating the high degree of caution. The big jump in deposits was probably due to higher dividends and bonuses paid in the last quarter of 2012 to avoid higher taxes in 2013.

For the past two weeks, global markets shuddered at the prospect of the Federal Reserve easing up on their quantitative easing program of buying government bonds.  Some have proclaimed that it is the end of the thirty year bull market in bonds, causing many retail investors to pull money out of bonds.  In several speeches this past week, Reserve Board members have reassured the public that quantitative easing will be here for several years.

As we have seen, households still shoulder a lot of debt weight, making it unlikely that either this economy or interest rates will experience a surge upward in the next several years.  An aging and more cautious population together with a declining participation rate in the work force indicates that another “Great Moderation” is upon us.  The previous moderation was one of political policy.  This moderation is led by consumers.  We can expect – yes, moderate, or lackluster – growth over the coming years.  The positive tradeoff for this subdued growth is the probability that the underlying business cycle of growth surges and corrective declines in economic activity will be subdued as well.

Summer Sale

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June 23rd, 2013

It would be a mistake for the casual investor to think that the decline in the market this week was due entirely to Fed chairman Ben Bernanke’s comments regarding future Fed policy.  There was little that was not anticipated.  The Fed will continue to follow a rules based approach to its quantitative easing program, scaling back its purchases of government securities if employment improves or inflation increases above the Fed’s target of 2%.  Bernanke also reiterated that the Fed would increase its purchases if employment does not improve and inflation remains subdued.  So why the drop?

Shortly after the conclusion of each Fed meeting, Bernanke holds a press conference, where he issues a ten minute or so summary of the meeting and issues discussed.  He then takes about twenty questions.  At the start of this past Wednesday’s press conference at 2:30 PM EDT, the market was neutral as it had been all morning.  The Fed chairman was more specific about the anticipated timeline of the wind down of quantitative easing if the economy continued to improve.   Although he was essentially repeating himself, the voicing of a specific and concrete timeline evidently jolted some sleeping bulls who surmised that the party was over; in the final hour of trading the SP500 fell a bit more than 1% in the final hour.  For many traders, it was time to take profits from the eight month run up in prices.  “Quadruple witching”, a quarterly phenomenon that occurs when stock and commodity options and futures expire, was approaching.  The few days before this event usually see a spike in volume as traders resolve their options and futures bets.

With much of the Eurozone in a mild recession and slow growth in emerging markets, the rest of the world perked up their ears as the central banker of the largest economy envisioned an easing of monetary stimulus sometime in 2014.

Overnight (Wednesday/Thursday) came the news that the Shanghai interbank rate had shot up from about 4% to 13%, a rate so high that it threatened to seize up the flow of money between Chinese banks.  This bit of bad news from the second largest economy added additional downward pressure on world markets.  For some time, analysts covering China have been warning about the amount of poorly performing loans at China’s biggest banks.  The spike in interbank rates, prompted by the Chinese government, was an official warning to Chinese banks to be more cautious in their lending practices.

On Thursday morning came the news that jobless claims had increased, adding more downward pressure.  The SP500 opened up another 1% lower that morning and dropped a further 1.5% during the trading day. This classic “one-two” punch knocked the market down about 4%.  European markets fell about 5%, while emerging markets endured a 7.5% drop in two days.

In the past four weeks, there has been a decided shift in market sentiment.  When the market is bullish, it tends to shrug off minor bad news.  As it turns toward a bearish stance, the market reacts negatively to news that just a few months ago it largely ignored.

Over the past two months, long term bonds have declined 10% and more.  Here is a popular Vanguard long term bond ETF that has declined 12% since early May.

For the long term investor, periods of negative sentiment can be an opportunity to put some cash to work.

Business Cycles

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June 16th, 2013

The manufacturing sector accounts for less than 20% of the economy but is probably the major cause of business cycles in the economy.  In the 1990s, the growing development of technology and business services in the U.S., together with what was called “just in time” inventory management, led some economists to declare an end to the business cycle. Cue the loud guffaws.

May’s monthly report on industrial production released Friday showed no monthly gain, after a decline of .4% in April.  The year over year change in the index was just under 2%.  In a separate report from the Institute for Supply Management (ISM) released a week ago, the Manufacturing Purchasing Managers Index (PMI) index for May fell into contraction, its lowest reading since June 2009, when the recession was ending.


New Orders and Production components of this index saw sizeable decreases.  Computer and electronic businesses reported a slowdown that they attributed to the sequester spending cuts enacted a few months ago.

The latest data for non-defense capital goods excluding aircraft from the U.S. Dept of Commerce showed an uptick after a period of decline in the latter half of 2012; however, there is a month lag in this data set.



The sentiment among small businesses improved somewhat, as shown by the monthly National Federation of Independent Businesses (NFIB) survey.  The overall index of 94 indicates rather tepid expectations of growth by small business owners.  Plans for capital spending to expand business are still at recession levels.

A business builds inventory in anticipation of sales growth.  Since the beginning of this year the net number of small businesses expanding inventory has finally turned positive.

  In a 2003 paper, economist Rolando Pelaez tested an alternative model of the Purchasing Managers Index that would better predict business cycles, specifically the swings in GDP growth.  Assigning varying constant weights to several key components of the overall PMI index, his Constant Weighted Index (CWI) model is more responsive to changes in business conditions and expectations.  In early 2008, the PMI showed mild contraction but Pelaez’ CWI model began a nose dive. It would be many months before the National Bureau of Economic Research (NBER) would mark the start of a recession in December 2007 but the CWI had already given the indication.  In May of 2009, the CWI reversed course, crossing above the PMI to indicate the end of the contractionary phase of the recession.  It would be much later that the BEA would mark the recession’s end as June 2009.


The CWI index is rather erratic.  We lose a bit of its ability to lead the PMI when we smooth it with a three month moving average but the trend and turning points are more apparent in a graph.

Before the 2001 recession the CWI index led the PMI index down.

OK, great, you say but what does this have to do with my portfolio?  Smoothing introduces a small lag in the CWI but it is a leading, or sometimes co-incident indicator of where the stock market is headed over the next few months.

Let’s look at the last six years.  In December 2007, the smoothed CWI crossed below the PMI, which was at a neutral reading of about 50.  The stock market had faltered for a few months but as 2008 began, the CWI indicated just how weak the underlying economy was.  The NBER would eventually call the start of the recession in December 2007.  In June 2009, the CWI crossed back above the PMI.  Coincidentally, the NBER would later call this the end of the recession.

The period 2000 – 2004 was a seesaw of broken expectations, making it a difficult one to predict because it was, well, unpredictable.  I did not show this example first because this period is a difficult one for many indicators.  Before 9-11, we were already in a weak recession.  Although the official end was declared in November 2001, the effects were long lasting, a preview of what this last recession would be. In 2002, we seemed to be pulling out of the doldrums but the prospect of an Iraq invasion and a general climate of caution, if not fear, prompted concerns of a double dip recession.

An investor who bought and sold when the smoothed CWI crossed above or below 50 would have had some whipsaws but would have come out about even instead of losing 15% over the five year period.

The present day reading of both the CWI and PMI are at the neutral reading of 50.  Given the rather lackluster growth of the manufacturing sector, the robust rise of the stock market since last November indicates just how much the market is riding on expectations and predications of the future decisions of the Federal Reserve regarding future bond purchases and interest rates. Over the past thirteen years, when the year over year percent change in the stock market hits about 22%, the percentage of growth in the index declines.

So what is a normal run of the mill investor to do?  The CWI, a predictor of business cycles, is not published anywhere that I could find. This and many other indicators are used by the whiz kids at investment firms, pension funds, by financial advisors and traders, to anticipate business conditions as well as the movements of the markets.  But look again at the SP500 chart above and remember that it is the composite of millions of geniuses and not so geniuses trying to anticipate the market.  As I have mentioned in previous blogs, when that percentage change drops below zero, it is time for the prudent investor to consider some portfolio adjustments.  Since 1980, the average year over year percent change in the SP500 is 9.7%, using a monthly average of the SP500 index. Despite the recent 20% gains, the average year over year percent gain during the past ten years is only 4.9%.  If we look back to the beginning of the year 2000, the average is only 3.1%.  Those rather meager gains look robust when compared to the NASDAQ index, which is still 25% below its January 2000 high.  Think of that – thirteen years and still 25% down. The Japanese market index, the Nikkei 225, is at the same level as it was in early 1985, almost thirty years ago.  Both of these examples remind us that we need to pay some  attention or pay someone to do it for us.

Stocks vs Bonds

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June 2nd, 2013

As the market makes new highs this past month, I am reading articles and seeing charts on asset allocation that reminded me of those I saw in 2000.  Here is a chart that appeared in the WSJ this weekend.

Mutual Funds typically report their performance over several time periods, usually 1, 3, 5, and 10 year periods.  This spring, as the SP500 index continue to peak, a ten year lookback window begins near a trough in the index in the spring of 2003.

Why did the WSJ writer pick 25 year and 35 year time periods as a comparison?  We can only guess but it just so happens that the starting points of these two lookback periods were also troughs in stock prices.  Why not pick 20 and 30 year time periods? Let’s look at the 25 year period which starts in April 1988.

What if the writer had used a 20 year lookback?  They would have started in April 1993, when the stock market was 72% higher.  I don’t want to take the time to calculate the difference in returns, including dividends, between the different strategies shown in the chart, but the reader can imagine that the difference would be significant.

Why use a 35 year lookback?  Why not a 30 year lookback?  In 1978, the SP500 index was again pulling out of a trough in prices after a slow slide in values during 1977.

Had the WSJ writer picked a 30 year window starting in April 1983, the stock market index was – again – 72% higher than in April 1978.  Again, we can imagine that the comparison of strategies would be significantly different.

Being aware of these peaks and troughs can help us evaluate past performance of various investment allocations.  Consider an example of a 10 year comparison of the SP500 vs a bond index fund like Vanguard’s VBMFX

The SP500 index shows the better return but, if we know that spring of 2003 was a trough in this index, we can view such a comparison with some skepticism.  A five year comparison tells a different story.

Now we are comparing performance starting with a downslide in the index, when the SP500 had fallen about 11% from its peak.  It is also close to the 3 year moving average of the SP500 index.

Based on a five year window and the fact that our starting point was a 3 year average in the SP500, we might conclude that our portfolio should contain mostly bonds.  Who needs the aggravation of the volatility in the stock index when we can make the same return with a boring bond index?

In a 3 year time frame, stocks have clearly outperformed bonds.

Our starting point of this 3 year window also happens to be the 3 year average of the SP500 index.  Not only that, it is just  a bit above the midpoint between the 2007 index peak and the trough in the spring of 2009.  We couldn’t ask for a more reliable starting point to make our comparison.

So we have a second reliable starting point but the conclusion we draw is significantly different from the conclusion we drew in the 5 year comparison.  Let’s look closer at this stronger performance of the SP500 vs a bond index.

Half of the better 3 year performance of stocks has come in just the last 6 months after the Federal Reserve announced their open QE program of buying government bonds until the unemployment index reaches a target of 6.5%.  The recent upsurge in stocks has “goosed” the comparison numbers upwards in favor of stocks.

Our conclusion is that historical performance numbers presented by mutual funds or an investment advisor cannot be taken at face value.  It is important to understand the starting point of the historical comparison, which can have a significant effect on the numbers.

Grandpa’s Index

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May 26th, 2013

Last week I wrote about the various benefits, particularly Social Security, that are based on the Consumer Price Index and the discussions about alternative measures of increases in the cost of living.  The term “CPI” is a general term for a specific index, the CPI-U, a widely used index of prices for urban (hence, the “U”) consumers that the Bureau of Labor Statistics compiles.

Today I’ll look at an alternative measure, the CPI-E, or Elderly index, which weights the expenditures of elderly consumers differently.  Since the sample size of this population is relatively small, the BLS warns that it is more prone to sampling error, i.e. that the sample may not accurately reflect the characteristics of the entire elderly population.  For the past decade or so, seniors have argued for cost of living increases in Social Security payments to be based on such an alternative measure.  Using the latest BLS survey comparison data, I constructed a chart to show the differences in weighting of the larger components of the CPI-U, the commonly used index, and the CPI-E, the Elderly index.

Housing and medical expenses are weighted significantly higher in the Elderly index.  A survey by the Employee Benefit Research Institute (EBRI) found that over 80% of 65 year olds own their own home.  The mortgage component of total housing costs stays relatively steady for the younger group of elderly, yet the CPI-E that the BLS compiles shows a 4% increase in this component.  The EBRI survey found that homeownership declines rapidly after 75, and it is this older group of the Elderly for whom housing costs rise.  The question is whether the CPI-E can be properly sampled and compiled to show a more accurate picture of costs for the elderly.

The medical component of the elderly index is almost twice that of the general urban population.  Although seniors have access to the subsidized Medicare program, the premiums for Medicare and costs not covered by Medicare are now borne by the elderly, rather than being fully or partially supplied as part of an employee benefit package.  In addition, people access more medical care as they age.  The combination of these two factors make it feasible that medical costs would be significantly higher for seniors.

Inaccuracies in measuring the housing component of the elderly index will be brushed aside by seniors receiving SS benefits.  Whatever measure increases benefits – well, that’s the most accurate one, of course.

An interesting note is the change in recent years of housing costs as surveyed by the BLS.  In 2007-2008, housing was 42% of total expenses.  After the housing and financial crises, that component had dropped to about a third of total expenses. (Source)

But the December 2012 CPI-U index does not reflect the results of more recent findings of BLS personal expense surveys because they are using 2009 -2010 weightings. (Data)

The largest part of the discrepancy between the actual changes in cost of living expenses and the published index is probably the “Owners Equivalent Rent” portion of housing costs which don’t reflect actual costs at all.  Instead they are a calculation of what a home owner would have to pay herself to rent her own home from herself.  No doubt, BLS economists would defend this phantom calculation as accurate but this calculation was never designed to allow for the precipitous drop in housing prices that we have experienced in the past few years.

Based on BLS surveys of actual, not the adjusted, cost of housing changes, there is a good case to be made that the economy is experiencing a continuing mild deflation, not mild inflation. Deflation has become an ugly word. Social Security payments, labor contracts and a host of benefits are tied to the CPI and rely on the cost of living to increase, not decrease.  Lawmakers in Washington have, in fact, mandated that Social Security payments can not decline if the CPI turns negative.  Deflation is reviled almost as much as too much inflation.  The Federal Reserve has a target of 2% inflation, meaning that it should start pulling money out of the economy if inflation rises above 2%.  On the other hand, the Federal Reserve should be pumping money like there’s a five alarm fire if inflation has turned negative.  Has the Fed been pumping money?  Yes.  Ben Bernanke, Chairman of the Fed, prefers to look at Real Personal Consumption Expenditures.  Per capita expenditures have just now risen above 2007 levels.

While some inflation watchers are shouting “The sky is falling” as the Fed continues to pump money into the economy, Mr. Bernanke is looking at the big picture and its tepid.  Tepid means fragile.  Here’s the big pic of the last 15 years or so.

Growth has moderated.  Bernanke has to be worried that low interest rates and continued purchases of mortgage securities by the Fed is helping inflate a stock bubble but he is equally concerned at the slower growth of the economy.  Despite the headline CPI numbers of below 2% inflation, the reality is that it may be closer to 0% than the headline index indicates.

What’s behind that slower growth of spending?  Look no further than something I write about each month, the lack of growth in the core work force, those aged 25 – 54.  These are the people who buy stuff and if a smaller percentage of them are working, then they buy less stuff.  Less stuff buying reduces inflationary pressures.